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Siddharth Rajeev, B.Tech, MBA, CFA

Anthony de Ruijter, BA. Econ

August 15, 2018

Canada Jetlines Ltd. (TSXV: JET) – Advances Aircraft Leasing Strategy, Strengthens Management Team

Sector/Industry: Airlines www.jetlines.ca

Market Data (as of August 15, 2018) Highlights Current Price C$0.50  Canada Jetlines Ltd. (“Jetlines”, “Company”) recently Fair Value C$2.57 announced a Definitive Leasing Agreement for two Airbus Rating* BUY Risk* 4 (EPA: AIR) A320 aircraft. The aircraft are expected to be 52 Week Range C$0. 19 - C$ 1. 42 delivered in the first half of 2019, and mark a significant Shares O/S 71 ,155 ,160 bounce back from delays announced in March. Market Cap C$ 35.58 mm  The company has also added significantly to their Current Yield N/A management team, with leadership augmented by strong P/E (forward) N/A track records in the low-cost aviation space. P/B 5.10x  Swoop Airlines, the Ultra Low-Cost Carrier (“ULCC”) YoY Return 131 .82 % YoY TSXV -10 .94 % subsidiary of WestJet Airlines Ltd. (TSX: WJA), has now *see back of report for rating and risk definitions. entered the market. However, we do not consider Swoop to * All figures in C$ unless otherwise specified. be a true ULCC due to the unionization of its pilots and flight attendants.  As labor costs and fuel costs (as well as other expenses) are likely to be equal between WestJet and Swoop, it is difficult to see how Swoop will be able to operate as a ULCC.  The global aviation industry has performed well in the past few years, and is forecasted to improve further with the economy. Jetlines stands to benefit from the positive macro

backdrop.  We are revising our fair value estimate to $2.57 per share and maintaining our rating at BUY.

Key Financial Data (FYE - Dec 31) (C$) 2016 2017 Q1-2018 Cash $91,397 $2,981,046 $6,774,774 Working Capital -$674,499 $2,698,286 $6,595,352 Debt $213,536 $0 $0 Total Assets $199,496 $3,564,831 $7,557,927 Net Income (Loss) -$942,925 -$9,067,694 -$956,910 EPS -$0.07 -$0.16 -$0.02

 2018 Fundamental Research Corp. “15+ Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com PLEASE READ THE IMPORTANT DISCLOSURES AT THE BACK OF THIS REPORT

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Secures Lease On June 13, 2018, the company announced that it had signed a Definitive Lease Agreement Agreement for for two Airbus A320 aircraft. Delivery of these aircraft is expected within the first half of Two Airbus 2019. The lessor of the planes, AerCap, is the world’s largest independent aircraft leasing A320 Aircraft company with a diversified portfolio of aircraft. AerCap has a customer base of approximately 200 airlines and operates in over 80 countries. The two A320 aircraft, which Jetlines is planning to lease, are virtually identical in design and are both twelve years old. The company has not disclosed the expected leasing costs.

The development follows a string of positive press releases, which came after the company’s slump in late Q1-2018, in response to an anticipated delay in operational launch. The company had previously expected a launch in the summer of 2018, but given the failure of their previous leasing agreement, we had revised our estimated launch date of the company to Q1-2019. Based on this press release, we are revising Jetlines’ launch date to the beginning of Q3-2019 . This development demonstrates that the company’s management remains committed to rolling out the airline as fast as possible, which we believe will be key to competing in the ULCC space.

Strengthens On May 22, 2018, the company announced that it had appointed ULCC veteran Lukas Management Johnson as CEO, effective June 18, 2018. Out-going CEO Stan Gadek has stepped down and Team will be returning to his consultancy practice. CEO Lukas Johnson has eight years of experience with U.S. ULCC Allegiant Travel Company (NASDAQ: ALGT), most recently as Senior Vice President, Commercial. During his time at the airline, Allegiant saw some of the highest operating margins in the industry (29.4% and 27.2% in 2015 and 2016, respectively), and annual revenues per plane grew by 30%. His areas of expertise include:

 Network planning  Revenue management  Operations research  Corporate strategy  E-commerce  Operations

Mr. Johnson will be making a $0.70 million investment into Jetlines’ operating subsidiary, Canada Jetlines Operations Ltd. Mr. Johnson will acquire a 5% stake in the subsidiary through a newly created subordinate class of shares. These shares will have limited rights and will be subject to a two-year restriction on transfer. At the end of this period, the shares will be redeemable by either the company or Mr. Johnson for a payment by the company, with payment based on an undisclosed formula based on Jetlines’ market capitalization at the time of redemption. The payment will be made either by cash, or depending on the approval of the TSXV exchange, in shares of the company. As details of the pay-out formula are undisclosed, we have incorporated the above into our valuation models by including 5% of the current shares outstanding as additional share dilution.

