Air Canada bailout buys time - but Canada Inc sells out to forces of protectionism

Last week, the formerly government-owned Air Canada announced it had managed to pull back from the brink, securing just over CAD1 billion in loans, probably enough to secure its future for the next few months.

Calin Rovinescu, Air Canada's President and CEO, was justly proud of his achievement, rightly observing that, "by any measure, raising CAD1 billion in new liquidity is a tremendous achievement, particularly in view of current credit markets and the state of the airline industry." There is no doubt that Mr Rovinescu (recently appointed and anointed by ACE head, Robert Milton) has remarkably achieved a hard won battle and apparently prevented Air Canada from bankruptcy, at least for this year.

A bailout by any other name….

But almost every dollar of the loans comes from the Canadian government and from the company's owner, ACE and associate company, Aeroplan. Despite its prominent billing in the story, GE Canada Finance Holding Company is a minor player. And then there are various amounts from sale and leaseback and aggregating an array of biscuit-tin savings which help to achieve the magic headline figure of CAD1 billion. The basic loan is for CAD600 million - nearly half of it from the Canadian government.

Yet how much damage does this faintly-disguised bailout do to the credibility of the airline industry? At best it is the preservation of a famous old national brand, securing the short term income of shareholders and a large private equity group, avoiding a difficult political decision by a government which wilted under pressure and which, by the way, temporarily saved some jobs.

At worst, it protects - against more efficient airlines which have to survive on their own merits - an inefficient airline which is hidebound by its unions, and a recent history of management judgments which were either simply bad or did not show the guts to make long overdue surgery. And, perhaps worst of all, the debt burden on the carrier now suggests that its long term future will be by no means secure, unless there is a remarkable uptick in the economy.

And, if the Canadian government is going to lend hundreds of millions of taxpayer dollars to underwrite Air Canada's attempts to avoid slipping once again into bankruptcy, there follows a powerful logic to protecting that investment. Logic - but that does not make it good policy.

With market-destructive results

Even more damning from a global view, the sequential policy flightpath is now plotted and will return Canada to the arcane protectionism of the 1960s. This involves preventing entry by foreign airlines. It commits to preferring the interests of Air Canada, a publicly-subsidised private airline (that used to be government-owned) over the interests of the tourism industry; and it deprives efficient, private competitors of gaining the advantage that was their due in a supposedly free marketplace.

Ominously too, it means that the unions and the private equity owners of ACE sense that the government, whatever it may have said in the recent tough negotiations, will probably continue to bail the carrier out if the going gets tough.

Ottawa has irrevocably embarked on this course and turning back now would mean facing up to the careless dumping of over a quarter of a billion dollars of taxpayers' money (add to that the long term cost to the tourism industry and individual consumers and taxpayers).

This is hardly the formula to encourage moderation by the airline's unions, even if they do receive, at least between the five main ones, around 15% of the equity in the carrier in return for their forebearance on the pension delays.

A Greek drama - the infernal triangle

It would have been fascinating to be a fly on the wall as this drama played out - the infernal triangle of: private equity group (ACE), which still owns 75% of the airline; the aggressive unions, which held the balance of power when Air Canada needed to escape its legislated pension obligations; and a government which was understandably unwilling to allow a large and iconic airline to collapse, leaving several thousand - direct and indirect - unemployed.

(1) The union deal. The first arm wrestle was between Air Canada and its powerful unions, when Air Canada sought to delay payment of its pension obligations. Having to pay would almost certainly have tipped the carrier into bankruptcy. A couple of the unions pushed it to the wire, requiring intervention by the government and appointment of a trusted mediator.

(2) The government deal. Whatever persuaded the unions to accept the deal - knowing anyway that the implications of their intransigence would be a bankruptcy protection filing - was undoubtedly enough to have created some feelings of indebtedness all round. The unions would have realised that their acceptance alone was not enough to keep Air Canada out of bankruptcy protection, so the next stage of negotiations would have been set in train.

(3) The ACE/Aeroplan deal. So, when it came to improving the company's financial stability, and there was nowhere else to go, the price of Canadian government support would at least have been that ACE and Aeroplan must dip substantially into their pockets too. ACE after all is 75% owner of the airline and Aeroplan still relies on it for part of its considerable income in its loyalty programme.

In this transaction both the unions and the government must surely have insisted that ACE put a large piece of its skin in the game if there were to be a deal. ACE had actually applied to be wound up as recently as Dec-2008, as Milton believed it had run its useful course. There was substantial shareholder opposition to the liquidation, which had been delayed, but ACE's involvement in the five year loan means now that the winding up cannot occur for the foreseeable future.

With all the history behind Air Canada, ACE and the unions, this complex agreement must have been enormously carefully sculpted, with extreme time pressures, the unions to mollify and in the middle of a deep recession. But rarely are there no untied ends in such a complex and compressed deal. Keeping it together will also be an achievement, as time passes.

