Description

Worst case scenario, this is a ~10% yield that should be covered nearly 4X over.  There’s a double discount here: Canadian preferred shares have been dumped en masse, and investors are overly concerned about the renewal of Aimia’s contract with Air Canada in mid-2020.   So you get paid handsomely to wait for these shares to once again trade near par - roughly a double from here.  There’s a good chance the contract gets renewed early -  perhaps in the next year or so – which would be a great catalyst.

(all amounts in C$ unless noted)

A word on liquidity: the series 1-3 preferred shares together have $165M in market value and trade about $150K per day.  I own the Series 2 exclusively, since it has the widest discount to par and it pays a floating interest rate (and since I had to enter a share price, shares out, and symbol, I entered the Series 2 data.  But they’re all cheap.  If I were more constrained by liquidity, I’d be happy owning all three.

Rate reset preferreds such as Aimia’s Series 1 & 3 began appearing in 2008, when interest rates were falling and everyone thought they’d rebound sooner rather than later.  Sold largely to yield-seeking retail investors, they now account for ~60% of the almost $67B Canadian preferred share market.  Floating rate preferreds – such as Aimia’s Series 2 – aren’t as common, but obviously offered another way to play this seemingly-inevitable rebound.  And of course, rates went on to sink even lower, especially around early 2015 when the retail investors started throwing in the towel.   This probably explains the initial swan-dive in the Series 1-3.

But it’s company-specific fear that probably explains why there’s been hardly any rebound.  The market is worried about what happens to Aimia when its contract with Air Canada (AC) expires in mid-2020.  Aimia grew out of Aeroplan – originally AC’s frequent flyer program – which was spun off from AC in 2005.  Today, Aeroplan is a full-blown loyalty “coalition” – in which lots of consumer-focused companies buy points (fka “miles”) to reward their customers.  Last year, just over 20% of points were purchased by AC to reward their frequent fliers.  70% were purchased by credit card issuers (CIBC, TD Bank, and Amex), and other ~10% by a hodgepodge of supermarkets, gas stations, etc.  But AC still remains hugely important to Aeroplan, since when these customers redeem their points, they spend 80% of them on airfare.  AC, along with its low-cost carrier Rouge, provides perhaps 86% of that 80%, while the other Star Alliance airlines provide the rest.

It might seem strange that anyone is freaking out about a contract that doesn’t run out for another 3.7 years, particularly when there’s never been any friction (in public, anyway) between the two sides.  And it is strange.  But it’s not totally crazy.  The CEO of AC has been flagging the upcoming renegotiation as a source of future cost savings[1].  The original contract was signed under some fairly unusual circumstances.   BMO’s analyst – perhaps the most bearish guy on Aimia – has gone so far as to say that “there is longer-term existential uncertainty around the Air Canada contract expiry in 2020.”

If you really think the contract won’t be renewed, this idea just isn’t for you.  Aimia might survive such an event,[2] but it’s hard to say how the cash flows would change.  At best you’d be in for a white-knuckle ride.

But it’s extremely unlikely that AC and Aeroplan part ways.  Yes, the new terms won’t be as good (but they’ll be good enough).  To understand why, one needs to know some history.  The current contract was probably not the product of an arms-length negotiation.  I doubt there was a negotiation at all.   Instead, this was the result of why I’d call “valuation-multiple arbitrage.”  Cerberus – which came to control ACE Aviation Holdings[3] through its 2003 bankruptcy - was looking for ways to pay down some debt at ACE and maximize the value of ACE equity.  To do so, they carved out some of AC’s higher quality income streams, including its frequent flyer program[4].  Thus, AC agreed to set aside 8% of its capacity for sale to Aeroplan at cost[5].  These flights were dubbed “ClassicFares” and in the early years they represented nearly all the flight rewards that Aeroplan offered.

It’s all about ClassicFares…

In addition to Aeroplan, Aimia today has lots of other loyalty-marketing operations around the globe.   But these cats & dogs basically just about offset corporate overhead, and thus Aeroplan remains the key to the fate of these preferreds.

So we need to estimate much a renewal could ding Aeroplan’s roughly $200M of annual free cash flow.   Let’s try to get a sense for how much room there is to renegotiate..  Looking at AC’s financials, it seems likely that variable costs are at least 75% of revenues.  See for yourself:

https://1drv.ms/x/s!Aqrw-OOY6WUhgP5PphXArKZqyAApwA

The exact amount looks a bit more like 80% to me, but to avoid quibbling and to be conservative let’s use 75% instead.

So if Aeroplan buys ClassicFares at cost, and cost is at least 75% of market prices, then we know that Aeroplan’s cost for ClassicFares is probably not more than 25% under-market[6][7].  Since the worst that AC would demand under a new contract is full market prices, the maximum increase over current prices would be 33% (=100%/75%-1).

We can also estimate how much Aeroplan is currently paying.  Consolidated “cost of rewards and direct costs” were 1,601.9 in 2015.  Star Alliance airlines were 43% of this number, and Aeroplan is the only Aimia coalition affiliated with Star Alliance.  

So, 1,601.9 * 43.0% = 688.8 total spent by Aeroplan on flight rewards (all from Star Alliance)

688.8 * ~86% = 592.7 spent on Air Canada/Rouge vs other Star Alliance airlines

592.7 - $180 cost of MarketFare revenue (more on this in a moment) = 412.7 spent on ClassicFares

33% max increase * 412.7 = $137.6M worst-case hit to Aimia’s FCF (approximately)

Which means…

200 of current annual FCF[8] – 137.6 = 62.4 FCF still available to pay preferred dividends

62.4 / 16.9 of preferred dividends = 3.7x worst-case coverage

But this is very much a hypothetical exercise.  There’s no way Aimia is going to pay even close to full retail prices for these seats.  Aeroplan’s MarketFare program proves that it can negotiate a discount to market rates for bringing AC a large volume of business.  Adding the ClassicFare flights to the mix, that volume of negotiated-rate business will more than triple.

