Will Canadian Airlines International survive until the weight of its financial liabilities start to lift two years from now? David Knibb weighs up the Calgary-based carrier's chances.

Canadian Airlines International is in a race against time. Two years from now its loan and lease obligations will ease, finally giving the airline some breathing space. But cash reserves are falling, and the flight attendants union is blocking urgently needed labour concessions, with the low season fast approaching. The burning question is whether Canadian's dwindling cash can last till its debt schedule eases enough to allow the company to address its chronic problems.

Canadian's financial record tells a sorry tale. The Calgary-based carrier has not made a profit since 1988, accumulating losses of over US$1 billion. In 1994, the carrier appeared to have found a white knight in the form of American Airlines, when the parent of the Dallas-based carrier, AMR, injected US$178 million. In return AMR gained a third of Canadian's equity and 25 per cent of its voting rights - the legal maximum. As part of that restructuring, Canadian warded off a legal challenge by Air Canada and its doubled-edged campaign to either merge the two carriers or emasculate its rival by buying all its international routes. When the dust finally settled two years ago, Canadian had hoped to put survival issues behind it and concentrate its effort on becoming profitable.

Wishful thinking. Instead of a forecast US$55 million net profit last year, the carrier ended up US$142 million in the red, with the weak Canadian dollar wiping out savings expected from its AMR services agreement. A subdued Kevin Jenkins, the carrier's chief executive at the time, blamed Canada's 'undeclared recession.'

But Canadian's employees, on whom he had placed tough demands, lost confidence and blamed Jenkins for the airline's continuing misfortunes. At the end of June, despite finally gaining a favourable vote from the machinists on key concessions, Jenkins suddenly quit.

One could hardly blame him. He had steered the airline through five turbulent years, overseen the largest voluntary restructuring in Canada's corporate history, and then been accused of mismanagement. His resignation actually took the unions by surprise.

Kevin Benson, who had joined the airline as chief financial officer less than a year before, became chief executive officer. Benson was handpicked by Jenkins, despite his limited airline experience. He came from a large real estate firm where, significantly, he supervised a restructuring that saved the company from bankruptcy. Since assuming the reins, Benson has declined all requests for interviews with any company officers.

Liquidity is the most immediate challenge. The company had US$146 million cash at the end of last year. That has since slipped to US$82 million, but the first half of the year is typically the slowest. Compared to a year earlier, however, when Canadian only had US$14 million and some analysts were predicting it would not survive the winter, the company's cash reserves are much stronger.

But Canadian is well short of the US$110-220 million in operating cash its managers had hoped to have by now. And more worrying is what the airline has done to sustain these limited reserves. Instead of relying on operating cash flow, the carrier has maintained liquidity through asset sales, mostly through the sale and leaseback of its fleet.

Take out the proceeds from asset sales and Canadian's cash reserves actually plummeted last year by almost US$50 million, while during the first half of this year the figure would have plunged another $163 million. These freefalls are largely masked by receipts from aircraft sales, which began seriously in the second half of last year and have continued into this year. In the 12 months to June 1996, the company raised $214 million through asset sales. In short, the airline is surviving by what Ted Larkin, aviation analyst at Bunting Warburg in Toronto, calls 'an on-going act of cannibalisation.'

David Bell, Canadian's treasurer, would put it differently. Earlier this year he told an aircraft finance conference in Geneva that in 1995 'we were facing an uphill battle in trying to convince new investors to assume Canadian Airlines exposure. That is a major reason that we chose to focus on the sale and leaseback market.'

In that market, Bell said investors were willing to focus on aircraft values rather than the airline's credit. Canadian successfully sold and leased back 33 B737s, most of them Stage II, and one A320. As a result, Bell predicted at the time that the company's liquidity 'is sufficient to take us through 1996 and into 1997, by which time our required principal repayments on debt are greatly reduced.'

And the debt repayment schedule is the focus here. AMR's chairman Bob Crandall blames Canadian for creating its own troubles by front-loading too much debt repayment as part of its earlier restructuring. But he too predicts the airline will survive until 1997 when its debt service schedule 'drops right off a cliff.'

