ANALYSIS: Canadian carriers seek cheaper capacity

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Canadian competitors WestJet and Air Canada have both added new carriers in the past few months, and expect these new players to allow for the addition of new capacity throughout their systems at lower costs than could otherwise be realised.

Both carriers are adding capacity, but the growth is focused on different areas. WestJet, which launched regional subsidiary Encore with Bombardier Q400 turboprops in June, is ramping up domestic capacity through primarily increased utilisation of its Boeing 737 aircraft as it optimises its mainline network as a result of having the Q400s in its system.

Air Canada, which launched leisure carrier Rouge on 1 July to sun destinations in the Caribbean, South America and Europe, is adding much of its new capacity planned for 2014 internationally on mainline routes across the Atlantic and Pacific. To do this, it is transitioning several existing leisure routes to its new Rouge leisure carrier, which operates under a lower cost structure.

With WestJet and Air Canada expecting 2013 full-year capacity to increase by as much as 12% and 2.5% respectively, analysts questioned what impact this growth would have on yields going into the second quarter. Despite these concerns, both carriers underscored their strategy of adding capacity without substantial additional costs, made possible by fleet renewal and cost controls.

Yields at Air Canada turned positive in the second quarter at 1.5%, while WestJet saw negative yields for the first time since 2010 with a 2% decline, points out Walter Spracklin, an analyst with RBC Dominion Securities, in a research note. Increased capacity can be seen as one factor related to the negative yield, he says, along with the special lower fares at Encore upon its entering the market on 24 June and issues with rolling out the premium economy section, which WestJet has acknowledged and says will be fixed upon its commercial roll-out on 17 August.

Despite WestJet's negative yields, RBC upgraded both carriers to an "outperform" rating after the second quarter results under the view that many of the concerns about implementing these new projects are now realised and can be expected. It expects yields to turn positive again in 2014.

"The areas of concerns relating to yield declines, capacity expansion and negative RASM are now well understood and we believe built into forward expectations," says Spracklin in the research note.

In the second quarter, WestJet grew available seat miles (ASMs) by 9.3% compared to the same three months of 2012. Traffic grew at a slower rate of 6.4% in the quarter. It expects system-wide capacity to grow between 11% and 12% in the third quarter, and between 7.5% and 8.5% for the full year. In 2014, capacity growth will be in the lower range of 4% to 6%.

Domestic capacity at WestJet grew by 5.7% in the quarter, compared to 14.8% growth in the transborder and international markets. The carrier expects domestic capacity to grow between 9% and 10% in the quarter and 5% to 6% in the full year for 2013.

Air Canada increased capacity by 2.2% in the second quarter of 2012, on the lower end of its guidance of between 2% and 3% shared at its investor day in June.

While WestJet's capacity appears to be peaking in the third quarter of 2013 based on RBC Capital Markets' analysis, Air Canada expects system capacity growth to continue to grow rapidly in 2014 on primarily international markets. The carrier expects growth of 1.5% to 2.5% in 2013 compared to 2012 and plans to see 2014 capacity levels grow 9% to 11% from 2013 figures.

About one-fifth of this will come from additional seats on reconfigured aircraft and a majority of the new available seat miles (ASMs) will be placed on international markets, says Michael Rousseau, the carrier's executive vice-president and chief financial officer in a 7 August earnings call. In the past few months the carrier has been adding several new routes and frequencies in line with its international growth plan, including Toronto-Istanbul, Toronto-Seoul and adding flights to Tokyo and Beijing.

On the Rouge aircraft specifically, it is expecting cost per available seat mile (CASM) savings of about 25% for operating the Airbus A319s and Boeing 767s in the fleet, based on the density of the configurations and other cost-savings measures like labour. About half of the savings will come from the seat density itself, says Rousseau.

Air Canada is reconfiguring its 142-seat Rouge Airbus A319s and 282-seat Boeing 767s to have a higher density than the aircraft configured under the mainline models. The aircraft are deployed on routes that the carrier had been serving with its Air Canada fleet and some new routes, like the seasonal Toronto-Dublin route that will become year-round when Rouge flies it starting from May 2014. It is also introducing some new routes, such as Toronto-Venice.

Also contributing to the capacity will be the new high-density Boeing 777-300s the carrier is receiving, which have 458 seats compared to the 349 on the in-service fleet. Air Canada has received one of these aircraft and expects four more deliveries.

Air Canada's domestic capacity grew at a rate of 3.1% in the second quarter, lower than WestJet's growth. Capacity fell 0.8% on transborder markets to the USA. Capacity across the Atlantic grew 2.5% in the second quarter, and capacity across the Pacific rose 5.7%. Capacity on leisure routes to Mexico, the Caribbean and South America, on the other hand, decreased 4.8% in the quarter.

"We are adding capacity, but that capacity is being added to enhance our margins," says Rousseau. "That capacity is being added at significantly lower operating costs than our current model," he adds, pointing out that if all of its cost savings initiatives were implemented today, it would reflect a 15% CASM reduction compared to 2012.

WestJet's chief executive Gregg Saretsky also pointed out in the carrier's own call that the carrier is focused more on margins than capacity and load factors, noting that the carrier operated flights at an "incredibly high" load factor that provided "unsustainable" results during the Canadian summer months in 2012.

Much of WestJet's added capacity will be from cost-effective red-eye flying, and about one-third will be attributed to new aircraft entering the fleet and the launch of WestJet Encore.

"While this may seem like a relatively large increase, it is important to note that approximately two-thirds of this capacity is being sourced from increased utilisation, the fleet reconfiguration project and increases in stage length and projected completion rate," says Vito Culmone, WestJet's chief financial officer on a 31 July earnings call. "In other words, we are working our assets harder and delivering the incremental ASMs at a lower incremental cost," says Culmone.

Earlier this year, WestJet set out a plan to reduce annual costs by C$100 million ($97.12 million) by the end of 2015 and said it expects to see C$50 to $75 million achieved by 2014.