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Air Canada stock has wings, but only for the short haul

To paraphrase British novelist Martin Amis, when it comes to investing in airlines, you should be a very nervous passenger but a very confident Valium taker.

The analysts loved Air Canada's third quarter. Operating income - that is, income before interest and taxes - was $327-million, easily beating most forecasts. Other yardsticks - load, yield, costs, business-class revenue - also impressed.

So if you're looking for a short-term trade, buying Air Canada might work. Stocks that are going up tend to keep doing so for a while, especially when skeptics abound.

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But this is no buy-and-hold investment. Air Canada has made excellent progress on costs and customer service, but so-called legacy airlines - old-school carriers with unionized work forces, multiple levels of service and generally higher costs - nearly always self-destruct in the long run. Look to Pan Am, United Airlines or the earlier version of Air Canada as examples of the troubles that can occur.

That's not to say that the current iteration of Air Canada doesn't have advantages. The airline's fleet is relatively new and the service is good - much better than it was, anyway. If you fly a lot you'll appreciate that Air Canada, especially in business class, is a very good airline, especially compared with many of its U.S. and European rivals.

Wooing customers to business class is crucial to Air Canada's success, because it's where most of the profit originates. Also key is growth in international routes. Both trends are favourable for now. Inevitably, though, competition is heating up, both from international airlines such as Emirates that are trying to add service in Canada, as well as from domestic competitors that are increasing capacity.

The threat of competition might be why the stock didn't go up much last week when the airline announced its forecast-beating earnings just as the overall market was catching fire. Or it could be that investors had already predicted the outcome.

Why You Should Buy

Still, it's not unreasonable to think that the stock might have room to move. Analysts are busy upping price targets and the market capitalization of the airline is only about $1.1-billion. When it went public post-restructuring in 2006, investors happily valued it at twice that, although the stock did nothing but fall after it left the gates.

The argument for buying the stock as a trade is relatively simple. The economy is picking up, the business traveller is coming back, revenue per seat is starting to rise. In addition, competition is muted in the domestic market, thanks to a convenient détente between Air Canada and WestJet, and costs have come down. Air Canada is generating enough cash to pay down its debt and has loads of money in the bank.

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It helps that the airline's shares are priced low in absolute terms (a $4 stock is easier to buy than a $40 stock) and in relative terms (the shares went public at $21). It also helps that Air Canada looks cheap compared with its peers on an enterprise-value-to-earnings basis.

Ultimately, though, this is a dubious bet if you don't think legacy airlines are viable in the long-term. Air Canada went broke once and almost did it again during the recession.

To buy this stock is to believe that there is a greater fool out there who will buy it from you for more than you pay. You have to assume that investors will be blind to the grim realities of this business. Among the headwinds are the airline's union contracts (opening up for negotiation next year), the threat of increased competition, rising oil prices, a big pension hole. I could go on.

The easiest (and probably riskiest) return has been made on this stock, which has quadrupled in price in a year or so. It gets a lot harder to make money from here unless you think airlines are solid businesses for the long haul. If you believe that, consider a bit of advice from someone who actually has experience running an airline - Richard Branson of Virgin. Asked what it takes to become a millionaire, his answer was: "That's easy. Start with a billion and start an airline."

Fabrice Taylor is a Chartered Financial Analyst

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About the Author
Investment Columnist

Fabrice Taylor, CFA, publishes the President’s Club investment letter, for which he and The Globe and Mail have a distribution agreement. More

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