AIR CANADA AC.CN
September 04, 2018 - 12:44pm EST by
Hamilton1757
2018 2019
Price: 26.50 EPS 2.55 3.59
Shares Out. (in M): 272 P/E 10.37 7.4
Market Cap (in $M): 7,200 P/FCF 10x 5x
Net Debt (in $M): 2,300 EBIT 1 2
TEV ($): 10 TEV/EBIT 8.3x 6.2x

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Description

 

Investment Thesis:

Air Canada (AC) is an outrageously cheap asset, run by a best in class management team, who recently announced a game-changing acquisition (its own loyalty program, Aeroplan) that’s worth somewhere between $2.5-5bn to AC (35-70% of the current market cap).  We expect the stock to reflect this value over the next several months when Air Canada communicates the specifics/accretion of the deal (following the Aimia shareholder vote) this fall.  Over the medium-term, we see multi-bagger potential, as meaningful FCF (in excess of 20% FCF yield / accelerating to sustainably in excess of 30% after 2020 w/ capex durably declining by $1bn) accretes to the balance sheet (delevering AC to less than a turn of Debt/EBITDAR over the next 12-months) allowing Air Canada to aggressively return cash to shareholders (which we expect to be extremely well-received by Canadian institutional investors).   As such, we expect the delevering/capital returns commensurate with their EBITDA margins closing the gap with US peers (due to the loyalty acquisition - more on that below) to drive multiple expansion to at least in-line with US peers (we believe the several turn historical discount to US peers was entirely due to the lack of a loyalty program).  Ultimately, we see no reason why AC shouldn’t trade at a premium to US peers, given its superior balance sheet (less financial leverage, 2.5bn pension surplus, and substantial NOL’s/tax attributes relative to US peers who are becoming tax payers again) as well as its superior competitive positioning (Canada is a duopoly with Air Canada commanding in excess of 55% market share). 

 

What is Aeroplan:

Note:  We encourage readers to read prior VIC write-ups on Aimia, which provide a wealth of information on Aeroplan, its history, etc.   

Aeroplan was Air Canada’s loyalty program that they began divesting in the early 2000’s to unlock shareholder value and later to raise cash from a position of financial distress in 2008 -- in total, Air Canada monetized this business netting proceeds of $2.6bn (when the program was substantially smaller than it is today).   Commensurate with its creation, a complicated and inefficient ecosystem was created between the banks (who distribute the credit cards and pay ~1% of customer transaction value to offer credit card customers a loyalty program), Aimia – the owner of aeroplan (the middleman, who collected cash from the banks and used the cash to purchase tickets on Air Canada at a discount when customers redeemed their points), and Air Canada, who provided 8% of all inventory for loyalty redemption.  To extract the most value from the program, Air Canada was saddled with a rather expensive commercial contract (providing Aimia with valueable inventory – e.g., seats they could otherwise sell to business travelers at high rates -- to Aimia at extremely attractive prices) which was set to expire in June of 2020.  Air Canada announced last May that it was terminating the contract and building its own loyalty program from scratch (which they claimed had an NPV of $2-2.5bn and would begin ramping in the middle of 2020).  We believe this was nothing more than a highly aggressive negotiating tactic by Air Canada’s CEO, Calin Rovinescu (who is considered a legendary negotiator and value-creator), which set Aimia’s stock price into a tailspin and ultimately allowed Air Canada to reacquire an asset that they monetized for $2.6bn over a decade ago for next to nothing. 

 

The Deal/Value to Air Canada: 

Air Canada (as part of a consortium including TD, CIBC, and Visa – the other partners in the ecosystem) announced a deal to acquire Aeroplan from Aimia for $450mm on 8/21, providing very limited disclosure re: the specifics/economics of the deal.  We believe Air Canada is actually putting up a diminimus (if any) portion of the $450mm and may actually be getting paid to take the program -- the rest is being put up by the banking partners.  Furthermore, AC likely negotiated improved economics from the banks relative to the $250mm of EBITDA Aeroplan was generating under the existing deal.

·         Supporting the above view, CIBC said on their recent earnings call that the deal would impact their capital ratios by ~10bs, suggesting it will cost them ~$200mm in cash contribution (either towards purchase price or perhaps to AC B/S to offset the points liability, which Air Canada used as a negotiating tactic – importantly, this liability is not a real liability, as AC controls the inventory, all of the US peers have points liabilities sitting on their balance sheets, and ratings agencies/credit investors know how to treat them – i.e., they don’t count them in their leverage ratios).  Meanwhile, given the size of the program, if CIBC is putting in $200mm, TD is likely 3x that and Visa is a little more on top of that, which gets us to $800-$900mm vs a purchase price of $450mm, supporting the general idea that AC was able to negotiate something extremely compelling (more below).  

