Pros see value in merged airline
The smart money has embraced Air Canada recently,
but fund managers are wary of Canadian Airlines.
ANDREW WILLIS
Saturday, October 9, 1999
In recent weeks, some of the world's largest fund managers have focused their attention, and their portfolios, on the proposed merger of Canada's airlines.
The likes of Boston's Fidelity Investments and the Caisse de d‚p“t et placement du Qu‚bec have taken multimillion-dollar positions in Air Canada as it deals with a hostile takeover from Onex Corp., backed by Canadian Airlines and American Airlines parent AMR Corp.
There's an old adage that says following the smart money is a winning strategy. Does that strategy now apply to Canada's airline industry?
There's reason to be cautious: this sector has been a money pit for investors over the past decade. Air Canada carried shareholders from an initial public offering price of $8 a share in 1988 to less than $6 when the merger debate began in August. Air Canada closed yesterday at $9.95, up 10 cents on the Toronto Stock Exchange.
Meanwhile, Canadian Airlines has destroyed wealth on an epic scale, dropping from more than $400 a decade ago to $1.65 on Friday, a fall that factors in share consolidations.
Despite this dismal track record, the prospects of the airline sector now have the money managers excited.
The simplest wager in the merger game starts from the assumption that with or without Canadian Airlines and Onex, the fortunes of Air Canada are on the rise.
Institutions started to buy Air Canada several months ago on the logic that arch rival Canadian Airlines faced a serious financial crisis -- analysts estimate the airline needs up to $300-million in new equity by year-end to keep flying -- and would be forced to abandon the long and costly battle for passengers. They also bought into Air Canada's previously announced cost cutting program.
In the notice of a special meeting that Air Canada mailed to its shareholders this week, the company noted that two of "the world's most sophisticated financial services groups," namely Bunting Warburg Dillon Read and HSBC Securities, predict an independent Air Canada would be worth $15 a share in two year's time.
While these fundamentals at Air Canada got institutions sniffing around, it took Onex's hostile bid to kick start interest in the stock. The attraction for institutions is the potential savings that come with a Canadian Airlines merger.
Onex's offer consists of $8.25 in cash or one share in a merged airline, called AirCo, for each Air Canada share. Much time and effort has been devoted to valuing the AirCo paper, with no real agreement on the subject.
However, it is clear that the merged airline would be able to cut its costs substantially -- at least 5,000 fewer employees are needed -- and those savings flow through to shareholders. The cost cutting translates into a higher cash flow, known on the Street as earnings before interest, taxes, depreciation, amortization and airplane rentals, or EBITDAR. Airlines trade on multiples of their EBITDAR, and a comparable U.S. carrier might be valued at five times EBITDAR. Apply this multiple to AirCo and you can demonstrate that it might be worth $16 a share.
Because it's uncertain whether investors will receive cash or AirCo paper, let's assume they receive half cash and half paper for each Air Canada share. In that scenario the half AirCo share would be worth about $8 -- assuming the cost-cutting yields the expected results -- and half cash, or $4.12. That means Onex's offer could be worth more than $12. Now you see why the institutions are piling in.
There's another game the pros play, one that ordinary investors just can't touch. Air Canada has non-voting shares that traditionally trade at a discount to its voting stock -- in recent weeks, the gap has been as wide as 60 cents.
In the event of a takeover, Air Canada's voting and non-voting shares are treated equally, and that gap will vanish. Money managers such as the caisse have constructed low-risk positions that will allow them to make that 60 cents a share on holdings of several million shares. If you are a $70-billion pension fund, this is time well spent. For the rest of us, trading costs eat up any potential profit.
The forgotten player in the airline merger has been Canadian Airlines. From an investment point of view, few institutions are climbing on the Calgary-based airline, despite the fact that Onex has bid $2 for a stock that's trading at $1.65.
Money managers are steering clear because the opportunity to make 40 cents has to be weighed against the risk of watching your money vanish. If the merger falls through, Canadian Airline's stock could go to zero as the company is forced into bankruptcy.
However, aggressive bond fund managers are buying Canadian Airlines debt, gambling that the airline will keep flying, and keep making interest payments. This debt dwells deep in the junk bond jungle.
Canadian Airline bonds that mature in 2006 pay 12.25-per-cent interest and changed hands last week at $65 for every $100 of face value. In comparison, Air Canada debt due in 2004 was trading at $96, and paid 6.75-per-cent annual interest.
If Onex's merger plan is approved, Canadian Airlines bond holders will be sitting pretty -- debts will be paid in full. The enormous gulf between the face value of the airline's bonds and the price they are now trading at indicates the merger's prospects remain very much in doubt. The smart money has embraced Air Canada in recent weeks, but fund managers remain wary of playing Canadian Airlines.
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