Canadian carriers Air Canada and WestJet blew their profits out of the water during the third quarter 2010 with 70% and 80% increases from 3Q2009. Even as they are celebrating their recovery, however, they are looking ahead at growing yield pressure in the face of rising capacity in the international arena alerting investors to what may be a growing problem in coming years.
The question is, will the capacity discipline shown by US and Canadian carriers, spill over into the international market. Delta, for instance, is using the savings resulting from the Northwest merger to expand internationally and it is more than likely United will do the same. While the discipline in the domestic arena is warranted given the low 2% GDP growth, the same cannot be said for the red-hot markets in Asia and the Middle East or even Africa where most carriers, except American, have set their sights.
WestJet’s 72% increase in net earnings in the third quarter was well and truly bested by Air Canada which posted an 82% increase in EBITDAR, growing CAD261 million to CAD581 million.
Yield dilution will likely impact Air Canada more than WestJet but the low-cost carrier will not escape given the increasing focus on the trans-border market, the only market that did not experience an increase in yields. The Pacific market has shown astonishing strengthening from last year’s trough but the increase in capacity there will likely dilute yields for the codeshare deal WestJet has with Cathay Pacific as well as Air Canada.
In the meantime, Air Canada CEO Calin Rovenescu fairly crowed about the fact that one third of its passenger revenue increase was driven by traffic and yield gains in the Pacific. He reported that system unit revenues increased 4.7% compared with the unit revenue performance in the Pacific which rose 24% in the third quarter, outperforming all other markets and delivering a 17.5% yield increase and a 4.8% load factor increase.
The two carriers will continue to benefit from growing traffic with both reporting sequential monthly improvements in yield. They will also benefit from Canada’s more friendly attitude toward transit passengers since it does not require a visa to sit in a sterile transit lounge as does the US. In addition, Canadian airports are now noticing the success Air Canada has had in luring passengers to connect over Canada. Traffic going to and from the US and Canada and Europe, Africa and Tel Aviv grew 12%, according to Air Canada. Airports are now streamlining processes and lowering costs to increase their competitiveness over US hubs.
“We believe that sixth freedom as well as originating traffic represents great potential for growth and Canadian airports are working to make Toronto, Vancouver and Montreal North American gateways,” said Rovinescu. “Toronto is not only lowering costs but streamlining processes that led us to add new flying between Toronto and a number of US cities. The number of US originating passengers more than doubled in the past year.”
Both carriers are focusing on revenue maximisation with Air Canada looking successfully to the premium cabin. It posted premium cabin revenue growth of $107 million, or almost 26% in the third quarter of 2010, driven by a 14% increase in traffic and a 10% improvement in yield compared to the previous year's quarter.
Success is just now kicking in for WestJet’s everyday low-fare programme. After a slow start as passengers waited for sales that didn’t happen, the reception is increasing. The new fare structure was designed to address the fact that the carrier’s fares were on sale for the vast majority of last year.
Despite concerns about oceanic yield dilution, Canadian carriers are likely to continue riding the wave experienced by their US counterparts as the economy recovers. Air Canada is maintaining its capacity discipline with no new aircraft deliveries until the 787 in the back half of 2013. Instead, it is relying on increasing utilisation with some impressive results.
The airline has experienced a 14% increase in traffic and a 10% improvement in yield just by increasing its utilisation by 8.2% to an average of 10.5 hours, according to CFO Mike Rousseau. Rovinescu described it a better way.
“Our focus on continuous improvements resulted in the addition of 3700 more flights, 12,630 more hours and 400,000 more passengers,” he said, “all with the same fleet we had last year. Our focus on maximising revenues resulted in premium revenues accounting for one third of the total increase in system passenger revenues and is evidence our initiatives are working.”
WestJet continues to increase capacity, especially in the trans-border and international markets but that capacity continues to pay off with higher RASM and yield. It has a single delivery in the fourth quarter and six additional aircraft are scheduled for next year. It also benefits from less trans-border seasonality positioning its schedule to respond to snowbirds in the winter and heat-stroke affected southerners who want to vacation in Canada in the summer. In addition, its new relationships with Cathay Pacific and American Airlines are designed not only to boost business traffic but smooth out whatever seasonality it does have.
Meanwhile, the two carriers are facing competition from Porter, which had a 41.7% increase in passenger traffic in October, in the trans-border and domestic markets where it is using the Q-400 and Billy Bishop Toronto City Airport to poach traffic from Pearson. Continental is also likely to come into that market. Interestingly, Air Canada finally gets back into the market that Porter built in February when its own Q400 service is launched there with new entrant Sky Regional Airlines, a subsidiary of Skyservice Business Aviation, under a capacity purchase agreement covering five aircraft.
