(By Neal Dihora, CFA) WestJet
) is a profitable, low-cost airline founded in 1996 and based in Calgary, Alberta. We believe its culture of ownership sets WestJet apart from most airlines; it counts more than 85% of 8,800 employees as shareholders. By the end of 2012, the firm will have delivered 31 consecutive quarters of profitability. The company has laid out a flexible growth plan through 2018, with commitments to purchase 35 new mainline aircraft offset by 33 lease expirations. Furthermore, the launch of a new regional airline, WestJet Encore, in the second half of 2013 includes commitments for 20 aircraft with the option to acquire 25 more. We believe WestJet's flexibility is evidenced by the wide range of capacity growth possibilities through 2018, from 12% to 62%. Our base-case scenario assumes capacity increases 40%. A new premium/business-class seat offering paves the way for improved revenue. We think a fully utilized business-class offering at a 50% premium could boost sales more than 8% with minimal cost increases. Shareholder-friendly activities include repurchases totaling nearly 9% of outstanding shares over the past two years and a CAD 0.08 per share quarterly dividend, equal to a 1.2% yield. We think WestJet is well positioned for growth and shareholder returns over the medium term.
WestJet serves 81 destinations in 18 countries and operated a fleet of 100 Boeing 737s as of December 2012. It will launch regional service with Bombardier's Q400 aircraft in late 2013 and is committed to purchasing 20 aircraft by 2016. The company believes its fares will be nearly 50% of those charged by competitors, and it offered evidence of prior campaigns where low fares resulted in materially stronger travel demand. We believe the company's culture will be the primary driver of customer satisfaction along with long-term results at both the regional and mainline operations, and with 91% of employees positive on the launch of a regional service, we expect WestJet to maintain its performance level.
Information technology spending of CAD 40 million over the past two years provides the foundation for improved customer experience and paves the path for higher revenue. WestJet introduced the first paperless ticket in 1996, and with the IT upgrades it has implemented it will roll out improved Web, kiosk, and mobile experiences in the coming years. Furthermore, the company will offer multiple fare classes, as opposed to its single-fare structure today; this could help increase revenue by allowing customers to pay higher fares for fully changeable schedules, for example.
We believe the culture, flexible capacity, and seat reconfiguration lay the foundation for growth. Furthermore, we think WestJet's strong balance sheet, with net cash that represents 20% of last-12-months revenue, provides the necessary capital to weather intermittent volatility. The company has executed well even in the face of extreme fuel price volatility and economic uncertainty, and we expect analogous outcomes in the years to come.
Culture Is the Main Differentiator
WestJet was founded in 1996 by Clive Beddoe (currently chairman of the board) with three Boeing 737-200 aircraft serving five cities in Canada with 220 WestJetters, as employees are known. The "Owners Care" culture permeates the organization. The firm has won numerous accolades, including being named one of Canada's 10 Most Admired Corporate Cultures for four years by Waterstone and being ranked as the third-best employer in Canada by Aon Hewitt in 2011. All nonexecutive WestJet employees from different departments-- pilots, flight attendants, maintenance, and others--vote a member of their respective teams to represent them in discussions with executives. This proactive communications team works with executives to align job security, pay, and growth opportunity concerns in an engaged process that has proven results over the past 17 years. All 8,800 employees are nonunion and more than 85% are WestJet shareholders. We believe that culture is the company's main differentiator, and a continuation of the engaged process between WestJetters and executives will serve the company well as it executes its growth strategy.
WestJet has experienced tremendous capacity growth since its founding, but many airlines have shown an ability to order aircraft. Conversely, WestJet has been able to improve load factors, increase sales, and manage costs, and we attribute a good portion of this success to its culture. When we look at the company's capacity as measured by available seat miles, traffic growth as measured by revenue passenger miles, and the resulting load factor, we see that the company flew more than 7 times as many miles in 2011 as it did 10 years ago. However, the load factor is higher now than in the past, a testament to good customer experiences and low fares.
Load Factor and Cumulative Growth in ASMs and RPMs
Source: Company reports and Morningstar estimates.
More than 85% of employees are also shareholders, and we believe this ownership culture has helped the company manage costs, as measured by costs per available seat mile excluding fuel (fuel is a globally traded good, and WestJet has little control over the price). WestJet executes at 30% of the cost structure as Air Canada, its main competitor in its home country. It has lower labor costs, significantly lower maintenance, and lower total aircraft costs. We think the company's motivated employees, single fleet, and lack of outsourced supply are the main drivers of these results.
We also compared WestJet's cost structure with other market players. We see that WestJet compares favorably with Air Canada (AC.B) along with the U.S. network operators (American Airlines, Continental (UAL), Delta (DAL), Northwest (DAL), United (UAL), US Airways (LCC), and America West (LCC)) and other U.S. operators (Alaska Air (ALK), Hawaiian Airlines (HA), and Allegiant (ALGT)). However, it experiences around 18% higher costs excluding fuel against the U.S. low-cost carriers (Southwest (LUV), JetBlue (JBLU), AirTran (LUV), and Frontier (RJET)) and Copa Airlines (CPA). We calculate that Panama-based Copa has a large cost advantage as its average employee cost is only CAD 30,000 per year, compared with around CAD 55,000 for WestJet. However, the average compensation for the low-cost carrier group is CAD 96,000, so labor costs are not the issue. We believe the disadvantages for WestJet are that airport fees and taxes in Canada are more than 4 times as much as in the U.S. These costs make up nearly 14% of revenue for WestJet. For Southwest, the comparable number is around 5%-7%.
