(all figures in $C)

 Overview: Groupe Aeroplan ("AER") began as Air Canada's frequent flyer program and has evolved to become a provider of loyalty marketing solutions with strong footholds in Canada, UK, and Italy.  The Company converted to a C-Corp in June 2008, three years after IPO'ing as an income trust.  Before 2005, Groupe Aeroplan was a partnership wholly owned by Air Canada (and before 2002, the Aeroplan program was completely integrated with Air Canada), Canada's largest airline.  AER generates lots of cash from its legacy Canadian business and will generate more over time through various budding growth opportunities.  Over the last few years, numerous non-recurring costs related to acquisitions and new launches, reporting segment changes, and changes from CGAAP to IFRS have made it cumbersome to analyze AER and obfuscated the Company's cash generating potential.  On a normalized basis, however, Groupe Aeroplan earned $1.25 in free cash flow per share in the last 12 months.  This year, I think AER generates ~$205mn in free cash flow (ex-1 timers) on a reduced share base of 172mn, a 10% yield on the current price, and I think free cash flow grows by 10% annually through 2013.  For that, we get a solid, highly-cash generative Canadian coalition business and at-the-money call options on future growth initiatives. 

 While the Company recently underwent a reporting change classifying results by geographic region (Canada, EMEA and US/Asia Pac), I describe the businesses below according to loyalty offering for ease of understanding.  The logic behind the reporting change is now that Carlson Marketing acquisition has been fully integrated, AER is positioned to offer a full suite of loyalty products to clients in various geographies.  For example, in each geography, AER can now: 1) help clients set up their own loyalty programs (proprietary services), 2) establish its own greenfield coalition program and/or 3) offer data analytics solutions (to help retailers better understand their customers and operate their stores more efficiently). 

 Coalition

 Over 2/3rds of AER's billings comes from Coalition business, which involves selling loyalty units (miles and points) to accumulation partners like airlines/retailers/grocers/gas stations/banks.  Consumers in Canada rack up reward points by using Aeroplan co-branded credit cards, like CIBC and AMEX when shopping at certain retailers.  When the consumer cashes in on his/her reward, Aeroplan will take the cash it received from accumulation partners and buy airline seats (or some other product or service) from redemption partners.  Groupe Aeroplan makes the spread between points sold and rewards redeemed.  The percentage of rewards that the Company expects will never be redeemed by customers is called "breakage" and is currently pegged at 21%.  Since AER is responsible for the redemption liability, the Company keeps a $300mn reserve on hand to fund rewards in the unlikely event billings cannot satisfy current redemption needs.  This reserve has never been tapped as gross billings run ~20%-30% above redemptions.  Cash flows are driven by gross billings ($ from selling loyalty units), which in turn are a function of new partners and membership penetration within those partners.  The barrier to entry is a meaningful network effect, as the bigger the membership base and the more frenetic the purchase activity, the more leverage when negotiating contract terms with partners, which last between 2 to 5 years.  I believe AER's network of dozens of accumulation and redemption partners developed over several decades would be difficult to re-create.

 Aeroplan Canada: A mature cash cow that accounts for nearly all of AER's consolidated EBITDA.  Groupe Aeroplan runs Air Canada's Aeroplan program, the 2^nd largest airline loyalty program in Canada with close to 5mn members and over 100 accumulation partners.  AER has carved out a dominant position in the high-end niche.  Aeroplan Canada recently negotiated a three year pricing contract with Air Canada for the purchase of miles, which continue to be the most popular member redemption rewards.  This is a relatively mature business segment with gross billings linked to high-end consumer expenditures in Canada. 

