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Inside the Market Contra Guys: Why we’re holding tight to our Transat shares in the wake of the Air Canada bid

Transat Shares Should Soon Fly Higher, read the headline on our article last September. Indeed they have, moving from about the $8 range to $11.54 at Thursday’s close.

The catalyst has been several suitors seeking to acquire this enterprise, with Air Canada the leading option with a bid valued at $13 a share. The two companies are now in 30 days of exclusive talks. We both feel that a takeover will happen, and being shareholders our primary question is, at what price?

One key to a deal with Air Canada is that Transat AT Inc. can leave the head office in Quebec, as is Air Canada’s, which would help to satiate the desires of the provincial government. No question, though, Ottawa’s lords of competition will be looking at this one closely, concerned that it will leave too much flight power in the hands of one operator. That would put upward pressure on prices, another knock to the pocketbooks of Canadian consumers.

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Perhaps a takeover by another party based in Quebec may be more palatable to the powers that be. There appears to be a number with an interest and the potential wherewithal to do a deal. Two major factors that make swallowing Transat even more attractive is that unlike virtually every other airline, Transat has no debt. That makes it an anomaly. In addition, there is about $620-million in cash in the corporate coffers. Given that the current price to do a deal is $525-million, the knight in shining armour could potentially do the deal with the airline’s own cash so to speak, albeit that money is there because of customers’ deposits. Still, so much cash could open the takeover option to more groups, a possibility that could increase the bid.

While Transat lost about $50-million last quarter and the bottom-line dances between red and black ink, with losses in four of the past 10 years, the macro environment for this industry shines. With the global population growing and becoming more affluent, there will be additional demand to fly. Also, because of our large immigrant population, many people will want to regularly return to their homelands, or have relatives and friends visit here, boosting the number of bums in the seats. This was also part of our logic after 9/11 when airline stocks were hammered. At that juncture, we nabbed KLM at US$9.36 and took a fair bit of criticism for doing so, as aviation was toxic at the time. It was sold in 2005 at US$30.99, after the merger with Air France. Criticize away.

One way that Transat plans to improve the bottom line is to build hotels. Doing this would allow the enterprise to vertically integrate, not only booking Air Transat flights, but taking passengers to corporate lodges, which when done efficiently is more profitable than just being an airline. This, however, is a capital-intensive project and we are skeptical about it because the process would tear through the pile of cash. Whoever does the takeover, if it is done, might put the kibosh to this blueprint. Transat has agreed to sideline this process for the moment.

It is worth noting that break-up fees are in order on both sides of the deal. If Transat marries another company, it would have to pay $15-million. With a share count of 37 million and change, that means that another offer would have to be at minimum 40 cents more per share than Air Canada’s to make it worthwhile. But if this country’s largest airline cannot get a deal done, it will pay Transat $40-million. That isn’t a bad recompense for not doing a transaction.

Our spidey sense tingles that a deal will be done with Air Canada, albeit some shedding of routes or assets will have to transpire to make regulators happy. It would not surprise to see flagship carrier put a bit more money on the table to close the agreement. If that does not work, another made-in-Quebec solution could come to the forefront, at or above the current bid. For those reasons, we will hold our shares tight to the vest and watch this competition play out. However, if we are wrong and no deal is made, the shares will almost assuredly plummet, and we’ll be left grounded.

Benj Gallander and Ben Stadelmann are co-editors of Contra the Heard Investment Letter

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