Canadian AirlinesBUS 419

Presented by:Lin Chiu

Wilson LamJoti Muker

Xueming YangCindy Yu

Agenda

Airline Industry Analysis Services Revenue Cost Structure Regulations Current Challenges Air Canada Business Strategy West Jet Strategy Risks

Air Canada

West Jet

Industry Segmentation

Industry Analysis

Services

Scheduled Flights / Chartered Flights: Transnational Regional International

Cargo

Revenue

There are two sources of revenue for Airlines:

Passengers Charters and cargos

Cost structure

Fuel Expenses

Wages & Salaries

Airport / Navigation Fees

Depreciation & Amortization

Maintenance

Food, Beverages, Supplies

Communications and Information Technology

Aircraft Rentals

Regulations

In the past few decades, government deregulation has dramatically increased competition and allowed the emergence of “low-cost carriers”

Some regulations still in place: Federal Aviation Authority (FAA) Airline Safety and Security Environmental Concerns

Challenges

In recent years, the airline industry has been affected by: Terrorism attacks & increased security costs Epidemic diseases (SARs, Swine Flu) Economic Crisis Fuel Prices

Canadian Market

The industry is slowly recovering from its decline in 2009 The compound annual growth rate of the industry

volume in the period 2008-2013 is predicted to be 4.7%.

Market Value Forecast

Strategies

Implementing cost reduction initiatives Reducing company sizes Reducing operations Entering into agreements with supplier

Airline alliances

Apply hedging programs

Air Canada Strategies

Cost Reduction: Corporate downsizing Capacity management Fleet renewal programs

Customer Driven Revenue: Multi-tiered Fares Web Platforms

Employee Incentives

WestJet Strategy

Four-pillars: People and Culture Guest Experience and Performance Revenue and Growth Cost and Margins

Risks

Operational

Strategic

Financial: Fuel Prices Foreign Exchange Rates Interest Rates

Hazards

Airline Risk Factors

http://en.wikipedia.org/wiki/File:Air_Canada_Logo.svg

Founded April 11, 1936 (as Trans-Canada Airlines) David Richardson (Chairman) Calin Rovinescu (President & CEO)

Headquarters in Montreal, Quebec

Subsidiaries Air Canada Cargo (operating division) Air Canada Jetz(operating division) Air Canada Vacations

Destinations: 178

Company slogan: GO FAR

Profitability in 4 year Interval

In thousands of Canadian dollars

Financial Statements

Reasons to Hedge

Should the Company Hedge ? YES!

WHY? Fuel price changes have a significant impact on

income Foreign exchange rate impact earnings and

operating costs Interest rate changes effect borrowing costs

Risk Management

Hedging Strategy

Michael RousseauExecutive Vice President & CFO, since 2007

Prior Position: Executive Vice-President & CFO in

Hudson’s Bay Company (HBC) Since 2001

Executive Financial positions in Moore Corporation, Silcorp Limited & The UCS Group

Education background: BBA degree from York University Member of the Ontario Institute of

Chartered Accountants since 1983

Risk Exposures & Strategy

Risk Factors: Strategy

Market Risk Derivative Instruments.

Credit Risk Review credit ratings on regular basis and sets credit limit.

Liquidity Risk Cash from operation & financing.

Fuel Price Risk Enter in derivative contracts: call, put options, swaps, collars. Adjust the strategy with market

Interest Risk Portfolio basis & swaps

Foreign Exchange rate

Forward foreign currency contracts and option agreements, swaps. Try to get positive CF on Mark-to-Market

Fuel Price Risk

Air Canada’s Cost Structure

Fuel Price Risk Exposure

Sensitivity on Operating Income

Estimated operating income impact from US$1/barrel increase in WTI – ($25 Million) estimates are derived from 2008 levels of activity and make use of management estimates.

A 1% increase in Jet fuel prices (CAD cents/litre) has an estimated operating income impact of ($35 Million)

Fuel Expenses – 31% of 2008 total operating expense, 25% of 2007 total operating expense

Hedging Ratio

For 2009:

35% of anticipated purchases of fuel

The contracts to hedge anticipated jet fuel purchases over 2009 is comprised of jet fuel, heating oil and crude oil – based contracts

For 2010:

14% of of anticipated purchases of fuel

Hedging Strategy Dec 2008

Hedge Strategy Jan 2009

How much did they make/lose off fuel hedges?

Comprehensive Income (Loss)

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Gain (Loss) on Financial Instruments

Interest Rate Risk

Interest RiskHigh level of Leveraging rate of 2008==$4691/$762 =615.616%

Section of Balance sheet:

Section of Cash Flow:

Interest Risk: Contractual Obligations:

Sensitivity Analysis

Interest Risk Exposure

Fixed rate debt

Floating rate debt

Lease on assets based on changes in short-term interest rates

Aircraft financing agreements

Interest Rate Risk

Objectives: Minimize the potential changes in cash flows from

changes in interest rates

Long term objective: 60% fixed and 40% floating debt Dec 31,2009 – 59% fixed and 41% floating Dec 31,2008 – 58% fixed and 42% floating

Designed to maintain flexibility in the Air Canada’s capital structure

Hedging Strategy Cont

Use of Derivatives 3 cross-currency interest rate swap, financing

Boeing 777 worth 300 million Terminated on Oct 1,2008, 4 million Gain

2 Interest rate swap, financing Boeing 767 14 million gain

19 forward interest rate to manage risks associated US and Canada interest rate market No gain or loss recorded

Foreign Exchange Risk

Foreign Exchange Rate Risk

Cash flow structure: Inflows primarily in Canadian dollars Large portion of outflows in US dollars

Majority of outstanding debt is US dollars US dollar debt act as an economic hedge against the

related aircraft

Foreign exchange risk on foreign currency denominated trade receivables and foreign currency denominated net cash flows

Foreign Exchange Rate RiskSection of Cash Flow Statement:

Section of Income Statement:

Foreign Currency Forward Contract / Option Agreements - USD to CAD(US$516 M)2009, Euro to CAD(EUR$3M)2010$64 M - Gain , $327 M recorded in foreign exchange gain related to these derivatives

Foreign Currency Forward Contract / Option Agreements- USD to CAD(US$297 M)1009, Euro to CAD(EUR$3 M)2010- $51M Gain

Currency Swap Agreements on operating leases (2007,2011)- $78 M notional amount.

