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Compliments of Brian Dunn, Terry Baker and Vesta Stevenson.
National Post Business Magazine
November 2001
By Jeff Sanford
SUBJECT: Air Canada
Company: Airline
Problem: Soaring losses, skyrocketing costs, public fear and a
recession
Question: How can Air Canada regain investor confidence and
profitabilty?
Everything, of course, is different after September 11. That goes for
many parts of the Canadian economy, from bond markets to car
manufacturing. But the sector affected most by the terrorist attack on
the World Trade Center is surely the airline industry.
Prior to the attack, airlines were already in poor financial shape -
Air Canada not least among them. Since the merger with Canadian
Airlines Corp., a deal that took out Air Canada's only real
competition, the stock price of the formerly government-owned airline
has rapidly lost altitude. While all airlines are suffering through
the current downturn (not to mention the sell-offs in the weeks after
the attack) Air Canada stock, before September 11, had already shed a
precipitous 70% of its value, dropping from some $20 a share to an
anemic $6. It was trading slightly above $3 after September 11.
It's not all Air Canada's fault. The economic slowdown has slaughtered
high-margin business travel. Passenger traffic, which had been growing
10% annually, dropped to 1% in June. A report earlier in the year by
the International Air Transport Association recommended that members
cut capacity or give up any hopes for profit this year, a prediction
that seems optimistic in hindsight.
What the outcome will be at the end of the year seems particularly
murky. Prior to the bombing, estimates were that the company could
lose up to $400 million this year. Most recently, the company reported
a second quarter loss of $108 million or 90¢ a share, the inverse of a
year ago when earnings per share were a cheery 88¢ a share. CEO Robert
Milton was also predicting results would be flat in the third quarter,
traditionally the best quarter of the year. And then September 11
happened. A few days later, Air Canada asked Ottawa for $4 billion -
and as we went to press, the federal government was offering airlines
support worth only a fraction of that. Air Canada's share? About $100
million.
Air Canada reacted to the slowdown with aggressive cost-cutting. In
August, the company announced 4,000 layoffs to take effect November 22
(the end of the two-year time period in which Air Canada agreed it
would not lay anyone off if it was allowed to merge with Canadian
Airlines), but then announced 5,000 more job cuts on September 26, as
well as grounding 84 planes, cutting capacity by a fifth. There are
also cuts to executive compensation, including a 10% reduction to
Milton's million-dollar salary.
Along with the slowdown, the bottom line has been clipped by high fuel
prices, which inspired Air Canada to temporarily tack a fuel surcharge
onto tickets, providing one more disincentive to fly. As well, an
attempt to warn institutional investors about an upcoming earnings
shortfall won the company a dubious distinction: the country's first
fine for selective disclosure.
To save, the company is also spending: Air Canada plans to purchase
new planes to replace the clunkers in the fleet (many from Canadian
Airlines) and is converting business class seats to economy to match
the demands of travellers and increase passenger loads. A $1.4-billion
enterprise-wide contract with IBM to take over the airline's computer
services is expected to save another $200 million.
Perhaps most important, Air Canada took a 30% stake in Skyservice
Aviation, the company behind ill-fated Roots Air. Air Canada intended
to convert what was supposed to have been a high-end flying affair
into its own discount airline to compete with regional carriers like
Canada 3000 and WestJet. In the wake of September 11, the discount
plan remains in a holding pattern.
Nevertheless, long-term, the move could be vital for Air Canada in its
fight with the regionals. In February, the Federal Competition Bureau
ordered Air Canada to stop offering ultra-cheap fares on several
routes where the company was competing with tiny CanJet. While the
order came too late for CanJet (it was swallowed by Canada 3000 a few
months later), the little airline and others like it revealed a
weakness at Air Canada, which was forced to compete as a discounter,
but with full-scale liabilities. Air Canada pilots will staff the
discount arm at slightly lower pay, though not as low as salaries paid
at the other regionals. Air Canada will aim to leverage economies of
scale, which allow it to buy insurance, train staff and finance
aircraft more cheaply than the regionals.
