Air Canada (TSX:AC)(TSX:AC.B) stock was crushed during the market crash. In a matter of weeks, shares lost nearly 70% of their value.
While the stock has bounced back a bit, it’s still trading at a significant discount to its former value. If the valuation discount narrowed completely, there would be 250% upside. Even if the gap narrowed by half, the stock would more than double.
Coronavirus fears are clearly behind the sudden plunge. But market conditions will eventually normalize, and cratering oil prices could provide a huge cost tailwind.
Is now the time to buy Air Canada stock?
Take a deep breath
Let’s look at the facts. Over the past few years, Air Canada has been one of the best-managed airliners on the continent. It’s no surprise that shares grew five times in value from 2016 to 2019. What drove this performance?
The biggest factor is profitability. Air Canada posted EBITDA margins of 19% last year — a figure that’s near the top of the industry. JetBlue Airways Corporation and Spirit Airlines Incorporated, both well-regarded competitors, witnessed similar EBITDA levels.
High margins are the result of efficient capital allocation. Last year, the company generated 16% returns on capital. That, in turn, produced around $1.4 billion in free cash flow. Free cash flow has been hard to come by for the airline industry. But companies that generate cash can afford to reinvest in their businesses for the long term.
For example, Air Canada invested in a new reservation system, which will produce annual savings of $100 million. It also spent more than $100 million to replace less-efficient aircraft, lowering long-term fuel costs. Its acquisition of Aeroplan, a loyalty program, should help drive higher-margin business customers.
Strong financial results have improved the company’s credit rating by five notches since 2012. The company has used this to reduce debt, lower financing costs, and free up collateral by purchasing new aircraft.
Air Canada was operating a terrific business. Once conditions normalize, it should be back to business as usual. But when and how will conditions normalize?
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The market crash isn’t over
The coronavirus bear market is taking a huge toll on Air Canada. On March 20, it temporarily laid off 5,100 employees. Ten days later, it laid off another 16,500 workers, slashing capacity by 90% and cancelling most of its international and U.S. routes. The CEO refused his annual salary, while other senior executives slashed their pay by 50%.
Most important, Air Canada recently revealed that it drew $1 billion from its lines of credit, as did other airlines. Stuck with pricey fixed assets and a 90% reduction in income, it’s only a matter of time before fresh cash runs out.
A few weeks ago, the International Air Transport Association estimated that the crisis would eliminate $113 billion in revenue for the airline industry — an estimate that didn’t even include the U.S. banning inbound flights from Europe.
“Without a lifeline from governments we will have a sectoral financial crisis,” the IATA said in a statement.
It’s abundantly clear that airlines like Air Canada will need government assistance to survive. The math simply doesn’t add up, especially if the crisis persists into the summer, a growing possibility.
“There is a heightened concern there will be increased airline bankruptcies in 2020 given the fallout from the coronavirus,” notes one Cowen Inc analyst. “We expect some governments to step in to help some airlines, but ultimately we expect more airlines to fail this year than last year.”
While Air Canada is a terrific airline, the market crash will potentially put the company out of business. Government help is a must. Will the company get assistance? What will the terms be? No one knows.
At this point, a bet on Air Canada will either pay off big or go to zero. With all of the other cheap stocks created by the market crash, I’m staying away from the airlines.
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.
The Motley Fool owns shares of and recommends Spirit Airlines. The Motley Fool recommends JetBlue Airways.
Fool contributor Ryan Vanzo has no position in any stocks mentioned.