To understand how it is possible that the banks are effectively paying Air Canada to take this extremely valuable asset (likely with improved economics – e.g., an increase in the price the banks pay AC per reward mile), it’s useful to look at the negotiating leverage airlines have over the banks commensurate with contract renewals.  As an example, quoting Mittleman’s recent letter to the Aimia board (see below link, which also is a useful read in understanding the value/history of Aeroplan):

http://www.mittlemanbrothers.com/wp-content/uploads/2018/08/AIM-CN-open-letter-to-BOD-08-06-18-FINAL.pdf

“In October 1999, CIBC paid Air Canada C$200M to extend their participation in Aeroplan for   another 10 years until 2009. C$200M, not to buy out the entirety of Aeroplan, just to maintain their participation in it for another 10 years. Then in 2003, despite Air Canada being in bankruptcy, CIBC apparently saw demand and earnings on its co-branded Aeroplan Visa cards good enough to agree to pay 19% more for rewards miles and advance C$350M to Air Canada to assist in its reorganization.”

 

Further elaborating on the value transition to Air Canada (from Aimia shareholders and the banks), it’s useful to think through the multi-party negotiation that took place:

·         Air Canada publicly told the market/their shareholders that the NPV of building their own loyalty program was $2-2.5bn, effectively establishing a BATNA (“best alternative to negotiated agreement”) of  positive $2-2.5bn (i.e., anything that they negotiated had to be worth at least $2-2.5bn to them or they would have no choice but to pursue building their own program -- wreaking havoc on their other partners).  However, given that Air Canada trades at a several turn discount to US peers on next year’s numbers (despite a superior b/s, tax attributes, and competitive positioning) and that the launch of their own program wouldn’t start until June of 2020 (which was fraught with execution risk and would likely be dilutive – i.e., would be a cost during the initial years of the ramp), it’s hard to argue that any of this value was/is reflected in the current stock price.

·         Meanwhile, Aimia historically traded with a ~$2.5-3bn market cap, prior to the market becoming concerned in 2016 that Air Canada was going to negotiate substantially improved economics post-2020, and ultimately going into freefall in May 2017 (bottoming out at a ~$200mm market cap) commensurate with Air Canada announcing that they were terminating the deal in 2020 and building their own program.  Aimia shareholders effectively panicked that the business would be a certain bankruptcy without AC as a redemption partner - as such, Air Canada convinced the market that Aimia’s BATNA was negative $2.5-3bn of value.  By agreeing to a $450mm sale Aimia shareholders effectively transferred $2-2.5bn of value back to AC.

·         Finally, the banks were generating ~$450mm of net income from Aeroplan linked credit cards and trade at 11x.  As such, the banks had a ~$5bn (completely irreplaceable asset that took 30-years to build) credit card portfolio to protect.  Furthermore, many of these credit card customers also had bank accounts with TD and CIBC (there were a number of articles in the Canadian press where consumers were threatening to not only clip up their credit card if they couldn’t redeem for Air Canada miles, but that they would also shut down their bank account), suggesting the potential impact could be in excess of the $5bn asset destruction. 

o   Note: Comments by TD on their recent 8/30 earnings call qualitatively allude to how valuable they believe the Aeroplan linked credit cards are to them -- “so a lot of things going well across and with the conclusion of the Aeroplan transaction I'd say, we'll have an embarrassment of riches across our credit card portfolio and offerings.”

If the banks were worried that 25% of the cards migrate in a base case (which assumes that Aimia was actually able to reposition the program via signing other redemption partners), but there were scenarios where there was a run on the bank/Aimia bankruptcy causing them to lose the entire asset, plus end up wearing the points liability to avoid a PR nightmare – i.e., furious consumers with TD credit cards whose points were rendered worthless), their BATNA was somewhere between negative $1.5 to potentially in excess of negative $5bn (which was obviously additional value that could be extracted by Rovinescu via improved pricing on travel reward miles and up-front cash).

 

Further triangulating the value that AC was able to extract:

Air Canada has publicly stated that they believe the difference between their EBITDAR margins and US peers of ~300bps is primarily due to the lack of a loyalty program, suggesting that they believe a fully ramped loyalty program is worth an incremental $500mm annually of EBITDAR, which is effectively stable cash flow to AC, given the lack of capex associated with a loyalty program and NOL’s at AC.  The $500mm EBITDAR uplift makes sense, given the $250mm of cash Aeroplan currently generates, commensurate with opportunity in the cost structure at Aimia/Aeroplan from the bloated culture, billings uplift (i.e., the opportunity to be more efficient in terms of the seats that loyalty program members are allocated – described in more detail below), as well as opportunity to extract additional value from a new agreement with their banking partners (i.e., making the assumption that the banks were willing to give up ~$100mm of the $450mm they currently make on the credit card portfolio through increased price paid per loyalty mile to protect the asset).  Given the stability of this cash flow (and that publicly traded loyalty programs trade at double digit EBITDA multiples), one could argue that this transaction is easily worth 5bn to AC, or 70% of the current market cap. 

