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Morningstar | Air Canada Eyes Higher Fares to Combat Rising Fuel Prices

On July 27, no-moat Air Canada released second-quarter results above consensus expectations, but management lowered its 2018 guidance. After adjusting for the time value of money, our fair value for the Canadian based carrier rose to CAD 29 from CAD 27.

On 8% capacity growth, Air Canada increased 11% revenue year over year; yields showed modest improvement (up 2%) over the second quarter last year. Air Canada’s business cabin revenue, which commands a premium, rose nearly 14% year over year. Management indicated its desire to raise fares to combat rising fuel prices, relying on comfort fares and potentially cutting capacity in the fourth quarter. Passenger revenue per available seat mile did rise 2.7% in the quarter on the back of 2% higher yields, which is encouraging.

During the second quarter, Air Canada successfully reined in cost inflation, and achieved a 1% decrease in adjusted CASM (unit costs excluding fuel and certain other items). However, total operating expenses rose 14% to over $4 billion, and unadjusted unit costs climbed 5.6%. The carrier kept a leash on nonfuel costs by continuing to drive cost transformation measures and by accelerating aircraft lease extensions, which drove a decrease in maintenance provisions. Management hopes to negate rising fuel costs with higher fares and it aims to mitigate approximately 75% of fuel price increases. While all this is good news, we are still anticipating a roughly 200 basis points contraction in operating margins versus 2017, which we forecast at just above 6.5% for 2018.

Management’s latest guidance includes returns on invested capital assumptions lowered from a midpoint of 14% to 12% for 2018. Under our ROIC methodology, which uses a slightly different calculation, we forecast capital returns coming at 11.5% in 2018. EBITDAR margin guidance for 2018 was also lowered from a range of 17%-20%, to 16%. However, cumulative free cash flow guidance through 2020 was retained.

We’re encouraged by management’s decision to pursue fare hikes in order to combat rising fuel costs, and we believe Air Canada’s operating margins will rise from a trough in 2018 to 9% in our normalized period, starting in 2022. Our bearish forecast for oil prices over the next several years--we’re modeling in $60 per barrel Brent by 2022--drives this margin expansion. Finally, based on the favorable economics that U.S. carrier have achieved from their loyalty programs, we’re assuming that if Air Canada’s proposed acquisition of Aeroplan (Air Canada’s previously divested mileage program) from Aimia is successful it will prove value-accretive. Regardless of the outcome, Air Canada has made it clear that it will establish its own frequent flyer program by 2020.