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Morningstar | It’s Cold for Westjet North of the Border; Lowering Our FVE. See Updated Analyst Note from 31 Jul 2018

We lowered our fair value estimate for no-moat Westjet to CAD 20 after the carrier generated a net loss of about $21 million and lowered full-year guidance. As expected, a labor dispute weighed on yields, as the carrier used discounts to sustain traffic, but added capacity from ultra-low-cost carriers, and higher oil prices also weighed on results. RASM, or revenue per available seat mile, fell about 2% despite the flat-to-up guidance management issued in the first quarter. Compared with the prior year, total traffic increased 6% on almost 10% transborder and international traffic growth. A sell-off ensued following Westjet's release, sending the shares 10% lower. At our new fair value estimate, we view the stock as fairly valued with a price/fair value estimate ratio of 0.90, but note our very high uncertainty rating.

Rising fuel costs, which drove a good portion of Westjet's 14% total operating cost increase, surged 34% over the second quarter last year. But even after excluding fuel and profit sharing, total operating costs still rose by more than 9% year over year. In a better fare environment, these costs wouldn't be concerning but given the poor RASM showing this quarter, we're alarmed. Our 2018 CASM-ex projection, or costs per available seat mile excluding fuel and profit share, calls for an increase of 2% over 2017.

Second-quarter guidance features lowered full-year capacity expansions, lowered CASM growth, and a RASM decline for the third quarter. Management expects RASM, revenue per available seat mile, will decline by 4% to 6%. Meanwhile, CASM-ex is set to grow 3%-4%, thanks in part to cost deferrals from the second quarter to the third quarter. Management plans to support margin growth by trimming capacity plans to 6% growth in 2018 instead of the original bogy of 8%. We maintained our 6% capacity growth assumption for 2018, but raised our fuel cost per liter and CASM-ex forecast, which lowered our 2018 operating margin to 3%.

Operating margins at Westjet have come under pressure, as the carrier expands from its traditional low-cost carrier model to new business models, while concomitantly facing a growing ULCC threat in Canada. Several new initiatives like Westjet Encore, Westjet Link, and Swoop have yet to produce accretive returns. In the Canadian air travel market, capacity additions from ULCCs have curbed yield growth despite rising fuel prices. We think we may be witnessing a replay of the early 2000s precipitating a fall in fares. Although these carriers eventually exited the market, they still created enough disruption and irrational pricing to send fares plummeting. We’ve incorporated these challenges into our 2018 forecast, resulting in 1% yield growth this year, down from the nearly 2% we were previously forecasting. While our midcycle forecast remains tied to $60 Brent, we acknowledge near-term fuel cost headwinds and now expect Westjet to realize a fuel price per liter of CAD 0.81 based on our outlook for oil prices, which fits squarely with management's guidance.

Our uncertainty rating of very high reflects our confidence level in Westjet’s ability to shift from the low-cost carrier model. Although the carrier managed doubled digit operating margins over the past five to 10 years, we expect margins to plateau at 9% through our normalized period.