The Stock

What to Buy: Chorus Aviation Inc (TSX: CHR/B, OTC: CHRVF) < CAD5.50

Why Now? We have an opportunity to lock in an 11 percent-plus yield on a regional airline that converted from a Canadian income trust into a corporation without cutting its dividend.

Airlines’ biggest expense is fuel, which tend to drive share prices in the near term. The threat of rising fuel costs hangs over the entire industry, and long-term supply/demand fundamentals argue for higher oil prices in coming years. But the current spike in energy prices is due to political events, which are always ephemeral.

Airlines can manage steadily rising fuel costs; it’s the unpredictable spikes that upset forecasts and planning. Moreover, events in Japan, the world’s third-largest economy and the No. 3 consumer of oil, will likely to tamp crude’s short-term momentum. That makes it likely jet fuel prices will back off the next few months, spurring stock prices of airlines.

As for Chorus itself, fourth-quarter and full-year 2010 results and January 2011 global air traffic numbers are healthy. That suggests the company will both grow this year and sustain its CAD0.15 per share quarterly dividend, with the next installment in March.

The Story

Roger’s on the road in Florida this week, out meeting American Association of Individual Investors (AAII) chapters across the Sunshine State. David, trying to push back against the feeling that he’s perhaps a little too tickled by the irony of suggesting an airline stock to a guy who regularly talks about how poor the view is from 30,000 feet, wrestles with his pitch before settling on a criterion that, although not specifically described within the Safety Rating Systems employed for Utility Forecaster, Canadian Edge or MLP Profits, exists in the penumbra.

Though not exactly recession-resistant, this regional airline–Canada’s No. 2 carrier–is stress-tested. That’s a key characteristic for a stock priced to yield double-digits.

David: If nothing else Chorus Aviation Inc (TSX: CHR/B, OTC: CHRVF) can take a punch. The share price went into slow, steady decline almost from the moment of its initial public offering in January 2006. But shrewd payout policies amid the worst credit/financial/economic crises in modern history–one that particularly decimated the airline industry–have left it ready to boost again provided economic activity stabilizes.

Roger: We’ve been kicking this around since you sent that “Chorus/Jazz is a no-cut converter yielding 11.4 percent, and global air passenger traffic was up 7 percent in January” e-mail last week. A lot’s changed since then.

David: It was last Tuesday, in fact, Mar. 8. And yes, things have gotten even more volatile, with the extremely tenuous, tragic situation in Japan managing to push the explosive uprisings in Libya, Bahrain and elsewhere across the MENA (Middle East North Africa) off the front page.

Chorus actually opened what was another rumor-and-tension filled day (Wednesday) at CAD5.16 and traded up as high as CAD5.26. What’s even more interesting to me is that from Jan. 25–the day it became clear that the protest in Egypt was something more lasting–through Wednesday Chorus is exactly flat in home-currency terms.

It closed at CAD5.22 on Jan. 25, and it closed at CAD5.22 on Mar. 16. At these levels it’s yielding 11.4 percent.

Roger: As you know, we’ve had Chorus as a speculative buy from time to time in Canadian Edge. I’ve hesitated getting more bullish for a couple of reasons.

First, this company has historically lived and died based on its relationship with Air Canada (TSX: AC/B, OTC: AIDIF), which has been near bankruptcy the past couple years. And even though management is diversifying its operation, the agreement with Air Canada that passes through costs and so forth is still critical. I always tell readers you have to know who’s writing the checks when you shop for yield. And the Air Canada connection–despite the Canadian government’s tacit guarantee against failure–is a worry.

The other thing is rising jet fuel prices, which always go up when oil prices do. That’s not a direct concern for Chorus because it can pass through those costs to Air Canada. But it certainly is for Air Canada, and if it gets too stressed you can forget about those pass-throughs. We’ve already seen one negotiation of that agreement to the detriment of Chorus in the past few years.

And with Air Canada revising downward its capacity growth forecast from a range of 5.5 to 6.5 percent to 4.5 to 5.5 percent and cutting routes this week, because of the anticipated impact of rising crude, it’s definitely a risk that it could happen again. That renegotiation was the key reason for Chorus’ dividend cut, when it was still Jazz Air Income Fund.

Bottom line: If things get bad at Air Canada again, risks to Chorus’ dividend will rise.

David: I saw the news at Air Canada, and it’s pretty much industry-wide. The International Air Transport Association (IATA)–which represents 230 airlines that account for 93 percent of global air traffic–revised its forecast for combined net 2011 profit downward to USD8.6 billion from USD9.1 billion. The IATA expects total revenue of USD594 billion for its membership. The industry earned USD16 billion in net profits in 2010, as passenger traffic surged on an improving international economy.

And it’s all about oil prices. The previous IATA forecast assumed an average 2011 price of USD84 per barrel. The new assumption is USD96. Even the IATA’s top guy says the price of oil–which is directly tied to the price of jet fuel–is the No. 1 risk to airline profitability.

