Air Canada (TSX: AC) stock fell 8.7% in the second half of July when the airline reduced its 2024 adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) forecast by a whopping $600 million. The revised forecast is $3.1 billion to $3.4 billion, compared with its previous forecast of $3.7 billion to $4.2 billion.
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Why did Air Canada reduce its EBITDA forecast?
The revised forecast comes as its summer holiday season (when revenues peak) showed tepid growth. Air Canada got entangled in price competition in certain international routes as the industry increased capacity. Competition is bad for airline investors as fierce pricing reduces revenue and profit margins, making capital investment in buying and leasing aircraft unsustainable.
During the pandemic, the airline industry was at its bottom. The sudden grounding of planes forced many airlines to retire planes. When the demand peaked post-pandemic due to revenge travel, the supply shortage worked in favour of airlines and helped them recover from the pandemic losses. However, airlines once again started increasing capacity by ordering planes.
The early signs were visible in the first-quarter earnings when Air Canada reported a net loss of $81 million as salary expenses and aircraft maintenance costs increased by 21% year-over-year. The industry is seeing a shortage of pilots, which means expenses will only increase.
When there is over-capacity, carriers offer discounts to fill in the seats at the cost of their profits. All this has commoditized air travel. And that is what Air Canada witnessed in the second quarter, which forced the airline to reduce its adjusted EBITDA.
These two signs show how vulnerable Air Canada’s profits are to the changing industry dynamics.
Was Buffett right about the airline industry?
The recent turn of events reminds me of Warren Buffett’s statement on airlines and why he offloaded all his stakes in the top four U.S. airlines at the onset of the pandemic. He simply cut his loss as the world had changed for airlines.
In 2007, he explained why he despised investing in airlines. Unlike other sectors, growth in airlines is bad news for investors. Why so? Building capacity involves significant investments in airplanes. Moreover, aviation turbine fuel and staff salaries make up 40% of the revenue. The industry does not maintain discipline in increasing capacity, which leads to oversupply and price competition, pushing several airlines into bankruptcy.
In 2016, Buffett invested in airlines as they showed sustainable profits, which looked like they had learnt to thrive together. But the pandemic changed everything. Investing in the growth of airlines is equivalent to funding their future losses. At such times, even if the airline stocks trade at depressed prices, the valuation is still high considering the future losses that follow overcapacity.
Should you buy Air Canada stock below $17?
At $16.16, Air Canada stock is trading at 2.8 times its last 12 months earnings per share (EPS). This valuation might look attractive, but considering the rising revenue and falling EPS tradeoff, even the 2.8 times price-to-earnings (P/E) ratio is expensive. Its high forward PE ratio of 6.6 times is the proof (forward-P/E ratio compares the stock price with the coming 12 months EPS estimates).
Moreover, at $16.16, the stock is trading at 8.2 times its book value per share. The book value is low as shareholders have been accumulating a deficit, which reduced the equity value to $705 million as of March 31, 2024, from $796 million as of December 31, 2023.
It would be better to stay away from all airline stocks till the industry achieves its new normal and stabilizes supply.
Buy this stock instead
The air travel demand continues. While this growth is hurting airline profits, it will add to the profit of Descartes Systems (TSX: DSG). Descartes provides supply chain management and logistics services, helping companies from various verticals to transport goods, services (airlines), and information via air, rail, road, and water. Rising travel demand, increasing regulations in global trade, and exports of North American liquified natural gas to Europe are some of the catalysts driving growth. In the long term, the e-commerce trend will drive growth.
I expect the stock to generate a 20% compounded annual growth rate over the next five years.
