July 16, 2012 / 11:39 AM / 5 years ago

Canada airline stocks look set to fly; buyer beware

Air Canada aircraft are seen at Toronto Pearson International Airport, September 20, 2011.Mark Blinch

TORONTO (Reuters) - Lower fuel prices and tight capacity have lifted the near-term profit outlook for Canada's airlines, but investors looking to buy into the sector will still need an appetite for risk and the ability to stomach turbulence.

While conditions appear clear for share price gains at the dominant Canadian carriers, industry watchers say threats abound, including the possibility of an oil price rebound, shifts in consumer confidence and stiff competition.

"Demand is strong, oil prices are low -- that's a good thing," said independent airline analyst Rick Erickson.

"(But) the airline industry as a whole, not only domestically but internationally, has so many variables that are completely beyond the ability of any manager to negotiate, manage or influence."

For the moment, analysts are positive. The Canadian economy's steady growth outlook, the airlines' conservative increases in capacity and the more than 15 percent decline in U.S. crude since the beginning of May point to stronger financial results for Air Canada ACb.TO and WestJet Airlines Ltd (WJA.TO), the country's two biggest carriers, for the next two quarters.

"We're setting the table for some earnings growth," said PI Financial analyst Chris Murray. "There's some opportunity there."

Last month, the International Air Transport Association repeated its forecast for global airline profits of $3 billion in 2012 , but boosted North America's share to $1.4 billion from a previous $0.9 billion estimate.

"Even a small drop in fuel prices can improve profitability by a considerable margin," National Bank Financial analyst Cameron Doerksen said in a note that maintains a "sector perform" rating on Air Canada.

"A 1-percent decrease in the price of jet fuel increases Air Canada's before tax income by roughly C$33 million," he said.

SHARES A "LOTTERY TICKET"

But investors eyeing the sector must be ready for risk and have a well-crafted entry and exit strategy, Erickson said.

"It's nice to buy a lottery ticket every once in a while," he said. "The ones (airlines) that are riskier are the ones where the money is to be made."

Montreal-based Air Canada, the country's biggest carrier, could be the poster child for that risk-reward equation.

With the company beset by labor friction, a life-threatening C$4.4 billion pension deficit and cutthroat international competition, Air Canada shares closed at C$1.01 on Friday, a fraction of their C$21 worth at their initial public offering in late 2006.

Two of the 13 analysts who track the stock have a "strong buy" rating on it. Five rate the shares a "buy", including Murray, who has a C$1.80 share target and expects Air Canada to see improved earnings. Six analysts have a "hold" rating.

Beyond the lift that typically accompanies stronger financial results, some analysts say Air Canada shares could pop higher once its labor issues are resolved.

Last month, an arbitrator chose management's final contract offer over a proposal by the airline's mechanics union. A similar arbitration process will play out this month with its pilots union.

The mechanics union is supporting Air Canada's request for the government to extend to 2024 its moratorium on payments to erase its pension fund deficit. The outcome of that effort and of Air Canada's quest to start a low-cost carrier are still unclear, but favorable results would also certainly bump its moribund stock higher.

TOUGHER TIMES AT TRANSAT

Money-losing tour operator Transat AT Inc TRZb.TO may face an even tougher turnaround.

While three unions recently agreed to wage freezes as the company digs into a return-to-profit plan, Transat has struggled with price-slashing rivals and weighty currency losses.

"It's a riskier proposition," Erickson said. "The beauty is, the value of the stock is quite depressed. So are you feeling lucky?"

Transat's stock has plunged more than 90 percent from a high point in late 2007, shedding more than half its value this year alone.

In contrast, WestJet is seen as a safe bet, albeit with less room for major gains.

Of the 15 analysts following the country's No. 2 airline, which plans to launch a regional carrier in the second half of 2013, four rate the stock a "strong buy", 10 have a "buy" and just one a "hold" rating.

"We've seen out of WestJet, in the last couple of quarters, certainly some improved earnings, and I think that's going to continue to accelerate," said Murray, who rates the stock a "buy" with an C$18 target.

That view was buttressed by strong June traffic data that showed WestJet and Air Canada flew fuller planes.

WestJet shares have jumped more than 40 percent year to date or 12 percent over the past 12 months.

LIFT FROM FALLING FUEL PRICES

RBC Capital Markets analyst Walter Spracklin estimates that for every 1 percent drop in jet fuel prices, Air Canada gets a C$30 million lift in EBIDTA (earnings before interest, taxes, depreciation and amortization), while WestJet, if fully unhedged, gets a C$10 million boost.

Both airlines have taken advantage of lower fuel prices by cutting ticket prices on selected routes to target traffic growth, the analyst said.

Air Canada had a sizeable sale on premium ticket prices in the first week of June, seeking to boost high-profit business class revenue. WestJet has cut prices for vacation destinations.

"The key here is that while ticket-pricing yields are coming in line with our estimates, lower jet fuel prices and better-than-expected traffic growth will likely be more than enough to drive solid quarterly results," Spracklin wrote. (With additional reporting by Allison Martell; Editing by Janet Guttsman, Peter Galloway and Jeffrey Hodgson)

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