The Precarious Situation of the Canadian Airline Industry

With low-cost entrants trying to launch new airlines, here’s what investors need to know about the evolving dynamics of the airline industry.

The Motley Fool

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.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

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

More on Investing

Pipeline
Dividend Stocks

Enbridge Is a High-Yielding Canadian Dividend Stock to Buy Now and Own Forever

Are you looking for a high-yielding Canadian dividend stock to buy? Enbridge (TSX:ENB) has plenty to offer investors.

Read more »

sale discount best price
Stocks for Beginners

3 TSX Growth Stocks You Can Buy at a Screaming Discount

These three growth stocks remain screaming buys, given their track records of growth and future opportunities for investors.

Read more »

Retirees sip their morning coffee outside.
Dividend Stocks

Why I’d Buy These 2 Healthcare Stocks Today (Besides the Cheap $10 Price)

Two small-cap stocks trading under $10 worth buying right now as promising healthcare plays in 2023.

Read more »

woman data analyze
Investing

Better Buy: Telus Stock or BCE?

Telus (TSX:T) and BCE (TSX:BCE) are dividend-growth stocks that seem like worthy pick-ups ahead of a recession year.

Read more »

Silver coins fall into a piggy bank.
Dividend Stocks

3 Dividend Stocks to Build Wealth in the New Year

These dividend stocks have proven they're set up for a strong future and have dividends you'll want to lock up…

Read more »

Dad and son having fun outdoor. Healthy living concept
Tech Stocks

Prediction: These Will Be 2 of the Strongest TSX Stocks in 2023

Tech stocks may have dropped during the last few years, but these two TSX stocks are bound for major growth…

Read more »

edit Person using calculator next to charts and graphs
Tech Stocks

This 1 Tech Stock Is My Hands-Down Choice Over Shopify

A small-cap tech stock with consistent revenue growth and nearly 300% profit growth is a better option over the TSX's…

Read more »

money cash dividends
Top TSX Stocks

Sitting on Cash? These 2 TSX Stocks Are Great Buys

Given their solid business models and stable cash flows, these TSX stocks could be steady investments in this volatile market.

Read more »