Air Canada

Northern Phoenix

By JONATHAN R. LAING

WITH JET-FUEL PRICES SOARING and many major North American airlines flirting with or mired in bankruptcy, few industries seem to have prospects so ugly.

Yet a few hardy souls, such as Sandy Prater of the hedge fund Ridgecrest Partners, have taken a flier in Ace Aviation Holdings, the reorganized holding company of flag carrier Air Canada. Says Prater: "The push-back I'm getting from Wall Street types for going into Air Canada is unbelievable, but there's an interesting fundamental story there that most people ignore because of their hatred of the industry."

Indeed, the company, whose shares have just begun trading in Toronto under the ticker symbol ACE, bears little resemblance to its beleaguered U.S. rivals. In fact, Air Canada completed the Canadian version of a Chapter 11 bankruptcy last fall and has emerged with dramatically lower costs as a result of union givebacks and debt forgiveness as well as renegotiated leases and vendor contracts. It's also prospering from a pickup in travel in North America and the recent demise of a low-cost domestic rival. Finally, it's in the early stages of a financial restructuring aimed at boosting value by selling stakes in non-core operations to the public.

Ben Cherniavsky of Raymond James in Vancouver estimates that Ace will earn 3.05 Canadian dollars a share this year and C$3.60 next year (excluding one-time items). The stock recently traded around C$36 a share, up sharply from the C$24 or so it fetched when it emerged from bankruptcy. Yet based on his sum-of-the-parts analysis, Cherniavsky has a six-to-12-month price target of C$48. Genuity Capital Markets, a Toronto investment-banking concern, sees it hitting C$54 in the same span.

The bankruptcy reorganization let Air Canada chop nearly C$2 billion in annual costs, a hefty amount for a company expected to generate slightly more than C$9 billion in revenue this year. About half the savings will come from new contracts reached with its sometimes fractious labor unions, according to Merrill Lynch analyst Michael Linenberg. These contracts will buy at least a modicum of peace until their expiration in 2009. True, wages will be subject to some revision next year, but any impasse would be subject to compulsory mediation. but productivity-enhancing work-rule changes are non-negotiable, and strikes and lockouts are forbidden.

The airline completed the Canadian version of a Chapter 11 bankruptcy last fall and has emerged with dramatically lower costs as a result of union givebacks, debt forgiveness and negotiated leases and vendor contracts.

Debt reduction and renegotiation of operating leases on equipment have lopped Air Canada's net debt obligations from around C$15 billion to under C$5 billion, according to Linenberg.

Air Canada now has a 45% share of international passenger traffic in and out of Canada, as a result of certain restrictions on foreign carriers. This high-margin business chips in about 40% of the company's revenue. The carrier's international business is also getting a boost from foreign travelers transiting through Canada rather than the U.S. to points overseas, thus avoiding the need for an American visa.

March saw the demise of the Canadian discount airline Jetsgo, which had mounted fare wars that made life miserable for both Air Canada and its primary, low-cost domestic rival, WestJet. Now the two effectively have a lucrative duopoly. They've boosted fares sharply and even imposed fuel surcharges without losing passengers.

THE BOTTOM LINE Shares of Air Canada's parent, Ace Aviation, could rise more than 30% in a year. But given the industry's penchant for disaster, they're more suitable for speculation than investment.

The restructured Air Canada, with 55% of the Canadian domestic market, is holding its own against WestJet, with a 27% share, because it has shifted much of its domestic passenger traffic to Jazz, its wholly owned regional carrier. That helped Air Canada generate a 7.2% operating margin in the second quarter, 1.5 percentage points better than WestJet's.

As a result of the bankruptcy reorganization, the U.S. private-equity firm Cerberus Partners has three seats on the ACE board and a 7.7% stake in the company, through convertible preferred stock. It certainly will encourage the company to unlock value.

A few months ago, Air Canada sold the public a 14.4% stake in its Aeroplan air-mile loyalty program, which boasts more than six million members and a number of blue-chip credit-card-issuer partners. Based on Aeroplan's current stock price, Air Canada's remaining holding in that company is worth some $2.3 billion.

The carrier recently announced plans for a similar spinoff of its Jazz operation and is likely to do an IPO of its highly successful maintenance, repair and overhaul unit, Air Canada Technical Services. ACTS, as it's known, already gets some 30% of its revenue from outsourcing agreements with carriers including JetBlue, Lufthansa and Delta.

That total is expected to jump as a result of a C$95 million investment Air Canada plans to make for 7% of the carrier that will be formed by the expected merger of US Airways and American West. In return, ACTS will likely receive C$1.5 billion in maintenance and overhaul work from the new carrier over the next five years -- if its bids are competitive, as is likely.

According to Raymond James' Cherniavsky, the enterprise values (actual or implied stock-market value plus net debt) of Aeroplan, ACTS and Jazz account for around half of ACE's current enterprise value of C$10.5 billion. But he thinks the mainline airline's enterprise value should be C$6.7 billion rather than the current implied total of C$5.2 billion. To reach that level, Ace Holdings shares would have to hit C$51.

Of course, lots can go wrong -- and has -- in the airline business. Jet-fuel prices could keep rising, or a major terrorist incident could cripple passenger demand. Thus, Ace Holdings shares probably are more suitable for speculation than investment. But betting men -- and women -- should be amply rewarded.