After posting astronomical returns in 2017, shares of Air Canada (TSX:AC)(TSX:AC.B) now trade nearly 90% higher than one year ago due to continued profitability and strength in the airline sector providing sky-high returns (115% return on equity) by Air Canada during the previous fiscal year.
While fellow Fool analyst Ryan Goldsman called Air Canada the “Short of the Year” on August 31 (a short that would have produced a negative return of nearly 11%, and much more after borrowing fees and trading costs), the vast majority of analysts remained bullish on Canada’s largest airline throughout the year (out of 16 analysts covering this stock, none had a sell rating and only one had an “underperform” rating, with the majority touting “strong buy” or “buy” recommendations throughout 2017).
As we all know, however, the past does not predict the future, and while the majority of analysts remain very bullish on Air Canada’s 12-month outlook, I believe some room for caution should remain for investors looking to enter this space at current valuations.
I don’t know if I would characterize Air Canada as a short play for 2018; however, I would recommend caution based on the following fundamental principles, which have changed since the beginning of last year:
Valuation catch up
First of all, the airline sector has gained ground on peer sectors that airlines have lagged for some time now, with valuation multiples generally increasing across the board. While Air Canada continues to trade at a significant discount to competitors such as WestJet Airlines Ltd. (TSX:WJA), with a 6.6 TTM price-to-earnings (P/E) ratio compared to a TTM P/E ratio of 10.7 for WestJet (similar discount for the four major American airlines who boast double-digit TTM P/E ratios), the reality remains that airlines are no longer the bargain bin option that investors such as Warren Buffett were able to take advantage of this past year.
They’re still cheap, but not “dirt cheap” for all you deep-value investors out there.
Debt remains an issue
As early investors in Air Canada will painfully recall, debt has been the deal-breaker for many investors considering Canadian airlines in recent decades; only a few short years ago, Air Canada was on the debt restructuring/bankruptcy protection path, struggling to stay alive amid skyrocketing expenses and flatlining revenues.
The macrocosmic environment has since improved, bolstering airlines’ operating environment and bottom lines, providing some cushion to the massive debt loads that Air Canada and its peers currently have on their balance sheets. A $14 billion debt load is nothing to sneeze at; however, with an operating cash flow of $3.3 billion per year, the expectation that debt repayments will become more manageable will make the path for the airline to being returning value to shareholders that much more feasible.
Air Canada remains a solid value pick for 2018, despite its 90% increase during 2017. Investors should remain aware of the long-term headwinds with Air Canada (as with all airlines), and act accordingly.
While I do not expect Air Canada to post 90% gains in 2018, the sky appears to be the limit for this airline, and this company has proven a worthy adversary for short-sellers looking to “time the peak” with this company.
Stay Foolish, my friends.
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*returns as of 5/30/17
Chris MacDonald has no position in any stocks mentioned in this article.