Westjet Airlines Analysis: Headwinds – Time to buy a ticket and get on the plane? (TSX: WJA)

Disclosure: One of us owns this.

Have you ever been on an airplane in extreme turbulence? The plane is dipping like a rollercoaster. Up, down. More down. Your neighbor beside you is holding onto their seat for dear life, white knuckles and all. Well, much like panicky airline passengers… some investors in Westjet are likely holding onto their desk right now (or maybe a glass of sangria) with white knuckles too.


Over the last 6 months the stock has hit quite the nasty air pocket, dropping about 35% to ~$18.  We are now not far off of the $15 bottom in 2016, which happened due to the (now over-hyped in hindsight) concerns over their exposure to Western Canada’s oil driven nature.

There are a few reasons:

-Fuel prices – Not a problem exclusive to Westjet but oil keeps on rising and as we write this article, prompt WTI is trading at ~$75. As a buyer of 1.5 billion litres of jet fuel a year, some think this is a major problem for Westjet.

-Strategy displeasure – Mr. Market is not happy with their plan. Originally Westjet was a simple Canadian copy of Southwest Airlines. Now they are launching Swoop and new international routes with new widebody planes. “Well, who are you? (Who are you? Who, who, who, who?) - I really wanna know (Who are you? Who, who, who, who?)”

-Pilot strike and associated cost advantage erosion – Westjet pilots recently voted to unionize and threatened to strike. A key crux of the matter was Westjet attempting to treat its low cost Swoop upstart pilots quite a bit differently than mainline ones. Thankfully this issue was resolved before one our last holidays! To resolve this though the Company and pilots agreed to binding arbitration, which is expected to increase labor costs via a deal similar to Air Canada’s long-unionized pilots. https://www.thestar.com/business/2018/05/25/threat-of-westjet-pilot-strike-over-as-airline-union-agree-to-settlement-process.html

-Increased competition from ULCC (ultra low cost carriers) in Canada – Most notably Swoop and Jetlines (and Transat flying around as well). You can see the two upstart strategies here:  https://jetlines.ca/strategy/ulcc-airline-model/ https://www.flyswoop.com/ultra-low-cost-carrier-ulcc-explained.html

-New CEO – In the middle of all of this excitement, the Company’s CEO Gregg Saretsky retired… abruptly in May and was replaced by Ed Simms. https://www.theglobeandmail.com/report-on-business/westjet-ceo-gregg-saretsky-retires-effective-immediately/article38247007/

Let’s evaluate these issues one by one.


But First - How have they done over the last 15 years?

To evaluate how Westjet has performed, we break it into two key items: Do they demonstrate 1) cost/margin control while growing, and 2) profitable growth.

Note: Before reading this article, we strongly recommend you read our article on the big four U.S. airlines and Berkshire Hathaway's 2016 purchase of about 10% of each, which can be found here.

1) Managing those margins

A key to airline profitability is ensuring your RASM is bigger than your CASM. RASM is revenue per available seat mile, which is basically total revenue divided by the total number of miles their planes fly. CASM is the cost of the mile. These are always measured in cents.

The table below shows how Westjet calculates their CASM. The industry as a whole is pretty consistent in the approach. However, three things to be wary of are: 1) depreciation and amortization calculations, where this is of course a non-cash estimate. Westjet is more conservative (read, less generous to itself) than certain other peers.. which we are happy about. 2) Maintenance charges, where airlines accrue major maintenance expenses based on the time to the next major maintenance event (say 5 years for an newish engine) and actual cash costs can differ – financial shenanigans (read, underreporting expenses) with this item would be a short-term gain long-term pain situation. We are not concerned here. 3) Management excluding “certain one-time items” from expenses. Westjet in general seems to have a lot fewer of these sorts of things than certain other peers.


The table below shows how Westjet has performed going back to 2002.

Over the last decade the Company has grown seat miles by 8% a year, while maintaining an above 80% load factor and a 10% margin per ASM. Not bad.

But it is important to not just buy a plane but to use it. A great way to keep margins strong is to just fly your planes less! Westjet is getting about 185-220 million ASMs out of each plane (you can also look at hours utilized). Their utilization is down over the last few years but it is also at a time when they are growing their fleet materially and optimizing it.

