Good day, ladies and gentlemen. Welcome to the Cargojet conference call. Please be advised that this call is being recorded. I would now like to turn the meeting over to Ms. Pauline Dhillon. Please go ahead, Ms. Dhillon.
Good morning, everyone, and thank you for joining us today on this call. With me on the call, we have Ajay Virmani, President and CEO, Jamie Porteous, Chief Commercial Officer, and John Kim, Chief Financial Officer. After some comments about the quarter, we will open up the call for any questions. I would like to point out that certain statements made on this call, such as those relating to our forecasted revenues, costs, strategic plans, are forward-looking within the meaning of applicable securities laws. This also includes references to non-GAAP measures like adjusted EBITDA and adjusted EBITDAR. Please refer to our first quarter press release and MD&A for important assumptions and cautionary statements relating to forward-looking information and for reconciliation of non-GAAP measures to GAAP income. I'll now turn the call over to Ajay.
Thank you, Pauline, and thank you, everyone, for joining Cargojet's second quarter conference call. Let me start by thanking my team for delivering another strong quarter with 12% revenue growth ex-fuel, margin expansion, and strong EBITDA growth over 30% in quarter two. We released our financial statements yesterday, so I'm not going to spend a whole lot of time on this on my remarks. However, we will certainly have questions- and- answers after. What I really want to talk about today is how Cargojet is successfully executing our plan strategy. More importantly, why I feel we are still in the early stages of our true potential. Over the past decade, we have been singularly focused on five key priorities. Build the best and most effective overnight cost air network in this country. Number two, maximize fleet and utilization of fixed assets and expand our business lines and diversify.
Number three, be relentless about our on-time performance. Number four, Cargojet culture leading to being one of the best employers in aviation. Number five, financial discipline to build long-term shareholder value. Over the past several years, we've been focused on capturing market share so that we could participate in what we saw as the hyper-growth segments of air cargo business. That is e-commerce. As you have seen in our results, particularly over the past five years, we have successfully been executing on our number one core strategy. This required a significant investment in building a network that now serves over 90% of the Canadian population with a next-day service. Given the time zones and geography we serve, it is no small feat. This is an extremely important competitive advantage for Cargojet, and we continue to improve this by constantly looking at optimization opportunities.
As a result, we have now become the de facto enabler of next-day e-commerce in Canada. Canadian e-commerce as a percentage of total retail sales is still behind the United States and Europe. We believe we are still in the early stages of harnessing this secular trend and have a lot of catching up to do. Canada is about 7% of the total sales when it comes to e-commerce, whereas USA is almost at 12%. As you can see, there is a lot of catching up that Canada has to do, and which means a lot more potential. We shared with you last week the impact Prime Day sale had on our volumes and fleet utilization through a press release. Summer has traditionally been slow period for our industry.
With Prime Day in July, back-to-school shopping day in August and September, Halloween in October, Black Friday in November, and of course, Christmas in December, spilling over to January with Boxing Day, we now see multiple shopping peaks. Our second priority has been to maximize our fleet utilization and traditionally, customers used our network from Monday to Thursday, with Fridays low since we are ground transportation. This used to leave our fleet idle on the weekends. We have been very successfully bringing in ad hoc charter and ACMI business that have helped increase utilization and expand margins. We have opportunistically added dedicated routes to USA and Mexico. We see more opportunities for this on the horizon, which also helps us diversify our lines of business.
We have recently looked at our margins and suspended our South America flights, which was one flight a week, in favor of operating the same aircraft domestically for the seven-day service that has recently been announced by our customers. We have also fine-tuned our domestic network and schedules, and we have freed up a 767-300 aircraft from our existing fleet, making our network more efficient and use that freed up aircraft for a newly acquired route to Mexico City starting in the next 60 days. The shopping patterns have now shifted to mobile services, mobile devices, and orders flow through to retailers at all times of the day. Online shopping on the weekends is now competing with bricks and mortar. We are not surprised to see the recent industry announcements to move their business to model seven days a week.
E-commerce retailers want to provide instant satisfaction to customers just like when they shop in a store. This means additional opportunities for our first fleet utilization. While this new trend will take some time to materialize, we believe we are in well positioned to take advantage of the opportunity without the need of any extra or new capital expenditure in the near term. Our third priority has been to be relentless in execution. This means driving an extremely high level of customer satisfaction by focusing on our key metric, which is on-time performance. This required us to build a world-class maintenance organization and a discipline in heavy maintenance routines that have consistently delivered two critical metrics, safety and on-time performance. Once again, I'm pleased to report that quarter two, our on-time performance remained about 99.5% or higher every night.
