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Air Canada: 100% Potential Upside

By Alexander MacLennan – Mar 6, 2014 at 6:43PM

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With a market overeaction and growth opportunities, Air Canada shares could be the best play in this industry.

Investors have reason to be cautious when a company's stock price surges rapidly, but sometimes, opportunities to buy in at a lower price come along after a temporary setback. With an improving financial situation and plans for responsible growth, Air Canada (TSX: AC.B) falls into this category of improved companies dealt a temporary stock-tanking setback.

From garbage stock to Bay Street darling to overreaction
Looking back to 2012 and early 2013, Air Canada looked like the poster child of financially troubled airlines. Slim profits and a $4-billion pension deficit worked to keep the airline's shares trading around the $2 range. But the story changed through 2013. By generating record earnings, eliminating the pension deficit, and successfully launching a new discount subsidiary, Air Canada rouge, shares of the airline soared to peak at just under $10 per share in early 2014.

Since its late January peak, Air Canada shares have been having a rough ride. A drop in the Canadian dollar dealt double digit percentage losses to Air Canada shares. Shortly after, earnings came in below analyst estimates, and the drop continued pushing shares down into the $6 range, around 40% off their peak.

Overblown issues
The first issue that stopped the ascent of Air Canada shares was the drop in the Canadian dollar from the $0.92 USD range down below the $0.90 USD level. Since the airline's revenues are primarily in Canadian dollars, and costs are primarily in U.S. dollars, this currency adjustment causes costs to increase as a percentage of revenue eating into earnings.

Fortunately for Air Canada, this is a Canadian airline industry-wide problem, and WestJet (WJA) realizes the issue, as well. WestJet launched a 2% fare increase to balance out the increased costs, giving Air Canada the opportunity to join in on the action with its own fare increases. The Canadian dollar has also managed to stop sliding and even regain some ground on its American counterpart since the initial slide. As of this writing, one Canadian dollar trades for around $0.91 USD.

Earnings were a story with two headlines. One touted the success of Air Canada in posting its best full-year results in its 77-year history, while the other talked of the double-digit percentage drop in the share price. Both stories were right, and the stock fell because analyst expectations were higher than the airline simply reporting record earnings.

Much of the earnings disappointment is attributed to severe winter weather. While it can certainly be a negative for short-term traders, long-term investors should realize that this is not a recurring issue, because this level of winter severity is beyond the norm. Taking a long-term view shows these earnings not to be an accurate picture of the airline as a whole.

Paths to gains
The first way Air Canada stock can rise is just by regaining some of its lost ground since late January. While the Canadian dollar is still lower than it was then, it has regained some ground, and Air Canada and WestJet have been reacting appropriately.

The second way is through future earnings growth. Air Canada rouge is in rapid expansion mode as it acquires the aircraft that are no longer cost-effective for mainline Air Canada to operate. As more of these planes arrive, the rouge fleet has the potential to grow from its current fleet of 13 aircraft to more than 50 planes.

Air Canada is also increasing capacity, but in a way that's more financially responsible than the capacity wars of the past. The capacity increases come from two main areas: using high-density configurations on existing aircraft for more passengers per plane (little additional cost), and introducing more international capacity in markets Air Canada does not heavily serve. In an industry where capacity increases typically scare investors, Air Canada is managing to grow without destroying market pricing power.

Potential to double
Analyst estimates for Air Canada's earnings point to a strong potential upside, and because Air Canada is taking numerous steps to effectively grow, this earnings growth is not unreasonable. Average estimates from Businessweek show 2015 earnings of $1.53. With a 10 times price-to-earnings ratio below that of most other airlines, Air Canada shares could double to more than $15.

Currently, Air Canada shares trade at less than five times these forward earnings. The best performing of the major airlines for 2013, Delta Air Lines (DAL 2.62%), also traded at a single-digit forward price-to-earnings ratio in late 2012. Turning these estimates into reality netted Delta a 2013 stock surge of more than 130%. While Delta Air Lines and Air Canada are still two very different carriers, the Delta example shows that if an airline can deliver, the market is willing to reward the shareholders.

Airline upside
Airline stocks surged in 2013, but Air Canada has had a rough start in 2014. However, I view the recent price drop as an overreaction and a buying opportunity. Future growth in both capacity and earnings gives Air Canada significant upside, and the potential to become a top performer in 2014.

Alexander MacLennan owns shares of Air Canada and Delta Air Lines and has the following options: long January 2015 $22 calls on Delta Air Lines, long January 2015 $25 calls on Delta Air Lines, and long January 2015 $30 calls on Delta Air Lines. 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. 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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