Is Air Canada (AC.TO) Ready to Take Off or Overvalued?

Not too long ago, Air Canada was a very troubled company. As recently as 2013, the stock was trading well below $2, and the company was in danger of bankruptcy.  However, thanks to a continuing tailwinds, in the form of a strong economy, a strengthening Canadian dollar, and falling fuel prices, the company appears to have been rescued from the brink of bankruptcy.  Indeed, shares in Air Canada have risen from around $7 in May 2016 to over $25 today.  So what does the future hold for Air Canada?

Air Canada Revenue and Profit Forecast 2017-09-20

Based on this projection, the run-up in price appears to have marginally over-valued Air Canada.  While the future cashflows of the company look strong, the value of the company from an equity investor’s perspective is weighed down by the level of debt carried by the company.

Air Canada still maintains a relatively high debt load.  Based on my analysis, the optimal debt load for Air Canada is approximately 50% of the value of the company.  At the moment, Air Canada’s equity value is just over $7bn CAD.  However, calculating the net present value of all leases, including operating leases and finance leases, as well as the long-term debt of the company and future Capital Expenditures commitments, the present value of all future Air Canada obligations stands at around $16.2bn CAD.  Thus, it would behoove the company to shed approximately $9bn in debt, between paying down existing debt and paying for future capital expenditures using retained earnings rather than debt.  This $9bn will come directly out of the future profits of the company, and is money that the company will be unable to return to shareholders in the form of dividends or buybacks.  Thus, this large debt load weighs down the company, and will hamper free cash flows to equity for a number of years.  While Air Canada’s bond rating has improved since its below-investment-grade near-bankruptcy days, there is still work to be done on this front.

Thus, while I project continued strong growth for the company, in the range of 5% revenue growth and 7% annualized growth in net income, free cash flow to equity investors will lag behind.  Air Canada is also in the midst of upgrading their fleet, with approximately $2.3bn in capital expenditures this year, and approximately $1.7bn planned for 2018.  These upgrades may improve future margins thanks to better fuel efficiency of the newer airplanes, but they also mean that free cash flow to equity investors will remain negative until 2020.  Based on this valuation, I do not believe the Air Canada is a good investment at this time, as their share price exceeds the underlying value of the cash flows of the company, despite a return to profitability.

Alaska Airlines (ALK) is under-priced and poised for growth

Alaska Airlines (ALK) currently represents a great value for investors.  While the share trades for around $75.59, the true value of the shares, based on projected future free cash flows to equity, is over $130, as shown below:

Alaska Airlines Revenue and Profit Forecast

Unlike many airlines, Alaska Airlines is a growing airline, actively expanding into a number of new routes.  Alaska Airlines is also making heavy investments in their infrastructure, including plans to spend approximately $3 billion dollars on Capital Expenditures between 2017 and 2019.  Passenger revenue has been steadily growing at Alaska Airlines, and rose at approximately 6.5% per year over the last five years.  This growth appears poised to continue.  Net margins have been between 6 and 15% in the last five years, largely dictated by fuel prices: When fuel prices are low, margins are much higher.  Accordingly, the value of the company depends, in part, on assumptions about future fuel prices, which can be unpredictable.  However, the margin of safety provided by Alaska Airlines’ heavily depressed stock price makes this stock a strong BUY, and provides a great deal of safety to investors, even in the face of potential fuel price increases and associated drops in operating and net margins.