After seeing its stock rise more than 400% alongside many fundamental improvements in the airline, Air Canada (TSX:AC.B) was hit hard in late January by an unexpected event. No, it wasn't a collapse in Canadian air travel demand, lackluster earnings, or a revelation of some book-cooking scheme. The culprit was Canada's currency itself.
As the Canadian dollar declined from parity with the U.S. dollar, seen over a year ago, the Canadian dollar closed 2013 around 5% lower. This was not a major issue: Air Canada built a modest decline in the Canadian dollar into its own forecasts.
But 2014 has brought another drop and a much faster one. Concerns about a weak dollar policy from the Bank of Canada knocked the currency to a four-year low as it fell below $0.90 USD. After reaching nearly $10 on Jan. 23, Air Canada shares were slammed by the currency concerns falling below $7 before rebounding into the mid-$7 range. Shares of Canadian rival WestJet (TSX:WJA) were also hit by the drop in the Canadian dollar falling more than 10% off their peak.
Why the Canadian dollar matters
When investors consider the risks of the airline industry, foreign currency exposure is usually not the first to come to mind. But for Air Canada and WestJet, the value of the Canadian dollar is a big deal.
While revenues are primarily collected in Canadian dollars (although international sales do help balance currency exposure), expenses are primarily in U.S. dollars. Oil is priced in U.S. dollars, and so are many aircraft leases and purchases. Additionally, Air Canada's large debts, although under control at this time, are largely denominated in U.S. dollars, meaning a drop in the Canadian dollar means larger interest payments and larger total debt levels.
The fall of Air Canada and WestJet shares began after the latest currency slide, but picked up speed as an article in the Globe and Mail noted the extent of the effects of a weak Canadian dollar.
Air Canada noted in its 2012 Annual Report that for each $0.01 change in the Canadian dollar, the airline would lose $33 million in yearly operating income. Although from the 2012 report, an analyst from National Bank Financial still considered the estimate fairly accurate saying, "The sensitivity would be slightly different in 2013, but I don't believe significantly so,".
While it's tougher to get an estimate for the additional costs at WestJet, the airline is almost certainly negatively affected for many of the same reasons as Air Canada.
U.S. airlines have been working on increasing fares in the wake of industry consolidation, greater pricing power, and a less cutthroat marketplace. In fact, higher fares played a major role in the doubling of Delta Air Lines' (NYSE:DAL) fourth-quarter profit. While U.S. based airlines still have more to work with in this arena as American Airlines Group is stitched together, Air Canada and WestJet are looking to fare increases as a way to weather the currency storm.
Long seen as the discount airline for the Canadian market, WestJet announced a 2% fare increase across the board following the decline in the Canadian dollar. This is clearly an opportunity for Air Canada to swoop in with its own fare increases. A report in the Globe and Mail notes that Air Canada has tried to raise fares multiple times on certain transborder routes, but WestJet refused to match the increase, causing them to ultimately fail.
Now it appears that WestJet is more willing to increase fares, as WestJet CEO Gregg Saretsky noted, "We are running WestJet like a business," to analysts in a conference call. Saretsky went on to say, "We'll make whatever changes are smart for the business, respecting the impact on demand." With the billions in fares sold each year, even a modest increase in fares could go a long way to making up the currency related losses.
Air Canada and WestJet are still significantly below their levels prior to the drop in the Canadian dollar. However, fare increases can make a large difference in making up the gap. WestJet launching a systemwide fare increase is a positive, as it gives Air Canada greater room to make up for greater costs.
As a result, I remain bullish on shares of Air Canada and WestJet, and view this sell-off as an opportunity to acquire shares at a better price.
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Alexander MacLennan owns shares of Air Canada, American Airlines Group, and Delta Air Lines. Alexander MacLennan has the following options: long January 2015 $22 calls on Delta Air Lines, long January 2015 $25 calls on Delta Air Lines, long January 2015 $30 calls on Delta Air Lines, long May 2014 $31 calls on American Airlines Group, and long January 2015 $17 calls on American Airlines Group . This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. 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.