Why Air Canada’s shares are soaring - and why their ascent should continue

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Investors may have been unprepared for Air Canada's recent liftoff. In 11 trading days since late September, it's up by more than a third, hitting a new 52-week high of $12.70 late last week. The company has only provided an innocuous, but positive, announcement on debt restructuring during this time.

As it turns out, a fair amount of the gain may be coming because big investors, particularly in the United States, are warming to the Air Canada thesis. Canaccord Genuity took Air Canada management on a "roadshow" for institutional investors in New York City in late September to tell the company's story. On Sept. 29, Credit Suisse started covering the stock with a target price of $17, more than 70-per-cent higher than the share price at the time. And late last week, RBC Dominion Securities issued a bullish report, with analyst Walter Spracklin calling it "by far the most interesting investment opportunity in [the transportation] coverage universe."

Certainly, Air Canada shares aren't the bargain they were two weeks ago. But they are still cheap by any measure, and the shifting sentiment suggests the stock may shed much of the discount it's had when compared with its U.S. peers.

First, though: Investing in airline stocks can be a notoriously unpleasant experience. The North American industry has gone through a multi-decade cycle of boom and bust, with the carriers reacting to their periodic good fortune with capacity expansion, cutthroat competition and bankruptcy. In the past few years, airline stocks have gained on the theory that this time it's different, as competition-stifling mergers will put a lid on the industry's destructive impulses. But any whiff of a problem with that investment thesis – such as an increase in available seats – can send shares reeling.

Some of this explains Air Canada's discount to the U.S. airlines. The company's "available seat miles," or ASM, have grown by a mid-teens rate in 2016, something that Credit Suisse analyst Julie Yates writes is "misunderstood" by investors. "[It] has driven concerns that Air Canada is flooding the market, particularly as demand slows owing to recessionary conditions in the oil economies of Alberta. However, we note that, while ASM growth is outstripping GDP growth, Canadian GDP is not the right measure," as 90 per cent of capacity growth is catch up in international markets, she says. "Seat growth rates in excess of GDP are growing into demand, not outpacing it."

Of course, this is just one part of the Air Canada picture. Mr. Spracklin of RBC acknowledges Air Canada has multiple risk factors "that kept many at bay," including elevated capital expenditures, zero-to-negative free-cash flow and high debt levels. "Historically these have certainly been good 'red flag' indicators of when to avoid airline investing," he writes. "Our argument has been that there is a sound strategic basis for these seemingly negative indicators." And, he says, we are beginning to see turning points in all of them, which "we expect will allay many investor concerns." Mr. Spracklin's Oct. 6 upgrade came with a target price of $18, up from $14.

Investors are still concerned, however. Even with the recent gains, Air Canada has a forward price-to-earnings ratio of 3.4, versus a median P/E of 10 for 17 small-to-large North American airline companies, according S&P Global Market Intelligence. (The three biggest U.S. legacy carriers have P/Es of 7 or 8.) Other valuation measures based on earnings that back out expenses like depreciation or aircraft rent also show Air Canada as bottom-of-the barrel cheap.

Ms. Yates of Credit Suisse believes some discount to the U.S. carriers is warranted, because Air Canada will continue to spend to upgrade its fleet of planes and because it has currency issues the U.S. carriers do not. (The airline's revenue is in Canadian dollars, but plenty of expenses are in U.S. dollars.) However, Air Canada has undergone structural improvements since 2013 that have improved its margins, she says, and as the company improves its balance sheet, U.S. investors should reward it "in the same way that investors rewarded U.S. network carriers."

Canaccord Genuity's Doug Taylor says the New York marketing trip was "well received," with potential investors understanding the capacity growth and the capital investments Air Canada has made, and looking forward to the possible uses of added free cash flow, whether debt repayments or even share buybacks. "People liked what they heard there."

Clearly so, given what's happened to the shares in the last two weeks. Once the story gets out to even more investors, it's possible the stock will rise well into 2017.