WestJet has increased capacity every year since at least 2001, and our base-case forecasts call for more of the same. However, it is important to note that the company has enormous flexibility, given its leased fleet expirations against committed new aircraft deliveries through 2018. Furthermore, WestJet has been increasing airline partner relationships that could reduce the necessity for additional aircraft. The regional operations will begin in late 2013 and could have as many as 45 aircraft flying by year-end 2018, with 20 purchase commitments and 25 options.
Our base-case scenario assumes that WestJet maintains its current fleet on lease along with purchasing 737-700 aircraft currently under contract and the regional operations only use the 20 currently committed aircraft and let the purchase options expire. The company announced a premium/business-class offering during the summer of 2012. It also increased the number of seats available on its 737-800 aircraft to 174 from 166, and we have included this in our analysis. We project a 40% total increase in available seat miles from year-end 2012 through 2018 (6% compound annual growth rate). This is much slower than the 22% ASM CAGR from 2001 through 2011, and even the 11% CAGR since 2006. However, WestJet is working off a much larger base of 100 aircraft at year-end 2012 versus just 27 aircraft at year-end 2001 and 63 at year-end 2006.
We assume a flat 970-mile stage length, or average distance of each flight, for our mainline ASM calculations. For comparison, stage length has advanced to 984 miles in 2011 from 458 miles in 2001. The company has said stage length could increase to 1,000 miles. If that were to occur linearly by 2018, it would add about 3% to the total capacity additions over the five years, to 43%. WestJet believes the regional operations will probably fly 300 miles per trip. We assume no changes in flights per day, but higher aircraft utilization would yield more capacity growth and, more important, higher profits.
WestJet could decide to execute two parts of its existing contracts that would allow growth to be much faster than in the base-case scenario. First, it could convert its Boeing 737-700 orders to the larger 737-800. Second, it could exercise the additional 25 Bombardier Q400 under purchase options for its regional operations. The total capacity increase from 2013 to 2018 in this case is 57%, for an 8% CAGR. Again, we assume flat values for stage length and flights per day, both important variables in calculating ASMs.
For the low-growth scenario, we assume that WestJet decides to allow its leases to expire, takes the 737-700 under purchase commitments, and allows its purchase options for additional Q400 to expire. This results in a 7% capacity increase by 2018, a 1% CAGR.
WestJet announced a seat reconfiguration during the summer of 2012 that will introduce premium/business-class seats into its mainline operations by early 2013. We assume that business-class fares will be on average 50% higher than economy. We believe this change could add more than 8% to revenue should WestJet achieve full utilization of premium seats on its current fleet structure. We project yields to improve somewhat faster than costs for our base and bull cases while we assume no impact in our bear case.
Strong Balance Sheet
WestJet carries a solid balance sheet heavy with cash, providing cushion to ride out volatility in the economy. Its gross cash of CAD 1.45 billion represented 45% of last-12-months sales as of Sept. 30, and net cash, offset by debt of CAD 780 million, was a healthy 20% of sales. The company has spent CAD 185 million repurchasing shares over the past two years. Diluted shares outstanding peaked during the fourth quarter of 2010 at 147.8 million. Following repurchases, this has been reduced by almost 9% to 135 million as of Sept. 30. In our base-case scenario, we see operating margins sustained at double-digit levels through our five-year explicit forecast. Even with high capital expenditures over the near term (we estimate CAD 2.8 billion), we see cash ending 2016 at CAD 700 million, down to 14% of sales. This assumes that the company pays cash for new aircraft, although it has employed debt and sale-leasebacks in the past.
Solid Operating Performance
WestJet has delivered strong performance over the years. The sales dip in 2009 was caused by the financial crisis while the operating margin contraction from 2007 to 2010 was driven by higher fuel prices. However, the firm's low-fare offering and excellent customer service have resulted in strong load factors of near 80% or higher since 2007. The ownership culture has managed to keep costs flat through the years, excluding fuel. For example, fuel cost per liter was CAD 0.90 in 2011 compared with CAD 0.64 in 2005 while CASM excluding fuel was 8.96 cents in 2011 and 8.72 cents in 2005. By curtailing those costs under its control, the company has ramped up operating profits over the years, and we see similar outcomes over the near term.
Sales, Operating Profits, and Operating Margins
Source: Company reports and Morningstar estimates.
In our base case, we assume that sales will increase an average of 10% per year. The company's culture should help maintain a low-cost structure, and we believe the carrier could see yield improvements as a result of the premium seat reconfiguration. Therefore, we think WestJet can maintain double-digit operating profit margins on average over the next five years. We implicitly assume that the regional airline, WestJet Encore, will operate at similar levels to the current mainline operations. However, our revenue per available seat mile assumptions may be conservative. We estimate that as long as the average regional fare is higher than CAD 68, those operations are likely to push up RASM, which we believe could result in an upward bias on revenue operating profits, assuming our cost estimates are in line. While this is unlikely to have a material impact in the near term as the regional operations are set to begin in late 2013, it could aid later years. Still, we believe our current estimates are reasonable, given the lack of real data upon which to test our assumptions.