As Peter Drucker previously said, "Culture eats strategy for breakfast." Therefore, I have been passionate about building the culture, service culture, from day one. Our fourth focus has been on talent management and employee engagement. Our ground handling employees often work in harsh conditions, loading and unloading with tight turnaround times. For the cargo airline, safety is at the core of everything we do. Let me tell you that it is a result of strong work environment, team culture, training, and work ethic. For us, it is not the flavor of the month. It is rather the way of our life. I'm so proud of each one of our employees who have delivered this exceptional performance to our customers. We have also taken proactive steps to manage the challenges that our industry will face with the new pilot fatigue rules coming into effect.
Working with our pilots union, we have implemented an innovative program to attract and retain qualified pilots. I'm also pleased to announce that with just one year after concluding our negotiation with the pilots union, both parties have extended the current collective agreement by additional three years, providing seven and a half years of predictability for our customers. Let me talk about the financial discipline, our fifth and final strategic focus. Over the past five years, we have won many new customers. As we have shared with you before, they are top-tier brands, and we have long-term contracts in place with them. We funded our growth through debt financings. We continue to carefully manage growth and investments and putting strategies in place to start repaying our debt in the medium term.
As I mentioned earlier, we are still in a very hyper-growth environment in the e-commerce space, and we are presented with strong growth opportunities with attractive economics that can drive long-term shareholder value. We will not be shy to invest in our business, but our default focus will be to bring debt levels down over the medium term. Let me conclude by looking ahead. Much of the macro trends today point to strong e-commerce future. It seems the past five years for us were largely a preparation to harness what is about to come. For example, mobile commerce is rising rapidly. People are shopping all the time. Number two, Canada's e-commerce sales still lag behind U.S. and Europe. Number three, recent industry announcements, including a seven-day delivery, will enhance our business to a full seven-day week.
Number four, Amazon's announcement to move Prime service from two days to one will have a major impact on the service levels that we are providing. Number five, focus of virtually all major brands on direct-to-consumer business models. Number six, number of retail store closures across North America, forcing consumers to use even more online channels. Number seven, increased use of automation in our warehouse and fulfillment centers. These are a few trends, but I'm sure there are several more you're seeing in the market. Looking at this, we feel we are just getting started. We believe we have made wise investments in our network. We have brought in great talent, and we focused on delivering superior service level to our customers. We firmly believe that we have the right ingredients to enter the next phase of our growth journey.
I'm also pleased to advise you that our focus in the next little while will remain on expanding our lines of business-like charters and ACMI, and while we continue to grow our domestic overnight business. Thank you very much. I have John Kim, our CFO, Jamie Porteous, Chief Marketing Officer, and Pauline Dhillon here to take any questions that you might have.
Operator, you can open the line for questions, please.
Thank you. We'll now take questions from the telephone lines. If you have a question and you're using a speakerphone, please lift your handset before making your selection. If you have a question, please press star one on your telephone keypad. If at any time you wish to cancel your question, please press star two. There will be a brief pause while the participants register for questions. Thank you for your patience. The first question is from Walter Spracklin, RBC Capital Markets.
Thank you very much. Good morning, everyone.
Morning.
Let's start with, Ajay, you talked about the shift toward buying more and obviously using that capacity more days of the week. Can you remind us what your current weekly, how many nights a week you're currently operating, what you plan to operate in terms of nights per week at the upcoming peak, and how soon do you believe that we could be on a seven-day a week, permanent part of your overnight schedule?
Yeah. Walter, I'll give you a little background on this, and then I will have Jamie expand on that. Right now we used to operate four nights a week, probably a number of years ago. We expanded it to the fifth night, and now we are into the sixth night on a regular basis. We are looking at a seventh-day operation. Presently, we are doing ad hoc flights for the seventh day, but soon to become after the summer and starting in September, we expect the seventh-day flight to continue on permanently. Besides operating on seven days a week, there's a lot of shift also, Walter, from which we still call a core overnight network. I think it'll be more appropriate to call it domestic overnight network rather than the core overnight network.
We are also seeing a lot of shift from domestic overnight network into more charters for the specialized type of sales, whether it's a Prime Day sale, back to schools. We are seeing a lot more charters shifting from domestic overnight into that space as well. Maybe Jamie, you can quickly expand on that.
Just to add, Walter, just to remind you, we've been operating the Sunday night scheduled service, certainly not the full network that we operate on the core Monday to Friday, but we've operated a Sunday night 767-300 to Western Canada and back since May of 2018. We have operated Saturday flights, the seventh day of our network, certainly this past month during Prime Week, and have that scheduled to continue again starting in Q4 for peak 2019. We fully expect that trend to continue and to grow into a scheduled weekly Saturday flight as we go into 2020 to meet that seven-day-a-week demand, particularly a big driver that will be once Amazon launches their next-day delivery in Canada, which is expected by the fourth quarter of this year.
Okay. And this obviously comes at no-. This revenue, and capacity growth is coming without the need for additional aircraft by adding nights of service. If you look at your current, and maybe John can chime in terms of how many aircraft are in your current program for delivery for this year, and if you could update us on the CapEx number for this year. Perhaps indicate to us, is your need for new aircraft as you shift to more days of week as opposed to more on the same day, does your need for new aircraft come down going forward?