2) How is that return on investment?

Part 2 – are they growing profitably. Both Westjet and Air Canada are kind enough to calculate that for you! (We still calculated it ourselves)

They calculate their return on investment very similarly – and we have included examples from their 2017 annual reports below. Basically they take before tax earnings + finance costs + implied interest on lease costs and divide by equity + long-term debt + off-balance-sheet leases. However, a few things to note:

-At the core – beware of estimates. Grossing up leases by 7.5x and assuming an implied interest rate of 7% seems reasonable (note that Air Canada grosses up by a smaller amount – 7.0x). They also both are affected by depreciation and maintenance cost assumptions and… one-time items.

-They both calculate before tax. One of us has strong feelings about this. If you could invest in a business that was making an annualized 30% return on a tropical island with 0% tax or a company making 30% in a business unfriendly place charging you 90% tax, which would you choose? Or, in other words, to ignore tax implications seems crazy but we are the only person on the plane screaming about this.


Air Canada's:


Calculating returns - We prefer it our way.

The table below shows their after tax return on invested capital and after tax return on equity.

A 21% average return on equity for a decade is quite impressive, particularly when Westjet has also made ~$710M of share repurchases since 2010, including $90.3M in 2017.


Are fuel prices something to worry about?

If you take a look at our article on the U.S. airline industry (see it here), one very important key aspect of the thesis is that as an industry the airlines are practicing price discipline. The thesis is that as an industry they are diligent about not creating too much capacity and maintaining airline ticket discipline as well.

As all Albertans will remember, oil dropped quite dramatically over 2014-2016, bottoming out at @$27/barrel in January of 2016. We took a look at how Westjet’s RASM and CASM correlated with jet fuel prices. Fuel has represented about 20-30% of operating costs in recent years. As expected, Westjet benefited from lower jet fuel prices but only temporarily as airline prices industry-wide as a whole drop.


Going forward, we expect the same to hold true for rises in jet fuel costs, albeit likely more slowly - No one wants to be the first to increase their fare price. That said, we view there being no permanent decrease in airline margins because of this.

One wild card is if oil and jet fuel increase so significantly that they materially reduce the affordability of flying leading to an industry-wide reduction in flights taken. Fuel is only 20-30% of costs and airlines were just fine when oil was $100. Or in other words, if oil hits $200 a barrel there are probably a lot bigger problems in the world than the cost of your next flight to Hawaii. 

The Strategy Change….

As we discuss in our recent airlines article (see here), Warren Buffett made a significant investment in the big four U.S. airlines (approximately 10% of each). While we are still waiting for him to call us back, we believe that the thesis is that the large North American airlines have significantly changed how they operate, are being more diligent with their capital, and also have numerous scale and regulatory advantages that has created a moat.

Going back to the roots of Westjet, it was born in 1996 as a simple low-cost carrier with a strategy copy-and-pasted straight from Southwest Airline’s latest investor presentation at the time. Simple plane fleet (Boeing 737s), non-unionized pilots and flight attendants, and good incentive pay for these staff instead of unionization.

It worked extremely well for awhile. A long while. But the world has changed. Co-Founder, former CEO, and Chairman Clive Beddoe continues to have significant influence on the Company. Clive has been instrumental in the original strategy and helping the company adjust course. For example, he pushed forward the Encore subsidiary strategy. These movements 1) mirror what U.S. airlines are doing (regional subsidiary feeders for example) and 2) are in line with what we think they should be doing. As a side note, Clive was likely a very key part of the CEO change, and we are just fine with that. He has a good track record of pointing Westjet in the right direction.

In a significant oversimplification our previous article – To remain competitive, airlines need:

1) Scale – bringing cost of capital advantages, purchasing advantages, and ability to handle increasingly large regulatory burdens. It should be noted that Westjet maintains an investment grade credit rating and is de-levering.

