Last year, the market was treating Air Canada (TSX:AC.B) as if the airline was preparing for bankruptcy. When combined with market bearishness across the airline industry, Air Canada's uncompetitive cost structure and poor outlook put shares into the sub-$1.00 range.
But since then, shares have more than quintupled in value as the airline has implemented two key factors.
Air Canada has been criticized for having an uncompetitive cost structure, but the Canadian flag carrier had another way to approach this. A new wholly owned subsidiary called Air Canada rouge was created to solve this problem, utilizing a lower cost structure.
Air Canada rouge saves on wages by paying workers using an alternative pay scale lower than that of mainline Air Canada. The airline then further lowers the cost per available seat mile (CASM) by using higher density configurations to put more seats on each plane. This has allowed Air Canada rouge to fly routes unprofitable for mainline Air Canada setting up new expansion in Europe and the Caribbean.
In the past, Air Canada and many U.S. based airlines trying to copy Southwest Airlines' (NYSE:LUV) approach have tried this strategy. However, the major airlines had very limited success in this area, with most of the discount subsidiaries folding, or being absorbed, back into the parent airline.
Meanwhile, Southwest Airlines was able cement its role as the discount airline of the U.S. domestic market, maintaining profitability the whole time despite the discount subsidiaries from the majors.
But Air Canada rouge is overcoming these challenges by using new routes that don't conflict with existing flights, and taking advantage of the lower pay for workers, and lower CASM, due to denser aircraft configurations. So, despite past difficulties in moving into this position, Air Canada rouge is looking to be source of expansion for Air Canada, allowing the airline to go on the offensive rather than play defense, as many other major carriers did with their discount subsidiaries.
Airlines like to be able to sell more seats, but they also need to be mindful of flooding a market with capacity. The dangers of even raising the possibility were shown earlier this year, when WestJet (TSX:WJA) shares slipped alongside Air Canada after WestJet announced it would be boosting capacity.
Being an international airline as well as a domestic one, Air Canada has many choices regarding capacity additions. Instead of dumping capacity on markets it already serves, driving down prices in the process, Air Canada is adding capacity in new markets. And Air Canada rouge allows Air Canada to add capacity where mainline Air Canada could not do so profitably. This way, Air Canada can generate additional revenue without creating a supply glut in an existing market.
Air Canada has also added five new high-density Boeing 777 aircraft to its fleet in a move that increases the number of seats available without dramatically increasing costs. The high-density configuration, while probably less comfortable for passengers, lowers CASM, boosting Air Canada's bottom line.
The effective management of capacity at Air Canada should be seen as a positive for WestJet, as well. Since WestJet primarily operates within North America, the capacity added by Air Canada in the international markets should not be as big of a problem as opposed to if the capacity was added within the domestic market.
Air Canada has come a long way from the near-bankrupt airline the market saw it as a year ago. Today's Air Canada is looking to grow using a low-cost subsidiary, and is managing capacity in a disciplined manner careful not to flood existing markets.
Even after this large run-up, I still see upside potential for Air Canada shares as the market fully digests these initiatives, and I will continue to hold my shares. Investors interested in an airline turnaround should do additional research to see if Air Canada deserves a slot in their portfolio.
Two airlines not needing a turnaround
Alexander MacLennan owns shares of Air Canada. 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.
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