Last April, this column predicted the shares (ticker: AC.Canada ) would gain 40% in a year (see Ahead of the Crowd, “Air Canada Stock Has 40% Upside,” Apr. 15, 2014). They’ve since climbed more than 50% to a recent C$11.73.
Don’t sell yet. From here, the stock looks likely to rise another 50% in a year and could double.
Air Canada is Canada’s largest air carrier and one of the 20 largest worldwide. Like the big U.S. carriers, it went through a transformation after the global financial crisis, negotiating labor costs lower and closing unprofitable routes. Recently, it has upgraded to more fuel-efficient planes and expanded leisure routes through Rouge, a low-cost subsidiary.
Vacationers typically pay less for flights than business travelers, so Rouge has lower revenue per mile flown by each passenger than Air Canada’s average. But it also keeps costs down through the use of seasoned planes and non-union labor. The cost savings is greater than the revenue differential, so more growth for Rouge puts Air Canada further into the black.
On Nov. 9, Air Canada reported the most profitable quarter in its 77-year history. Third-quarter revenue rose 9% to C$3.80 billion. Profit was 8% higher at C$323 million. Adjusted for foreign exchange effects, writedowns on fuel hedges and other one-time items, profit jumped 25% to C$457 million. Adjusted earnings per share rose 12% to C$1.55.
For all of 2014, Wall Street estimates earnings per share will come in at C$1.77, up 47%. Next year, it predicts an 89% surge to C$3.34. The latter number puts shares at a strikingly cheap multiple of 3.5 times earnings. For comparison, Delta ( DAL ) trades at 10 times projected 2015 earnings.
One reason for the minuscule valuation is that Air Canada, like its peers, is benefitting from a recent plunge in fuel prices that investors worry will prove temporary. Air Canada’s fuel savings have more than made up for a recent slide in the value of the Canadian dollar, which has raised the cost of items that are typically priced in U.S. dollars, like insurance and parts. In 2015, Air Canada will likely save C$1.5 billion on fuel, but higher currency-related costs will reduce its savings to C$550 million, reckons investment bank Imperial Capital.
If oil prices rebound, profits for Air Canada will surely shrink--but probably not collapse. Look at distant estimates for earnings. Wall Street expects earnings to peak this year and then slide to C$2.55 a share by 2017 as oil prices normalize. That would put the stock at 4.6 times earnings--still less than one-third of the valuation of the broad U.S. stock market. A 50% rise in the stock price over the next year would put it at 6.9 times the 2017 earnings projection. A doubling would put it at 9.1 times.
If oil prices stay lower for longer than investors expect, the shares could benefit from higher-than-expected earnings. Even if crude rises, airlines in general appear due for higher valuations to reflect improvements made in recent years: rapid consolidation, sharply reduced operating costs and improved pricing power. And shareholders who’ve enjoyed big gains in U.S. carriers could soon turn more of their attention northward.