In Canada we have many great companies, eh. Tim Hortons has helped keep our workers going to work through our ridiculous winter. We have some oil, potash and other raw materials that other countries want/need. Our banks are pretty bulletproof, and have been voted among the safest in the world, though I would give some credit to our regulators. We also have a great airline, but does that make it a good investment?
When I first started taking this whole investing thing serious, I felt that if I didn’t buy a company with a “moat” I was doing something wrong. You are supposed to buy a company with a moat and just leave it alone. Nobody told me about valuations getting extreme in one direction or another. Take a look at some of the most popular moat businesses: JNJ, WMT, MSFT, KO, HD, etc. Now, look back 10 years and see the return. After you’ve done that look at them in the currency I get paid in, the Canadian dollar, and you’ll see that moats may not always be a good investment. Very high valuations and an undervalued Canadian dollar would have given an average return less than a Government of Canada 10 year bond. Up until this point, the blog has focused on non-moat businesses, the companies do not operate at a competitive advantage but they also do not operate at a disadvantage.
WestJet has a sustainable competitive advantage, it our largest low-cost airline. WestJet’s business model was based on the wildly successful Southwest Airlines. It’s largest competitor, Air Canada (AC.A), is stuck with much higher operating costs than WJA. Both are debt heavy, but AC.A is so leveraged that it needed emergency loans from the government during the slowdown. There are 2 main reasons why WJA has an advantage:
- AC.A has higher operating costs, mostly from the unionized labour force and the long-term pension liabilities.
- Major US carriers aren’t allowed to fly in Canada (from one Canadian city to another). WJA can simply chip away at AC.A, as long as AC.A avoids bankruptcy, like Toyota did with GM.
Lets take a look at the RASM (revenue per available seat mile) and CASM (cost per available seat mile) and the load factor of the two.
Load factor looks to favor AC.A, until you look at the massive capacity expansion that WJA has undertaken. Since 2005, AC.A has almost the same ASM (available seat miles) while WJA has almost doubled theirs.
|Spread (ex fuel+forex)||2005||2006||2007||2008||2009||TTM|
I took out some expenses: forex, fuel and non-recurring. Forex because the charge is volatile and we want to compare how the two operate against each other. Fuel because it is the largest cost to both and also volatile, with WTI fluctuating and each company having their own hedges. Though fuel is a real expense, I just want to take a look at the advantage of WJA. Earning an extra penny does not seem like much, but put over the total ASM of 18,000,000 (ttm) and you can see the advantage. WJA even expanded capacity during the recession, although not by much. We also know that WJA has a pretax ROIC in the mid-teens, excellent for an airline.
- Price to TBV is 1.25
- Ev/Average Ebitda is 6.0
- Price to 3yr average E is 14
- Price to peak E is 7.8
- Trading at half of EPV
Well, not cheap. But not expensive given the competitive advantage. I know what you are thinking, what about oil prices? Yes, fuel is WJA biggest expense, at around 30%. But there are some things to keep in mind:
- WJA has only a single class configuration plane, this keeps the maintenance/service expense cheaper as you don’t need to train technicians on many different types of aircraft
- WJA has a very young fleet, with the average 4.8 years old
- The average stage length per flight is growing. With so much fuel being burnt on take-off, keeping the plane in the air longer will help the fuel mileage
- 20% is hedged, although not at an attractive price
- Generally rising oil price brings a rising Canadian dollar, which will help mitigate the the higher costs when translated back to the Canadian dollar
We can look into our crystal ball and try to predict future earnings through the RASM-CASM spread using normalized numbers. Lets try capacity expansion of 10% in the next year, followed by 5% for each of the next 4 years. The airline has 90 planes now and plans to have 114 by end of 2014, with 135 by 2017. By 2014 WJA could have 23,500,000 ASM. With average RASM at 0.14, gives us 3.3 billion in revenue. CASM (ex-fuel) at 0.055 or 1.2 billion. Now fuel, I will just say that the cost of fuel will double from today, or about 1.3 billion. This brings EBIT to 0.9 billion (3.3-1.2-1.3). I don’t know what WJA debt load will be or how much cash they will have, so I will just say fair price is 5X EBIT or 4.2 billion, or around $29 dollars per share. A another big risk how many shares will be outstanding. The different stock options plans as well as the employee share purchase plans has slowly increased the amount of shares outstanding. Lets say for the next 5 years that the diluted share count increased by 3% per year bringing the total to 168 million shares by 2014. This will decrease the fair value to $25/share by 2014. Using a discount rate of 15% plus an extra 25% margin of safety, I get a trigger of $9.50. I cannot emphasize how crude these numbers are, so don’t let this be your only source of valuation. It just gives you an idea of what is possible. Of course, these can change very quickly, and this is the type of company that may loose its advantage at any time. If that happens, you do not want to own WJA.
- Competition. Though WJA still has an advantage over AC.A, there is always the threat of added competition. AC.A has done some restructuring lately, thereby reducing the advantage that WJA has.
- Management/execution. We hope that management continues to exploit their advantage. They must continue it, even if the capital markets don’t like it.
I have owned WJA for years, it was one of the first stocks I bought. It is almost a rite of passage to hold on to a cyclical through a recession and feel the pain when the share price gets cut in half. That is why you need to use valuation metrics and have the ability to laugh at the “price targets” of analysts. I remember when everyone was tripping over themselves to raise the price target for WJA. If that isn’t the sign of a top, I don’t know what is. For the record, I went heavy into WJA under 10 (around 12% of my portfolio). Given the strong balance sheet and competitive advantage that WJA has, I am comfortable owning shares here. All this doesn’t take into account any possible new code-sharing plans. I put fair value at $20-$25 and under anything under $11 is time to back up the truck (or plane, get it?). Maybe Mr.Market will give us that gift again.
The author is long WJA at time of writing.