Strategy

The good, the bad and the ugly: Air Canada

Air Canada is once again burdened by a familiar load of troubles that may drive it back into the abyss.

Air Canada (TSX: AC.B) – Domestic and international airline
Established: 1937 (as Trans-Canada Air Lines)
Employees: 23,900
Altman’s Z-Score: 0.72
Probability of bailout: moderate

How did it go bad?

It would be difficult for a company to acquire more baggage than Air Canada. Back in April 2003, the airline filed for protection from creditors — and emerged 18 months later with reduced labour, pension and other costs, and fewer varieties of aircraft in its fleet. Yet today, the company is burdened by a familiar load of troubles that may drive it back into the abyss.

Last year’s extraordinarily high fuel costs wreaked havoc with Air Canada’s financials, contributing to a fuselage-scorching annual loss of more than $1 billion. That oil prices have since retreated (to about US$44 per barrel) is a great relief to the industry, albeit less so for Air Canada because it hedged more than one-third of its fuel purchases for this year at capped prices reaching US$99 a barrel. Today the problem is falling demand: Air Canada’s passengers and cargo traffic are both down considerably. The International Air Transport Association calls the current situation “the worst revenue environment for 50 years.”

Even as it contends with an eroding market, Air Canada must also manage its rocky relationship with employees. Their pensions took a beating in last year’s stock slide, raising the prospect that the Montreal-based company will face increased funding obligations this year and beyond. Meanwhile, several union contracts will expire in June, and discussions have been somewhat bellicose, raising the possibility of labour unrest during the peak summer travel season. David Newman, an analyst with National Bank Financial, described this as a potential “tipping point.”

All of that might be manageable, were not Air Canada up to its tail fins in debt. Ben Cherniavsky, an analyst with Raymond James Ltd., has called the company “extremely leveraged.” It’s a common observation: Air Canada owed nearly $5.4 billion at the end of last year, of which more than $660 million was current. Much of this debt is in U.S. currency, so the loonie’s drop increased the burden.

How ugly is it?

According to Bloomberg, the Altman’s Z score for Air Canada is 0.72; anything less than 1.8 suggests a high probability of bankruptcy. So things could get very bad indeed.

The airline has been taking steps to remain aloft. Responding to last year’s soaring fuel bills, it cut the number of flights to various destinations and continued upgrading its fleet with more efficient aircraft. It also cut staff and other costs, and recently laid off hundreds of flight attendants. As a result, Air Canada’s planes are taking off with fewer empty seats, and the company’s burning less cash.

It may not be enough: Air Canada is perilously close to violating debt covenants. When its cash holdings fall below $900 million, for example, its credit card processing company can withhold a portion of ticket sales. (The formula used to calculate Air Canada’s required cash balance will change this summer, potentially raising the threshold as high as $1.3 billion.) The company had just $1 billion in cash at the end of last year, and acknowledges it will have a tough time maintaining sufficient cash.

This wouldn’t be such a problem if credit card companies were in an indulgent mood. But when airlines went bankrupt in recent times, many credit card companies got burned; in accordance with their agreements with cardholders, they wound up refunding customers for purchased fares as airlines folded. If those companies start sitting on ticket proceeds for 90 days, many airlines won’t be able to cope. “Airlines rely on advance bookings,” explains Jacques Kavafian, an airlines analyst at Research Capital Corp. “They use the cash they receive on advance bookings to pay their ongoing expenses — they shouldn’t, but that’s what they do.” Kavafian says Air Canada could violate its covenants by April or May, forcing it to file for protection from creditors.

Debt-rating agency Standard & Poor’s recently downgraded the airline’s debt to B- from B. “We anticipate Air Canada will likely seek to obtain external financing in credit and leasing markets and maintain operating cash flow,” analyst Greg Pau wrote in a research report. The report noted the airline’s new Boeing 777s could be used to support such a financing, but also observed that credit markets “could remain difficult” this year.Air Canada may yet pull out of its nosedive. CEO Montie Brewer hopes that if lower fuel costs persist, the resulting savings will offset the effects of reduced demand. CIBC World Markets analysts Chris Murray and Max Vichniakov praised the airline’s capacity reductions in a recent report, arguing it is well-poised to return to strong cash flows. As recently as December, the airline was able to raise more than $450 million, suggesting lenders remain indulgent. And some observers downplay the probability of labour disruption, betting that workers have no stomach for risking their jobs during a recession.

What if?

If Air Canada had a dime for every time someone dissed its service, its liquidity problems would be less acute. The company has been so important to air travel in this country that it seems everyone has at least one complaint. Some would celebrate its demise. Kavafian deems a complete liquidation the best-case scenario; another group of investors could begin afresh without the cumbersome labour agreements and high costs that have plagued Air Canada for years. “The best outcome is to let this thing go and restart from scratch, using the same airplanes and so forth,” he says.

Air Canada’s collapse would throw the country’s transportation system into chaos, albeit not so much as it would have a decade ago. It has lost so much market share that competitors, such as WestJet Airlines, could likely fill much of the gap in the domestic market. And with aircraft and pilots available in great numbers, new airlines are not difficult to start.

Kavafian isn’t counting on Air Canada’s demise, though. More likely, he says, it will be bailed out by government. “They feel throwing $200 million at the company is cheaper than having to deal with the mess that may arise in restructuring, and the disruption it might cause,” he laments. But given that Air Canada failed to address many of its problems the first time around, it’s difficult to believe it will reform itself into a more robust entity while firmly latched to the taxpayer’s teat.