The lenders

The base credit agreement covers CAD600 million of loans, with the possibility of another CAD100 million which may be drawn down in the next 12 months. This debt doesn't come cheaply - a minimum of 12.75% interest - and, together with some other transactions, means that Air Canada has now hocked everything in the store.

EDC: An "innovative commercial solution"?

Perhaps most ironically, the biggest part of the loan comes from Export Development Canada (EDC). EDC is Canada's export credit agency, "offering innovative commercial solutions to help Canadian exporters and investors expand their international business." Yes, the wording was indeed "innovative commercial solutions". Recreating history can be an expensive - and apparently even innovative - process. EDC stumped up CAD150 million.

Canada Account: a high risk investment

The Canadian government, through its "Canada Account", is to lend another CAD100 million. According to the EDC's announcement, the Canada Account is used when a transaction "falls outside the scope of EDC's Corporate Account, usually due to a combination of risks, including the size of the transaction, market risks, country capacity, borrower risks or the financing conditions, but nevertheless is determined by the federal government to be in Canada's national interest."

The words risk and national interest shine brightly in that sentence.

EDC's CEO Eric Siegel, was quoted as saying his agency's loan was on "commercial terms". If the loans are "on commercial terms" why is the government the only lender prepared to make them? The answer: the risk is clearly too high for the market. And, as an objective and practical judgment, what does that say for Air Canada's chances of survival beyond the short term?

Aeroplan and ACE

Aeroplan will lend CAD150 million and ACE another CAD150 million. Both of them can afford it. They have done pretty well out of Air Canada. Unlike its former, near-bankrupt airline parent, Aeroplan still has a market capitalisation of around CAD2 billion. This, and Jazz Air and Air Canada's MRO activity - now Aveos - which Mr Milton also successfully floated out of Air Canada, has been a sore point for the unions, most of which accuse him of asset stripping and enriching himself. (Whether or not the former is true - and he is certainly rich by most standards - Air Canada would probably have been in deep trouble anyway, never having recovered from an injudicious purchase of the failed Canadian Airlines, along with its debt mountain and merger complexity, just before SARS struck.)

Air Canada -B share price graph: Dec-2006 to Aug-2009 (CAD)

Source: Centre for Asia Pacific Aviation & Toronto Stock exchange

Raiding the biscuit tin

To please the analysts it was helpful to arrive at a headline figure that just crossed the line at a billion dollars (Canadian). This meant cobbling together a few other pieces to get the figure up. There is an amount of CAD220 million from an unnamed supplier - which, given the size of the amount would have to be an airframe manufacturer; but the nature of this, whether loan, deferral or whatever is not specified.

GE Aviation Capital has concluded a sale and leaseback of three B777s for a capital amount of CAD122 million (as the aircraft are worth some three times that amount, presumably the balance is already hocked, whether in the form of debt or attachment).

There is also an agreement to delay repayment of a CAD82 million secured loan - which may count as a contribution for accounting purposes, but still leaves a considerable level of indebtedness in place. And, finally, Boeing has agreed to "amend certain commercial terms", such as financial adjustments and deferred delivery dates. Boeing has also agreed to shift 10 of Air Canada's 23 B787 options to purchase orders, which do not carry the same financial commitments.

Mortgaging the present - and the future

For Air Canada, there won't be much left in the kitty after this arrangement.

According to the carrier's statement, its "obligations under the Credit Agreement are secured by a security interest and hypothec over substantially all of the present and after-acquired property of Air Canada and its subsidiaries."

A burden to bear - 12%+ interest

The lowest interest rate payable on the main loans is "at least" 12.75%. If that is the lowest rate, then the Canada Account's loan, with its apparently much higher risk, could be significantly higher; at least it should be, to protect the taxpayers' interests. As could ACE and Aeroplan's. In rough terms at least this means that Air Canada, stripped of any un-mortgaged assets, will be paying probably CAD100 million a year in interest payments alone on just this debt - before capital repayments and payments on its other debt. For this loan, CAD30million in capital is payable each anniversary beginning in August 2010. The repayments are backended, with CAD120 million payable in 5 years.

Then there are all the new sale and leaseback and related expenses. The leasebacks won't come cheaply either……

The carrier will clearly need every cent it can get on its balance sheet; Air Canada lost over a billion dollars in the six months to 31-Mar-2009.

Air Canada net profit/loss: 1Q07 to 1Q09 (CAD)

Source: Centre for Asia Pacific Aviation & Air Canada

It is even losing big money simply flying aircraft. It had an operating loss of almost CAD200 million in the first quarter of 2009 alone.

Air Canada operating profit/loss: 4Q06 to 1Q09 (CAD)

Source: Centre for Asia Pacific Aviation & Air Canada

Apart from two solid third quarter results, in 2007 and 2008, Air Canada has been bumping along the bottom for some time.

And even the successful WestJet last week reported a steep drop in profits for the Jun-2009 quarter, citing continued weak economic conditions. The bad news for all North American airlines this year is that there is little hope of the third quarter providing the comfort of previous years either. Summer bookings have been slim and yields still weak, by all accounts.