That prediction runs into two problems, however. First, while it is true that Canadian's debt schedule drops $18 million this year, lease obligations are rising almost as fast. Indeed, much of its 7.5 per cent increase in aircraft rentals last year was due to leasing exactly those aircraft the carrier had sold to raise cash.

Second, combining loan and non-cancelable lease obligations, Canadian's total long term liabilities only fall 2.4 per cent this year. Next year they drop another 7.3 per cent, but the 'cliff' that Crandall foresees, when these obligations fall 18 per cent, does not occur until 1998 (see table p42). That is a year later than Bell predicted. This extends Canadian's purgatory and underscores the question of whether the carrier can remain liquid when it is fast depleting the assets it has available to convert into cash. 'Only for so long,' says Larkin. 'Then you have to rely on cash flow from your on-going operations.'

Canadian has considered another option. In June, while Benson was still CFO, he revealed he was studying an equity injection to ease the company's longer term cash needs. But with shares trading at a 'junk' level around US$1.50 after a high of US$22 (after a 20-to-1 consolidation), shareholders would likely fight any equity offering. Recognising this, Benson said he was considering 'quasi-equity that would not result in heavy dilution.' He did not elaborate, and nothing more has been said about it.

Yet Larkin is sceptical about market reaction to any Canadian offering. 'Institutionally, there's not much investor receptivity out there,' he says.

To compound matters, Canadian has to finance 10 A320s on order, with deliveries starting next year. Net of current deposits, the company will need US$426.5 million in cash or debt financing over the next five years for these aircraft. This is on top of its current obligations. Remove the option of further asset sales or an equity offering and the airline's potential cash sources look meagre.

Canadian is naturally pursuing Larkin's suggested course in the hope of generating cash from its operations. To that end it is pursuing both cost and revenue strategies. On the cost side, it is trying to pare another 14 per cent off current seat mile costs of 8.8 US cents.

Much of that burden has fallen on Canadian's employees. New contracts with five of the six unions bring it close to its $91 million goal in annual wage savings. But each contract requires comparable concessions from each of the six unions and with Canadian's flight attendants holding out, the potential savings remain tantalisingly out of reach.

The flight attendants are resisting more cutbacks because they feel they have already borne the brunt of earlier sacrifices by taking shares in lieu of wages only to see their value plummet. 'We've done our best to get them through their financial problems,' Sheri Cameron, the flight attendants' union chairperson, told reporters, 'but there's a limit.'

In September the flight attendants voted overwhelmingly to give their union a strike mandate, but the appointment of a federal mediator means that a strike cannot take place pending a conciliation process.

Fleet and route decisions are largely on hold pending the outcome of this process, even as the 'ugly domestic scene,' as one analyst calls it, grows uglier. On the revenue side, WestJet and Greyhound Air, both low fare startups in Canadian's backyard, have inevitably pushed the Calgary-based carrier toward trying to attract higher yield business traffic. WestJet is temporarily grounded by a dispute with regulators over maintenance records, but it expects to begin operating again by early October.

In response to the appearance of these low fare rivals, Canadian may transfer some routes to its Canadian Regional Airlines subsidiary, but the bigger plan is to go after higher yield traffic. That means more frequencies on trunk routes, including the Canadian Shuttle on the Vancouver-Calgary-Edmonton triangle and offering better inflight service than the new entrants. The carrier also aims to broaden its codesharing alliance with American on transborder routes, which carry high levels of business traffic. Inevitably, however, most of these features hurt rather than help the campaign to cut unit costs.

Some analysts question whether this play for the business traveller is too little too late. Air Canada has been far more aggressive in launching new US routes. Canadian has simply lacked the aircraft needed to match that growth. On Canada's two busiest domestic routes, Toronto-Montreal and Toronto-Ottawa, Air Canada remains dominant. 'For the Blue Team [Canadian] to muscle market share away from the Red Team [Air Canada], which has a frequent flyer programme solidly in place, is a tough task,' notes Larkin.

