Investors Should Love Air Canada's Latest News

How did Air Canada remove a major drag on its stock?

Jan 25, 2014 at 9:32AM

Last year was a huge year for Air Canada (TSX:AC.B), as the carrier posted record profits, shook off solvency concerns, and saw multibagger returns in its share price. But the final score from 2013 is still being tallied, and the latest announcement from the airline shows another big win for Canada's largest airline.

Pension problems
As the economy entered into recession, Air Canada was dealt hard blows on all fronts. A sharp drop in air travel demand hurt profits while, at the same time, new ultra-low interest rates destroyed returns on the airline's pension plan.

Air Canada's archrival, WestJet (TSX:WJA), avoided this pension issue by having a different type of retirement system structure for employees. Unlike Air Canada, which follows a defined benefit pension plan, WestJet's retirement program is largely a share purchase plan where WestJet matches share purchases by employees for up to 20% of their gross income.

By 2012, the pension issue at Air Canada showed itself in full force as the pension deficit ballooned to more than $4 billion. By 2013, the airline entered into a pension relief program with the government allowing the airline to make defined contributions during the next seven years instead of being forced to fully fund the pension plan immediately.

Fixing the issue
While Air Canada posted large year-over-year gains on its income statements, other forces were at work to benefit the airline. The year 2013 brought a massive market rally alongside rising bond yields -- both positives for large pension plans.

At the beginning of 2013, the pension deficit stood at $3.7 billion, but an announcement on Jan. 22, 2014, notes that Air Canada expects the deficit to be eliminated after final valuations are completed, and the pension plan to even have a small surplus. The airline attributes the reasons for this to a nearly 14% return on investment in 2013, amendments to the pension plan, a $225 million payment by the airline, and the application of a 3.9% discount rate in calculating future liabilities.

Going forward
The announcement sent shares of Air Canada up more than 8% in Toronto trading, and was accompanied by a series of upgrades from analysts. In the near term, this removes a major piece of uncertainty from the airline, and further distances it from its financially unattractive past.

But looking further out, things get more interesting. As part of the government pension relief program Air Canada entered into in 2013, the airline is not allowed to pay dividends or buy back stock. However, Air Canada notes that it can opt out of the pension relief program under certain circumstances.

The airline says it does not expect to opt out of the program in 2014, but does leave the door open to doing so in the future. By opting out of the program, Air Canada would no longer need to contribute the average of $200 million per year to the pension plan specified in the program. In the Jan. 22 announcement, Air Canada noted that up to $200 million per year could become available for "shareholder value enhancing initiatives" if it exits the relief program.

With the airline aggressively purchasing new aircraft, I have a tough time seeing the "shareholder value enhancing initiatives" going higher than $200 million. Nonetheless, I could see a share buyback program launched in 2015 if Air Canada opts out of the pension relief program. Unlike dividends, which investors expect to continue indefinitely, share buybacks can be turned on and off, making them adjustable for airline fortunes. This is probably a key reason why Alaska Air Group (NYSE:ALK) launched share buybacks before later instating a small dividend.

Air Canada has also run share buybacks in the past: Once in 1999, as the airline fought a takeover bid from Onex Capital and AMR, and again in 2011 and 2012 as part of a plan that called for repurchasing up to 10% of the outstanding shares.

Long term, a more stable Air Canada could offer a dividend, as well, following the strategy at Alaska Air Group to enhance value through buybacks first. It's far too early to speculate on a yield from Air Canada, but I would expect it to at least begin small following in the footsteps of Alaska Air Group and Southwest Airlines (NYSE:LUV). For now, dividend investors interested in Canadian aviation can still pick WestJet, which is currently yielding around 1.5% -- an amount higher than nearly any other airline.

Another step
Air Canada has come a long way from the sub-$1 stock it was less than two years ago. The elimination of the pension deficit has removed yet another obstacle to Air Canada's recovery, positioning the airline to begin a possible share buyback in 2015. With the potential for share buybacks, international growth, and shares trading at less than 10 times forward earnings, I still see upside for Air Canada shares.

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Alexander MacLennan owns shares of Air Canada. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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