2) An expanding web of marketing and partner agreements and rewards schemes – We discus this in depth in our other article, where airlines can maintain higher more profitable load factors by creating partnership agreements with other airlines. In Westjet’s case, they are expanding their partnership with Delta among others noted below and have been very successful with their RBC Mastercard offering. http://www.travelweek.ca/news/analysis-westjet-and-delta-want-to-expand-with-a-joint-venture-whats-the-impact-for-the-travel-industry/

We view Swoop and the 787 dreamliner (i.e. international flights) as extensions of the above items and a rational response to the changing environment. Both Westjet and Air Canada now operate low cost carriers and international flights, which must be quite discouraging for any competitors out there (Canada is a small market after all). Frankly, our view is that the competitive nature of the Canadian airline industry makes it very unlikely that any of the upstarts are able to become the next Westjet and instead will likely only have success on certain specific routes. The entire North American airline industry has gone through a long history of capital destruction and the transition to large scale financially strong stable airlines is a rational if not the healthiest outcome.

Note on unionization - It should be noted that we believe that Westjet becoming unionized was inevitable and we are not concerned about it. As an industry it is becoming more regulated, including rules around pilot and flight attendant scheduling, and as an industry it is significantly unionized already with no one really having a material labor advantage over others. We expect that Westjet’s overall employee cost per job role will be very similar to Air Canada and view this as a permanent erosion of this cost advantage.


Valuation – What would you pay for that ticket?

The core of our thesis is that Westjet will continue to do well but not as well as before. We believe that there are is permanent reduction to their cost advantage vs Air Canada. But that’s OK and assumed. Secondly, the Swoop and international expansion are rational changes in strategy and ultimately it is not a great environment for upstart competitors. Canada is a small market after all.

Westjet is targeting to grow its fleet from 167 to up to 265 by 2023-2027 and expects to be able to grow its fleet over the next few years while still having free cash flow (we agree with this). Looking a few years out, you would be sitting on a 3-6x P/E investment based on the current share price and the assumptions below.

We expect that the next 20 years will be harder than the last 20 for Westjet but you don’t have to keep getting rich at the same rate you have in the past.


Kraft Heinz Analysis Notes June 2018 - Would you like some Ketchup on your Kraft Dinner?

When you hear the word ketchup you likely think “Heinz” and when you think of macaroni and cheese you’ve probably got Kraft Dinner in your mind and flashbacks to childhood. Thanks to Warren Buffett, of Berkshire Hathaway fame, and 3G (the sometimes unloved “efficiency-oriented” managers) have put these two companies together. The idea was simple – Step 1) Buy Heinz in 2013, Step 2) make it more efficient through scaling input purchases and consolidating plants, and turn it into an acquisition vehicle, 3) buy more brands to get more scale, lower cost more, and take bought brands to new places, 4) rinse and repeat.

Things seem to be ticking along OK, especially with the acquisition of Kraft in 2015. Although the synergies and such seem reasonable, it has left it with an awkward structure with two head offices. When WB and 3G bought Heinz in 2013 for $23 billion they promised they would keep the head office in Pittsburgh, the Company’s hometown. Then they bought Kraft for $46 billion or so, a much larger Company based in Chicago, and here we are today. But that’s a sidenote. The real challenge is that the Mr. Market is just not happy with how things are going. Although initially the stock continued to climb it has recently dropped from ~$94 to $54.11, with a recent recovery to the $63ish range.


What's going on with the stock?

· One issue is that it is just simply extremely hard to grow consumer staples brands and immediate growth hasn't materialized so they are now out of favour. There is a lot of pressure from competitors, a push by large chains to move towards private labels, and other issues leading to the moat not quite being as good as it used to be.

·Concern that the 3G aggressive relationship will hurt their ability to buy the next KD. 3G has had a bit of trouble with negative press to put it lightly. Their hostile takeover attempt of Unilever did not help – Here is a good article about it: https://www.reuters.com/article/us-unilever-m-a-kraft-3g/3g-capitals-austere-empire-building-weighs-on-krafts-unilever-bid-idUSKBN15X01T

·Noise – lot’s of it. The Company has gone through a massive restructuring over the past few years, they are trimming/”renovating brands”, and sprinkle in things like significant tax changes, and you have quite the murky picture.

The table below shows how noisy things have been.


Here’s the cost breakdown of the restructuring they have gone through as well as the impact of the U.S. tax code changes.