Another part of the revenue strategy has been to shift capacity to higher yield international routes. Again, Canadian has been limited by the makeup of its fleet, but it has made modest gains by moving capacity from some less lucrative European routes to Asia and building more codeshare alliances in the Pacific, where it remains Canada's dominant carrier. This winter Canadian will add flights to China and Taiwan, and will codeshare on new routes to Nagoya, Manila and Kuala Lumpur. In Europe it is pulling out of Frankfurt and Paris and expanding its codeshare deal with British Airways.

Yet Canadian is not necessarily secure in its hold on the Asia-Pacific market, with Air Canada still arguing, although less forcefully, that its rival is the beneficiary of a route allocation policy which prevents dual designation until a market exceeds 300,000 annual passengers. This policy also benefits Air Canada on its own routes, but it appears more frustrated by it than protected. Ross MacCormack, Air Canada's vice president for corporate strategy, claims 20 per cent of Canada's traffic to Asia is lost to US carriers because Ottawa is barring Air Canada from adding the trans-Pacific capacity needed to keep it. 'We've paid Canadian Airlines' mortgage for the past eight years,' adds an angry Yves Dufresne, Air Canada's international affairs director. 'We almost own Canadian for having subsidised them indirectly,' he claims, citing the costs he claims Air Canada has borne from these restrictions. 'I'm very critical of Canadian's senior management for spooking politicians into maintaining this [policy].'

Some Canadian aviation sources predict the clock is running out on government support for Canadian. Ottawa is a more vocal free market advocate these days; some say it will be compelled soon to apply that to its own aviation policy. Yet, as one insider notes, 'whenever the government has faced a hard choice on its two major airlines, it always found a way to compromise.'

The whole question of support for Canadian aggravates east-west political tensions within Canada. Overt aid would anger voters in Quebec - Air Canada's base. Four years ago Canadian took a US$51 million loan guarantee from provincial governments in British Columbia and Alberta, both in the west, to shame Ottawa into putting up a US$36.5 million loan guarantee for Canadian on its own.

The political equation today would be finely balance between the fallout from a government propping up an airline weighed against 17,000 layoffs and the prospect of consumer complaints if Canada were left with only one major airline.

In turn that poses the question of how much the likes of WestJet and Greyhound could fill any vacuum. And Larkin does not rule them out. 'Never underestimate the potential for new entrepreneurs to enter this field,' he says. 'With plenty of available aircraft, trained personnel, and no slot problems in this country, there are always other people willing to get into the airline business.'

Assuming Ottawa fails to come to Canadian's aid should the carrier need bailing out, the carrier's management may yet be able to rely on the parent of partner American Airlines to ride to the rescue again. On the surface, the proposition is not attractive, as AMR could not increase its control in line with any further investment.

But AMR is finding a roundabout way of exercising its influence through the transborder transfer of management expertise. Mary Jordan, president of American Eagle carrier Wings West Airlines, is the latest executive to move north, to take over as president of Canadian Regional Airlines. She joins American alumna Barbara Amster, who is now Canadian's senior vice president for marketing and sales. Moreover, Douglas Carty, the brother of American's Canadian-born president Donald Carty, has moved up from vice president finance to replace Benson as CFO. Only time will tell whether company and family ties are as good as voting rights.

American plans to make Vancouver its major trans-Pacific hub. Amster told the Globe and Mail that this will help raise Canadian's Asian revenue from US$570 million last year to $1.2 billion in 2001.

In helping Canadian, AMR could be driven by a less tangible motive in its desire to protect its reputation as a services provider, which helps turn around struggling carriers. AMR has touted its 20 year service agreement with Canadian on this premise and should Canadian fail AMR's credibility loss could easily exceed its investment in Canadian, which in reality is less than the price of two MD-11s. Thus, if Canadian's own management fails and the politicians shy away from bailing the carrier out, the fate of Canadian Airlines could be decided in Dallas.

Source: Airline Business