I think you really pointed out a good point there, Walter. If we are expanding our network into the weekend, we won't need new aircraft. You're right pointing out that we did reduce our fleet forecast by one 767-300, which in Canadian dollars is about a CAD 40 million CapEx spend. That was early in the year, that's something that we thought we would need to acquire another aircraft, with the efficiencies that we've achieved with the existing aircraft, even in light of new flying, we still feel that we don't need that extra 767-300. Our CapEx should be lower by about CAD 40 million this year.
Walter, we've also, by realigning our network and making some changes to what we are doing and how we are doing it, we've been able to free up an aircraft to fly, which we just got a confirmation literally and in the last 24 hours, to fly a new route for one of the customers to Mexico City within 60 days.
We won't be, at this point, adding another aircraft.
Yeah. That'll be done with existing aircraft. Basically, we have reduced it by one and put one more aircraft to utilization. You can technically think that it's two aircraft that we've been able to synergize.
One thing that wasn't in sort of our earlier or previous quarter, you'll notice in our fleet notes, we've bought some engines. We've done a deal for eight spare engines, essentially, that will help us greatly reduce our engine overhaul costs in the next 24 months. You'll see that these came off a couple 747s that we're parking, and we'll take the engines off and just keep them parked for the future use or sale. That'll be CapEx of about CAD 30 million that we didn't have previously.
It's a timing issue because these aircraft, we picked it up for at least 30% - 40% better than the market price, which will help us not sending our engines to overhaul shop and use these engines. Long term, over the next couple of years, it'll pay off in a big way.
That's fantastic. We had you at 225 total for this year. I'm hearing you minus 40 now for the lack of an aircraft or one less aircraft, but plus 30 for the engines. Is that the right?
Yeah. I think around 200 at this point is about right.
Okay. We had you at 75 for next year. Is that still hold?
Yes. As you might appreciate, the fleet plan is a bit fluid depending on the business that we have, but no changes really for next year.
Yeah, we don't anticipate that we'll add anything until we are definitely committed to a number of hours.
We have the 767-200 delivery slated for the end of Q1 next year, and that's the only aircraft, and that's already encompassed in the fleet plan.
Got it. Okay, my last question here is on the volume. It was a little bit more muted this quarter, kind of similar to last quarter. You've obviously talked a lot about the significant growth in e-commerce, so presumably, this is less growth or declines in non-e-commerce. Just wondering if you could break out, kind of what was the growth rate of e-commerce and how much of that your business is roughly represented by e-commerce and reaffirm, if you can, if it is the decline in the non-e-commerce growth and some of the reasons what would've caused that decline.
Yeah, I can answer that, Walter. You're right. To be sure and just to reinforce Ajay's comments, we are definitely not seeing any decline in e-commerce. We're continuing to see significant double-digit growth in the e-commerce space domestically across the country, and no signs of that slowing down. Some of the softness in the tonnage that we saw in Q2, a combination of couple things. Q2 is not traditionally, those months are not heavy shopping months. There's no significant Prime Day or Black Friday shopping that really spikes up the e-commerce. In spite of that, e-commerce was strong during that month.
As a percentage of our overall revenues, as I think we've indicated before, it's a little difficult for us to accurately predict because we see directly from companies like Amazon, but indirectly, they're still a big user of our other customers, and there's other e-retailers that are shipping with our customers. But I'd say it's somewhere 20%, 25% of our overall core revenues. We definitely saw some softness on the tonnage on the overnight network as a result of softening and really in-
Non-e-commerce.
In non-e-commerce business and overall global air cargo demand softening. We saw that certainly our interline volumes of traffic that we get from international carriers through major gateways in Canada was down 25% or 30%. We saw softening. In fact, we took actions that Ajay alluded to in his comments of suspending service to Lima and Bogota because of softening demand. I think during the quarter, we canceled seven frequencies between Canada and Germany, again, primarily because of softening demand, and that also affects the tonnage on the domestic because not all that traffic is just operating or we're not carrying it just from Europe into Hamilton. It's connecting to and from our domestic network. That's really where we saw the softening.
That's why, Walter, we've started to view this business more as it's very difficult to engage in a quarter to quarter on overnight and that kind of stuff because the shipping and the buying patterns have changed. Example, in quarter two, there was no real event day that was flagged. One of our observations was that a lot of people were not buying enough even through e-commerce in quarter two because of the well-advertised and publicized Prime Day coming up in July. A lot of people were holding back and saying, "Well, I'll order it three weeks from now when I get a great discount." I think we now have to start rationalizing the business more like on a full year sort of basis because of the buying patterns and the shipping patterns of people as well.
Really appreciate the color. Thanks, everyone.
The next question is from Doug Taylor, Canaccord Genuity. Please go ahead.
