Despite Quadrupling, This Airline's Still a Good Value

After a sharp rise in a stock price, many investors are tempted to see shares are inherently overvalued. While quick rises can often be times for caution, it is important to look at underlying factors to see if the rally is justified. In the case of this airline, there seem to be many reasons to see shares as fairly, if not undervalued.

Airline on the brink?
Last summer, investors could have picked up Air Canada (TSX: AC.B  ) shares for under C$1 as economic factors and a general airline industry bearishness weighed on the stock. But since then, Canada's largest airline has shown major progress toward a brighter future by:

  • negotiating a delay in the full funding of its pension plan, preventing this liability from making Air Canada insolvent;
  • reporting a profitable year 2012 with expectations of profits in future years;
  • launching its discount subsidiary airline Air Canada rouge;
  • far exceeding Q2 2013 earnings estimates;
  • refinancing high-yielding notes at lower rates;
  • projecting improved cost savings; and
  • successfully managing capacity concerns by adding capacity in new markets and adding more by putting more seats in each plane.

Needless to say, the current Air Canada is being viewed in a different way than a year ago with shares now approaching C$5.00 each.

Future catalysts
For a stock like Air Canada to continue rallying, it needs to show more positives. But for Air Canada, a few important catalysts are expected to happen over the next several months.

Cutting fuel consumption is important to airlines as jet fuel represents a major expense. For Air Canada, part of this fuel consumption cut is expected to come from the airline's order for 37 Boeing 787 Dreamliners due to begin deliveries in early 2014. For its own part, Canadian rival WestJet (TSX: WJA  ) is also stepping up its fleet modernization with orders for 65 Boeing 737MAX aircraft. In the case of each airline, the type of aircraft makes sense. Air Canada flies many long-distance and international routes where the 787 would see the most effective use while WestJet's 737MAX order keeps in line with the airline's large usage of the 737 to save on maintenance costs.

Air Canada rouge also provides a new growth outlet for Air Canada. Instead of adding Air Canada rouge capacity to markets served by mainline Air Canada, rouge is going to operate routes that would be unprofitable under mainline Air Canada's cost structure. Because of this, Air Canada is able to increase capacity without creating overcapacity in markets where it already operates.

And like it or not, Air Canada has another way to increase capacity without increasing flights. The airline is packing more seats into existing aircraft, allowing it to generate more revenue with a minimal increase in costs. While passengers may not like these higher-capacity configurations, they go to a core point of making Air Canada into a more profitable carrier.

International expansion is also expected to play a major role in Air Canada's future. European expansion comes at a time when the recession in the eurozone is expected to end and return to slight growth next year. And Air Canada is also increasing its involvement in the Asia/Pacific region by expanding a codeshare with Air China (NASDAQOTH: AIRYY  ) to include more cities in both Canada and China. As a market with a growing middle class, leisure travel in China is poised to continue growing and this codeshare with Air China puts Air Canada in an excellent position to capitalize on it.

Catalyst wrap-up
All together, analysts forecast strong earnings at Air Canada over the next few years based upon both expansion and cost cuts. Data from Businessweek forecasts FY2013 EPS of C$0.79 and FY2014 EPS of C$1.05, making the stock priced very attractively at current levels.

For Air Canada, this rally has fundamental factors behind it both in past performance and future catalysts. Therefore, those interested in an airline investment should further examine Air Canada despite its impressive run-up.

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