WestJet Airlines faces capacity pressure as it still continues to record solid financial results


Canada's WestJet is preparing to face some pressure from competitive capacity increases in CY2015 as rival Air Canada ratchets up its supply through the expansion of its low cost unit rouge and aircraft upgauging.

At the same time WestJet is facing cost pressure in CY2015 as the shorter stage lengths performed by its regional subsidiary Encore become more pronounced in the airline's results. Even as Encore continues to create some cost headwinds for WestJet, the company believes its regional airline continues to stimulate demand in markets too thin for narrowbody aircraft.

Despite some external and internal pressures, WestJet's fundamentals remain strong. The company holds strong cash balances and favourable debt ratios while continuing to deliver shareholder returns.

  • WestJet is facing competitive pressure from Air Canada's capacity increases through the expansion of its low-cost unit rouge and aircraft upgauging.
  • WestJet's regional subsidiary Encore is creating cost headwinds due to shorter stage lengths, but it continues to stimulate demand in thin markets.
  • WestJet plans to slightly slow its capacity growth in 2015, while Air Canada plans to expand its capacity increases.
  • WestJet expects an acceleration of industry capacity in Canada, particularly in sun markets for the winter period.
  • WestJet has regained yield strength in the second half of 2014, but industry capacity and discounting could create yield headwinds in 2015.
  • Despite industry challenges, WestJet retains solid profitability and strong financial ratios.

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WestJet envisions an acceleration of industry capacity in Canada

WestJet during CY2015 plans to slightly slow its capacity growth to 4% to 5% compared with a 6.5% increase in CY2014. For CY2015 the airline estimates that Encore will represent roughly half of WestJet's system wide growth as the company takes delivery of nine Bombardier Q400 turboprops in CY2015.

WestJet capacity and unit costs projections: 4Q2014, YE2014 and YE2015

WestJet's rival Air Canada plans to expand its capacity increases year-on-year in CY2015 to 9% to 10% growth versus a rise of 7% to 8% in CY2015.

See related report: Air Canada's declining yields could continue as it prepares for a capacity push in CY2015

Presently WestJet estimates that it will increase domestic supply in CY2015 of 4% to 5%, and Air Canada projects a similar rise in its domestic capacity. Both airlines have steadily increased domestic supply throughout CY2014 as Air Canada estimates 4% to 5% growth year-on-year and WestJet projects a 5% to 5.5% rise in domestic ASM growth.

Previously, both airlines have indicated that the market was absorbing the available supply, and that pricing traction remained solid.

See related report: Canadian airlines remain bullish that their domestic capacity growth is keeping pace with demand

But WestJet CEO Gregg Saretsky in a recent earnings discussion with analysts and investors remarked that "the industry capacity is looking like its going to start accelerating" even as its own capacity starts to moderate.

WestJet also forecasts some added capacity in sun markets for the winter period

Publicly, WestJet does not appear to show any concern about growing industry capacity, that also includes continued expansion of rouge into sun markets for the winter 2014/2015 season. In addition, independent charter carrier CanJet is also planning to add service into those markets during the same time period.

Mr Saretsky maintained his commitment that WestJet remains focussed on its goal of delivering a 12% return on invested capital, and "all of the capacity adjustments that we are planning for next year have that in mind".

However, WestJet's chief executive did acknowledge that even as the airline has favourable forward bookings for its sun destinations, "I think, however, it will be a tough winter". He observed that CanJet has "been late to the market, and so we are seeing some downward pricing pressure". Although WestJet has its own vacations business, Mr Saretsky stated the airline is not exclusively dependent on package travel. "We are to some degree, insulated from some of that downward pressure that will apply to those who are only selling vacation packages".

WestJet continues to regain yield strength in 2H2014

Even with ample increases in Canadian domestic supply throughout CY2014, WestJet in 3Q2014 grew its yields 2.3%, which helped to drive unit revenue growth of 2.6%. For the first nine months of 2014 WestJet's yields increased also grew 2.6% and unit revenues increased 2.4%.

WestJet yield, unit revenue and unit cost performance: 3Q2014 vs 3Q2013 and 9M2014 vs 9M2013

It is a turnaround from late 2013 and 1Q2014 when WestJet faced some pressure on its yields driven by the introduction of Encore and pricing pressure in some of its markets.

