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The Precarious Situation of the Canadian Airline Industry

Investors don’t need any more reassurance of the strength of the Canadian economy than the arrival of new start-up airlines entering the fray. With Vancouver-based Canada Jetlines revealing plans to drum up $10 million and Calgary-based Jet Naked announcing plans to raise up to $50 million, what do investors need to know about the evolving dynamics of the Canadian airline industry?

The allure of the industry

Many entrepreneurs and investors have been drawn to the airline industry due to the enormous attractive value proposition it provides to customers – there is no real substitute for air travel.

On paper, the economics of the business are deceptively simple: get as many passengers as you can on a plane while ensuring the total price charged covers the costs and makes a profit.

In reality, operating and competing in an airline industry is extremely challenging.

Overburden of debt

If investors were to look at all the airlines that ceased operations – Canada 3000 (2001), Jetsgo (2005), Harmony Airways (2007), Zoom Airlines (2008), Skyservice Airlines (2010) – the common theme is an overburden of debt that leads to bankruptcy. The major detriment to the airline industry has always been a combination of elastic demand, high variable costs, and high fixed costs, leading to inability to service debt and ultimately to bankruptcy.

In recent years, Calgary-based WestJet (TSX: WJA) has significantly deleveraged its capital structure from $1.3 billion of long-term debt and $378 million in cash in 2006 to $689 million of long-term debt and $1.3 billion of cash in 2013. In contrast, Air Canada (TSX: AC.B) remains heavily in debt with $3.9 billion of long-term debt and $2.2 billion of cash in 2013.

Relatively, WestJet appears to be more strategically prepared for the next economic downturn.

Low-cost airline survival guide

To survive and thrive in the Canadian airline industry, new entrants must display two key strengths: operational discipline and strong capital structure.

First, the new entrants must remain steadfast in attaining the lowest cost structure and operate an a-là-carte business model where every customer decision point can be monetized. The new entrants may even suggest that customers ship their luggage using FedEx or UPS ahead of time in order to unbundle the customer flying experience. Low-cost airlines must continuously innovate, disrupt, and differentiate from the existing conventional industry value chain models.

The new low-cost airline paradigm must also display a strong capital structure where either zero debt is employed, similar to U.S.-based Spirit Airlines, or where cash on hand significantly offsets debt, such as with U.S.-based Alaska Air Group.

Ultimately, as the Canadian economy continues to power along, Air Canada and WestJet are enjoying record-breaking operating profits. As the allure of airline profits dangle for prospective new entrants, they must remain operationally disciplined and employ a strong capital structure to manage the volatility of demand.

If investors are interested in the industry, they should invest only in those players with the strongest of balance sheets built on high cash and a minimum of debt.

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Fool contributor Patrick Li, CPA, CMA has no positions in any of the stocks mentioned in this article.

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