As a side note – It’s interesting to see how the recent tax reforms have impacted the Company. The table below is from their 2017 annual report.

The reasons why we are looking at Kraft Heinz in the first place:

1)      Capacity to take pain as Thomas Russo says (see our article about his 2017 Value Investing talk) and capital diligence. Being backed by 3G and Berkshire Hathaway and most of the management team being from 3G will allow the Company to take short-term pain for long-term gain. This is evidenced by a $2.1 billion dollar restructuring reorganization of the combined company (which led to 4,900 redundancies for those keeping count), brand adjustments and wind downs. Currently Berkshire owns 26.7% while 3G owns 23.8%, making them the two largest shareholders with effective control. The third largest shareholder is 3.7%.

2)      Strong brands and significant economies of scale combined with 3G’s management. Their efforts seem to be showing some fruit with improved EBITDA margins in both the U.S. (70% of sales) and Canada. It will be worth watching closely how they continue to adjust their brands and those strategies in Europe and the Rest of the World.

3)      Brand Strategy

Although 3G is known for cost cutting, in this case it is not just about costs. They are focusing on Renovating Brands and White Space initiatives.

An example of a Renovation is what they recently did with KD:

“Our renovation of Kraft Mac & Cheese is a great example of evolving an iconic brand to meet consumer preferences for cleaner ingredient lines. We did that in 2016, replacing artificial colors, flavors and preservatives. We launched the renovation with an unexpected twist: we didn't tell anyone. That's right. We changed the product without telling mom while successfully preserving all the qualities the consumer loves, the cheesy, multi-goodness. Driving not only consumer reappraisal but also making Kraft Mac & Cheese part of the cultural dialogue with over 1 billion impressions. It led to 2016 being the first year-over-year growth in Kraft Mac & Cheese in 5 years. And together with other innovations like Cracker Barrel Mac & Cheese in deluxe cups, drove category growth in both 2016 and 2017.”

White space initiatives are a bit different. A product example is their recent launch of Heinz Seriously Good Mayo, where the strategy is to leverage the Heinz ketchup brand. #2 The second type of white space opportunity is “entering a new category in a market where the brand hasn't previously had a presence. An example of that is our launch of Planters into China. China's net market is at $4.2 billion in annual sales, growing 11.5% annually, so a significant opportunity for the Planters brand to travel abroad.”

They summarize their sales growth strategy quite concisely:

“Beginning with our strategic plan work in 2016, we identified 3 global brands, 5 global platforms and foodservice as our biggest opportunities. Currently, these 3 brands and 5 platforms represent about 2/3 of our retail sales.


The opportunities to expand the global brands and platforms we've identified is tremendous. To put the opportunity in context, in 2016, only 10% of the countries that we served had 2 or more of our global priority brands. And over the next 3 to 5 years, we expect to have 2 or more of our global brands into markets representing 80% of the countries we serve. So we have big plans to move quickly. We also have a big need to smartly prioritize. So how do we prioritize at a local level? In each market and in each region, we prioritize our big bets through clear portfolio roles, with the goal of strengthening and expanding our core categories and brands. We organize our categories by portfolio role based on share, profitability and category attractiveness in order to guide investment decisions in our portfolio.”

It's essential to read the Company’s February 2018 Business Update - http://ir.kraftheinzcompany.com/static-files/67db0f7b-755c-44a4-8f9e-7455d2781aa6


What does cash flow look like anyway?

We put together the following simplified summary table outlining how cash flow looks over the last few years.

The Base Case cash flow really is a “base” scenario, in that per share cash flow has a few tail winds behind it, namely 1) settling in of restructuring (like a factory hitting its stride once it’s worked out the kinks of the line), 2) the Company’s continued brand initiatives providing fruit, 3) continued share repurchases (303,048 in Q1), and 4) incremental value through further mergers (in Q1 they bought Cerebos Pacific Limited of Australia/New Zealand in Q1 for $238M).


It's an interesting company at an interesting time and we will continue to look at it. It can’t be ignored though that this business is getting harder, not easier, over time.