 There has been some concern recently about higher redemptions over the next few years pressuring cash flow.  With any coalition program there's a tradeoff between breakage and billings growth: you can have very high breakage by discouraging member engagement and generate high near-term profits at the expense of future gross billings; on the other hand, you can have very little breakage but impair your profit margins.  Management has introduced several innovations this year to improve member engagement at the expense of near-term cash flows - for example, a new Star Alliance online booking tool that highlights available seat inventory and increases the number of airports available to members.  A program like this is expected to increase member engagement and pull forward redemptions but not really change overall breakage assumptions.  As Buffet said once said about insurance company financials, coalition program P/Ls are also like "self-graded" exams; management makes a current estimate of unused reward units but the ultimate redemption pattern may go unknown for years.  I would venture to say, however, that this is a business less prone to "fat tails" and history serves as a reasonably reliable guide for the future.  In Groupe Aeroplan's case, CEO Rupert Duchesne has been with AER from the very beginning and over the course of a dozen years has experimented with different engagement/disengagement initiatives to assess the redemptions/billings trade-off.  In any case, compared to two other well-known peers, Groupe Aeroplan has the lowest breakage rate assumption.

Breakage Rate

Groupe Aeroplan            21.0%

Multiplus                         23.3%

ADS                                28.0% 

Several other recent data points worth noting: 1) Canadian monthly retail sales (ex. fuel and auto) are weak, growing at a tepid 30bps so far this year compared to 3% growth in 2010.  On the other hand, VISA credit and debit payment volumes and transactions in Canada have grown at a high-single digit pace.  2) RASMs and RPMs at Air Canada grew mid-single digits in the most recent quarter with RASMs having shown positive growth for the last 5 quarters.

 Nectar UK - Nectar is the most popular retail loyalty program in the UK with over 17mn members (this is folks who have been active card users over the last year), touching half of UK households.  It is the country's only major loyalty program that is independently owned.  Unlike GA Canada, which started as an internally housed frequent flyer program, Nectar UK has its roots in retail and operates as a mass market offering.  While the program has been around for 8/9 years, it is still signing new partners and growing its membership base (Aeroplan Canada took a dozen years to reach full maturity).  Nectar UK's largest partner (and Groupe Aeroplan's 3^rd largest customer by billings) is Sainsbury, the 3rd largest grocer in the UK with 16% market share.  Sainsbury effectively used Aeroplan points to garner customer loyalty and escape price wars during the recession.  Sainsbury comps (ex. fuel) remained positive throughout 2008/2009 and grew at 2.3% and 1.9% during the 1^st and 2^nd quarters of this year, respectively.  The UK economy has clearly been weak but household spending on food and non-alcoholic beverages never contracted y/y in any quarter in 2008/2009 and grew mid-to-high single digits during most of the recession. 

% y/y change

Household Consumption Food and non-alcoholic beverages

1Q06                               4.75% 1.98%

2Q06 4.39% 1.85%

3Q06 4.87% 6.19%

4Q06 4.66% 4.82%

1Q07 5.48% 5.49%

2Q07 5.00% 6.47%

3Q07 4.94% 5.09%

4Q07 5.03% 8.55%

1Q08 6.60% 8.27%

2Q08 5.65% 9.43%

3Q08 5.97% 9.56%

4Q08 2.15% 6.32%

1Q09 -1.82% 6.25%

2Q09 -3.50% 5.11%

3Q09 -2.99% 3.03%

4Q09 0.24% 3.13%

1Q10 3.19% 4.44%

2Q10 6.30% 4.27%

3Q10 5.88% 6.93%

4Q10 5.15% 4.37%

1Q11 4.99% 6.93%

 Apart from grocers, Nectar UK announced a new partnership with British Gas, the largest gas utility in the UK with > 12mn customers, which is replacing legacy customer EDF, the 5^th largest utility in the UK with 5.5mn customers.  This is a meaningful deal, and one that will contribute to gross billings in 2012 after a year of ramp-up.  Within the first 8 weeks of the launch, 1.5mn people have already signed up for the program, 300k of which are new Nectar members. 

