Can a Bailout Protect Air Canada (TSX:AC) From Going Bankrupt?

Air Canada investors are walking on thin ice. A bailout can dilute shareholder interest whereas bankruptcy can leave them with nothing.

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The COVID-19 pandemic has put the world’s top airlines on the ventilator. Many airlines won’t survive without a bailout, and Air Canada (TSX:AC) is no exception. It has reduced capacity by 90% and is burning cash to fund maintenance, employee salaries, airport rent, and interest on loans. At this rate, it may exhaust its cash reserves in a few months and file for bankruptcy.

What AC needs is revenue, and that will come when the travel ban is lifted and travelers are willing to buy plane tickets. Travel will normalize when the COVID-19 curve flattens. It took nine months to contain the SARS epidemic in 2003. The COVID-19 pandemic is worse than SARS and could take even longer to be contained. Until then, AC needs to maintain enough liquidity to stay afloat.

Air Canada is at risk of bankruptcy 

AC’s highest fixed cost is salaries for its 35,000 employees and maintenance fees for its 180 aircraft. Like all other airlines in the world, AC will report losses in 2020. The deepest loss from the COVID-19 pandemic will be reflected in its second-quarter earnings when the revenue is at an all-time low.

The company is adopting various methods to generate revenue and preserve cash. The firm has converted some of its passenger planes into cargo planes to generate revenue. It has refused to give cash refunds to passengers whose flights were canceled due to COVID-19. It has suspended the share-buyback program and plans to reduce capital expenditures by $750 million.

AC has $5.9 billion in cash and short-term investments with which it can fund its operations in the second quarter without generating any revenue. Once this cash is exhausted, the firm will be left with $15.5 billion in long-term debt, thereby risking second bankruptcy. A government bailout will give AC the much-needed cash to stay afloat.

How can a government bailout help Air Canada? 

A government bailout can take different forms. It can be in the form of grants, which is free cash that the company doesn’t need to return to the government. It can be in the form of long-term, low-interest loans. It can also be in the form of equity or preferred stock purchases. The first two forms of bailout can benefit shareholders by injecting cash in companies without affecting their holdings. However, the third form of bailout can dilute shareholders’ interest.

The U.S. government is giving out $25 billion in payroll support to U.S. airlines in the form of grants, low-interest loans, and equity warrants. For instance, Delta Air Lines is getting $5.4 billion in government funding, which includes a 10-year loan of $1.6 billion and warrants to purchase “about 1 percent of Delta stock at $24.39 per share over five years.”

The Canadian government has not announced any bailout package for the airline industry. But if it plans to walk in the U.S. government’s footsteps, Air Canada could be eligible for over $1 billion in bailout money, according to Scotiabank analyst Konark Gupta. In the meantime, AC has applied for the Canada Emergency Wage Subsidy program. Under the program, the government will pay 75% of the employee wages from March 15 to June 6.

Can a bailout give Air Canada shareholders some respite? 

Even with a bailout, AC stock can go to $0, as the share price reflects the company’s future earnings potential. Back in 2003, the SARS epidemic pushed AC to bankruptcy. It took the company 18 months to emerge from bankruptcy and another four years to return to profitability. The stock bottomed to $0.78 in 2009 and traded below $3 for the next four years. It only started to rally in 2013, rising from $1.76 to $52.7 in January 2020.

Investors: Beware of the crashing airplane 

AC stock rose 140% from its March low but is still down 60% year to date. The recent rally is a result of better-than-expected first-quarter earnings of U.S. airlines. The rally is unsustainable, as the impact of COVID-19 on AC’s future earnings remains uncertain. It would be prudent to stay away from this crashing airline until the COVID-19 fog clears and safe landing is guaranteed.

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 recommends BANK OF NOVA SCOTIA. Fool contributor Puja Tayal has no position in the companies mentioned.

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