See related report: WestJet will increase capacity after recording a rebound in yields during 2Q2014

For 4Q2014 WestJet estimates that yields will remain flat or increase slightly; however, as fuel prices remain low WestJet expects to continue to grow margins, which on an operating basis increased 1.8ppt year-on-year in 3Q2014 to 12.5%. WestJet's larger rival Air Canada recorded a 13.8% operating margin.

Mr Saretsky concluded there are "a lot of moving parts" in the Canadian market place and explained: "I think we can expect there to be a little bit more fare discount activity". But he also believes that WestJet is participating in some of the fare discounting. The lowered fares offered by Encore are driving demand growth of 30% to 60% in some markets.

WestJet's new first bag fee that took effect on 1-Oct-2014 is also allowing the airline to lower fares its lowest pricing tier.

Encore and industry capacity could create yield headwinds for WestJet in CY2015

WestJet delivered a better than expected cost performance in 3Q2014 as its unit costs excluding fuel and employee profit sharing declined 0.7% versus previous estimates of flat to 1% growth year-on-year. The improvement was attributed to a change in marketing expenditures and maintenance recovery from two lease extensions executed in the quarter.

The airline has refined its costs guidance for CY2014 to a rise of 1% to 1.5% compared with previous projections of 1.5% to 2% growth, driven in part by its 3Q2014 cost performance and other areas of cost discipline.

But as nine turboprops come online in CY2015 WestJet is forecasting a unit cost increase of 2% to 3%, due to Encore's shorter stage lengths becoming more pronounced in the airline's systemwide results.

Both Air Canada and WestJet refrain from offering forward looking unit revenue or yield guidance, but with some of the discounting occurring in the Canadian market place, WestJet could see some headwinds in CY2015. Air Canada, which is also contributing to some of the discounting through the operation of rouge and operating a higher portion of economy seats, is comfortable with a trade off in yields for declining unit costs. It believes as long as its costs fall faster than yields, its margins will remain intact.

But WestJet could face a scenario where its costs rise faster or at the same rate as yields. The airline still has upside for ancillary revenue, but as Mr Saretsky also pointed out, Encore's shorter stage lengths offer a lesser opportunity to sell add-ons.

WestJet retains solid profitability and strong financial ratios

As it faces some industry capacity headwinds in CY2015, WestJet's financial foundation remains strong. Its 3Q2014 profits did fall almost 19% due to CAD45.5 million (USD40 million) pre-tax loss on 10 Boeing 737s it is selling to Southwest Airlines. Absent that charge, WestJet's earnings grew 32% year-on-year to CAD85 million (USD75 million).

Its expenses increased 7% to CAD883 million (USD779 million) while revenues grew 9% to CAD1 billion (USD882 million), resulting in an operating profit of CAD125 million (USD110 million) compared with CAD99 million (USD87 million) the year prior.

WestJet selected financial results: 3Q2014 vs 3Q2013 and 9M2014 vs 9M2013

WestJet ended 3Q2014 with CAD1.4 billion (USD1.2 billion) in cash, and as of Sep-2014 its cash as a percentage of trailing 12 months revenue was 36.5%. Its adjusted net debt to EBITAR was 1.49.

Canada's increasingly dynamic aviation market could undergo more strategic shifts

Canada's aviation landscape has undergone some interesting structural changes during the last couple of years as both its major airlines have created and launched subsidiaries to fill what they deem as holes in their long term strategies, each moving into the other's previous domains.

To date each enterprise seems to be meeting expectations, even through the headwinds of the initial start-up periods.

It is too early to determine of there is the danger of overcapacity in the domestic Canadian market in CY2015; but the two major airlines operating in that space are working to ensure they appeal to the range of passenger segments, which bodes well for consumers, but could place short term pressure on the financial results of Air Canada and WestJet if demand falls short of expectations.

If demand starts to weaken, both airlines now have solid financial footing that allows them to withstand a change in consumer behaviour. But one wildcard for both Air Canada and WestJet is the aspiring ULCC startups aiming to leverage the Canadian market.

If those airlines are successful in actually launching operations, they could disrupt pricing traction just enough to disrupt the more comfortable duopoly in Canada's market place that the two major airlines are apparently heading towards.

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