In addition to a new CEO, the company also announced on June 20, 2018, that it had appointed a new Chief Commercial Officer (“CCO”), Javier Suarez, effective July 30, 2018. Mr. Suarez has over 10 years of airline executive experience, and was most recently Vice

2018 Fundamental Research Corp. “15+ Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com PLEASE READ THE IMPORTANT DISCLOSURES AT THE BACK OF THIS REPORT

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President, Network Planning, Revenue Management, E-Commerce, with VivaAerobus, a Mexican low-cost carrier. Mr. Suarez also held previous positions with Vueling Airlines S.A., a Spanish low-cost carrier that is majority owned by International Airlines Group S.A. (LSE: IAG).

During his tenure at VivaAerobus, Mr. Suarez was part of the management team that took the airline from breakeven in 2014 to the most profitable airline in Mexico by 2017, whilst also growing the fleet from 13 aircraft to 32 between 2014 and 2018. During this stint, he also launched 55 new routes with a 98% success rate. This success was mirrored during his time as a Director, Network Planning, Scheduling, Slots and Corporate Affairs with Vueling Airlines, where he launched more than 200 routes over three years, achieving a 92% success rate, whilst also growing the fleet from 38 to 105 aircraft in four years. Mr. Suarez also exhibits an impressive academic background, with a Masters in Management from Harvard University, a Masters in Marketing from ESIC Marketing School in Madrid, and a B.A. (Airline Business Administration) from the Autonoma University of Madrid.

As a pre-revenue operation, we see these additions to Jetlines’ management team as pivotal to the future success of the company. Both Mr. Johnson and Mr. Suarez have impressive track records in the aviation industry, and in particular, with ULCC/ low-cost carriers. As Jetlines prepares to launch in 2019, with the intentions of being Canada’s first true ULCC, having leaders who have relevant track records will be crucial to initiating and maintaining operations whilst keeping a lean cost-structure.

Competitor WestJet subsidiary Swoop Airlines (“Swoop”) was officially launched on June 20, 2018, Swoop Begins with a maiden voyage from John C. Munro Hamilton International Airport to Abbotsford Operations International Airport. Though Swoop have now succeeded in beating Jetlines to market, we note that Swoop is not as separated from parent WestJet as may seem on the surface. The difference between Jetlines and Swoop is that whilst Jetlines is a standalone company completely focused on a ULCC business model, Swoop remains an extension of WestJet, despite efforts from the latter to define Swoop as a true ULCC. This means that whilst Swoop benefits from WestJet’s existing resources and expertise, it is also exposed to many of the same constraints.

One of the most significant of these include the sharing of pilots between WestJet and Swoop, an issue we have highlighted in the past. On May 27, 2018, a Federal mediator ordered that Swoop pilots be represented by the Air Line Pilots Association (“ALPA”), the union which represents WestJet’s main carrier pilots. Now that the pay scale between WestJet and Swoop will largely be the same (due to both pilot groups being unionized), our suspicion that WestJet would be unable to keep Swoop’s labor costs low appears to be confirmed. On August 1, 2018, it was reported that the majority of WestJet’s flight attendants were also unionized following their successful vote to have the Canadian Union of Public Employees (“CUPE”) represent them, and we believe that this measure will extend to Swoop flight attendants as well.

Without being able to keep Swoop’s labor costs below those of WestJet’s, we believe that WestJet may see less than optimal Return on Invested Capital (“ROIC”) on their Swoop

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carrier. Furthermore, as fuel prices are forecasted to increase, WestJet may have little room to cut Swoop’s costs to realize margins superior to their legacy carrier. Whilst Swoop may generate economic profits via demand boosts from price stimulation, we speculate that Swoop’s business may eat into WestJet’s existing sales, as WestJet customers that had previously little alternative turn to cheaper Swoop flights instead. If this were to happen, the cannibalized sales would be realized at a lower price point, resulting in a net negative outcome for WestJet.

With the recent events suggesting that Swoop may have trouble operating as a true ULCC, it appears that WestJet may be pursuing too many initiatives concurrently. Other major WestJet initiatives include:

 International expansion and evolution of WestJet to include globally networked flights. This could see an upgrade of traditional WestJet flights to incorporate features more attributable to legacy carriers, making the airline more attractive to higher budget consumers. This, however, comes with all the CAPEX costs required to upgrade existing planes and purchase new units, and likely will increase the burden of operating costs as well.  A Joint-Venture with Delta Airlines (NYSE: DAL) to expand both airline’s trans- border capabilities.

The market also appears to think that WestJet is doing too much with too little, as exhibited by the company’s share price, which has plummeted almost 35% in 2018.

