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How a Record Year Destroyed Air Canada Shares

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Those researching Air Canada (TSX: AC.B  ) today will find two very different types of headlines. One type highlights how the airline posted its best numbers in its entire 77-year history, and the other points to a disappointing earnings report. Here I'll break down why this record year disappointed Bay Street, why shares fell over 20% on the day of the report, and how investors could profit from this drop..

The report
As a standalone document, Air Canada's earnings report would look positively upbeat. Adjusted earnings for 2013 were six times greater than 2012 earnings and Air Canada CEO Calin Rovinescu called 2013 a "watershed year" on the conference call.

But earnings reports don't exist by themselves; they exist in comparison with analyst expectations. Posting adjusted earnings of $0.01 per share, analyst estimates were too high with expectations of $0.11 per share.

Further depressing shares is the expectation of lower results for the current quarter. With more severe weather in January, many investors are cautious on results for the current quarter.

Currency concerns also weighed on the stock, as the drop in the Canadian dollar relative to the U.S. dollar hurt current results and some investors worried this exchange rate would hurt future results.

For long-term investors, I would consider this degree of a sell-off to be disproportionate to the content of the report. Looking at the progress Air Canada has made, as well as its current performance, shares have plunged back into value territory.

One issue that long-term investors should be able to look beyond is the weather-related component of the report. December and January have been exceptionally severe, prompting major flight cancellations and even the temporary stoppage of operations out of Toronto Pearson International Airport. Unless this level of winter severity has become the new normal, Air Canada should be able to shake off this problem for future earnings.

The other issue has a greater future role to play. The slump in the Canadian dollar compared with the U.S. dollar has driven up costs for Canadian carriers. Both Air Canada and WestJet (TSX: WJA  ) were knocked off their highs in January, when the currency took a sudden drop below the $0.90 USD level. Since then, the Canadian dollar has move back closer to $0.91 USD.

Even a few cents can make a difference for airlines where major expenses are priced in a foreign currency. However, Air Canada and WestJet have recognized these concerns and have both raised fares 2% to partially compensate for greater costs. If the Canadian dollar remains low, more fare increases could be in store for the future.

Air Canada is taking additional measures to compensate for the currency drop. The carrier is continuing to slash costs. With these measures being implemented, Air Canada expects cost per available seat mile, or CASM, to fall 2.5% to 3.5% for the full year of 2014. These CASM reductions even take into account the current weakness in the Canadian dollar, as Air Canada expects the currency to trade at a rate of $1.10 CAD to $1, USD which is about the current exchange rate.

With Air Canada shares closing Feb. 12 at $6.22, shares are at their lowest level since the 2013 rally. At the peak of the rally, Air Canada shares were beginning to approach shares of other airlines in valuation, but the latest drop puts them squarely back in value territory.

Consider that, despite the lackluster Q4, Air Canada's adjusted 2013 full-year adjusted earnings still came in at $1.20. This gives the airline a current price-to-earnings ratio of only 5.2. Virtually every other publicly traded airline has a higher P/E ratio than this. In fact, even if earnings remained the same for 2014, a forward P/E ratio of 5.2 is still well below industry levels.

In the long-term, I still maintain my estimate that Air Canada shares can trade at 10 times earnings based on fundamental improvements in operations and international expansion that diversifies beyond the home market of Canada. At 10 times earnings, a level still below the industry average, Air Canada shares could trade nearly 100% higher.

The bottom line
The Q4 earnings report did miss estimates, but the long-term outlook for Air Canada shows this degree of sell-off to be unwarranted. With Air Canada shares trading at such a sharp discount to the industry, I view this sell-off as an opportunity to acquire shares at a lower valuation.

Although I have owned Air Canada shares since they were below the $2 level, the growth and value aspects of the airline would have me acquiring additional shares if this stock didn't already make up such a disproportionate share of my portfolio. For investors currently with less exposure to Air Canada stock, this investment if definitely worth a further look at these levels.

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  • Report this Comment On February 13, 2014, at 4:29 AM, tfjng wrote:

    I totally agreed, December Weather was a lot worse than Jan, and that AC CEO already reported a record loading for January 2014, Canadian dollar has gone back up almost 2 cents since, which is about $66 million in cost reduction. Furthermore, all airlines applies surcharges to fuel which they charge changes with accordance to fuel prices, most of these are being paid by the customer, it should not affect the airline operators. AC is way under value with comparison to other airlines, even smaller airlines are trading at above $10/share. One much needed improvement is customer service, those they employed front line staff are extremely rude to customers and you can find it on many reviews by customers, their union is to thank for that...

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Alexander MacLennan

Alexander MacLennan is a Fool contributor covering Industrials, Airlines, and Financial companies. He is always ready for a good growth or turnaround story and tries to find them before the market does.

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