For the moment, the economy and the slowdown in air travel are Air
Canada's preoccupation. But even if the industry returns to "normal,"
Air Canada still faces major challenges. A recent panel review of the
Canada Transportation Act criticized the company's market dominance
and the new U.S. ambassador, Paul Cellucci, raised the issue of an
expanded open-skies agreement. If that ever happens, bigger,
deeper-pocketed American air carriers could compete with Air Canada on
domestic routes. And while terrorism has shoved that debate to the
back burner, there is going to be an intensive debate about the
security of the Canada-U.S. border. Whatever the final outcome, Air
Canada is likely to be affected.
Is there any upside? Government money will help get the airline
through some short-term turbulence, but cash flow is a major concern.
With $10.7 billion in credit obligations on the books, the company's
debt situation has for several months drawn the attention of market
watchers. To stay liquid and generate cash flow, Air Canada is selling
and then leasing back its aircraft, which means the company is relying
on asset sales to stay above water. According to an analyst who dusted
off the sell sticker for the stock, the company is "dead money" for at
least the next year, and won't generate positive earnings until at
least 2003. And that was before the bombing.
Needless to say, the company faces very intense challenges over the
near term. With a market cap below $1 billion, there is speculation
the company could soon be dropped from the TSE 60 index. Not only
would that be a big blow to the corporate ego, but it would put
downward pressure on the stock as funds that benchmark the index drop
it from their holdings. The company that many thought would bottom out
between $8 to $10 per share is trading at a third of that.
Question: How can Air Canada regain investor confidence and get its
profits to take wing?
Margot Northey Dean, Queen's School of Business and Douglas Reid,
Assistant Professor of Strategy
"The priority is to take steps to become the carrier of choice. Rather
than trying to maximize yields and protect revenue, Air Canada must
retain customer loyalty".
Air Canada's core structural problem is its high cost base relative to
competitors. Unions negotiate away most economic gains won from good
strategy. Like other airlines, Air Canada has difficulty generating
additional customers simply by cutting prices. People either have to
travel, or they don't.
Air Canada's challenge now is to be the carrier of choice for anyone
travelling in Canada or abroad. This has been complicated by its
decision to rescue Canadian Airlines (mainly for political reasons)
and take on its ruinous debt. Pragmatically, the airline's first
obligation is to manage cash. The company has been taking the right
kind of actions - layoffs, fleet downsizing, sale/leaseback, credit
renegotiation, debt-equity conversion and eliminating discretionary
expenditures. There may be little else it can do on this front,
because other than headcount there isn't much left to cut.
In the short-term, the priority is to take steps to become the carrier
of choice. Rather than implementing rules to maximize yields and
protect revenue, Air Canada must do what it can to retain customer
loyalty. This means enabling ground personnel to exercise their
judgment in handling exceptional requests such as rebooking with no
penalty. Leveraging its successful Aeroplan program won't be enough,
as a big problem faced by all airlines today is decline in demand,
especially in business demand, as well as fears about safety. Given
that passengers are now likely to spend more time waiting at airports,
the company could make investments in waiting areas to enable the
customer to recover some lost time. This may include making
workstations available, offering free or low-cost Internet
connectivity along with small amenities such as bottled water.
In the medium-term, market for air travel may itself be experiencing a
fundamental change - a secular shift in demand. One of the
consequences of the dot-com meltdown has been a renewed corporate
focus on cost management. This was exacerbated by the terrorist attack
on the World Trade Center. Many corporate travel managers, prodded by
senior management, have concluded that "no-frills" carriers such as
WestJet offer value that is in keeping with today's leaner times. Once
the recovery comes, will executives revert to flying on higher-cost,
"more-frills" carriers - or stick with the lower-cost alternative?
The answer to that critical question must drive Air Canada's future
choices. Let's assume the worst, namely, that a non-cyclical shift is
underway in passenger demand. Here is what Air Canada should do:
Cap WestJet's appeal, to prevent it from growing. That means deploying
its already-announced "no-frills" carrier to compete head-to-head on
WestJet's best routes.