 

Strategic Value of having a fully ramped loyalty program:

The importance and value of having a fully ramped loyalty program for an airline cannot be overstated – the airline effectively owns ~100bps (depending on the arrangement with the credit card partner) on all credit card spend (in this case on 5mm consumers) and then the airline controls how/when points associated with that credit card spend are redeemed (i.e., airlines should be driving these redemptions onto seats they otherwise couldn’t/won’t sell, helping them to manage load factor and maximize revenue per seat).  Given that credit card spend typically tracks GDP (only inflecting downwards by a few percentage points during a recession), and the operating costs associated with managing the loyalty program are negligible, these programs provide cash flow in a stable & recurring way (which is particularly valuable during a downturn, when load factors drop and the opportunity cost of putting a frequent flyer on a seat that otherwise couldn’t be sold drops close to zero).  A WSJ article on 8/27 “Airlines Cash In on Loyalty Credit Cards” is an informative read in further understanding the value of these programs to the airlines.

·         Today, Aeroplan generates ~$1.1bn of billings annually (net of the $200mm received from Air Canada) relative to ~$150mm of operating costs and very little capex (~$25mm).  Meanwhile, as noted above, billings track credit card spend (which tends to track GDP), so that $1.1bn of billings likely only inflects down a couple percent in a recession – as such, a fully ramped loyalty program such as Aeroplan (note: the Westjet CEO recently highlighted how difficult/time consuming/and valuable these programs are to build – suggesting his own loyalty program was in its “infancy” after 7-years! -- https://www.bnn.ca/westjet-ceo-air-canada-s-new-loyalty-strategy-a-huge-opportunity-for-us-1.918797), provides an airline with a massive annual cash inflow of ~$900mm in a stable & recurring way.

·         Meanwhile, although Aeroplan is a viewed by those inside the industry as a well-designed, fully ramped loyalty program (that stands up against any loyalty program managed inside US peer airlines), as alluded to above, the current arrangement is inefficient and is not extracting the value that it should for the ecosystem as a whole (particularly AC).  Airlines should be pushing their loyalty program members onto seats they otherwise won’t/can’t sell (e.g., encouraging members to redeem miles during downturns and build them during upcycles).  Contrast this with the current contract with Aimia, where Air Canada was guaranteed ~$567.5mm of revenue (receiving more like $700mm of revenue), but was obligated to pay in excess of  $200mm to Aimia for services to administer its own frequent flyers (so, net ~$500mm of revenue) while also providing Aimia access to valuable inventory on every flight no matter what (e.g., they were putting families on their way to vacation on seats AC could otherwise sell to business travelers at extremely high rates – check out AC’s comments on the “billings” opportunity on their historical conference calls) and it’s not particularly hard to imagine that there’s an opportunity to drive several hundred million dollars of additional revenue (that effectively drops to the bottom line by being more efficient with how they allocate seats. 

·         Additionally, when discussing building their own loyalty program, Air Canada recently highlighted the value of the data that loyalty programs provide (needless to say, Aeroplan has 30-years of data on their consumers. 

o   “The company is unbelievably excited about this opportunity, just not from a financial perspective, we put numbers out there as to what we think this is worth to us, but also from a data perspective. Because we have virtually no data right now in our customers. We fly most Canadians. We fly 48 million customers a year. And we've got some data on our Super Elites and Prestige customers, our tiered customers, but rest of the data is lost on us. And we think we can do a much better job on the customer side if we have the right amount of data. And we certainly built the technology for it. And now, we're looking forward to populate that with good data that will allow us to better tailor our product to the customer needs.”

 

Air Canada Valuation:

At 7x fwd cons.  EPS (a nearly 5-turn discount to competitor Westjet) and sub 4.5x EV/EBITDAR (before the accretion of the aforementioned loyalty transaction), AC was arguably ridiculously cheap on a standalone basis without the loyalty program – particularly in light of the transformation that the company has undergone recently.  For instance, over the past several years AC has dramatically improved its cost structure through aggressive restructuring of regional capacity contracts, higher aircraft density, long-term labor contracts with less arduous increases locked in place through 2025 (which provides for both revenue growth and margin expansion), as well as from fuel efficiency and maintenance savings from replacing nearly all of its fleet with brand new aircraft between 2015-2020.

Furthermore, the industry duopoly in Canada faces fewer price wars and less ULCC incursion than peers in the US.  Meanwhile, new labor negotiations/contracts with pilots at its chief competitor, Westjet, are driving the cost curve steeper (creating a backdrop for even firmer industry pricing).  As a result, Air Canada has been guiding to cumulative FCF of $2-3bn between 2018-2020 (before any benefits from Aeroplan). 

 

Best in Class Management:

The aforementioned transformation of Air Canada is the handiwork of a phenomenal CEO.  Calin Rovinsecu is not your typical Canadian CEO (former M&A/restructuring attorney, Chief Restructuring Officer of Air Canada during the 2000 bankruptcy, Co-Founder of Canaccord Genuity in-between stints at AC, etc.) and is renowned for his negotiating acumen.  The below article is informative in understanding how impressive Rovinescu is as CEO of Air Canada.

https://www.theglobeandmail.com/report-on-business/rob-magazine/we-reveal-the-best-ceo-of-2013/article15650640/

 

Risks:

·         It’s an airline – economic fluctuations, capacity increase concerns in Canada (albeit AC is the primary culprit), fuel prices, etc. 