Industry In our update report in March, we reported on the failure of Jetlines’ previous aircraft lessor Update to guarantee the delivery date of two Boeing (NYSE: BA) aircraft that were to be leased to Jetlines earlier this year. The reason given by the company pertained to the unexpectedly high level of demand for aircraft. In addition, issues with new engines resulted in airlines holding onto planes for longer, leading to even less aircraft supply. Though the delay in Jetlines’ expected launch date resulted in a sharp blow to the company’s share price, we believe that Jetlines stands to benefit from very promising macro indicators.

The International Air Transport Association (“IATA”) reports monthly and annual statistics regarding the aviation industry. As shown in the chart below, IATA reports that air passenger volumes, as measured by revenue passenger kilometers (“RPK”) or the kilometers flown by paying airline passengers, is steadily increasing over time on a seasonally-adjusted basis. The increase in air traffic can largely be attributed to steadily decreasing airfares globally, demonstrating the demand boost from price stimulation.

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Air Passenger Volumes

Source: IATA

A large part of lower global airfares can be attributed to increased air connectivity as

measured by unique city-pairings. As IATA forecasts, unique city-pairs have more than

doubled (108%) over the past two decades, with real transport costs having more than halved

(-53%) during the same period.

Unique City-Pairs and Real (Inflation-Adjusted) Transport Costs

Source: IATA

In addition, providers of capital are expected to be sufficiently rewarded during 2018, continuing a trend that began in 2015. Prior to 2015, the average ROIC of global airlines were found to be short of the estimated industry WACC, except for a select few carriers (which we believe include global ULCC’s and other low-cost carriers). Equity providers were found to be the investor class most affected by the lack-luster returns during that period, as debt investors were rewarded adequately by an industry that exhibited little issue in servicing debt and often secured loans with real assets (the aircrafts themselves). However, the trend seems to be shifting, with global aviation ROIC forecasted to exceed the industry’s WACC.

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Return on Capital Invested in Airlines

Source: IATA, The Airline Analyst

Most of the industry’s excess ROIC has typically been generated by North American carriers. We suspect that this is largely due to the prevalence of ULCCs and other low-cost carriers in the North American region, where the abundance of unique city-pairs, domestic travel and inter-airline competition lead to reduced airfares. We speculate based on the below chart, that North American airlines (largely U.S. based carriers), are successfully able to offset lower airfares with increased passenger traffic.

Return on Capital Invested in Airlines (Geographically Segmented)

Source: IATA, The Airline Analyst

Against this backdrop of global growth and increased air travel, we believe Jetlines stands to benefit as they prepare to take to the skies.

Financials At the end of Q1-2018 (ended March 31, 2018), the company had cash and working capital of $6.77 million and $6.60 million, respectively. The following table summarizes the company’s liquidity position:

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Key Financial Data (FYE - Dec 31) (in C$) 2016 2017 Q1-2018 Cash $91,397 $2,981,046 $6,774,774 Working Capital -$674,499 $2,698,286 $6,595,352 Current Ratio 0.16 6.41 12.77 LT Debt / Assets - - - Cash from Financing Activities $561,851 $6,562,411 $4,770,066

Source: FRC

The company currently has 6.30 million options outstanding (weighted average exercise price of $0.36 per share) and 18.35 million warrants outstanding (weighted average exercise price of $0.43). Currently, we estimate that 5.39 million options and 10.07 million warrants are in-the-money. If all the in-the-money options and warrants were exercised, the company could raise an additional $5.29 million.

Valuation The below outlines our updated revenue forecasts for the company:

2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E No. of Aircraft (year-end) 0 2 6 10 14 18 22 26 (a) Average in the year 0 2 4 8 12 16 20 24 Passenger capacity per aircraft 180 180 180 180 180 180 180 Occupancy rate 80% 80% 80% 80% 80% 80% 80% (b) Avg no. of passengers per flight (a) 144 144 144 144 144 144 144

Aircraft utilization (block hours per day) 12 12 12 12 12 12 12 No. of flights per day per aircraft 4 4 4 4 4 4 4 (c) Total no. of flights per year per aircraft 730 1,460 1,460 1,460 1,460 1,460 1,460

d = (a x b x c) Total passengers per year 210,240 840,960 1,681,920 2,522,880 3,363,840 4,204,800 5,045,760

Average fare (base) $115 $115 $115 $115 $115 $115 $115 Average fare (ancillery) $34 $34 $34 $34 $34 $34 $34 (e) Average total fare $149 $149 $149 $149 $149 $149 $149 f = (d x e) Total Revenues $31,337,954 $125,351,816 $250,703,631 $376,055,447 $501,407,263 $626,759,078 $752,110,894 Operating Costs (all-in) $27,577,399 $109,056,080 $215,605,123 $319,647,130 $421,182,101 $520,210,035 $616,730,933 OPEX / Revenue (all-in) 88% 87% 86% 85% 84% 83% 82%