Carve out as much value from Air Canada as possible and use the
proceeds from IPOs of its most valuable elements to pay down its
$10.8-billion debt. The company has announced its intentions to do
this with Aeroplan; other elements such as its technical operations,
cargo and regional service could also be carved out and floated.
Ensure that any gains made through restructuring, innovative strategy
and risk-taking are not lost at the bargaining table to unions set on
replicating the successes of their U.S. brethren.
If possible, Air Canada should get Star Alliance to take on some of
Air Canada's operating functions in the shorter term and, in the
medium term, leverage the combined strength of several of the world's
leading airlines to bulk-purchase aircraft, fuel and other essential
supplies.
The road to recovery will not be easy. But Air Canada is a world-scale
airline with a proud history. It can win if it remains focussed,
disciplined and above all clear that in this industry, hearts are won
first and wallets follow
Daniel F. Muzyka Dean, Commerce and Business Administration,
University of British Columbia
"The ability to 'ratchet down' operations and 'ratchet up' operations
rapidly would reassure investors that Air Canada's management is
capable"
For Air Canada's profits to "take wing" and build sustainable investor
confidence, my belief is that a number of choices will be required
over the coming years. The current views of the financial analysts
suggest a range of opinion from "buy" to "fly them, don't buy them."
Combined with current turbulence in the worldwide airline industry -
as a result of the mounting economic slowdown and recent events in the
United States - I believe Air Canada might be able to pique investor
interest if it concentrates on the following initiatives:
Maintain focus on a set of customers: Air Canada needs to avoid a trap
common to monopoly service businesses: a lack of clarity about whom to
focus the service model on. Air Canada's recent move into the discount
air carrier business raises questions about its target market.
Continue to manage cost and productivity: In a market that is
increasingly North American, if not global, Air Canada is at risk if
it is in the bottom half of the top 10 when it comes to productivity,
especially if (when?) "open skies" are declared in North America.
Complete the integration: I spoke with flight crews and ground staff
on several of my recent flights, and most still tend to identify with
Air Canada or Canadian Airlines. Investors, who are often customers,
too, will be more confident about the future when they sense a
completed integration and the evolution of "one team."
Demonstrate Adaptability: Given recent events, another element that
would enhance investors' interest is whether Air Canada management
demonstrates its ability to adapt when the demand changes. The ability
to "ratchet down" operations and "ratchet up" operations rapidly
(during the inevitable recovery) and with minimal difficulties would
reassure investors that Air Canada's management is both knowledgeable
and capable.
Having said all of this, there are some additional
challenges to be reckoned with:
Mounting financial leverage: The current financial leverage of the
company is high and growing as measured by both the direct debt and
the fixed obligations created by the sale and leaseback of equipment.
The added debt and lease financing had been incurred primarily to
cover the cost of the Canadian Airlines acquisition. However, the
increased size of the debt is magnified by the fall in Air Canada's
equity price. Air Canada is now operating in junk-bond territory,
raising capital costs. Though the current cash position is not
perilous, the debt situation is worrisome and limits future investment
options.
U.S. airlines have received an assistance package from their
government and Air Canada has asked for "equivalent" assistance from
the Canadian government. While it now appears the airline will receive
about $100 million, it will not likely go beyond current losses to
compensate for Air Canada's pre-existing financial challenges.
Monopoly as a gift and a curse: Air Canada controls 85% of the
revenue-generating airline capacity in Canada - a near monopoly. In
the short run, exercising monopoly power may have financial benefits,
but in the long run it is likely to attract further negative attention
from the Competition Bureau, incite consumer resentment and lead to
further government intervention. Air Canada may be less exposed if it
chooses not to guard its entire share. Ceding inappropriate capacity -
capacity that doesn't fit one's service model - is often a good thing.
The bottom line is that the road ahead for Air Canada is a turbulent
one. There are certainly opportunities for Air Canada and its
investors to win. For the investors, I would suggest that no matter
what happens, the flight to a successful new future is probably best
taken with seatbelts attached.
Vesta