Is Air Canada's Rally Set to Continue?

About a week ago, I discussed some of the reasons for Air Canada's (TSX: AC.B  ) strong stock performance over the past year. If the airline closed above its then-52-week high of $3.40, I promised I'd give it another look. Here's why that ended up happening sooner than I thought.

Industry rally
As stocks react to positive developments over time, or as investors pile in, sensing a move upward, many companies can rise on momentum-style buying. With shares up more than 22% since the beginning of September (as of Sept. 17), and up nearly 100% year to date, there is clearly an uptrend happening in Air Canada's stock. But what's driving this rally?

Airlines in general have been rallying this year, with United Continental Holdings (NYSE: UAL  ) and Delta Air Lines (NYSE: DAL  ) up 41% and 96%, respectively, year to date. These companies have benefited from a rebounding economy and disciplined capacity measures, both of which helped them post substantial earnings increases. Not only is the industry's situation getting better, but investors are also beginning to see a new perspective on airlines: stable profits fed by higher fares and load factors and reduced competition.

I don't see this perspective fully priced into airlines yet, however. Using Businessweek's earnings estimates and closing prices from Sept. 17, Delta Air Lines trades at only 7.8 times its 2014 fiscal year earnings, and United Continental trades for even less, at 7.3 times its 2014 earnings.

Although United Continental has missed estimates or lowered guidance in the past couple of years, earnings anywhere near these estimates would still leave the airline trading well below the broader market average. On Delta's side, the situation continues to improve. With its merger with Northwest Airlines now behind it, Delta is focusing on slashing debt, running its oil refinery, and even returning capital to shareholders through a dividend and buyback program.

When major players in an industry rally, their surging stock tends to place buying pressure on industry peers. In Air Canada's case, it has robust earnings to accompany its rising shares. The company's latest quarterly report solidly beat estimates, causing a pop of around 25% the day of the announcement, and setting the latest stage of its rally in motion.

Earnings forecasts point to an even brighter future ahead for Air Canada's earnings, with 2014 fiscal year consensus estimates of $0.96 per share. That makes the stock look extremely undervalued at less than five times its 2014 earnings.

Another index inclusion
The big news out of the U.S. airline industry last week was the inclusion of Delta Air Lines in the S&P 500, where it joined Southwest Airlines and became the only legacy carrier in the index. This helped Delta shares move higher in the days following, as the positive news was eaten up by investors who now view Delta as a safer investment. Its shares likely came under buying pressure from S&P 500-related funds as well.

Air Canada was also invited to the S&P/TSX Composite, however, which is much like a Canadian version of the S&P 500. Although there are not nearly as many S&P/TSX Composite funds as there are S&P 500 funds, Air Canada's presence in the index may increase some funds' willingness to add shares of the airline. Additionally, investors will now see Air Canada shares in the same index as WestJet shares, decreasing the perception of WestJet as the financially healthy Canadian airline, and Air Canada as the financially unhealthy one.

Turnaround at Air Canada
Although Air Canada is not the strongest player in the industry, its compelling valuation makes it my top pick in the airline industry. Through a combination of growing earnings, positive industry trends, and shifting investor sentiment, Air Canada shares have more than tripled off of their lows last summer. Despite this impressive rally, I view these factors as continuing drivers for shares going forward.

Possible risks to this rally include an economic slowdown, more aggressive capacity additions, or a spike in jet fuel prices. Barring any of these situations, I see Air Canada as an excellent value in an industry that is itself broadly undervalued. As with any company, however, investors should watch Air Canada and the airline industry as a whole closely for any positive or negative news that could affect their investments.

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