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Can Air Canada Stock Hit $10?

The list of troubled legacy airlines that provided little joy to their shareholders is long and include illustrious names such as American Airlines (NASDAQ: AAL) and Air France. The problem with airlines is that they are capital intensive, have little control over their major input costs and intense competition.

Air Canada (TSX:AC.B) also had its fair share of problems including a period under bankruptcy protection and major pension fund deficit obligations in 2009 and in 2013. The company share price reached $20 in 2007 but has been on a steady decline until last year when it improved dramatically from below $2 to almost $8 by the end of the year.

Air Canada has made significant strides
The current CEO, Calin Rovinescu, appointed in 2009, took significant steps to improve the operating position of the company including cost savings of more than $500 million by 2011. These steps resulted in improvements in almost all of the key operating and cost measures and the achievement of a net profit in 2013 (the first since 2007).

The company has a four point strategy to further improve its operating results including additional cost reductions and revenue enhancements. Given the impressive record of delivery of the current CEO, one cannot rule out further improvements in profitability over the next few years.

But the headwinds are strong
The company faces significant challenges in the years ahead. One item which is not within its’ control is the price of jet fuel which makes up 25-30% of revenue. Although the company has a limited hedging program in place, the weakening Canadian Dollar further serves to increase the cost of fuel to the company.

The registered pension plans solvency deficit of $3.7 billion that existed at the end of 2012 was expected to be erased during 2013. In terms of an agreement reached in March 2013 with the Government of Canada, an amount of at least $1.4 billion will have to be contributed by Air Canada to the pension plans over the next 7 years in addition to its pension current service payments. Under the agreement Air Canada is also not allowed to pay any dividends or make any share repurchases.

The adjusted net debt (including the capitalisation of operating leases) of the company amounted to $4.4 billion at the end of 2013. The interest cover remains uncomfortably low.

While the operating cash flow generation was solid in 2013, the free cash flow was sharply negative for the first time since 2009 and ascribed mainly to the acquisition of four Boeing 777 aircraft. The company expects capital expenditure of $5.0 billion over the next 5 years which will continue to put considerable pressure on the free cash flow.

The company currently has a zero tax rate as a result of previous assessed losses. However, when this runs out normal corporate tax rates will create a drag on after tax profits.

The company has negative equity which implies that in the case of liquidation, shareholders will not receive any value for their shares. This may not be a very likely scenario but nevertheless does not provide any comfort and may imply that the company will have to raise equity capital at some point in the future.

The valuation is appealing
The stock is extremely cheap at a forward price to earnings ratio of 4.8 times and an enterprise value to earnings before interest, tax and depreciation of 4.5 times. These valuations are also at a considerable discount to other major airlines including WestJet Airlines (TSX:WJA).

Foolish bottom line
Air Canada is a major franchise with a much improved operating structure. The stock is too cheap and may have upside potential to around $10 but this does not, in my view, provide adequate reward for the potential downside risk.

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Fool contributor Deon Vernooy does not hold a position in any company mentioned in this report.

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