·         Deal Risk: Although it requires an Aimia shareholder vote, it’s highly unlikely this deal falls through (Mittleman is close to a 20% holder of Aimia and publicly supports the deal, while other large holders are fatigued and supportive of the deal as well). 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

·         Aimia shareholder vote / Air Canada communicating to the street the value of the deal

·         FCF accreting to the business / capital returns

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    Description

     

    Investment Thesis:

    Air Canada (AC) is an outrageously cheap asset, run by a best in class management team, who recently announced a game-changing acquisition (its own loyalty program, Aeroplan) that’s worth somewhere between $2.5-5bn to AC (35-70% of the current market cap).  We expect the stock to reflect this value over the next several months when Air Canada communicates the specifics/accretion of the deal (following the Aimia shareholder vote) this fall.  Over the medium-term, we see multi-bagger potential, as meaningful FCF (in excess of 20% FCF yield / accelerating to sustainably in excess of 30% after 2020 w/ capex durably declining by $1bn) accretes to the balance sheet (delevering AC to less than a turn of Debt/EBITDAR over the next 12-months) allowing Air Canada to aggressively return cash to shareholders (which we expect to be extremely well-received by Canadian institutional investors).   As such, we expect the delevering/capital returns commensurate with their EBITDA margins closing the gap with US peers (due to the loyalty acquisition - more on that below) to drive multiple expansion to at least in-line with US peers (we believe the several turn historical discount to US peers was entirely due to the lack of a loyalty program).  Ultimately, we see no reason why AC shouldn’t trade at a premium to US peers, given its superior balance sheet (less financial leverage, 2.5bn pension surplus, and substantial NOL’s/tax attributes relative to US peers who are becoming tax payers again) as well as its superior competitive positioning (Canada is a duopoly with Air Canada commanding in excess of 55% market share). 

     

    What is Aeroplan:

    Note:  We encourage readers to read prior VIC write-ups on Aimia, which provide a wealth of information on Aeroplan, its history, etc.   

    Aeroplan was Air Canada’s loyalty program that they began divesting in the early 2000’s to unlock shareholder value and later to raise cash from a position of financial distress in 2008 -- in total, Air Canada monetized this business netting proceeds of $2.6bn (when the program was substantially smaller than it is today).   Commensurate with its creation, a complicated and inefficient ecosystem was created between the banks (who distribute the credit cards and pay ~1% of customer transaction value to offer credit card customers a loyalty program), Aimia – the owner of aeroplan (the middleman, who collected cash from the banks and used the cash to purchase tickets on Air Canada at a discount when customers redeemed their points), and Air Canada, who provided 8% of all inventory for loyalty redemption.  To extract the most value from the program, Air Canada was saddled with a rather expensive commercial contract (providing Aimia with valueable inventory – e.g., seats they could otherwise sell to business travelers at high rates -- to Aimia at extremely attractive prices) which was set to expire in June of 2020.  Air Canada announced last May that it was terminating the contract and building its own loyalty program from scratch (which they claimed had an NPV of $2-2.5bn and would begin ramping in the middle of 2020).  We believe this was nothing more than a highly aggressive negotiating tactic by Air Canada’s CEO, Calin Rovinescu (who is considered a legendary negotiator and value-creator), which set Aimia’s stock price into a tailspin and ultimately allowed Air Canada to reacquire an asset that they monetized for $2.6bn over a decade ago for next to nothing. 

     

    The Deal/Value to Air Canada: 

    Air Canada (as part of a consortium including TD, CIBC, and Visa – the other partners in the ecosystem) announced a deal to acquire Aeroplan from Aimia for $450mm on 8/21, providing very limited disclosure re: the specifics/economics of the deal.  We believe Air Canada is actually putting up a diminimus (if any) portion of the $450mm and may actually be getting paid to take the program -- the rest is being put up by the banking partners.  Furthermore, AC likely negotiated improved economics from the banks relative to the $250mm of EBITDA Aeroplan was generating under the existing deal.

    ·         Supporting the above view, CIBC said on their recent earnings call that the deal would impact their capital ratios by ~10bs, suggesting it will cost them ~$200mm in cash contribution (either towards purchase price or perhaps to AC B/S to offset the points liability, which Air Canada used as a negotiating tactic – importantly, this liability is not a real liability, as AC controls the inventory, all of the US peers have points liabilities sitting on their balance sheets, and ratings agencies/credit investors know how to treat them – i.e., they don’t count them in their leverage ratios).  Meanwhile, given the size of the program, if CIBC is putting in $200mm, TD is likely 3x that and Visa is a little more on top of that, which gets us to $800-$900mm vs a purchase price of $450mm, supporting the general idea that AC was able to negotiate something extremely compelling (more below).  