Roger: I guess I’m less worried about that now because of why oil prices have risen as they have. The history of political events driving oil prices higher is that they tend to be short-term in nature, followed by steep drops. I think the threat to supply in the Middle East has had such a great effect in 2011 because global supply and demand continue to tighten. But at least in the near term I think we can expect at least some unraveling of this price jump, and that has to be bullish for Chorus.

There’s also the issue of passenger traffic growth, which of course is tied to economic growth. That actually is expected to be more robust, with global economic growth now forecast at 3.1 percent as of March, up a full 0.5 percentage point from December’s projection.

Finally, there’s even good news on the Air Canada front. It’s taken some hard work but it looks like Air Canada is getting its act together. It’s improved a forecast it just provided in February. And it’s introducing base fare increases and fuel surcharges on a market-by-market basis to better match its costs, while it continues to monitor routes that could prove unprofitable if fuel costs push higher.

Would you agree the crisis of near bankruptcy has made it more disciplined, more nimble?

David: That’s what to me makes Chorus a quintessential target for Big Yield Hunting.

It’s up 26.3 percent in the four and a half years since the Halloween Massacre. That’s when Canadian Finance Minister Jim Flaherty introduced a new tax on income trusts starting in 2011. But it’s also underperformed almost every other index, including the S&P/Toronto Stock Exchange Composite Index, The only reason it beat the S&P 500 was because of the Canadian dollar’s strength.

It has done well since April 2009. In fact, I’d call that chart a thing of beauty. You know you could have had Jazz Air Income Fund for less than two loonies a unit in April 2009? Yeah, that’s right. Check the yield.

Roger: It’s currently paying CAD0.15 per share per quarter. Its final income trust distribution scheme was the CAD0.05 per unit per month that was first paid in September 2009. From February 2007 through August 2009 the company paid CAD0.0838 per unit.

David: This was the first and still only time Jazz/Chorus cut its regular payout.

Roger: Its first distribution as an income trust was in March 2006, CAD0.0703 per unit; from April 2006 through January 2007 it paid CAD0.0729 per unit per month. So management is clearly not averse to dividend increases when circumstances permit.

David: So in April 2009 the yield was in the neighborhood of 50 percent. In fact we reported it as 49.1 percent in the April 2009 issue; you could look it up.

Roger: Ah, nice Thurber/Stengel/baseball reference, and nice way to point out the rich historical database we have on the CE website.

But back to the stock at hand: It’s not realistic to build a long-term investment strategy around bottom-picking. I’ll cut right to the chase: Is it safe, and can it grow?

David: The dividend, you mean.

Roger: Specifically, yes, and generally as well. My advice on what was Jazz Air Income Fund at that time–April 2009–was “hold.” My comment on the stock was, “Air Canada bankruptcy could hurt trust but management says it is insulated.” The payout ratio was 83 percent.

David: We also wrote it up as part of a broader look at transport stocks in the CE coverage universe in the May 2010 Feature Article:

The trust’s share price has staged a solid recovery since bottoming around USD2 in early 2009. Business, however, has remained very difficult, evidenced by the 40 percent dividend cut last August. That’s in large part due to the troubles of Jazz’ parent Air Canada, which continues to ring up losses and remains perilously close to bankruptcy.

Statements by CEO Joe Randell to the effect that Jazz should be able to hold its current distribution after converting to a corporation have been encouraging. So are the trust’s recent moves to expand operations globally, for example last month’s CAD15 million investment in a Uruguayan regional carrier. Unfortunately, there are just too many risks attached to Jazz’ 12 percent-plus yield for us to rate it a buy.

We quoted it at USD4.82 per unit when that issue was published on Friday, May 7, 2010, with a yield of 12.2 percent and still a “hold” rating. The payout ratio for the most recent reported period–which would have been the first quarter of 2010–was 68 percent.

Look, Jazz/Chorus–or is it Chorus/Jazz?–was too risky for an income-oriented letter such as Canadian Edge. But is has proved its dividend at least relatively safe, and the mid-2009 cut, by 40 percent, left plenty of room for upside.

Roger: Which is why we now rate it a “buy” up to USD5. But let’s not pull any punches here. This company has had a lot of ups and downs the past several years. And the chart shows that you want to buy it when the ups are ahead, not the downs. That dividend cut was vicious both for the dividend and the share price. The problems at Air Canada were at the root of it, which in turn were spurred in large part by the spike in jet fuel prices.

Let’s talk about why we think that’s not going to happen again, at least not anytime soon.

David: Yeah, I thought full-year 2010 and fourth-quarter numbers were solid but unspectacular compared with 2009, which proved to be the great turnaround year for the airlines. I’d start with the 16.9 percent decline in cash flow on higher expenses.

Roger: Our readers need to know that cash flow, not traditional earnings per share, are the metric for measuring Chorus’ profitability and therefore dividend safety. So that is a very big number for the company. But that decline looks like a one-off event to me.

For one thing, block hours increased 7.7 percent, indicating the business is growing. And many of those higher expenses were one-time items, such as what it cost to make acquisitions and to convert to a corporation. That last item is no small check to write for a mid-sized company.

