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All of a Sudden, the Market Loves Air Canada

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A little over a year ago, shares of Air Canada (TSX: AC.B  ) traded under a dollar as investors feared the airline's high debt levels, pension liability, and a general bearishness overshadowed the airline industry. Since then, shares have more than quadrupled nearing C$4.50 in Friday trading. So why do the markets love this stock, and is there still room to buy?

Although there is still a lot of debt at Air Canada, the carrier is making strides to make it more manageable. Last month, Air Canada refinanced around $1.4 billion in long-term notes, some of which yielded up to 12%, at lower rates. Not only has this lowered the airline's interest expense, but the stronger balance sheet puts Air Canada in a better position to finance its upcoming Boeing 787 purchases.

Air Canada was also able to manage its pension liability with an agreement it reached in March with the Canadian government. Under the agreement, Air Canada will be granted until 2020 to fully fund its pension and in exchange, executive pay restrictions were put in place and the airline is banned from paying dividends or engaging in share buybacks.

While the elimination of potential dividends and share buybacks is a negative, the extension of the pension funding timeframe is a major positive and prevents Air Canada from becoming insolvent over this obligation.

But the big news that drove Air Canada shares higher on Friday was improved guidance on the airline's cost-cutting program. As rival WestJet Airlines (TSX: WJA  ) has grown in the Canadian market, Air Canada's higher cost structure has come under pressure. Branding itself as a discount alternative to Air Canada, WestJet has taken a major role in the Canadian market.

Guidance in the September report noted that cost per available seat mile should fall 3% to 3.5% for the third quarter compared with the 1.5% to 2.5% forecasted in August's guidance. This is a major benefit for Air Canada as it tries to become more competitive with rivals such as WestJet.

Analyst reactions
Following this improved guidance, analysts have been raising price targets on Air Canada shares, noting that these results could drive shares higher. The following table summarizes some of the price target changes.

Analyst Company Old Price Target New Price Target
National Bank of Canada C$3.75 C$4.75
RBC Capital Markets C$4.00 C$5.50
BMO Capital Markets C$4.00 C$5.00

Future potential
As part of a fleet modernization strategy designed to cut fuel consumption, Air Canada currently has 37 Boeing 787s on order. The planes may be financed with ordinary long-term notes, but Air Canada may choose to utilize enhanced equipment trust certificates, or EETCs, as it did with its Boeing 777-300ERs. EETCs allow airlines to finance new aircraft through a program in which the EETC is backed by the aircraft itself. As a result, interest rates on EETCs are typically lower than those on ordinary debt.

By taking the new jets a couple of years later, Air Canada also avoids some of the bugs that plagued United Continental (NYSE: UAL  ) and its 787 fleet. Although the planes were fixed in the end, United Continental was forced to ground the 787s as safety issues arose and the 787 needed further testing.

Air Canada also formed a new subsidiary airline called Air Canada Rouge to compete for discount-oriented leisure passengers on European and sun routes. The Rouge fleet is expected to grow significantly as Air Canada shifts older planes to Rouge. By using Rouge to fly routes that wouldn't be profitable under mainline Air Canada's cost structure, Air Canada can add capacity while not creating overcapacity on existing routes. And in an industry where capacity is a major concern, this is a financially sensible way to grow.

Gaining altitude
Even after a major run, Air Canada shares still offer more upside potential as future catalysts kick in. Additional cost savings combined with better financing terms have made market sentiment more bullish, but Air Canada still has more savings to implement through a more modern fleet and the expansion of its discount carrier. Investors ready to invest in the airline industry shouldn't rule Air Canada out just because of its big rally.

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