Yes. Thank you. Good morning. There's obviously a lot of excitement around the shift to seven day a week scheduling and volumes. Can you talk through how when you go to your partners, Canada Post or any of your other significant partners, then talk about negotiating, adding those routes, do you do it through increasing the contractual minimums? How we should think about that as you add that to your permanent schedule?
Basically whenever a new flight or a six day or a seven-day flight comes on, we don't operate a flight on speculation. We look for minimum guarantees from certain customers to make sure that the flight pays for and leaves us with a margin. Yes, they make a certain commitment for that seventh day flight, and we look for certain minimum guarantees on it. Yes, it forms part of the contract at the end of the day.
Okay. How should we think about the volume growth potential versus redistributing between what would've been, I guess, Monday or Sunday night traffic and moving earlier and onto the weekend? You've obviously had some experience adding a route before, or should we expect when you do make that permanent for there to be some sort of step function change in the revenue profile and the growth profile?
I think our experience was that our concern initially when we started the Sunday night flight was exactly what I think you're suggesting, is that there would be some dilution to the next day. We may have seen that with the very short term, but we found that all of the revenue that was associated with our Sunday night flight was all incremental new revenue that was added. It was just a result of continued 24-hour-a-day, seven-day-a-week online shopping that drove that volume and we would expect to see the same. We saw the same during Prime Week for a Saturday flight, and I think we would expect that same incremental growth of new business on the seventh day.
Okay. It's fair to say, as we contemplate the increased volumes and that seventh day or sixth and seventh day permanently, the contribution margins in terms of the profitability of the excess volumes, given a large fixed cost infrastructure is going to be significantly superior to the overall margin profile of the company right now, i.e., it'll be very margin accretive if you're not adding aircraft?
Yeah, I think that's a good assumption, Doug. That makes sense.
Yeah. Could I get you to go so far as perhaps pegging what you'd see the variable cost as part of the cost picture for that incremental traffic?
I think if you look at our detailed cost breakout in our MD&A for fuel expense, you know that fuel and probably the commercial costs like landing and navigation, those will step up in proportion to the number of flights. Those will be variable. When you look at overall, say, crew costs or other maintenance staff.
Heavy maintenance or-.
Heavy maintenance. Really, if you look at the margins in terms of the percentage of cost to revenue for our fuel and commercial, that's sort of the gross margin.
We expect significant margin improvement.
It'll definitely be, yeah. If you're looking to try to pin down a number, you'll kind of have to back into that by looking at those parts of our cost, Doug.
Yeah. That's very helpful. You've obviously identified this Mexico City route that you'll be starting up in the next 60 days. Can you talk about the dynamics or the potential profitability of that route relative to the one that you just canceled to South America and the puts and takes there?
Yeah. South America route was not an ACMI route, that we took the commercial risk on it, and it was very marginal business, but it sorts of helped get some business flowing into our network and also connect our Cologne flight with it. There were some advantages of it, but it was not a very high-margin route. When we had an opportunity to expand one more Mexico route, as you know, we already operate one Mexico route into Guadalajara. This was to Mexico City. We had an opportunity to do six days a week service into that. This is going to be certainly at no less margin for the ACMI that we do today. It's about 2,400 hours a year, roughly.
Yeah.
It's a very sort of high-density route. We feel pretty good that the margins of this is going to be absolutely quite attractive and probably close to or better than the ACMI margins we're doing. Just so you know that today, with this aircraft going into an ACMI service, which is guaranteed revenue, compared to the South American, which was not guaranteed revenues. Six out of our 24 aircraft, which is 25% of our aircraft, are now committed to ACMI service, which is again, our way of diversifying and not just totally relying on the overnight network. We, as an airline, are expanding into charters, into ACMI, into a full-service cargo airline rather than just the domestic overnight.
Our focus in the next year would certainly be to reduce the dependence while we continue to grow the e-commerce and overnight network, but expand our lines of business to have more of ACMI and more of certainly charter business into our portfolio.
Yeah. Doug, we've announced in the past when we've added sort of ACMI cross-border routes, roughly what those revenue numbers would be. I think in the next quarter, we'd be reporting what the incremental revenue would be from the new routes. Until we've kind of finalized that contract, that will be available for the next quarter.
All right. I'll look forward to that disclosure. Thank you. I'll pass the line.
The next question is from Cameron Doerksen at National Bank Financial. Please go ahead.
Yeah. Thanks very much. Good morning. I guess maybe just a question on the pilot extension? You've mentioned this retention bonus, which obviously is probably something you need to do to keep the pilots, so that's good news. I'm just wondering how that sort of CAD 20 million is going to be accounted for. Is that going to be sort of spread out over the life of the union contract? Is that, I guess, a cash payment that we'll see in Q3?
Yes, it will be spread out over the seven-year contract. More importantly, that we have started a program which our customers are fully aware of because some of them own their own airlines and run their own airlines. The press has been quite a bit active on the shortage of pilots and the need for retaining and attracting new talent for flying. We have started a program and meeting with our customers and presentations with recovering. This is a regulatory change, which is going to cost an increase in cost, our goal is to fully recover this cost of any pilot over onto our cost from our customers, because most of our contracts have the right to recover that kind of cost, which is mandated by the government.
