Description

Low risk liquidation play with an estimated 14% to 20% IRR.

Summary

Long ACE Aviation (TSX: ACE.A or ACE.B) and short 0.9546 Air Canada shares (TSX: AC.A or AC.B) to earn the difference between the current market price of $10.60 and the liquidation value (current NAV of $11.72).

Overview

ACE Aviation (“ACE”) is a holding company listed on the Toronto Stock Exchange.  ACE was formed out of the reorganization of Air Canada in 2004 and formerly held stakes in numerous operating businesses such as Aeroplan, Jazz Air, Air Canada and ACTS.  Over the past few years, ACE divested all of these holdings and sold down most of its Air Canada stake.  Currently, ACE’s principal assets are $356mm in cash and an 11.1% equity interest in Air Canada.

For a more in-depth background, you can view past VIC write-ups on ACE from 2006 (http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/2375 ) and 2004 (http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/1525 ).  However, these theses focused on spin-offs of subsidiary companies and post re-org equity re-rating, respectively.  My thesis focuses on the liquidation.

On February 10 2012, the ACE Board announced its intention to seek shareholder approval to wind up and distribute its assets to shareholders.  The wind-up is contingent upon a shareholder vote, which is taking place on April 25 2012 (record date of March 6 2012).  If the vote is successful, ACE intends to make two liquidating distributions:

1. Initial distribution of $250mm to $300mm cash within weeks of the shareholder meeting. 
2. Final distribution of remaining assets ($80mm to $130mm in value) in mid 2013. 

Valuation

As at December 31 2011, ACE had $356mm cash, 31mm class B shares of Air Canada, additional Air Canada warrants and a tax liability of $5mm.  Also, ACE has substantial tax pools, including $91mm in net operating losses and $340mm in capital losses.  I have ascribed no value to these tax assets in my analysis.

ACE has a current NAV of $11.72 per share and net cash of $10.81 per share.  It is trading at a 9.6% discount to NAV and a 1.9% discount to net cash.

The above table shows a high and low case regarding the expected initial and final distributions. 

The high case assumes a $275mm initial distribution (mid-point of $250mm to $300mm guidance) in May 2012 and the residual distribution in June 2013.  The high case assumes expenses up until liquidation of $7mm, as stated by the company in the Q4 2011 MD&A. The high case ascribes no value to the tax assets and ignores interest income from the cash. The company is currently earning ~$3.5mm in annual interest payments from the 1.02% average interest rate on its cash.  Note that this will decrease substantially after the initial cash distribution expected in May.  The high case results in a 20% IRR.

The low case assumes initial distribution of $250mm (low end of guidance) and guesstimates additional value leakage of $5mm, or $0.16 per share.  This leakage is used to account for higher than expected liquidation fees and additional unexpected taxes over and above any potential value for tax assets.  This also assumes no interest income or value for the tax assets.  The low case results in a 14% IRR.

My analysis assumes one is hedged on the Air Canada exposure and therefore I have no opinion on that stock.  That being said, if one was interested in buying AC.A shares, buying ACE.A instead would allow you to get AC.A for free.

Capital Structure

Due to foreign ownership restrictions, non-Canadian investors can only own 25% of the voting rights of ACE.  To implement this restriction, ACE adopted a dual share class structure.  Class A shares are for non-Canadian investors.  Due to the fact that many more non-Canadian own the stock than Canadians, the A shares have proliferated and their voting power per share has decreased substantially.  At this point, each class A share only has 0.34 votes per share, while each class B share has 2.82 votes per share.  Given that the record date for the vote on liquidation was on March 6, voting rights are now a moot point if you are looking to purchase shares.  Investors can buy either class of shares, then they will get flipped into whichever class necessary depending on domicile (ie. Offshore investor buys B shares and then flips them for A shares).  The A's are more liquid.

Why Is It Mispriced?

ACE used to be a well-followed name, with plenty of capital markets attention.  However, only one sell-side analyst now actively covers the name (and does quite a poor job in my opinion).

Many traditional investors lost interest once the company began shedding a good chunk of its operating businesses.  The company has not had an operating business in a quite a few years.  At this point, it is currently in liquidation mode, and as such it is getting kicked out of equity indices.  For example, ACE.A was deleted from the MSCI Canada Small Cap Index on February 29 2012.  On that day, the A shares traded 1.44mm shares, vs average annual volume of 50,232 shares and dropped $0.22 under heavy selling pressure.

Another reason this stock is mispriced is due to the tax issues.  Since the distributions will be treated as deemed dividends, U.S. shareholders will be stuck with a 15% withholding tax and other taxable Canadian investors will take a tax hit.  This 15% tax currently makes the liquidation uneconomic, and those affected by this should sell to the unaffected in a tax arbitrage.  However, U.S.holders can get around this with a swap through your broker.  The swap fees will of course lower your IRR.

Shareholders

Catalyst