  Nectar Italia - GAE's 75% owned greenfield initiative.  After $20mn in launch investments in 2010, Nectar Italia is positioned to leverage billings growth.  Italy is a large market with 58mn consumers, 25mn households and the 4^th largest European grocery sector.  Italian consumers already participate in multiple loyalty programs with numerous retailers; however, Nectar Italia is the country's first coalition program offering 1 card for multiple partners, providing AER with an important first mover advantage.  Italy has a fragmented but consolidating retail sector, and Nectar Italia is in a good position to benefit from the industry's maturity path.  The launch has already well exceeded expectations:  Since March '09, in addition to signing its minority partner, Auchan (the 12^th largest retailer in the world), Italia inked an agreement with Unicredit, the largest bank in Italy with over 7mn customers and 4,000 branches.  This year, the program has signed several new partners including Perelli, a tire manufacturer, and Magneti Marelli, which operates an auto repair franchise chain.  Nectar Italia has already exceeded its 5mn member 1 year target, reaching ~7mn members (or over 23% of Italian households) and is currently the largest loyalty program in Italy.  Italia is reaching break-even on an adjusted EBITDA basis.  While management achieved $65mn in gross billings in 2010, profitability will be pressured in 2011 due to higher redemptions -  typically, a new coalition program will see high point accumulations the first year followed by redemptions  > accumulations the following year.  At maturity, I would expect Italia to see adjusted EBITDA margins similar to those in Nectar UK (high single digits). 

 Other budding coalitions: 1) In September 2009, AER made an initial $23mn investment in PLM, which owns Aeromexico's Club Premier, a frequent flier program in Mexico.  An additional $12mn investment in 1Q11 brought AER's ownership to just under 30%.  PLM is run-rating at around $100mn in gross billings with 2.8mn members and nearly 60 commercial partners.  Applying a 20% EBIT margin to the business (similar to Aeroplan Canada) implies maybe $4mn-$6mn to AER.  The Company expects Club Premier to begin dividend-ing out these earnings starting 2012.  2) This summer, Groupe Aeroplan announced a JV with Indian conglomerate Tata to establish a retail coalition program in India.  Management has not yet provided much detail as it is still early days.  3) Finally, the Company has a 60% interest in Air Miles Middle East, a small frequent flyer program with 1.7mn members.

 Other - GAE licenses infrastructure and the Nectar brand to enable retailers to run in-house loyalty programs in markets that are not developed enough to support coalition.  This is basically the same technology that is being used in Nectar UK and Italy.  These arrangements provide access to high growth markets with little capital risk.  South America is a budding opportunity for AER, with private consumption expected to show double digit growth in Chile, Brazil and Argentina.  Chile - stable, urban and relatively wealthy - is the Company's first stab at the region.  Since launching in August 2010, Nectar Chile already has ~3mn members and has signed an agreement with Cencosud, one the largest retailers in South America that has aggressive expansion ambitions in the region. 

 Data Analytics

 I&C: this is a small (10s of millions of dollars of revenue) but rapidly growing retail data analytics business that is used by retailers and consumer goods product companies.  It was acquired along with Nectar UK in the Company's December 2007 $715mn acquisition of Loyalty Management Group, and is working with over 130 customers, including a recent agreement with CVS and Coles, the largest grocer in Australia.  Revenue comes in the form of 1-year (or longer) licenses that offer customers a self-serve web-portal to access customer analytics.  The details of nearly every transaction at Sainsbury, from SKUs to ticket price to customer information, is compiled into a database and organized in intelligent ways for the retailer's use to predict future customer buying patterns, stock shelves and procure goods.  For example, the software might estimate the age of a mother's infant based on the type of diapers she buys to allow the retailer to customize future marketing.  Opex is still outpacing revenue growth but I expect contribution margins to be high as the business matures. 

