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There is chaos in the air. Airlines worldwide are struggling to catch up with the recovery in demand after the pandemic lockdown forced many to reduce capacity. Even though airlines’ revenue jumped threefold, rising oil prices and fewer aircraft increased their operating costs. Many airlines have filed for bankruptcy. The recent bankruptcy is of Scandinavian Airlines, as it looks to reduce debt and raise capital. Should you be worried about Air Canada (TSX:AC)?
Air Canada struggles to restart
Air Canada is overwhelmed with the number of passengers. It is facing difficulty accommodating travelers, and this is the scenario worldwide. But things have become worse for Air Canada, as its flight cancellations and delays have put it among some of the worst on record in the world. The struggle of restarting with a record pent‑up demand has forced Air Canada to reduce its July and August flight schedule to control traffic.
The hopes of pent-up demand are what has been driving Air Canada’s shares in 2021. Now, when that was happening, AC shares breached the $20 resistance and dipped to $16. Why?
In 2021, the pent-up demand was supposed to boost revenue and reduce cash burn. But an over US$100 oil price, rising interest rates, and looming global recession were not factored in. These variables came in 2022 after Russia invaded Ukraine and created an oil supply crunch. The increased demand has increased airline losses, as they are investing in capacity in an inflationary environment. By the time it boosts capacity, a recession could slow demand, making capacity a liability. This is not the only impact of a recession.
Air Canada’s debt
A recession dries up capital in the economy. Scandinavian Airlines filed for bankruptcy protection, so it could get favourable terms with creditors while it keeps operations in sync with demand.
What concerns me is that Air Canada’s liquidity requirements are growing while its losses are slowing. In the first quarter, it doubled its liquidity requirement to $5 billion while it reduced losses by 25%. The first quarter is the time when operations were smooth for Air Canada. Now, it is chaos.
AC’s $8.5 billion cash reserve was sufficient to meet its current liabilities. But this liquidity is drying up. How long can AC sustain it? If it looks to raise more debt, that will come at a higher cost. So far, the airline has not shown any signs of financial strain. The management is confident it can handle the $7 billion net debt on its balance sheet.
How much is too much?
The pressing issue is not the long-term debt but the working capital. Does Air Canada have enough cash reserve to fund its operations and repay its current portion of debt?
It is using the cash reserve to pay for accounts payable. I am not much worried about advanced ticket sales, as cancellations won’t affect its cash reserve. But I would keep an eye on its operating cash flows.
Air Canada’s $16 billion long-term debt is more than three times its $5.1 billion market capitalization. The company is funding its operations with this debt. A looming recession will only delay the recovery. Time is ticking for Air Canada, as the $10 billion liquidity won’t hold long.
The $16 billion debt may be too much for a company making a $1 billion quarterly loss. But it could become unmanageable if the $10 billion liquidity falls to $5 billion and the airline is unable to inject new capital in a recession.
What should you do?
Stay away from Air Canada stock. If you own the stock, sell it, as the stock is unlikely to touch the $20 price in this economy. However, it could plunge to less than $2 if the recession is severe and the airline files for bankruptcy.