Chorus Aviation (CHR.B)

Chorus Aviation is the holding company for Jazz, the dominant regional airline in Canada that works in close partnership with Air Canada. The majority of the Chorus business is structured in the form of a Capacity Purchase Agreement (CPA) with Air Canada, whereby Air Canada is responsible for scheduling, pricing, distribution, marketing, advertising, and customer service, and Chorus actually operates the flights (that is, Chorus provides the planes, the pilots, mechanics, etc.). Under the CPA, Air Canada collects the revenues from these flights and then pays Chorus under a relatively complicated formula that passes through certain costs such as fuel and terminal fees, and is keyed to the number of hours flown, number of passengers, and other variables. Chorus can also receive incentive fees each quarter depending on how well it performs in terms of on-time performance, baggage handling performance, and customer satisfaction.

Chorus presents a compelling investment opportunity for a few reasons:

• It currently trades at a very undemanding ~5.7x earnings and ~3x TEV/EBITDA, and currently pays a $0.0375 monthly dividend for a yield of ~11%.
• Because of the CPA, Chorus is insulated from most of the vagaries of the airline industry, primarily passenger revenue and fuel costs. This makes the earning power of the company much less volatile and thus lower risk.
• The benchmarking arbitration case between Chorus and Air Canada that had been ongoing since 2010 and which had cast a pall on the company was successfully resolved in November of 2013, with a complete victory for Chorus.
• Chorus has a shareholder-friendly management team that has done several things recently that indicate management’s view that the stock is cheap; in February of 2014, the company redeemed most of its convertible debentures (with the rest redeemed in the second quarter of 2014), and initiated a share buy-back that has already resulted in the cancellation of 1.7mm shares.
• Chorus has a very seasoned work-force that includes a higher than normal percentage of senior employees who earn significantly higher wage rates; this has created the opportunity for the company to invest in highly accretive voluntary separation programs ($10mm in 2013 and ~$15mm in 2014) that have payback periods of less than 24 months.

The CPA has the effect of replacing one kind of risk, namely market risk associated with demand for air travel and energy costs, and replacing it with contractual risk. The current CPA term expires at the end of 2020, and is subject to renewal on terms to be negotiated for two additional 5-year periods.

The best indication of how much the CPA insulates Chorus from market risks is the historical earnings record, which shows markedly less volatility than that of a traditional, stand-alone airline over the period:

The key provision of the CPA is the mark-up on controllable costs that Air Canada pays to Chorus. Under the current terms of the agreement, this mark-up is set at 12.5%. The key risks to Chorus are that Air Canada fails to renew the CPA after it expires in 2020, or that Chorus negotiates an extension with Air Canada that pays a lower mark-up rate, which would put pressure on margins and dividends for Chorus.

I believe that Chorus is very likely to negotiate an extension to the CPA before it expires. Indeed, the CEO of Chorus, Joseph Randell, was quoted in a 2/20/14 article in The Globe and Mail saying that “We’re open to negotiations at any time.” From the standpoint of Air Canada, Chorus is basically the only game in town in terms of a regional partners, since it is many times larger than the next largest regional airline, and is already set up to work well with Air Canada’s systems. Furthermore, despite the arbitration process between the companies, the relations between the respective management teams are said to be cordial, and Chorus has performed quite well as measured by various metrics, such as the percentage of flights on time. Thus there is no fundamental reason why the companies can’t continue to work together if they can agree on a pricing formula that makes sense for both sides. Since there is no competitor that is even close in scale to Chorus (the only other notable competitor is WestJet’s Encore regional airline, which currently operates just 14 planes, compared to 125 planes for Chorus), the negotiations are not quite as one-sided in favor of Air Canada as they might be at first blush.

In the meantime, investors can collect a double digit yield and have downside protection in the event of a market dislocation such as what happened in 2008-2009 because of the way the CPA is structured. Chorus is relatively under-leveraged for an airline, with $393mm of total debt and $106.4mm of cash, compared to EBIT in the last twelve months of $146.5mm. 

• Extension of CPA with Air Canada
• Continued voluntary separation agreements with senior employees.