Capacity Expansion Amid Rising Costs Will Erode Profits And Limit Earnings Growth

Key Takeaways

• Planned capacity expansion may undermine revenue growth if demand doesn't meet supply increases amid cost pressures.
  
• Rising costs and fleet modernization could negatively impact net margins and earnings, limiting free cash flow.
  
• Achieving a collective agreement with pilots and strong international market performance position Air Canada well for operational stability and long-term revenue growth.

Catalysts

Provides domestic, U.S. transborder, and international airline services.

• Air Canada's management plans to increase capacity by mid-single digits in 2025 despite cost pressures, focusing on expanding their transborder and Sixth Freedom network, which could suppress revenue growth if demand does not match increased supply.
  
• Rising operational costs, including airport fees, regulatory changes, and a new pilot agreement, are expected to put downward pressure on net margins, with the full impact to be felt in 2025.
  
• The company anticipates more intense unit cost pressure in 2025 due to regulatory environment changes and airport infrastructure fees, which could impact net earnings negatively.
  
• Air Canada is undergoing fleet modernization, with a substantial capital expenditure cycle over the next few years, which may limit free cash flow generation, potentially affecting earnings.
  
• Maintenance expenses have been adjusted due to contract renegotiations and higher planned CapEx, leading to potential challenges in managing cost efficiencies and impacting profit margins.

Air Canada Future Earnings and Revenue Growth

Assumptions

• Analysts are assuming Air Canada's revenue will grow by 5.2% annually over the next 3 years.
• Analysts assume that profit margins will shrink from 11.6% today to 3.9% in 3 years time.
• Analysts expect earnings to reach CA$996.6 million (and earnings per share of CA$2.89) by about December 2027, down from CA$2.5 billion today. However, there is some disagreement amongst the analysts with the more bullish ones expecting earnings as high as CA$1.4 billion.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 11.8x on those 2027 earnings, up from 3.6x today. This future PE is greater than the current PE for the CA Airlines industry at 11.5x.
• Analysts expect the number of shares outstanding to decline by 1.3% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 8.97%, as per the Simply Wall St company report.

Air Canada Future Earnings Per Share Growth

Risks

• Air Canada's achievement of a new collective agreement with its pilot group without significant disruptions ensures operational stability, which can support future revenue growth and protect net margins.
  
• The strong performance in international markets, especially with new routes exceeding expectations and 18% cargo revenue growth, suggests potential revenue and earnings upside.
  
• The stable demand in domestic and U.S. transborder markets and the strategy of leveraging efficiency in Air Canada's fleet and network planning could help maintain or improve profit margins.
  
• The introduction of a new share buyback program indicates confidence in the company’s balance sheet and financial health, potentially benefiting shareholder value and supporting earnings per share.
  
• Air Canada’s diversified strategic assets, including a robust loyalty program, significant partnerships, and investment in fleet and technology, position it well for sustained competitiveness and long-term revenue growth.

Valuation

• The analysts have a consensus price target of CA$26.44 for Air Canada based on their expectations of its future earnings growth, profit margins and other risk factors. However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of CA$34.0, and the most bearish reporting a price target of just CA$17.2.
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2027, revenues will be CA$25.7 billion, earnings will come to CA$996.6 million, and it would be trading on a PE ratio of 11.8x, assuming you use a discount rate of 9.0%.
• Given the current share price of CA$25.45, the analyst's price target of CA$26.44 is 3.7% higher. The relatively low difference between the current share price and the analyst consensus price target indicates that they believe on average, the company is fairly priced.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.