So, when all is said and done, what is left. Is this a healthy airline which will generate long term benefits for the nation, whose taxes are once again being used to prop it up? Or is it simply a stopgap to satisfy political and union pressures? Today you would get pretty long odds against Air Canada still flying in three years' time.

Aeroplan: the heart of the matter for ACE

Aeroplan, has committed to advance CAD150 million to the airline, but this is conditional on certain conditions being satisfied, including the "repayment in full and termination of the revolving loan and security agreement entered into by Aeroplan and Air Canada on June 29, 2009."

The Aeroplan loyalty plan evolved out of a hived-off Air Canada Frequent Flyer Programme and is seen as a model for how to profit from using an airline to generate separate value in a separate awards programme. "Groupe Aeroplan" today owns not only Aeroplan, "Canada's premier loyalty program", but since splitting from Air Canada, has acquired and/or developed "Nectar, the United Kingdom's leading coalition loyalty program". But there's more.

ACE and Aeroplan mixed feelings about the Middle East?

The most poignant item of its ownership however is that Groupe Aeroplan now owns 60% of Rewards Management Middle East, the operator of Air Miles programmes in the UAE, Qatar and Bahrain.

Why poignant? Because, while ACE's Chairman, President and CEO, and mastermind of the whole structure, Robert Milton, publicly opposes the entry of the Gulf airlines into Canada (to protect Air Canada), ACE is progressively helping Aeroplan evolve away from its reliance on the flag carrier.

For, although the airline aspect of the loyalty programme has now been heavily reduced, Aeroplan still relies on Air Canada as the cornerstone of the highly valuable loyalty programme. And that is a high risk position for Aeroplan to be in.

As the company's most recent annual report noted, "in 2008, Groupe Aeroplan purchased approximately $490 million in rewards tickets". But Aeroplan has been moving quickly to reduce its reliance on Air Canada since it suffered the shock of Air Canada's descent into bankruptcy in 2003/04. Relying on Air Canada alone was clearly an unacceptably high risk position for the independent loyalty programme.

This risk had to be downsized. In 2008 alone, Aeroplan "reduced exposure to Air Canada with gross billings representing 17% in 2008 (down) from 25% in 2007", according to Aeroplan.

One good indicator of how ACE and Aeroplan view Air Canada's future will perhaps be whether Aeroplan continues to reduce its reliance on the flag carrier.

International policy?

There have been few voices raised against the bailout of Canada's flag carrier. But some sectors are highly concerned at its implications: airports and the tourism industry in particular.

In order to use CAD100 million of taxpayer funds to prop up Air Canada from the Canada Fund, the government must first judge the action to be "in the national interest". At this time, almost any action to maintain jobs, at least where unions are involved, arguably falls into that category. But, where however job creation will be stifled - in the tourism industry for example - that same national interest should arguably also apply.

The Canadian government is now once again investing in a flag carrier (the only way a high risk loan using taxpayer money can be interpreted) and sending a message to the world that the old days of protectionism are back. It has specifically sent that message to the airlines of the Gulf states, which are anxious to increase service into Canada, but are being rejected.

The sole purpose of that rejection is to protect Air Canada and its Star Alliance partners. Mr Milton has said that new airlines should be allowed in only if their capacity is limited to the end-to-end traffic they carry - and he apparently has the agreement of Ottawa, even though that the same logic does not apply to other hub airlines.

Once that stance is taken, how can other relationships be transparently seen to remain "liberal"? Either the government takes the same position in other cases, or it discriminates. Neither approach can be satisfactory.

WestJet has not had a lot to say about the bailout. This is perhaps understandable. There is little point in providing a target for all those who have vested interests in the continuation of Air Canada. And, anyway, WestJet itself has just concluded a deal with the SkyTeam group to cooperate on international operations. So it too has a strong interest in keeping unwelcome competitors out of the Canadian long haul market.

Where to now with government intervention...

After all the dust settles - for the time being, at least, there are many fundamentals that airlines and governments must confront. If this downturn continues to rip the insides out of the legacy airlines, something different has to emerge.

One approach - actively endorsed by IATA, the airlines' global association - is to get governments out of the way and allow and industry (which has never in history returned its cost of capital) to restructure and become more rational. That means removing national ownership restrictions and ending protection of flag carriers.

Yet, if Canada, supposedly one of the more liberal aviation countries in the world, is prepared to turn the clock back 40 years in this way, what chance is there of real change?

This suggests that we may even face an about turn in aviation regulation, where governments come to a conclusion that the socio-economic benefits of the airline "industry" are so great that intervention is essential. If the survival of sufficient numbers of major airlines is threatened, anything is evidently possible.

There is not a major international legacy airline today that has not achieved its position as a result of massive protectionism and/or government ownership over the years. Canada is now seeking to retain the high moral ground by excluding sovereign wealth-supported airlines, yet provides the same support to its own carrier, merely reverting to type.

If others follow suit, there will be ructions. Whatever the case, Canada Inc is not showing the sort of leadership that most others are looking for. And the saddest part of all is that the bailout is unlikely to succeed for the long term.