    To understand how it is possible that the banks are effectively paying Air Canada to take this extremely valuable asset (likely with improved economics – e.g., an increase in the price the banks pay AC per reward mile), it’s useful to look at the negotiating leverage airlines have over the banks commensurate with contract renewals.  As an example, quoting Mittleman’s recent letter to the Aimia board (see below link, which also is a useful read in understanding the value/history of Aeroplan):

    http://www.mittlemanbrothers.com/wp-content/uploads/2018/08/AIM-CN-open-letter-to-BOD-08-06-18-FINAL.pdf

    “In October 1999, CIBC paid Air Canada C$200M to extend their participation in Aeroplan for   another 10 years until 2009. C$200M, not to buy out the entirety of Aeroplan, just to maintain their participation in it for another 10 years. Then in 2003, despite Air Canada being in bankruptcy, CIBC apparently saw demand and earnings on its co-branded Aeroplan Visa cards good enough to agree to pay 19% more for rewards miles and advance C$350M to Air Canada to assist in its reorganization.”

     

    Further elaborating on the value transition to Air Canada (from Aimia shareholders and the banks), it’s useful to think through the multi-party negotiation that took place:

    ·         Air Canada publicly told the market/their shareholders that the NPV of building their own loyalty program was $2-2.5bn, effectively establishing a BATNA (“best alternative to negotiated agreement”) of  positive $2-2.5bn (i.e., anything that they negotiated had to be worth at least $2-2.5bn to them or they would have no choice but to pursue building their own program -- wreaking havoc on their other partners).  However, given that Air Canada trades at a several turn discount to US peers on next year’s numbers (despite a superior b/s, tax attributes, and competitive positioning) and that the launch of their own program wouldn’t start until June of 2020 (which was fraught with execution risk and would likely be dilutive – i.e., would be a cost during the initial years of the ramp), it’s hard to argue that any of this value was/is reflected in the current stock price.

    ·         Meanwhile, Aimia historically traded with a ~$2.5-3bn market cap, prior to the market becoming concerned in 2016 that Air Canada was going to negotiate substantially improved economics post-2020, and ultimately going into freefall in May 2017 (bottoming out at a ~$200mm market cap) commensurate with Air Canada announcing that they were terminating the deal in 2020 and building their own program.  Aimia shareholders effectively panicked that the business would be a certain bankruptcy without AC as a redemption partner - as such, Air Canada convinced the market that Aimia’s BATNA was negative $2.5-3bn of value.  By agreeing to a $450mm sale Aimia shareholders effectively transferred $2-2.5bn of value back to AC.

    ·         Finally, the banks were generating ~$450mm of net income from Aeroplan linked credit cards and trade at 11x.  As such, the banks had a ~$5bn (completely irreplaceable asset that took 30-years to build) credit card portfolio to protect.  Furthermore, many of these credit card customers also had bank accounts with TD and CIBC (there were a number of articles in the Canadian press where consumers were threatening to not only clip up their credit card if they couldn’t redeem for Air Canada miles, but that they would also shut down their bank account), suggesting the potential impact could be in excess of the $5bn asset destruction. 

    o   Note: Comments by TD on their recent 8/30 earnings call qualitatively allude to how valuable they believe the Aeroplan linked credit cards are to them -- “so a lot of things going well across and with the conclusion of the Aeroplan transaction I'd say, we'll have an embarrassment of riches across our credit card portfolio and offerings.”

    If the banks were worried that 25% of the cards migrate in a base case (which assumes that Aimia was actually able to reposition the program via signing other redemption partners), but there were scenarios where there was a run on the bank/Aimia bankruptcy causing them to lose the entire asset, plus end up wearing the points liability to avoid a PR nightmare – i.e., furious consumers with TD credit cards whose points were rendered worthless), their BATNA was somewhere between negative $1.5 to potentially in excess of negative $5bn (which was obviously additional value that could be extracted by Rovinescu via improved pricing on travel reward miles and up-front cash).

     

    Further triangulating the value that AC was able to extract:

    Air Canada has publicly stated that they believe the difference between their EBITDAR margins and US peers of ~300bps is primarily due to the lack of a loyalty program, suggesting that they believe a fully ramped loyalty program is worth an incremental $500mm annually of EBITDAR, which is effectively stable cash flow to AC, given the lack of capex associated with a loyalty program and NOL’s at AC.  The $500mm EBITDAR uplift makes sense, given the $250mm of cash Aeroplan currently generates, commensurate with opportunity in the cost structure at Aimia/Aeroplan from the bloated culture, billings uplift (i.e., the opportunity to be more efficient in terms of the seats that loyalty program members are allocated – described in more detail below), as well as opportunity to extract additional value from a new agreement with their banking partners (i.e., making the assumption that the banks were willing to give up ~$100mm of the $450mm they currently make on the credit card portfolio through increased price paid per loyalty mile to protect the asset).  Given the stability of this cash flow (and that publicly traded loyalty programs trade at double digit EBITDA multiples), one could argue that this transaction is easily worth 5bn to AC, or 70% of the current market cap. 