Foreign Exchange Rate Risk

Summary of Gain (loss) on Financial Instruments

Fuel Risk Interest Risk

Forex Risk

Gains/losses

Loss Gain Loss

Reported Amounts

(208) 18 (655)

Effective?

Company Background

• WestJet began service on Feb 29, 1996. – founded in 1996 by the team of Calgary

entrepreneurs

• Canada’s leading high-value low fare airline.

• WestJet flies an average of 383 flights everyday

Profitability in 4 Year Interval

In Thousands of Canadian Dollars

Operating Expenses

Risk Exposures & Strategy

Risk Factors: Strategy

Market Risk Try to accurately predict market movements

Credit RiskCash and cash equivalent

Liquidity Risk Maintain current ratio > 1

Fuel Price Risk Enter in derivative contracts: costless collars and swaps. Adjust to market expectations

Interest Risk Canadian dollar fixed interest rate debt

Foreign Exchange rate

Forward foreign currency contracts and option agreements, swaps

Outline of Risk Factors Related to Derivative

Securities

• Jet Fuel Price Risk• Changes in crude oil and fuel prices

• Foreign Currency Risk• Canadian-US dollar exchange rate

• Interest Rate Risk• Interest rate fluctuations

Income Statement

Cash Flow Statement

Reasons to Hedge

Should the Company Hedge ? YES!

WHY? Dependent on jet fuel and prices are volatile Currencies exchange rates fluctuations causing the

value of assets and liabilities and/or future cash flows change

Interest rate fluctuations changes the value of financial assets and liabilities and/or future cash flow

Fuel Risk

Jet Fuel

Consumed 210,090,434 litres of fuel in 2008

Every $1 USD Δ per barrel of crude oil ≈ $ 7 million annual Δ in fuel costs

Every 0.01¢ Δ per litre of fuel ≈ $ 9 million annual Δ in fuel costs

Jet Fuel Hedging Philosophy

As approved by the Board of Directors:

Hedge a portion of anticipated jet fuel purchases

Established maximum hedging limits

Up to 36 months

Using crude-oil based commodities

Average Market Price of Jet Fuel

Basis risk

Jet Fuel Price Hedging Strategy

Mixture of fixed swap agreements

Costless collar structures in Canadian-dollar WTI crude oil derivative contracts Short position in call option Long position in put option

2008 hedge ratio: 30 percent

2009 hedge ratio: 14 percent

2010 hedge ratio: 32 percent

As of December, 2008 Fuel Hedge Derivative Holdings

Fuel Cost

2008 Balance Sheet and Income Statement~ Note 11

Interest Rate Risk

Interest Rate Hedging Strategy

85 % of borrowing is done at low interest through debt guaranteed by Export-Import Bank in the US

Borrow 1.3 billion CANADIAN

Fixed interest rates

Borrow in Canadian funds- use Canadian cash inflows to pay Canadian outflows

Contractual Obligations and Commitments

Foreign Exchange Risk

Foreign Currency Exchange Risk

Arising risks Fluctuations in exchange rates on US-dollar

denominated asset and operating expenditures Aircraft fuel, leasing expense, maintenance costs

and a portion of airport operations costs. US $99.5 million in 2008 Between 2008 and 2009

The average US exchange rate increase from 1.0651 to 1.1425

Foreign Currency Exchange Hedging

Strategy To reduce foreign exchange risk:

Hold US-denominated cash and short term investment Foreign exchange forward contracts

In 2010 US 7.3 million per month for the period of Feb to

Oct US $65.4 million at a weighted average contract

rate of 1.0671 per US dollar

Foreign Currency Exchange Risk

Foreign Exchange Forward Contact average contracted rate on the forward contracts was

1.0671 (2008 – 1.0519) US dollars to Canadian dollars, average forward rate used in determining the fair

value was 1.0512 (2008 – 1.2178) US dollars to Canadian dollars

2008 2009

Average contracted rate on the forward contracts

1.0519

1.0671

Average forward rate used in determining the fair value

1.2178

1.0512

Foreign Currency Exchange Risk

Impact of foreign exchanging hedging Every one-cent change in the value of the Canadian

dollar versus the US dollar will have an approximate $9 million impact on our annual operating costs

$9million =($6 million for fuel, $3 million related to other US dollars denominated expense)

Five Year Foreign Exchange Graph

Foreign Currency Exchange Risk

In 2007, lose 12.8 million

In 2008, gain 31 million

In 2009, lose 12.3 million

2008 2007

Summary of Derivative Instruments

Carry Amount

Future Outlook

Expect a economic recovery

Jet fuel prices stabilized and decreased in 2009

Do not expect to see the same relief on costs going forward

Hedged about 32 % of anticipated fuel requirements for 2010 35 % of the total volume hedge using costless collars 65% of the total volume hedge using fixed swap agreements

Summary (2008)

West Jet Air Canada

Market Share 36% 57%

Gain (Loss) on Jet Fuel Hedging ($18 millions) ($92 millions)

Gain (Loss) on Foreign Exchange Hedging

$31 millions ($822 millions)

Gain (Loss) on Interest Rate Hedging $18 millions

Questions ?

Thank you