Chapter 12

Optimal Capital Structure in the Airline Industry:

Air Canada versus WestJet Airlines

The commercial air transport industry has historically been a highly risky business from the perspective of investors. Veterans of the industry often tell the following story:

Question: Do you know how to get a million dollars by investing in the airline industry?

Answer: Invest a billion dollars and wait a few years. By that time it will be worth only a million dollars.

The industry is extremely competitive, with many new carriers entering the business, often with a plan to offer low-cost service and attract customers from the larger airlines. Price wars are common and profits suffer. The bankruptcy rate among airlines is one of the highest of any industry.

In addition to the aggressive price competition in the industry, airline firms also have huge fixed costs and very low variable costs. In finance, this characteristic is called high operating leverage. It costs nearly the same to fly a plane half empty as it does to fly it full. Hence, very small changes in the load factor (percentage of seats filled on each flight) have a huge impact on profitability. As we will see in the following two chapters, when a firm has a high degree of business risk (due to volatility in prices, quantities sold, and operating costs, and to high operating leverage), it is prudent to use a capital structure with a low degree of financial leverage. Low financial leverage means that the firm uses relatively small amounts of debt to finance the assets of the firm.

Because of the high business risk of the airline industry, we would expect to see the best firms in the industry use relatively small amounts of debt to finance their assets. Arguably the best firm in the worldwide airline industry is Southwest Airlines. It has the lowest cost of operation per passenger mile of any of the major airlines. It has made a profit every year since it was founded. In 2001, Southwests capital structure (based on book values) consisted of approximately 60 percent equity and 40 percent long-term debt.

The young Canadian airline, WestJet Airlines, based on the Southwest business model, was started in Calgary in 1996 to serve five cities with three aircraft. Since then, WestJet has steadily expanded its service to other Canadian cities from coast to coast, serving 23 cities in 2003 with more than 35 aircraft. WestJet (WJA) went public in 1999 and is listed on the Toronto Stock Exchange. Investors who paid $100 for WJA shares in July 1999 had an investment worth $363 at the end of 2002. In 2000, WJA was the second most profitable airline in North America, just behind the world leader, Southwest Airlines. At the end of 2002, WJAs capital structure (based on book values) consisted of approximately 58 percent equity and 42 percent long-term debt, not much different from Southwests capital structure.

In contrast, Air Canada has struggled over the years to achieve profitability since it went public. By 2000, after a period of sustained losses and the merger with Canadian Airlines, the capital structure had slipped to barely 3 percent common equity and 97 percent long-term debt. The firm also had a substantial amount of fixed-cost lease obligations outstanding. The year 2001 was not a good one for the airlines, and it was unclear whether Air Canada would survive as an economically viable enterprise. At the end of 2001, Air Canada had a negative shareholders equity (i.e. the book value of its liabilities exceeded the book value of its assets) of $938 million.

Although Air Canada may never have planned for the capital structure it experienced, its poor operating performance in a very risky industry resulted in a highly leveraged capital structure that has kept the airline in a precarious financial position during much of the past decade.

As this example illustrates, there is an important connection between the business risk that a firm faces and the choice of an optimal capital structure. The following two chapters discuss these concepts.