 Proprietary

Carlson Marketing:  In December 2009, the Company acquired Carlson Marketing for $280mn in cash on hand and debt.  Carlson Marketing is a fee-driven business (vs. a liability management business like AER's coalition business) that designs, implements and consults on in-house loyalty management programs.  For example, in India, Carlson Marketing is working with Kingfisher Airlines to differentiate the King Club loyalty program.  Other prominent customers include Nokia, HomeServe and Starwood.  The acquisition has also given AER expanded geographic presence (especially in the US and Asia) and a more complete set of loyalty offerings - management attributes the I&C win at CVS to Carlson's large North American presence.  Carlson also implemented the bookings systems and provides the call center support for Nectar UK's recent foray into airline rewards with easyJet.  Earlier this year, Carlson lost $60mn of VISA transaction processing business because it was unwilling to accept zero margin contract terms during negotiations, a sizeable hit to 2011 billings on a 2010 base of $419mn in US & Asia Pac (this segment is most of Carlson Marketing).  According to management, Carlson simply did not have the economies of scale to compete on price in this highly competitive space.  While Carlson continues to sign up new clients at a robust pace, these are single-digit-million deals, so it will take some time to replace VISA.  Additionally, the US portion of Carlson Marketing (which is the vast majority) continues to exhibit weakness - this, plus the VISA loss was the major source of total adjusted EBITDA missing Street guidance in recent quarters.  I wouldn't expect meaningful improvement in Carlson until US employment turns and am modeling just 2%/2.5% billings growth over the next 2 years.

 All the above businesses are split up by geography (Canada, EMEA, US/Asia Pac).  The vast majority of consolidated EBITDA ($360mn+) comes from Canada, with EBITDA from other geographies basically offsetting corporate expenses. 

 Valuation: Management has guided to adjusted EBITDA* of between $355mn - $365mn in 2011, inclusive of all one-time restructuring costs and VAT accruals.  In the first half alone, those one-timers come to ~$17mn.  Taking lower end of the guidance range and adding back these one-time costs, I get to ~$205mn in normalized free cash flow, calculated as follows:

Adj. EBITDA 372

- Capex (55)

- Interest expense (44)

+ Interest income 13

- Cash taxes (70)

- Preferred dividends (11)

Normalized FCFE 206

*Adjusted EBITDA simply takes EBITDA and adds 1) changes in deferred revenue and 2) changes in future redemption costs.  This is a negative working capital business model - cash is collected from accumulation partners before it is used to purchase seats so growth is a source of cash. 

Groupe Aeroplan has 17mn shares remaining under its NCIB to be used by May 2012.  This implies a share count of ~172mn by the end of the year.  So, even if free cash flow doesn't grow, the Company is still generating $1.20 of FCFE/share, a 10% yield off the current price.  But if management is right that redemptions over the next year or so are higher than normal, then free cash flow could have a run-way for growth in 2013 and beyond.  Management recently guided towards adjusted EBITDA of $425mn by 2013, which translates into ~$260mn in FCF.  Using up the remaining NCIB would provide a share count of 163mn, implying ~$1.60 / share, so even if the multiple doesn't reset, we annualize at ~10% and get our 10% coupon.  But, I think AER is an above-average company and don't think it unreasonable to apply a market multiple.  At 15x per share free cash flow, this is a $24 stock by 2013.

Risks: Air Canada, which nearly went bankrupt in 2009, is still a large partner, accounting for 13% of gross billings and 44% of redemption costs.  However, the Canadian government rescued the airline with a $1bn loan package to which AER contributed $150mn, and which was recently repaid.  It is worth noting that gross billings at Aeroplan Canada contracted 3.1% during 2009.  Still, less drastically, there is the risk that Air Canada seats simply become less attractive when compared to those of other carriers.  Another risk is recent changes recommended by the Competition Bureau in Canada that could encourage debit card/cash spending at the expense of credit cards.  Finally, there is the risk of a slow-down in consumer spending in the developed world, as the Company's success is still ultimately tied to spending patterns in Canada and the UK. 

 Debt: Maturities are well-spaced with $200mn due in April 2012, $150mn due September 2014 and $200mn due in January 2017 against $109mn of cash on the balance sheet (ex. redemption reserves and $31mn in anticipated VAT outflows in 2012).  AER is compliant with all covenant ratios and its debt is rated BBB- by S&P.