The bottom-line number is, of course, the payout ratio based on free cash flow, which is cash flow less what it costs to maintain Chorus’ fleet. That came in at 81.9 percent, higher than I’d like to see but not bad in what should be a low-watermark year.

Looking ahead, management should be able to cut a number of costs, from fuel excise taxes to airline surcharges. And it’s also had success paying down long-term debt, which will cut interest expense, boost free cash flow and further bring down that payout ratio.

David: A year ago management announced its intention to acquire outright 15 aircraft and secure options for 15 more. Chorus closed the deal for the first 15 (eight delivered in 2011, seven in 2012) the day before it announced 2011 results.

I’m encouraged by its plans to expand outside North America by investing in the regional carrier Pluna, which will reduce its dependence on Air Canada. There’s the five-year deal with Thomas Cook to operate six Boeing 757s during the winter months, which will boost its business to vacation destinations in the Caribbean. Two planes went into service in November 2010, and all six were on line by December.

Roger: I know some investors and their advisors would say these deals make the company more complicated to follow. But to me the key issue has always been the reliance on the capacity purchase agreement with Air Canada. Management really has no choice for the long term but to try to branch out.

But it’s going to be Air Canada that drives the performance in 2011 and almost certainly 2012 as well. As long as Air Canada stays in good shape, Chorus will be, too.

David: Guidance is for a payout ratio based on cash flow of between 70 percent and 80 percent for 2011. That’s based on billing between 390,000 and 400,000 block hours and Air Canada being able to handle a labor dispute without real disruption.

Roger: Which, as we know, isn’t always a given. Odds, however, should favor a deal this year. You have to look with a microscope to see wage pressures in this economy. Both sides clearly have a lot to lose by not shaking hands and moving on.

David: I agree.

We haven’t addressed the corporate conversion. Chorus didn’t cut its dividend when it converted this year from an income trust. But we should mention the benefits of conversion: more efficient capital management, more comparable performance metrics to the rest of the industry, the ability to attract new investors, more liquid trading of securities and the reversal of a CAD70 million valuation allowance on certain taxable assets.

And as a corporation, the story line on Chorus goes from the same old income trust deal to the fact that it has high-quality branded airline operations such as Air Canada Jazz, Jazz and Thomas Cook Canada.

Roger: Those are all positives to be sure. And they’ve been duly noted by the Bay Street analysts who follow Chorus. Despite all the turmoil in the energy markets, there are four “buy” ratings and four “hold” ratings, with no “sells.” Air Canada’s ratings are 11 “buys,” one “hold” and zero “sells.”

Also noteworthy: None of these guys have changed their ratings–for either Chorus or Air Canada–since oil prices started spiking. That’s saying something.

Let’s go ahead and recommend Chorus Aviation Inc as a buy up to USD5.50. Anyone who buys below that price will get a double-digit yield as well as potential capital gains of 25 to 30 percent as Chorus grows its business. That gain will come a lot faster if the Middle East crisis cools and oil loses some of its “political price premium.”

David: Thanks, Rog.

Bag Chorus Aviation Inc (TSX: CHR/A, OTC: CHRVF) and its 11 percent-plus yield under USD5.50.

I’d like to add a note to our readers: Market action in recent days has, of course, been quite volatile, in line with developments in Japan. It’s important at times such as these to be on alert for facts, not hysteria. Thus far we’re not aware of any company-specific exposures that would prompt a “sell” for any of our open positions. We will continue to monitor for same.

We’ve commented in recent days on the still-unfolding situation at Fukushima-Daiichi and the general impact on markets, as have our colleagues Elliott Gue and Yiannis Mostrous, at www.InvestingDaily.com.

Roger’s Flash Alert to Utility Forecaster subscribers and Elliott’s to The Energy Strategist clients provided indispensible advice on how to approach it from a portfolio management perspective.

Roger and I, as noted above, will continue to track our open positions and will provide updated advice as necessary via Alert.

And though the mainstream media continue to bombard us with what remains a limited threat, thousands of Japanese have already died as a result of last week’s earthquake and tsunami, people and pets.

And millions more have been displaced. Please keep these humans and animals in mind.

Thanks for reading.

• August 19, 2010: New Flyer Industries (TSX: NFI-U, OTC: NFYIF)–Buy < USD11
• September 16, 2010: Avenir Diversified Income Trust (TSX: AVF-U, OTC: AVNDF)–Buy < USD6
• October 22, 2010: Otelco (NYSE: OTT)–Buy < USD20
• November 18, 2010: Telstra Corp Ltd (Australia: TLS, OTC: TLSYY)–Buy < AUD2.80, USD13
• December 16, 2010: Capital Product Partners LP (NSDQ: CPLP)–Buy < USD9.50
• January 20, 2010: Cellcom Israel Ltd (Israel: CEL, NYSE: CEL)–Buy < USD32.50
• February 22, 2011: DUET Group (Australia: DUE, OTC: DUETF)–Buy < USD1.70
• TODAY: Chorus Aviation Inc (TSX: CHR/A, OTC: CHRVF)–Buy < USD5.50