‘IN THE EPICENTRE OF A STORM’

The bloom came off the rose for Canadian airline stocks in 2015 despite plunging fuel costs, and 2016 could prove to be even more challenging as capacity additions continue to eclipse economic growth.

After impressive gains in 2013 and 2014, shares of both Air Canada and WestJet Airlines Ltd. ended the year with double- digit declines amid investor fears “that the Canadian market is plagued by carriers that are adding too much capacity into a weak economic environment,” according to a recent analysis by Ben Cherniavsky, who follows the airlines for Raymond James.

In the first 11 months of the year, Canada’s two biggest airlines added seven per cent more capacity to the market between them in an economy that’s eking out growth of about one per cent, according to Cherniavsky.

And Calgary- headquartered WestJet appears to be more at risk because of its high level of exposure to Alberta, where the economy is thought to have contracted in 2015 due to the oil price rout.

“Who knows exactly where we are in that cycle, but it doesn’t feel like we’re at the bottom yet,” WestJet CEO Gregg Saretsky said in a recent interview.

“I think things are going to get a lot worse in Alberta before they get better, and we’re sort of sitting here in the epicentre of a storm … 25 per cent of our capacity originates in Alberta.”

Saretsky said the Alberta economy is the greatest challenge facing WestJet in 2016, but he’s prepared to redeploy the airline’s fleet as needed.

“It’s not like we’ve built a hotel in a destination nobody wants to travel to anymore; we can actually pick up our planes and say we’re going to fly them in different places,” he said.

“As we think about 2016 and what we’re going to need to do, you’re going to see a fair amount of redistribution of our capacity away from some of these softer markets into markets that are a little more robust,” like Central Canada and other parts of Western Canada, he added.

Another concern facing WestJet is its capacity to sun destinations, particularly from Alberta. According to analysis by National Bank analyst Cameron Doerksen, WestJet’s capacity to the Caribbean, Mexico, Hawaii and Florida will be up 8.3 per cent this winter, while capacity to sun destinations out of Alberta will rise 18 per cent.

Saretksy acknowledged that there are “pockets” where demand isn’t keeping pace with capacity, but said there are also southern markets that have remained “very strong.”

“The winters are long in Canada, and even with the economic softness people will give up a lot of things before they give up their trip to the sun,” he said.

Ultimately, WestJet is prepared to reduce its capacity if necessary, Saretsky added.

“We’ve worked for 20 years to get our investment-grade credit rating and we’re certainly not going to sacrifice that for the sake of keeping planes flying,” he said.

For now, the airlines can af- ford to expand capacity faster than GDP — even if it means lower fares — due to the steep drop in jet fuel prices.

According to a recent fare survey conducted by RBC Capital Markets, yields ( the average fare paid per mile, per passenger) are expected to fall three per cent at Air Canada and 2.2 per cent at WestJet in the fourth quarter compared to a year earlier.

Cherniavsky expects the decline in yields to continue into 2016, a factor that could eventually lead to lower profits at both airlines.

“According to our calculations, it is only lower fuel prices that (are) responsible for the margin and profit expansion that both Air Canada and WestJet have reported recently,” Cherniavsky wrote.

“Hence, the problem is that unless oil goes to zero, investors can’t count on this single variable being the source of sustainable earnings growth in the future.”

WINTERS ARE LONG IN CANADA.