Canadian Airlines finally made a profit last year. A tiny net result of only C$5.4 million ($3.5 million)may have looked like a molehill amid the Rocky Mountains that crowd Alberta's western sky. Yet that molehill deserves notice for two reasons. It was the Calgary-based carrier's first profit in nine years. And, more importantly, it was on target with the carrier's four year recovery plan.
But before anyone declares the dawn of Canadian's golden age, they would do well to look at whether the premises of that plan remain sound, and whether last year's profit accurately portrays the company's current condition. There are reasons to be wary about both.
There have been false dawns before over the last decade as restructuring plans followed one after another - a phenomenon noted as far back as ancient Rome by Petronius Arbiter, when he complained that "we tend to meet each new situation by reorganising". The most recent restructuring came late in 1996, when the carrier feared it would not survive winter, typically a white-knuckle time for airlines in Canada. Seeking relief from creditors, the airline group entered the country's largest voluntary restructuring. This is now the start of year three under that plan.
The key elements have been strict cost controls and an overhaul of the route network. In particular, Canadian has attempted to dovetail its services with those of alliance partners British Airways and American Airlines, whose parent AMR group stepped in to take a 25% in the carrier as part of the rescue. Thus Canadian has left the Atlantic to its partners, except for services to London and Rome, while building on its own strengths on the high-yield Pacific and growing its Vancouver hub into a North American gateway to Asia.
The formula appears to have paid off with last year's modest profit. Although the result represents a net margin of under 0.2% on sales of C$3 billion, it seemed that the years of heavy losses were finally over. But even this profit does not show how much Canadian is still deferring in debt repayments.
When things were at their bleakest three years ago, Bob Crandall, then AMR chairman, remained bullish on his Canadian investment. Back then, Crandall predicted that the airline's heavy debts would "drop right off a cliff" by 1997. But he was too optimistic on two counts.
First, he only looked at debt. Had he also included long-term lease obligations, his so-called "cliff" would have come even later. Crandall's bigger mistake, however, was to assume Canadian would retire debt as it matured. Instead, it is pushing an ever-growing bow wave of debt ahead of it. When times are tight, debt retirement takes a back seat to the continuing preoccupation with liquidity. During 1995-6 Canadian raised cash by selling aircraft and leasing them back. A year later when it ran out of assets to sell, it declared a payment holiday.
Long term debtDuring that bleak 1996-7 winter the company deferred nearly two thirds of the C$270 million in payments due to lessors and lenders. With this "cash bridge" Canadian survived the winter. But now, as part of its recovery plan, it has to make up those deficits with interest. The company started doing that in October and plans to continue until the end of 2000.
Last year's profit did not improve the balance sheet. The company made little dent in its long-term debt and lease obligations which stood at C$826 million. By July they were up above $850 million or twice what Crandall had hoped.
Canadian has tapped the capital markets twice this year. It raised a total of some C$380 million in two bond issues, and used at least a third of that to retire existing debt. The refinancing was costly. The first offering, secured against assets, was pegged at 10% interest. The second, unsecured offering, was fixed at 12.5% and the uptake was some C$35 million less than planned.
Toronto's investment bankers wondered earlier this year if Canadian might try to parlay its profit into a share issue. But with the company's current share price, even treasurer David Bell had to admit that that a share offer made "no sense".
Borrowing to repay debt shows how much the company is still preoccupied with liquidity. UScredit rating agency Standard & Poor's warns that servicing these "very high debt levels" remains "susceptible to any adverse event or deterioration in operating performance". In other words, Canadian stays stable only if nothing goes wrong.
Unfortunately weak demand is threatening that stability. "I think they are running behind plan this year," warns Jacques Kavafian, analyst at HSBC Securities in Toronto. "The Canadian economy is weak. A price war is going on in western Canada. The market is soft everywhere they operate except to the UK." Kavafian sees cash flow as Canadian's key challenge. "If they could get a 2-3% net margin on their revenue, debt would not be an issue," he says.
Ted Larkin at Toronto's Gordon Capital agrees. "They're still in a cash collection mode. They've really screwed costs down, but the challenge for them is filling aircraft," he says, raising fears that Canadian will not come anywhere near its projected C$90 million profit this year. "The latest guidance they're giving us is to expect something more around the break-even level," he says. Canadian's own chief executive Kevin Benson has more or less confirmed this outlook.
Revamping the fleet may have helped to raise revenues, but caught between the needs of liquidity and debt retirement, Benson has had little room for manoeuvre. Canadian has deferred delivery of 10 new Airbus A320s that were due to start arriving last year. Now the first two are expected in 1999 at the earliest with the rest even later. A Boeing 767 is due in December with a second in the spring, along with one of the A320s. All three aircraft will be on operating lease. Except for these additions, Canadian lumbers on with a fleet that now has an average age of 15 years.
The only noticeable fleet change this year has been the addition of more Fokker F28s. They fly at off-peak hours under a regional banner on domestic triangles in the east (Montreal- Ottawa-Toronto) and west (Vancouver-Edmonton-Calgary). This down-gauging freed up Boeing 737-200s for more cross-border services to the USA.
Lagging on US routesCanadian's delay in building US routes has left it far back in Air Canada's wake. Both carriers codeshare all over the US with their respective partners, American and United Airlines. But Air Canada exploited the open skies bilateral early launching one-third more US routes in its own right than Canadian, with an even wider margin on frequencies. Air Canada's Toronto hub gives it some geographic advantage. But, unlike Canadian, which has built US routes primarily to American's hubs to feed its Vancouver gateway, Air Canada has developed point-to-point services from Toronto to business centres across the USA.