Right. How have those conversations gone so far? Has there been any pushback from customers on that?
I think the customers are very sensitive to the fact that we don't want to ground planes and we want to run because obviously the country is going to be 2,000 pilots short next year. We started our program way ahead of everybody else. We want to make sure that, number one, our priority is to retain our great pilots that we have today. Number two, to attract new pilots into this company. Our conversations with our customers have been very positive. They totally understand the impact because they have faced the same impact with their own mainline airlines. We don't anticipate, obviously, everybody's going to do their homework and due diligence, and we are fully transparent on what our cost increase is going to be because of this regulation. We are sharing all the information from them.
So far, we have not had any pushback except, basically they want to make sure that we are recovering what it's costing us and not sort of being opportunistic about it, and it is not in our DNA to do that anyway. It's gone pretty good so far, and we expect that by the end of the year, we will have, I would say at no later than, majority of it will probably be in the recovery and pricing by the end of the year. Some of it might lag over into the first quarter of 2020 because our customers do have budgets, and they make annual budgets. We are a little bit careful to make sure that we work with them and not sort of upset their plans as well.
Okay. No, makes sense. That's good to hear. Just technically build the CAD 20 million, that sort of cash retention bonus, is that something that'll be paid out in the.
Yes, the accounting for it, [Doug], and the total number will depend on how many pilots we have on staff in a certain time next year. If it's around CAD 20 million, roughly half of that will amortize over the first four years, and the other half will amortize over the sort of the seven and a half year period.
Okay. Just final one from me, just on the leverage, you mentioned that one of the priorities you have is to pay down some of the debt. I'm just wondering if you've had any, I guess, changes to your sort of target leverage. I think in the past you've kind of talked about being below 3x the leverage. Is that still kind of the target?
Well, I think the target is zero. A couple things we should probably think about this year are CAD 125 million debenture issue at 4.65%. Those are in the money. Our first opportunity to convert those is December 31st this year. We're thinking about that. There's a lot of compelling reasons to call those debentures at the end of the year. That would take out about CAD 120 million-CAD 125 million of debt. In terms of the rest of the debt, as Ajay pointed out in his opening remarks, we are focused on the near term to use all of our available free cash that we haven't invested to reduce the debt.
Okay. Great. That's all the questions I had. Thanks very much.
The next question is from David Ocampo at Cormark Securities.
Quick question on the overnight business. Kind of when I back out the volume growth, it looks like pricing was a very strong 7%-8%, which seems quite a bit higher than the CPI for the year. Just wondering what the delta is there.
I think it's the mix of customers, really. As some of our customers are growing at a faster pace than others, with pricing at Cargojet is really largely volume-based. As customers grow, they'll probably see better pricing. That's what's really driving it. Our CPI contractual increases have all gone through as under contract, and they're fixed in terms of the type of percentage increase. That's what you're seeing is a change in the mix of customer revenue. Also, if we look at our backhaul rates, they've probably firmed up a bit.
Yeah. I could just add, David, that the other thing that would impact the yield improvement is the accelerated growth of e-commerce. Those customers, all of our rates are volume-based, so the smaller customers that are growing at an accelerated pace, the average yield that we're getting or the average rate per pound is proportionately higher. Some of the general cargo customers that are not in the e-commerce space that haven't been growing, where we've seen some softness, some of them have minimum volume commitments where they haven't made the minimum volume commitment, but they have to pay the minimum guarantee. Proportionately, the yields go up.
Right. That makes sense. I guess on the weekend point, if you do have to add any incremental aircraft, how is the current market for the 767 now?
Yeah. Just to be clear, we're not adding any aircraft with the weekend plan.
We will not have to add any aircraft to go to a seven-day a week network.
Yeah. In terms of availability of aircraft, there are 767-300s available now in the next 12 months for delivery. I would say the market has improved. We're always looking for aircraft, but at this point, we're not planning to add any.
Okay. Last one from me. I know the Morningstar contract. I'm not sure if there's any update there, but it was supposed to be up for renewal this year. If you guys can provide any color on that'd be great.
Yeah.
Yeah. Our information is that they're facing similar issues with the pilot issues. They are trying to work with FedEx and Morningstar. Obviously, they don't reveal what they're doing. We don't expect them to. We have no indication of whether they have extended or how long they've extended. I guess they're fighting through some of the aviation issues that we have with them. I personally don't think it's going to come out for a bit anytime soon, because we have some challenges that are going on in the industry. We're not sure as to what their thinking is, but we're certainly on top of it, and they know that we're waiting, and once we get the idea, we will be able to share.
Okay. That's great. I'll end the call.
The next question is from Nick Corcoran at Acumen Capital. Please go ahead.