EBIT $3,760,554 $16,295,736 $35,098,508 $56,408,317 $80,225,162 $106,549,043 $135,379,961 EBIT Margin 12.0% 13.0% 14.0% 15.0% 16.0% 17.0% 18.0%

Tax 27.0% 27.0% 27.0% 27.0% 27.0% 27.0% 27.0% Net Income $ 2,745,205 $ 11,895,887 $ 25,621,911 $ 41,178,071 $ 58,564,368 $ 77,780,802 $ 98,827,371 Net Margin 8.8% 9.5% 10.2% 11.0% 11.7% 12.4% 13.1% Source: FRC

Updated assumptions include the following:

 Launch date further pushed back to the beginning of Q3-2019. Total aircraft in 2019 forecasted as the two initial Airbus A320 aircraft; growth rate in the fleet maintained at 4 aircraft per year.  Passenger capacity updated to 180 per aircraft, reflecting differences in the Airbus A320 model compared to the Boeing 737-800 series.  Other assumptions as per our last update report in March.

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The below table outlines the various fair values of Jetlines’ shares given different debt-equity financing mixes. Investors may refer to our initiating and update reports where we outline our valuation methodology. Note that in this update, we have updated the required start-up capital to $55 million, as per company disclosures. The previous assumed start-up capital was $43 million.

New Shares Total Shares Fair Value Issued 100% equity at $0.50 per share 115,789,474 195,386,869 $1.65

50% equity at $0.50 per share 57,894,737 137,492,132 $2.15

100% equity at $1.00 per share 57,894,737 137,492,132 $2.35

50% equity at $1.00 per share 28,947,368 108,544,764 $2.72 100% equity at $1.50 per share 38,596,491 118,193,886 $2.73

50% equity at $1.50 per share 19,298,246 98,895,641 $2.99

100% debt - 79,597,395 $3.37

Average $2.57

Source: FRC

We are revising our fair value estimate on Jetlines’ shares from $2.73 per share to $2.57 per share and maintaining our BUY rating on the company.

Risks We believe the company is exposed to the following risks (list is non-exhaustive):

 Our valuation is dependent on a second half of 2019 launch. Delays or other changes to the operational timeline could significantly impact our valuation.  High barriers to entry due to existing duopoly, as well as large initial operating cash requirement.  External surcharges that are beyond the company’s control could affect their ability to charge sufficiently low prices and stimulate new demand. These charges include taxes, airport fees, etc.  The company is in early stages and has yet to commence operations.  The existing Air Canada (TSX: AC)/ WestJet duopoly dominates the Canadian aviation market.  WestJet has released their own ULCC fleet, Swoop. Though we speculate Swoop is not a true ULCC, Swoop still benefits from WestJet’s existing resources.  Access to capital and share dilution.

We are maintaining our risk rating at 4.

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Fundamental Research Corp. Equity Rating Scale: Buy – Annual expected rate of return exceeds 12% or the expected return is commensurate with risk Hold – Annual expected rate of return is between 5% and 12% Sell – Annual expected rate of return is below 5% or the expected return is not commensurate with risk Suspended or Rating N/A— Coverage and ratings suspended until more information can be obtained from the company regarding recent events.

Fundamental Research Corp. Risk Rating Scale: 1 (Low Risk) - The company operates in an industry where it has a strong position (for example a monopoly, high market share etc.) or operates in a regulated industry. The future outlook is stable or positive for the industry. The company generates positive free cash flow and has a history of profitability. The capital structure is conservative with little or no debt.

2 (Below Average Risk) - The company operates in an industry where the fundamentals and outlook are positive. The industry and company are relatively less sensitive to systematic risk than companies with a Risk Rating of 3. The company has a history of profitability and has demonstrated its ability to generate positive free cash flows (though current free cash flow may be negative due to capital investment). The company’s capital structure is conservative with little to modest use of debt.

3 (Average Risk) - The company operates in an industry that has average sensitivity to systematic risk. The industry may be cyclical. Profits and cash flow are sensitive to economic factors although the company has demonstrated its ability to generate positive earnings and cash flow. Debt use is in line with industry averages, and coverage ratios are sufficient.

4 (Speculative) - The company has little or no history of generating earnings or cash flow. Debt use is higher. These companies may be in start-up mode or in a turnaround situation. These companies should be considered speculative.

5 (Highly Speculative) - The company has no history of generating earnings or cash flow. They may operate in a new industry with new, and unproven products. Products may be at the development stage, testing, or seeking regulatory approval. These companies may run into liquidity issues, and may rely on external funding. These stocks are considered highly speculative.

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