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Stocks - The Trader: Stocks Start December in Style; Comforts of Cash

Barron's

December 6, 2004, page MW2 Byline Michael Santoli

Great Black North

Canadians last week used the occasion of a presidential visit to complain that they felt undervalued by Americans. That's arguable. But, in the market for airline stocks, it appears that Canada is indeed being denied its due.

ACE Aviation Holdings is the parent of Air Canada, the dominant carrier north of the border with nearly 60% domestic market share and a virtual lock on routes overseas from Canada. The company emerged from bankruptcy court protection Sept. 30 in good form, with less-costly labor and supplier agreements than before and its powerful franchise intact.

The company's stock trades actively on the Toronto Stock Exchange with an additional listing on the U.S. over-the-counter Pink Sheets, and has risen from 20 to 30, in Canadian dollars, since leaving bankruptcy. Yet some careful investors who appreciate Air Canada's considerable advantages over comparable old-line carriers continue to see plenty of upside for the shares.

Air Canada sought bankruptcy protection in the aftermath of 9/11 and the SARS scare, which ushered in the industry's worst-ever slump. The company had also recently digested the acquisition of Canadian Air and was fending off the low-cost startup WestJet in its home market.

The timing of the bankruptcy allowed the company to wrest major concessions from its workers and plane suppliers, and placed its pilots' current pay on par with some discount carriers. This leaves the airline with 10,000 fewer employees and enviable control over its costs at a time when the big U.S. legacy carriers still have to bargain and plead for labor relief.

As currently structured, ACE Aviation has an equity market value of $2.9 billion, with debt and lease obligations totaling $4.6 billion. (All figures are in Canadian dollars.) That makes it the third-largest North American carrier by equity value and one of the least leveraged major airlines in the industry.

And yet, despite its financial and operational edge, the company is valued at a meaningful discount to other big North American competitors.

Aggregating the public equity and outstanding debt, ACE has an enterprise value of about $7.5 billion. The company has endorsed a forecast of $1.6 billion in 2005 earnings before interest, taxes, depreciation, amortization and plane rental payments. The four big North American carriers not in bankruptcy (Northwest, Continental, American and Delta) fetch EV/EBITDAR ratios around seven-times for 2005 (compared to 4.5 times for ACE), conservatively using the market values of these companies' debt for comparison. (EBITDAR is the industry's preferred gauge of cash flow, which takes account of airlines' differing proportion of owned versus leased planes.)

That estimate of 2005 cash flow was made months ago, before the most recent run up in oil prices. But ACE Aviation's third-quarter results, at a time of peaking crude prices, were well ahead of forecasts, thanks to the company's success in ratcheting down costs other than fuel.

The stock also acts as a neat play on the rapid strengthening of the Canadian dollar versus the U.S. currency, which is up 17% since May to nearly 84 U.S. cents. The airlines costs for fuel and most lease and debt payments are denominated in U.S. dollars, so the drop in the greenback to 12-year lows against the Canadian currency has been a huge boon.

Ivan Krsticevic, portfolio manager at Elliott Associates who follows the airline sector, calculates that the currency moves have effectively reduced the company's net debt and lease obligations by $1 billion, a huge windfall that ACE might now be looking to lock in. Elliot, a $4 billion hedge fund, received ACE Aviation shares after having been a creditor during bankruptcy protection and is holding on in hopes of further appreciation.

Krsticevic points out that if the company's valuation discount to its peers were simply cut in half -- let alone eliminated, as it arguably should be -- the shares would be worth 40.

ACE's cash-flow forecast for 2005 is based almost entirely on cost savings now in place, rather than on wild-eyed expectations for revenue growth.

That said, passenger traffic has remained solid and the company has a sensible strategy for leveraging its market position. Namely, it is allowing its home-market market share to inch lower and is removing domestic capacity, rather than compete dollar for dollar with the discounters.

Meanwhile, it is exploiting its near-exclusivity on trans-ocean flights from Vancouver, Toronto and Montreal by reaping attractively high fares. For a cosmopolitan nation with lots of immigrants and global-trade ties, that's a pretty good posture to assume.

Revenue from routes between Canada and destinations outside North America should come to 29% of total revenue next year, says analyst Nick Morton of RBC Capital Markets.

Another advantage Air Canada has over most other big carriers is ownership of some ancillary businesses that could be spun off or sold to realize their obscured value. One of them, Aeroplan, is the company's popular frequent-flier and rewards program, which includes partners such as the large bank CIBC and American Express.

Its sales are now being reported separately, and last quarter rose at a 25% annual rate. A buyout firm a few years ago reportedly offered to invest in Aeroplan at a rate that implied a value of almost $1 billion for the unit.

With so much going for the company, it's worth asking why the stock continues to carry such a discount. One possible answer is that the U.S. legacy airlines are still valued too highly. A more tangible point is that almost all of the shares went to creditors, many of which had no interest owning it and have been selling. The stock's relative illiquidity and low profile on Wall Street are also possible factors.

So far, too, sell-side analysts have generally struck a cautious tone, not unusual for a post-bankruptcy situation that's exposed to higher oil prices and needs to win back investor trust.

This could mean opportunity for those who latch on to the story before it becomes too widely told.