From the Scratch and Dent Bin: Air Canada

Alexander is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

This is the first in a series of articles written with the objective of pointing out stocks that are underpriced, but only slightly damaged. Like open-box electronics, they still have to be useful and work properly, but a little ding here and there has drastically dropped the price. Yet unlike electronics, investors can turn around and sell their purchase for a higher price once, the market realizes the item's flaw is repairable over time. So what's under the big yellow sign at the back of the store today? Canada's largest airline, Air Canada (TSX: AC.A) (TSX: AC.B)

Airlines are known for numerous risks, including labor strife, fuel cost exposure, and high capital costs, but previous events in the industry indicate airlines can nonetheless be undervalued. Holders of United Airlines, now United Continental Holdings (NYSE: UAL), saw returns of over 500% from the share price bottom in mid-2009. Fears of imminent bankruptcy were dragging down the stock price and when those fears failed to materialize the share price surged alongside other airlines including Delta Airlines, US Airways, and Continental Airlines.

Strikes, and bankruptcies, and pension problems, oh my!
Unlike U.S. carriers, Air Canada used to be owned by the Canadian national government before it was fully privatized in the late 1980's. The airline was a founding member of the Star Alliance and acquired Canada's second-largest carrier, Canadian Airlines, in 2001. The good times did not last, and the aviation slowdown in the early 2000's forced the airline to declare bankruptcy in 2003.

The airline emerged from bankruptcy and entered the market at C$21 per share, but it has since been hit hard by the global recession. Rumors have circled around a possible second bankruptcy, but the airline has been able to avoid this so far.

In addition, according to CBC, workers for Air Canada staged wildcat strikes which disrupted service and damaged the airline's brand image in the eyes of its customers. Another looming problem on the airline's stock is its pension plan, which is reported to be underfunded by approximately C$4.4 billion. If its required funding date is not extended, the pension plan alone could spell disaster for Air Canada. The airline is currently in talks to remove this threat, but a decision has yet to be made.

If it's garbage, why buy it?
In short, the airline is damaged, but not as bad as the market is pricing it. Losses at Air Canada have been dramatically reduced from more C$10 per share in the depths of the recession, to only C$0.05 per share in the most recent quarter. Furthermore, the airline claims it would have been profitable if not for a US$120 million write-off for the failure of Aveos and labor related problems. This is a very positive trend, indicating that the airline could soon begin to manage its costs through profits and further reduce chances of bankruptcy.

Labor problems may continue at Air Canada, but the imminent threat to its operations has subsided. In arbitration, a new contract was reached with terms favorable to Air Canada. The decision even allowed Air Canada to create a discount airline that it wholly owns. Discount airlines are becoming increasingly popular, and Air Canada now has a chance to enter the market. The airline has attempted such a move before, with limited success, but Air Canada plans to commit more funds and aircraft to this attempt than its previous one.

Air Canada has been a strong advocate for fleet modernization as well. On its website, the airline states that it currently has 18 Boeing 777s, and plans to add more 777s along with Boeing 787 Dreamliners beginning in 2014. The young age of the airline's fleet will help Air Canada in their cost reduction plans by lowering fuel and maintenance costs over the next few years. Air Canada is taking advantage of modern aircraft to benefit their shareholders by acquiring planes to reduce costs and stay solvent, rather than American Airlines, which placed its order for new planes after declaring bankruptcy.

Ongoing repairs
Unlike items from a scratch-and-dent bin at your local electronics store, companies can repair themselves, if properly managed, over time. Air Canada offers an excellent prospect of overcoming its current flaws and rebuilding shareholder value. There are certainly risks with this stock, including another strike, increased fuel prices, or a fall in demand. Still, I believe the current situation is not as bad as the stock is trading for. If Air Canada can turn itself around without a restructuring, the share price could move back in line with other airlines, which have risen considerably since the bottom of the recession. I find this risk/reward situation to be positive, and I've taken a small speculative stake in Air Canada. But as with most scratch-and-dent deals, all sales are final.


TulipSpeculator1 has shares of Air Canada. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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