     

    Strategic Value of having a fully ramped loyalty program:

    The importance and value of having a fully ramped loyalty program for an airline cannot be overstated – the airline effectively owns ~100bps (depending on the arrangement with the credit card partner) on all credit card spend (in this case on 5mm consumers) and then the airline controls how/when points associated with that credit card spend are redeemed (i.e., airlines should be driving these redemptions onto seats they otherwise couldn’t/won’t sell, helping them to manage load factor and maximize revenue per seat).  Given that credit card spend typically tracks GDP (only inflecting downwards by a few percentage points during a recession), and the operating costs associated with managing the loyalty program are negligible, these programs provide cash flow in a stable & recurring way (which is particularly valuable during a downturn, when load factors drop and the opportunity cost of putting a frequent flyer on a seat that otherwise couldn’t be sold drops close to zero).  A WSJ article on 8/27 “Airlines Cash In on Loyalty Credit Cards” is an informative read in further understanding the value of these programs to the airlines.

    ·         Today, Aeroplan generates ~$1.1bn of billings annually (net of the $200mm received from Air Canada) relative to ~$150mm of operating costs and very little capex (~$25mm).  Meanwhile, as noted above, billings track credit card spend (which tends to track GDP), so that $1.1bn of billings likely only inflects down a couple percent in a recession – as such, a fully ramped loyalty program such as Aeroplan (note: the Westjet CEO recently highlighted how difficult/time consuming/and valuable these programs are to build – suggesting his own loyalty program was in its “infancy” after 7-years! -- https://www.bnn.ca/westjet-ceo-air-canada-s-new-loyalty-strategy-a-huge-opportunity-for-us-1.918797), provides an airline with a massive annual cash inflow of ~$900mm in a stable & recurring way.

    ·         Meanwhile, although Aeroplan is a viewed by those inside the industry as a well-designed, fully ramped loyalty program (that stands up against any loyalty program managed inside US peer airlines), as alluded to above, the current arrangement is inefficient and is not extracting the value that it should for the ecosystem as a whole (particularly AC).  Airlines should be pushing their loyalty program members onto seats they otherwise won’t/can’t sell (e.g., encouraging members to redeem miles during downturns and build them during upcycles).  Contrast this with the current contract with Aimia, where Air Canada was guaranteed ~$567.5mm of revenue (receiving more like $700mm of revenue), but was obligated to pay in excess of  $200mm to Aimia for services to administer its own frequent flyers (so, net ~$500mm of revenue) while also providing Aimia access to valuable inventory on every flight no matter what (e.g., they were putting families on their way to vacation on seats AC could otherwise sell to business travelers at extremely high rates – check out AC’s comments on the “billings” opportunity on their historical conference calls) and it’s not particularly hard to imagine that there’s an opportunity to drive several hundred million dollars of additional revenue (that effectively drops to the bottom line by being more efficient with how they allocate seats. 

    ·         Additionally, when discussing building their own loyalty program, Air Canada recently highlighted the value of the data that loyalty programs provide (needless to say, Aeroplan has 30-years of data on their consumers. 

    o   “The company is unbelievably excited about this opportunity, just not from a financial perspective, we put numbers out there as to what we think this is worth to us, but also from a data perspective. Because we have virtually no data right now in our customers. We fly most Canadians. We fly 48 million customers a year. And we've got some data on our Super Elites and Prestige customers, our tiered customers, but rest of the data is lost on us. And we think we can do a much better job on the customer side if we have the right amount of data. And we certainly built the technology for it. And now, we're looking forward to populate that with good data that will allow us to better tailor our product to the customer needs.”

     

    Air Canada Valuation:

    At 7x fwd cons.  EPS (a nearly 5-turn discount to competitor Westjet) and sub 4.5x EV/EBITDAR (before the accretion of the aforementioned loyalty transaction), AC was arguably ridiculously cheap on a standalone basis without the loyalty program – particularly in light of the transformation that the company has undergone recently.  For instance, over the past several years AC has dramatically improved its cost structure through aggressive restructuring of regional capacity contracts, higher aircraft density, long-term labor contracts with less arduous increases locked in place through 2025 (which provides for both revenue growth and margin expansion), as well as from fuel efficiency and maintenance savings from replacing nearly all of its fleet with brand new aircraft between 2015-2020.

    Furthermore, the industry duopoly in Canada faces fewer price wars and less ULCC incursion than peers in the US.  Meanwhile, new labor negotiations/contracts with pilots at its chief competitor, Westjet, are driving the cost curve steeper (creating a backdrop for even firmer industry pricing).  As a result, Air Canada has been guiding to cumulative FCF of $2-3bn between 2018-2020 (before any benefits from Aeroplan). 

