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Morningstar | Maintaining our FVEs for Canadian Airlines After Updating Market Expectations

We maintain our fair value estimates of CAD 20 for Westjet and CAD 35 for Air Canada after reviewing our outlook. Likewise, we maintain our no-moat ratings and stable moat trends. Air Canada shares trade at a material discount to our fair value estimate, but Westjet shares appear fairly valued.

These operate as a duopoly in an air travel market characterized by expensive government fees and taxes that get passed on to travelers, reliance on U.S. transborder travel, and a limited market size. Because this environment isn’t conducive to material economic profits, Air Canada has worked to improve returns through cost transformation that included optimizing routes and retooling its fleet. Realizing the limitations of the Canadian market, the firm also embarked on global expansion strategies, ordering widebody aircraft and capitalizing on sixth freedom traffic (flying U.S. passengers internationally from Canadian airports). Air Canada also plans to revitalize its loyalty program. Initially, the carrier planned to launch a new rewards program in 2020, but its announced acquisition of Aeroplan will jump-start this process, adding 5 million members and generating CAD 1.4 billion in added value. Acquiring Aeroplan allows Air Canada to capitalize on highly favorable loyalty program economics, with operating margins approximating 60%.

Westjet on the other hand, found success in the Canadian domestic markets for years, capitalizing on the low-cost carrier model, but rising fuel prices and union complications changed this narrative. Now, Westjet plans to improve returns by turning away from its low-budget origins, catering to more affluent travelers, and incorporating transatlantic and transpacific routes on its network. While we assume revenue growth will remain robust through Westjet’s aggressive capacity expansion, we don’t model strong gains in pricing, and project margins will fail to reach record levels of the past five years.

For Air Canada and Westjet, we project operating margins will expand through our 2022 midcycle year on the heels of oil prices receding to our $60 Brent midcycle oil price. Operating margins expand over 200 basis points for both Westjet and Air Canada between 2018 and 2022. Nonetheless, we assume global air markets slip into decelerating growth as we enter the late innings of an upcycle that began in 2009. We expect falling oil prices and slowing demand will pressure passenger fares for both carriers, leaving yields flat to down through our five-year stage I projection period.