Morning, and thanks for taking my questions. I just have a couple. The first one is, how has the growth on the backhaul routes been? I guess, what would the seasonality of those routes be?
On our domestic overnight network, are you referring?
Yeah, on the backhaul routes.
Yeah. With the exception of, as I noted before, most of our interline revenue, traditionally or historically, have focused on filling those backhaul routes with that lower yield interline business that's coming into major gateways like Vancouver in the belly or on actual pure freighters coming internationally from Asia. That softened a bit. On the e-commerce side, we've seen tremendous growth, not just on our historical head haul routes, but with, as an example, the opening of fulfillment centers by companies like Amazon in Calgary and additional ones in Vancouver. We're seeing significant growth in two-way e-commerce traffic, which is helping to fill the backhaul. It's kind of a combination of both. I would say overall, we're seeing a much higher percentage of growth on the backhauls than we've historically seen, and at much better yields than the traditional interline business.
Great. Then, if I heard correctly, you've canceled that Cologne flight.
No, we've suspended service to Lima and Bogota to South America. We still operate two weekly scheduled flights between Canada and Cologne. We canceled a couple through Q2 because of softness. We have no intention of suspending service to Cologne. We'll continue with that as we go forward.
What should we think about your routes to places like Lima and Bogota going forward? Are you going to resume those flights if there's adequate demand, or are you just going to focus on that?
We will certainly operate it on certain times of the year when the demand is high for certain produce, flowers, and stuff like that. At this stage, we are focusing more on, as I said, we just want to make sure that the pilots' issue, for example. We want to make sure that our resources, whether it's pilots or whether it's aircraft, go towards the highest yielding routes. We would do Bogota, Lima, if there's nothing else to do. To be honest with you, with the seven-day service coming on and getting ready for the peak, start in another six to eight weeks. The semi-peak starts, then back to school stuff, the Black Friday stuff coming on. We would rather divert our resources, whether they're pilots, maintenance, or aircraft, into those than into the marginal routes.
We have scheduled authorities to Bogota and Lima, and we have good general sales agents and handling agents set up. We would be tackling those markets at high-demand times and do more charters rather than scheduled service.
That's great color. Thank you.
The next question is from Ben Cherniavsky at Raymond James. Please go ahead.
Morning, guys.
Morning.
Morning, Ben.
Just on the pilot issues, I recognize that's an industry-wide issue for you in Canada, but my understanding is U.S. cargo shippers have been exempt from those kinds of changes to pilot fatigue rules. Does that in any way make you less competitive on ACMI business transborder against some carriers who might not have the same kind of cost increases in their labor?
One thing, Ben, keep in mind that we do have our labor cost and some of the costs in Canadian dollars, which is still a big advantage. The U.S. government has exempted the cargo carriers from fatigue rules. To be honest with you, those are helpful to UPS and FedEx, which operate 300 or 400 aircraft each. The kind of market we have with our customers, I don't think there's a major impact. As far as the charters are concerned, we are still very competitive because, again, our costs are in Canadian dollars for salaries and some of the other stuff we do. I don't think we're losing a competitive advantage, but it certainly will put some pressure on us to be more competitive on those charters. So far , it hasn't impacted us in any big way.
As you probably know, we made it clear in the press as well, that for three years we've lobbied with the government to ensure that we stay competitive. Unfortunately, our voices have not been heard and they think a pilot is a pilot, whether it's cargo or whether it's passenger, whereas U.S. did make that distinction. We never know with the governments, things can change. Right now, they were trying to implement this in 2020, we hear that it might be extended for another year. The competitive side of things haven't really impacted us yet, we're fully aware of it, we will make sure that we keep our costs down to offset that situation.
What's the trade-off between lower costs on Canadian labor and the higher cost of aircraft in U.S. dollars?
Because keep in mind that the U.S. pilot salaries, taking U.S. into account, are much, much higher than ours. A lot of U.S. carriers have very mature level of pilots, which mean our average age of the pilot might be 10 or 12 years, whereas some of the other companies that operate in the U.S. have pilots that have been working in the same company for 15 or 20 years. Their scales are much higher to begin with. I don't think we have lost much competitive advantage in terms of charters or our ACMI ability. As a matter of fact, we just won the Mexican route. That could have gone to an American carrier. It was being operated by a Mexican carrier at that time. We don't feel that this is going to play out as a major factor in our charter business.
John, in the MD&A, no discussion that I can see on EPS, but the reported number was CAD 0.32 this quarter. It appears there were some gains, CAD 4 million or CAD 5 million. Was it FX or gains on disposal?
No. Yeah, I think that- sure. Those gains-. Go ahead.
Sorry, what would the adjusted EPS be after tax on excluding that gain?
Well, the gains, we hedged our incentive program, and we also had some hedges on employee options. Those gains would typically be reported as part of the bonus employee expense. Because the program hasn't fully started, we reported those separately. I think those gains are, in terms of the hedges of our equity swaps, those really are operational in nature, and they'll be offset against employee costs or crew costs, going forward. I don't know. They're not one-time gain or loss on disposal or something that's non-operating. They are in fact, operating. I don't know. Yeah, there's a reason that they're not.