After a lot of hemming and hawing, Air Canada acknowledged that Sky Regional was chosen over Jazz because of its lower costs. For its part, Jazz is diversifying with its new Thomas Cook charter contract with two 757 aircraft.
Unlike WestJet, Air Canada benefits from huge international feed. However, given its deal with American and Cathay, it is heading in the right direction and it will be only a matter of time before its US peers begin to see international as the next phase in their continuing evolution.
While Air Canada has spent the past 18 months restructuring itself into a 21st century legacy carrier, WestJet has reined in its growth, tempering it, while not altogether stopping it. Still it is growing where it counts – internationally – and, as with Air Canada keeping a wary eye on the domestic market.
Both will be converting to the International Financial Reporting Standards and expect it to take a hit in the conversion with higher costs although detailed guidance is not expected until later in the fourth quarter. However, both agreed that the conversion will not affect the underlying fundamentals of the business which are growing stronger every quarter.
Despite the IFRS headwinds and the threat to international yields, US and Canadian carriers can take comfort in the fact that passengers are back, especially the high-yield premium passenger they have been courting so hard.
Clearly, the Air Canada’s hard work over the past 18 months has not only paid off but delivered dividends. Rovinescu described it best when he said the company was “firing on all cylinders” in the quarter. Indeed, on the increasing international capacity, he said one of the reasons Air Canada was early out of the box in increasing oceanic capacity was because “we wanted to operate on all cylinders” as quickly as possible.
It is set to get a boost once the trans-Atlantic revenue sharing kicks in through its Star Alliance partnerships with United and Lufthansa, especially since it is retroactive to 1-Jan-2010. The JV is scheduled for completion in the fourth quarter.
Air Canada reported operating income of CAD327 million in 3Q2010 compared with operating income of CAD68 million in the third quarter of 2009, an improvement of CAD259 million or 381%.
As it heads into its historically weak quarters, with oil prices on the rise, it is relying on the continuing success of its Cost Transformation Program. “It is more than cost reduction,” said Rovinescu. “It is streamlining processes and ensuring continuous improvement is leveraged across all branches. It is finding new revenue sources and eliminating waste and the road blocks to our cost competitiveness.”
It is clearly working. Unit costs ex-fuel declined 5.3% in line with guidance during the third quarter. All in all, a pretty impressive performance for a carrier than many said was out for the count two years ago. It is however, facing increased costs although it seems to have found offsets. For instance, Jazz capacity purchase costs have risen CAD1 million but the combination of its amended rate, the stronger Canadian dollar and reduced flying will offset that. Commission expenses also rose CAD21 million or 41% in the third quarter but was more than offset by the increase in incremental passenger revenues, according to Rousseau.
It expects CASM ex fuel to decline 2.5-3.5% in the fourth quarter and by 4-4.5% for the full year. It has made solid progress on its Cost Transformation Plan achieving CAD300 million of the 2010 target and CAD350 million of the CAD530 million target expected at the end of 2011. These have been achieved by contract improvements, process and productivity improvements and revenue maximisation.
Rousseau added that passenger revenues jumped CAD322 million or 13% on the improving economy and the business travel recovery. Traffic, he said, grew 9.7% while yield grew 3.2% while the revenues from the premium cabin jumped CAD107 million or 26%.
It will be tweaking the fleet even further in the fourth quarter as it doubles its capacity between Toronto and China as it offers daily, year-round flights to Shanghai, Beijing and Hong Kong. It is also upping its service to Tokyo, doubling the Vancouver offerings with new service to Haneda, which, said Rovinescu will complement its service to Narita.
Operating expenses increased CAD97 million or 4% from the third quarter of 2009, mainly due to the capacity growth of 8.2%, higher base fuel prices, as well as increases in pension and commission expenses. Partially offsetting these increases was the impact of a stronger Canadian dollar on foreign currencies compared with the third quarter of 2009, which reduced operating expenses by approximately CAD70 million from the same period in 2009, as well as a reduction in aircraft maintenance expense year-over-year. Cost Transformation Programme (CTP) initiatives also reduced various operating expense categories, including wages and salaries, capacity purchase fees paid to Jazz, food, beverage and supplies, airport user fees, information technology, terminal handling and "other" operating expenses.
Unit cost decreased 4.1% compared with the third quarter of 2009. Excluding fuel expense, CASM decreased 5.3% year-over-year. The airline cited a stronger Canadian dollar on US dollar operating expenses, capacity growth, longer stage lengths, increased utilisation and its CTP initiatives for its performance.
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