     

    Best in Class Management:

    The aforementioned transformation of Air Canada is the handiwork of a phenomenal CEO.  Calin Rovinsecu is not your typical Canadian CEO (former M&A/restructuring attorney, Chief Restructuring Officer of Air Canada during the 2000 bankruptcy, Co-Founder of Canaccord Genuity in-between stints at AC, etc.) and is renowned for his negotiating acumen.  The below article is informative in understanding how impressive Rovinescu is as CEO of Air Canada.

    https://www.theglobeandmail.com/report-on-business/rob-magazine/we-reveal-the-best-ceo-of-2013/article15650640/

     

    Risks:

    ·         It’s an airline – economic fluctuations, capacity increase concerns in Canada (albeit AC is the primary culprit), fuel prices, etc. 

    ·         Deal Risk: Although it requires an Aimia shareholder vote, it’s highly unlikely this deal falls through (Mittleman is close to a 20% holder of Aimia and publicly supports the deal, while other large holders are fatigued and supportive of the deal as well). 

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    ·         Aimia shareholder vote / Air Canada communicating to the street the value of the deal

    ·         FCF accreting to the business / capital returns

    Messages


    SubjectMistake in heading
    Entry09/04/2018 01:39 PM
    MemberHamilton1757

    Apologize.  Market cap, debt, etc. are all obviously in billions, as opposed to millions.


    SubjectComps etc
    Entry09/04/2018 03:39 PM
    MemberTeton0321

    Hamilton1757 - really interesting and thank you. Quick questions.

    1. How does your 4.5x EV/EBITDAR compare to comps and are you capitalizing rent at 8x or something else? Are you including tax assets, pension surplus, etc?

    2. Is there a way to understand the accretion upside from Aeroplan beyond just the roughly high-$180s EBITDA that it has run at the last few years plus some rough guesstimate of how they can run the plan better themselves?

    3. When exactly is the vote, how soon will management articulate specifics, and what will those specifics be (best guess)?


    Subjectquestions
    Entry09/04/2018 03:53 PM
    Membertharp05

    Thank you for interesting idea.  A few questions

    How do you get to $2.5B pension surplus?

    Do you have a sense of maintenance capex?  It looks like the business has been cumulative FCF negative for most time periods, what have they done to now expect +2-3B over the next few years?  What is prompting changes now under CEO that's been around for nearly a decade?  Is historical FCF less relevant with the new annual cash flow generated by the loyalty program?

    Do you have any sense of why, given apparently superior industry structure to US and best in class management, returns on capital and margins have not been stronger?  Is this completely due to lack of loyalty program?

    Thanks


    SubjectRe: Comps etc
    Entry09/05/2018 09:12 AM
    MemberHamilton1757

    Peers are ~6.5x EV/EBITDAR -- a 2-turn rerating is worth $22 per share (or 83% of the market cap) without even counting the accretion from Aeroplan.  Yes, I’m using sell-side numbers and capitalizing rent, but I’m not including the tax assets or pension surplus (which would obviously make it much cheaper) b/c the sellside doesn’t adjust for that (and I didn’t want to get into a confusing Adj. EV/EBITDARP calculation)

    1.       Is there a way to understand the accretion upside from Aeroplan beyond just the roughly high-$180s EBITDA that it has run at the last few years plus some rough guesstimate of how they can run the plan better themselves?

    Excluding corporate & other negative EBITDA businesses at Aimia (which obviously won’t travel), Aeroplan run-rate was more like $250mm of EBITDA (check out page 56 of the Aimia Q4 ’17 presentation dated 2/14/18 – Aeroplan adj EBITDA was $278mm in ’17 and $234.5mm in ’16) .  Meanwhile, the major banking partners cut marketing spend on the cards b/c they’ve been worried about the future of the program (see TD’s comments from their Q1’18 call), so topline has arguably been depressed as a result.  Furthermore, there are arguably additional cost/synergy opportunities (Aeroplan was starting to build out their own program as part of the negotiation and has been incurring duplicative costs and Aimia ran the business with a massively bloated cost structure – they old Aimia management team was easily addressing $70mm across the entire business, but our understanding from speaking with the new management team is that $70mm was just scratching the surface) as well as billings opportunities (from running the program more efficiently to maximize REVPAR as well as from improved economics from the banks, per the write-up).  Frankly, I think $500mm of EBITDA might be conservative.

    2.       When exactly is the vote, how soon will management articulate specifics, and what will those specifics be (best guess)?

    The vote hasn’t been scheduled yet – I’m told this fall (but obviously it behooves everyone to get it done quickly, so I’m guessing its an Oct/Nov event).  As for when/what AC management communicates to their shareholders, I expect them to continue to be very secretive about it until after the Aimia shareholder vote – at that time, perhaps they will continue to be conservative re: the billings opportunity, etc (no need to run around town and brag about how you just destroyed your partners in a negotiation -  and might as well keep that in your pocket to “beat and raise”); however, they need to provide the street with some guidance re: the accretion in ’19 – also, whatever they communicate needs to look like its worth at least $2-2.5bn to them or their own shareholders will question why they did the deal, so I would assume the communicate that it’s at least a $250mm EBITDA uplift, (likely more, since they only trade at 4.5x EV/EBITDAR).   


