Air Canada (TSX: AC) stock has given investors a wild ride ever since 2020. That year, the stock crashed 75%, falling from $50 to $12.50. The reason why the stock crashed so sharply was because the COVID-19 pandemic brought about travel restrictions. Travel to some foreign countries was banned, and provinces implemented 14-day quarantines for Canadian visitors. People could still travel within their provinces, but inter-provincial and international travel plummeted. That hit airline revenue hard.
In its 2020 fiscal year, Air Canada’s revenue fell 70%, and its net income swung from a substantial profit to a $5 billion loss.
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The situation today
At AC’s Tuesday closing price of $17.50, the stock had recovered just 40% from its 2020 low. AC stock is 40% higher than it was when its earnings were negative, its profit was down 70%, and the underlying company required a government bailout. The increase in revenue since 2020 has been far greater than 40%.
Low multiples
At today’s price, Air Canada trades at just 3.8 times earnings and 1.5 times cash flow. These are some low multiples — so much so that you have to wonder why AC stock looks so cheap. In the ensuing paragraphs, I will address the concerns of those questioning Air Canada’s cheapness.
The big concern
The big concern investors have with Air Canada is the fact that the company has a massive amount of capital expenditures planned for the next two years. “Capital expenditure” means spending on things like property, plant, and equipment. The more such expenditures you have in a given year, the less that year’s free cash flow (FCF) is.
FCF is a common measure of how much cash can be taken out of a business and paid to investors. If a company’s free cash flow is $0, it implies there is no cash to pay to investors without eating into assets.
Forward guidance
When Air Canada released its earnings last week, it reported that it expected near-breakeven FCF for this year. It also affirmed continued capital expenditures into 2026. This would seem to imply that Air Canada has at least two years of little to no dividend-paying ability ahead of it. However, three things should be noted:
- The company said it expected a stable free cash flow of $1.5 billion per year by 2028. That is $5 per share using the 2028 share count expectation of 300 million shares. If we assume that that amount does not grow any further after 2028 and that 10% is an appropriate rate to discount AC’s cash flows at, then AC’s discounted cash flow valuation is $37.50 — and I’ve used a fairly high discount rate here.
- The main capital expenditure that Air Canada is making in the coming years is the acquisition of new airplanes. Airplanes have useful lives of 20-30 years; they are not like cars that lose 10% of their value the second they’re driven off the lot or computers that become obsolete in a few years. So, the asset value that AC’s capital expenditures add to its balance sheet will not deteriorate quickly.
- Air Canada will use the newly acquired planes to add international routes, so this is not purely maintenance capital expenditure. The rate of capital expenditure should slow after the new fleet is acquired, and the company expects the new routes to take revenue to $30 billion.
So, Air Canada is saying that it expects $1.5 billion in annual free cash flow by 2025, and the capital expenditure plan would seem to permit that to actually happen. For this reason, its stock is likely undervalued today — even on the assumption of no cash flows for the next two years.