Further Readings
Heinz Buyout Article – 2013 - https://www.reuters.com/article/us-berkshire-heinz/buffett-brazils-3g-team-up-for-23-billion-heinz-buyout-idUSBRE91D0PY20130214

February 2018 Company “Post-Integration Business Update” - http://ir.kraftheinzcompany.com/static-files/67db0f7b-755c-44a4-8f9e-7455d2781aa6


AlarmForce (TSX:AF) – Why did 3G Buy and Sell AlarmForce? And why didn't we buy it?

Whenever you can, you should check your original investing thesis and see how things turn out.

In November of 2017 BCE Inc. (Bell) (TSX:BCE.TO) (NYSE:BCE) announced was going to acquire AlarmForce Industries Inc. (TSX:AF.TO), Canada’s lone public home security and monitoring services company, for approximately $166 million ($16/share).

We took a look at this company in November of 2016 (a year before almost exactly to the day). At that time it was trading at ~$10/share. The Company had a new management team, was in the middle of a brand and product refresh, and started outstourcing product development. Our conclusion was “wait and see” in the sense that we liked what the Company was doing but things were just too unclear for us to buy – effectively it was execution risk. Full details here: http://www.canadianvalueinvestors.com/home/2016/11/17/alarmforce-tsx-af-will-they-keep-your-dollars-safe

Interestingly, Pavel Begun, Managing Partner at 3G Capital Management, recently spoke at Ivey Business School and covered why they bought the business originally:

3G owned AlarmForce for just about a decade before you sold it at the end of last year [2017]. Would you be able to walk us through your original thesis as well as why you sold?

The original thesis was that you had this business that had a significant competitive advantage within an industry where everybody else did things in a highly inefficient manner. So more specifically if you look at the home alarm industry what you see is that pretty much all the players distribute their services through a network of dealers. Unlike everybody else AlarmForce distributes its products and services direct to consumers, so they take out a huge layer of cost, and as a result they were able to sell their product and service cheaper than everybody else. And yet they still enjoy a significant margin advantage. So, when I looked at AlarmForce and the structure of the industry it reminded me of GEICO back in the day because GEICO had a very similar industry structure and a very similar advantage. And with AlarmForce I thought well look, you are going to be in this large and growing industry, you have probably 1/10th of 1% of the market share, you have a significant cost advantage versus everybody else, and you have the industry structure that restricts adaptation because if you sell through dealers it’s very hard for you to say well I’m just going start selling direct because that’s going to, I guess this, piss off your network and they might leave.

So that was the theory and it was working well early on for the first maybe four or five years and then things got off track a bit. There was a significant technology change within the industry, there were changes to marketing channels, and there were changes to the product suite as well. And those were tough challenges, but they were not insurmountable, so I think you could have overcome those challenges. But management struggled to do it, so the company did not grow as much as I originally expected.

But in in the right hands that business was still worth a lot of money because at the core they still retained their low-cost advantage and the industry structure was still such that existing players could not adapt their marketing strategies to sell direct. And that was not lost on potential buyers and in November of last year Bell decided to make an offer for AlarmForce at a 65 or 75 percent premium and so we ended up selling. So, we really didn’t have a choice but at the end of the day we still earned a good IRR depending on the time of purchase and the price of purchase, because we purchased AlarmForce at a number of different times at different prices. We earned anywhere between 14 to 23 percent IRR on that investment.

Lesson learned: Keep checking your thesis, and make sure you didn’t miss anything that you could have foreseen.

3G’s initial thesis was good. The world changes and in this case unforeseen technology changes eroded some of AlarmForce’s business and advantage, but the core thesis that they had a structural competitive advantage – by not having to rely on a network of dealers – remained sound.

And us? We missed out on a 60% upside in one year, sure, and on the day of the announcement we definitely had FOMO. But after reviewing the situation, it was not foreseeable that they were going to be bought at this time (although it is a logical outcome). There was still a lot of execution/management risk (something that 3G would have had much more insight into as a large long-term shareholder and they also had a Board seat) and 3G also benefited from a lower cost base vs where the shares were trading when we reviewed the Company.

2008 Globe and Mail Article on 3G's purchase/thesis


2017 Bell Acquisition Announcement