    SubjectRe: Re: Comps etc
    Entry09/05/2018 09:56 AM
    MemberTeton0321

    Thank you Hamilton 1757. Super thorough and helpful responses. Very interesting. 


    SubjectRe: questions
    Entry09/05/2018 10:38 AM
    MemberHamilton1757

    How do you get to $2.5B pension surplus?

    Please see page 47 (Pension funding obligations) as well as page 104 (Note 8. Pension and Other Benefit Liabilities) of the AC Annual Report:

    As at January 1, 2017, the aggregate solvency surplus in the domestic registered pension plans was $1.9 billion. Based on preliminary estimates, including actuarial assumptions, as at January 1, 2018, the aggregate solvency surplus in Air Canada’s domestic registered pension plans is projected to be $2.5 billion.”

    Do you have a sense of maintenance capex?  It looks like the business has been cumulative FCF negative for most time periods, what have they done to now expect +2-3B over the next few years?  What is prompting changes now under CEO that's been around for nearly a decade?  Is historical FCF less relevant with the new annual cash flow generated by the loyalty program?

    As noted in the write-up, capex should durably decline in excess of $1bn in 2020 (to less than $1.1bn) – they have been buying planes, replacing nearly their entire fleet between 2015 and 2020 (with new low cost, fuel-efficient planes). 

    I think Quads1025 write-up from back in 2015 is useful in understanding the transformation to the cost structure that’s happened over the past several years – Aeroplan was the final feather in Rovinescu’s cap.   Large changes have been happening for the entirety of the past decade since Rovinescu was called back in to save AC from bankruptcy (achieved through negations with unions, regional carriers, etc).  Yes, historical cash flow is less relevant due to a dramatically different cost structure (thanks to transformation that’s been underway for years), completely delevering the balance sheet (paying down high cost debt and purchasing their airplanes), capex durably declining following the fleet upgrade in 2-years, and finally the loyalty program which should provide for a $500mm+ uplift in FCF annually (which will come in like clockwork and thus, is a massively stabilizing force for an airline during a downturn).  In short, the concept of AC completing a multi-year “transformation” IS the thesis (i.e., historical numbers aren’t relevant re: understanding the earnings power going forward). 

    Do you have any sense of why, given apparently superior industry structure to US and best in class management, returns on capital and margins have not been stronger?  Is this completely due to lack of loyalty program?

    Yes, I expect margins, ROIC’s, etc will ultimately exceed those of the US carriers. 


    SubjectRe: question on fuel costs
    Entry09/05/2018 10:53 AM
    MemberHamilton1757

    I wouldn’t get too carried away re: oil prices and their impact on this investment.  The industry is a duopoly and thus, they have pricing power (i.e., the ability to pass on higher oil prices to the consumer, albeit with a bit of a lag).  To the extent that a spike in oil prices results in demand destruction, they will cut capacity to continue to drive load factor. 

    As an example, although it’s nowhere near as consolidated as the Canadian industry structure, the US market has consolidated in recent years thanks to bankruptcies, M&A, etc. (helping promote more rational industry behavior).  Furthermore, high oil prices flip the cost structure (to becoming much more variable than fixed).  Look no further than 2011 as an example of just how much the industry has changed in the US (with a much less attractive industry structure) -- we had an oil price spike due to Middle East unrest), European debt crisis, weakening global economy, Japanese nuclear disaster at Fukushima, etc -- historically, that combination of factors would have bankrupt the airline industry, however, all of the US carriers generated substantial FCF that year. 


    SubjectRe: Re: questions
    Entry09/05/2018 07:14 PM
    MemberBismarck

    How did you get TD paying 3x as much? I see that Aeroplan has about 50% more gross billings from TD than CIBC. 


    SubjectRe: Re: Re: questions
    Entry09/06/2018 11:51 AM
    MemberHamilton1757

    It's an estimate given to me by consultants based on their assumptions re: profitability of the card portfolios to the respective banks (as a sanity check, TD's '15 guide re: 15 cent uplift to earnings from the CIBC transaction suggests they were expecting it to be ~$280mm of earnings a few years ago), coupled with the value from their exclusive right to mass market Aeroplan credit cards & broader banking products.  It's obviously fuzzy math designed to be a sanity check/make a point -- i.e., its not uncommon for the banks to pay upfront cash as well as increase the price they pay per point during these negotiations (TD itself paid Aimia $100mm upfront and 16% more per mile commensurate with it purchasing ~50% of the card portfolio from CIBC back in 2014), which seems particularly plausible in this situation (given whats at stake).  


    Subjectpension
    Entry09/13/2018 04:36 PM
    Membertharp05

    can you help me understand the difference between the $2.5B solvency surplus you referenced and the $1.07B net benefit obligation on p.105 of the annual report? Thanks.

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