They are?
No. Well, they are, because they're non-cash. They haven't been exercised yet in terms of realizing the actual gain. As a non-cash gain, we've taken them out. It's really more operational in nature.
All right. Even with that, maybe you can just explain how, because I'm still, as you know, trying to get familiar with the economics for your business, but the utilization looks pretty good. Your cargo revenue per day is up. Block hours are up. Volumes, although marginally up, but still up, and EPS and operating margins are down. How does that work? Where's the offsetting variable in that?
I think in terms of looking at where our EPS could be improved, it's finance expenses. It's the level of debt, Ben, that we've accumulated because of this incredible sort of growth period in the last few years. That will move the needle significantly once we're able to pay down the debt and reduce those finance costs, because I think they're running around a little over CAD 40 million per year. Our depreciation, when you bring new freighters into the fleet, in the first 10 or 15 years, you will have depreciation that's running a little higher than what your sort of normal replacement capital cost will be. It's mostly finance costs, Ben, that we need to pay down our debt to improve our EPS.
Yeah, I think even above the finance line, the EBIT, the margin is lower.
Yeah.
It is not a short-term phenomenon. That's the real cost of operating the aircraft, presumably to generate revenue, right?
Ben, you have to, again, look at the different aspects of our P&L, and you'll see that the one line that's really grown substantially is our depreciation.
Right, but that depreciation drives the revenue because you're an asset-intensive business, right?
We're depreciating assets that are 25 years, sort of in terms of lifespan. We're depreciating them quicker than that, and we're also depreciating parts of the aircraft, because under IFRS, you have to componentize. We're taking a hit on depreciation in the first, again, 5-10 years of the life of the aircraft that will start coming down to a more normal number that looks more like our maintenance CapEx, which is.
In 5-10 years?
No, I think, yeah, that's about right.
Okay, thanks.
Once again, please press star one if you have a question. The next question is from Gianluca Tucci at Echelon Wealth Partners. Please go ahead.
Hi, guys. Good afternoon. Congrats on a good Q2.
Hey.
Gianluca.
I have a question here in terms of expectations for the balance of 2019. We're about halfway or a third through Q3 here. In terms of your top customers, what are their expectations for peak volumes compared to prior years? I don't know if you can quantify, but qualify, if you may. So far in Q3, taking into account Amazon Prime Week, is that volume growth consistent to the past year trends that have been observed?
Hey, Gianluca, it's Jamie. Just to answer your questions, and the last one first, we definitely saw significant double-digit growth in Prime Week volumes this year as compared to previous years, which was kind of what we were expecting. I think we actually operated seven dedicated charters in addition to the additional flying that we did both directly and indirectly for Amazon during that week. The forecasts for e-commerce remain extremely optimistic for the back half of this year. We're extremely confident about our full-year outlook, given the fact that there's more significant shopping events in the back half of the year, including Prime Week, than there are, as Ajay mentioned before, with Black Friday, Cyber Monday, and the traditional Christmas peak period.
Back to school.
Back to school starting in August and September.
Okay. We should expect similar kind of peak growth demand for the holiday period this year, plus all of these other ad hoc things that you're doing.
We just started discussing peak requirements with customers right now, like in the last couple of weeks.
Yeah.
We have not seen anything that makes us to believe that it'll be anything less than what we've seen before. As a matter of fact, we're expecting some increases.
Excellent. Thank you, Ajay and Jamie. Just a question on the pilot incentive program pass-throughs. I guess, John, if we think about this on a per volume or per pound basis, what's the kind of delta that can be expected in terms of the pass-throughs to your customers?
Well, at this stage, because depending on what the customer contracts are and stuff, that is stuff that we are in the middle of negotiations with customers at this time. Obviously, customers who have a lot more business and a lot more contractual commitments and volumes would have slightly different than the other ones. It'd be tough for us to sort of relay what percentages on the phone. The bottom line is we intend to recover our costs.
Yeah, I think we'll have more clarity in our future disclosures once we've sat down with the customers and also have more certainty about the timeline. We know what our costs are. That CAD 20 million is spread out over seven years. In terms of the absolute total increase in cost on an annualized basis, Gianluca, that's something we're still working out. It's going to be north of CAD 10 million at least then. We don't have a firm number that we're comfortable sharing right now.
Well.
Thank you.
There's confidentiality.
Right. Sorry. Look, I know Ben's off the questions, but just for everyone else and Ben's benefit, when you look at our business model and especially the comments that we've made and outlined in terms of our efficiency, we've always felt that Cargojet has a lot of leverage in terms of being an airline, having some high fixed costs. To the extent that we can grow our top line without increasing our air fleet, just by utilizing the assets more, I mean, harnessing this e-commerce growth with a minimum amount of capital, that's really what's going to move the needle for our EPS. The interest expense will come down. Depreciation, it is, as I said, 5 -1 0 years on a 25-year asset. It's a bit heavier.