As a result Air Canada now carries about 45% of all Canada-US passengers while its rival's share is a mere 15%. And that gap is likely to grow. Canadian's fleet plans are about as certain as picking next year's hockey champions, while Air Canada, which already has one of the world's youngest fleets, has committed to a three-year spend of almost $1.4 billion on new aircraft.
This lag in US service hampers Canadian in several ways. Transborder routes attract a higher share of business travellers. That means better yield and more opportunity to build loyalty to support other parts of the network. US routes are also less seasonal, a big benefit during Canada's winters.
Transborder US routes have gained still more importance over the past year as a hedge against foreign exchange losses. Canada's dollar has plunged to record lows, down 11% against its US equivalent. With fuel, lease payments and most debts due in US dollars, the weak Canadian currency has been painful, with few US earnings to offset the inflation.
Canadian is caught in other catch-22 dilemmas. If it ever makes a respectable profit, it will attract the kind of pressure Air Canada faced this summer. For several years Canadian's employees have accepted wage and productivity concessions. They were especially bitter over the last roll-backs, feeling they had already sacrificed enough. But they sacrificed again to avoid being out of work.
Air Canada's profit last year drew fire from its pilots who argued they had taken pay and conditions cuts in the early 1990s to help their carrier through a crisis and should now share in its profits. Air Canada's earlier troubles were not as severe and its employees were never asked to concede as much as Canadian's. Yet, Air Canada's pilots went on strike for 13 days, grounding the airline during Canada's busiest travel season. Under the final settlement, Air Canada's annual pilot payroll increased by only about C$10 million, but the strike itself had a net cost of some C$290 million. And now it must deal with its other unions. A profitable Canadian could expect similar scenarios.
The biggest clouds on Canadian's horizon loom over the Pacific, however. By concentrating overseas flights on Asia, Canadian has capitalised on its strength, its geography and the alliance with American. But the timing could hardly have been worse. Just as it cut routes to Europe and increased its Vancouver gateway, Asian economies began to crash.
Canadian has taken its biggest hit in Japan. Two years ago it was adding flights to exploit exclusive rights it enjoys under Canada's single designation policy to Tokyo. Now it is cutting Tokyo frequencies and shifting to smaller aircraft. In the past year Japanese traffic has dropped by 7.8%. Given that historically Canadian has relied on Nagoya and Tokyo routes for 10% of its revenue, the effects could be devastating. Traffic to Kuala Lumpur, Bangkok and Manila, has also been unremarkable.
Chinese fortunesOnly the Chinese have saved the Asian strategy. Ethnic Chinese travel, aided by Canada's liberal admission of Hong Kong residents, has kept aircraft full on routes to China and Taiwan. Canadian's Hong Kong traffic, carried on double daily flights, was up by one-third in July over the previous year. With nine weekly flights, Canadian's Taiwan traffic grew by more. Daily Beijing flights were so popular that Canadian had hoped to open a second China gateway in Shanghai this year, but slot constraints have delayed a launch until at least the first half of 1999.
Thanks to the "three Chinas", Canadian's overall Asian traffic has risen 14.7% in the last year. "We continue to see growth in Asia despite declines in Japan," says chief financial officer Doug Carty, breathing a sigh of relief.
Technically, Canadian should also benefit from the closer ties with its BA and American partners following the official launch of the oneworld branding together with Qantas and Cathay Pacific. Yet the alliance could also unsettle the Canadian carrier's strategy of feeding UStranspacific traffic into its Vancouver gateway. To date, it has made sense for American to channel passengers north into Canadian's stronger Asian network, but now oneworld offers other options via Cathay. If Japan Airlines also joins oneworld, as many predict, it could divert even more transpacific traffic. American also gained daily Tokyo flights of its own this year under the new US-Japanese bilateral.
Larkin at Global Capital wonders if American will eventually scale Vancouver back to a secondary transpacific gateway. In short, only a year after rejigging routes to focus more on Asia, the market dynamics are changing.
This could prove a double blow if Canadian's short-term growth in Asia continues. Under Ottawa's single designation policy, Canadian loses its exclusive routes to any country when its annual passengers on scheduled flights exceed 300,000. Air Canada began to undermine Canadian's Asian monopoly four years ago when it gained routes under this policy to Hong Kong and Osaka. It claims Canadian's Taiwan traffic has now passed the magic number, entitling Air Canada to serve Taipei.
Ottawa may protect Canadian by limiting its rival's frequencies, as Air Canada complains it is already doing in Hong Kong. If it doesn't, Canadian could lose the benefit of a monopoly in its fastest growing Asian markets. Success produces its own catch-22s. Short-term success could be even worse if it allowed Air Canada to spoil Canadian's party in Taiwan just as American began switching Asian traffic to its own flights or other oneworld partners.
Canada's route policy obviously cut both ways. But the only Asian country where Air Canada enjoys a monopoly is South Korea and Seoul is not currently a growing market. Hence, under Canada's designation policy, Canadian's focus on Asia gives it more to lose. If Ottawa abandons this policy in favour of multiple designation everywhere, as Air Canada insists it should, then Canadian would only lose sooner rather than later.
Any recovery that takes four years is tricky. In the third year of its plan Canadian is falling behind, and the longer it takes to catch up the more conditions will change. Larkin sums up Canadian's predicament with a sigh and the observation: "It's a tough go."
Source: Airline Business