The thing I think that will really move the needle on our EPS in the next three or four years is our ability to increase our cash flow without increasing the size of our fleet.
That's very helpful, John. Thank you.
Good.
If I could just ask a question about this, I guess, phenomenon, I think, around the world about e-commerce. How much of your business has been sourced out of Asia in terms of the Alibaba or the DHgates of the world? Have you seen an uptick from e-commerce parcels sourced out of Asia over the past few years?
Not directly, Gianluca. I assume some of that business indirectly is on our network through some of our direct customers, but we haven't had any direct relationship or any direct insight into that. I'd just be guessing to give you a number. I think that's certainly a tremendous opportunity as part of future growth of e-commerce that we'll benefit by.
I agree. No, that's good. Thank you, guys. Then just two last questions here for John. I think you gave your CapEx guidance for 2019 of CAD 200 million. How should we be thinking about depreciation for 2019 and 2020?
Yeah, I think with the last of the aircraft that we added on at the end of last year and the beginning of this year, we're approaching a run rate that should be fairly consistent for the next five or six years, given the amount of flying that we do. Depreciation will go up as our block hours go up, because now the engine depreciation is probably one of the bigger components. Typically, you'd expect your depreciation to be similar to your maintenance CapEx. As I said, the maintenance CapEx should be a bit lower than that depreciation figure. We're getting to the point now where once we stop adding two or three aircraft a year, your depreciation figures should be fairly static.
Understood. Thank you, guys, and keep up the good work. Thanks, guys.
Thank you.
Thanks.
The next question is from Nauman Satti at Laurentian Bank. Please go ahead.
Hi, it's Nauman from Laurentian here. Just a quick question with regards to your other revenue. I understand it's still a small component of your business, but how much of that is from ground handling services? Do you guys have any contract with other airlines on that?
Yeah. It's a small component of our business, but it's actually a highly profitable one because of our investment, about CAD 25 million-CAD 30 million we made in ground support equipment to provide service to our customers continues. We have been handling some airlines on a regular basis. A couple of our customers are regular, we do it at five or six different airports. We also handle a lot of ad hoc ground handling for charters that come in, whether they're military charters. For example, we were very big in handling the F1 race in Montreal. We certainly view that as an incremental business because we already have the staff, most of it on our team, and we already have the equipment. It's a very high market, a high-yield sort of business for us.
Yes, we have regular business as well, and we do a lot of ad hoc handling of various aircraft that come into the airport. The decision we made a number of years ago to go to our self-handling was for a similar reason. Number one, to get control of our service and the quality of product we put out, and number two was to enhance the revenues from this, which we have successfully done. We don't want to take on too much because it'll jeopardize our service, but anytime we can squeeze in some third-party handling, we definitely do that. We also do third-party maintenance of aircraft as well at certain stations. We just actually won from UPS.
We handled one of their MD-11s in Toronto for maintenance. We just won an award from UPS as the best maintenance organization providing service to UPS aircraft as third-party maintenance as well. Those are little pockets of business that we always try to squeeze in whenever we have extra capacity.
Fair enough. As you add more customers on this line of business, my assumption is there's not too much cost addition there as you add more customers operating there, which is good.
Little bit of incremental labor, but no cost in equipment, for sure.
Fair enough. Thank you.
Yeah, no further questions registered at this time. I would like to turn the meeting back over to Mr. Virmani.
Thank you, everybody, for joining the second quarter conference call. As I've said during my opening remarks and in between, we continue to focus on our core strategies that I outlined, and I think the biggest change or biggest achievement that we want to get into is more diversification and flying more charters and more ACMI, and also continue to grow and expand into the e-commerce world. I think that there's a lot of potential in that. We feel we're just getting ready for it. We have seen some slowness in general cargo, but not in the e-commerce world. All I want that I've been thinking about this e-commerce thing while I look at the trends and the volumes, is that this has now become more of a utility for people.
Like you need your hydro, you need your water, you need your gas, now you need your shipments in the morning before nine o'clock or when you order, you want it instantly the next day or the same day. This has become more of a utility, we see a lot of daily products like from toilet paper to toothpaste to Listerine being shipped by e-commerce. I think people's dependence on this is a lot more as people are not going to the brick-and-mortar stores, that they're depending for a lot of their daily needs. Even if there's a slowness down in general trend of shipping or in economy, we feel that certainly that e-commerce and the daily requirements of people are not going to change.
The shift in the whole e-commerce shipping from occasional buy to daily product buy is now something else that we view as a utility. Again, we see a lot of catching up to do with Europe and U.S. in terms of sales, and we continue to focus on that. Thank you very much, everybody, and we look forward to talking to you after quarter three.
The conference has now ended. Please disconnect your lines at this time. Thank you for your participation.