Since the supply of ClassicFares is limited, Aeroplan has long offered flight rewards to members who can’t get a ClassicFare on the flight they want.  The first iteration of this was the Avenue program, followed by ClassicPlus in 2006, and finally by MarketFare in 2014.  These were a small part of the mix at first, but they’re ~30% of Aeroplan flight rewards today and total ~$180M in annual revenue to AC.  While the prices on these are closer to market rates, they’re still at a significant discount, particularly for members who earn lots of points on a regular basis.

Finally, keep in mind that AC doesn’t hold all the cards.  One big reason is that the revenue that AC gets from MarketFare flights comes with attractive margins.  MarketFare rates were negotiated just a few years ago, when neither party was in any sort of weak bargaining position, thus AC is likely still happy with these prices.  It would be hard for AC to replace all of this lost revenue – creating a new coalition requires signing a major credit card issuer, and it’s not clear who that would be.  Canada’s top 4 issuers (RBC, CIBC, TD, BMO) have something like 72% of Canada’s general purpose credit card purchase volume (5th place has ~6%), and they’re all pretty tied up as far in terms of loyalty coalitions.

Another big reason is that Aeroplan has developed close relationships with essentially all of AC’s best customers in the process of managing AC’s frequent flyer program.  If AC were to take its program back in-house, one can imagine all sort of ways these customers could get upset and take their business to WestJet, Porter, American, et al.

By the way, Aeroplan’s earnings come from more than just the gross profit on ClassicFares:  In 2015, It might[9] make some money on MarketFares too, albeit a smaller margin.  It definitely makes money on non-airfare rewards, which now attract ~20% of all points spent, and carry gross margins much higher than the margins on airfare overall.  It probably makes some money on various travel-related fees (e.g. flight change fees), as well as a tiny profit for managing AC’s frequent flyer program.  Last and certainly not least, Aeroplan makes money on the points that members never use, which in theory would be 100% gross margin revenue.

Catalyst – early renewal

Aeroplan has a 6/28/2019 deadline by which it must notify AC if it intends to not renew the CPSA on 6/28/2020.  But Aimia has a debt maturity on 5/17/2019, and AC has a veritable “wall” of debt maturing in 2019, so one would expect the renewal discussion to get underway in 2018.  From there, it’s not a stretch to think that Aimia might be able to push for a deal in advance of its 1/22/2018 debt maturity[10], which would allow it to refi at a decent rate and free up cash for its hefty dividends and buybacks.  (Aimia’s capital allocation certainly doesn’t suggest any nervousness about Air Canada.)

Starting negotiations early won’t put Aimia in a bad negotiating position, for the simple reason that generates nearly enough free cash flow to pay down all three pieces of debt as they come due.  In fact, Aimia is prepared to do just that for the upcoming January 2017 maturity.  The CFO will give an update on this issue during the 3Q16 call in November.  In addition, there’s also:

1. excess cash of $130M[11]

2. a $300m revolver which is nearly untapped

3. Cardlytics biz is on the block - worth maybe $70m.  A sale should be neutral or better to FCF.

4. 48.9% stake in PLM – a Mexican loyalty coalition built around the frequent flyer program of AeroMexico.  This business is a gem – grows quickly while throwing of lots of FCF.  PLM has been rumored to be worth US$1B[12], which would put Aimia’s stake at C$650M (note that a sale would reduce FCF by ~$15M - the dividends Aimia receives from PLM).  It’s highly likely that PLM will be IPO’d eventually.

But what if Air Canada goes bankrupt again?

AC has been doing well for a while now.  Last I checked, adjusted[13] net debt to EBITDAR was below 2.5X.  Interest expense + aircraft rental was ~1/3 of EBITDAR.  But of course, there could still be trouble if demand drops severely enough.  The question is, what then would happen to the current contract?

Thankfully, we can look to history as a guide.  In 2009 AC went through an out-of-court restructuring and the contract remained intact.  If AC were to actually file, the contract would probably still survive.  Management addressed the reasons why at their Analyst Day on 10/1/13 and I’ve pasted their words below.  But if you’re short on time, it boils down to:

1. Canadian bankruptcy law forces debtors to abrogate contracts completely or not at all (unlike Chapter 11 in the U.S., where they can tinker with individual terms).

2. This contract brings in a critical amount of FCF for AC which it couldn’t fully replace, or at least not quickly.  Therefore, it’s unlikely that any judge would allow them to abrogate the contract.

3. Since AC is the national flag carrier, the government would probably come to the rescue, as they did in 2009.

CEO Rupert Duchesne  – “Luckily or unluckily in 2009, we had a chance to put it to the test when Air Canada did get close to filing for bankruptcy. We did an out-of-court refinancing of the airline. We participated. We lent them $150 million at 12.75% coupon, which was I think fair with the risk, if anything. But I think that's very illustrative of the -- at the point that it really gets serious, we are a critical source of cash flow for the airline and being able to make up in a very short period of time for the loss of that would be almost impossible. And therefore, there wasn't the even any discussion at that time of what we going to do and see if we can find somebody else to do this for you. ... Also in a bankruptcy filing there's a whole lot of sort of legal and accounting issues that make it extremely hard for them sort of day off to do without, and we don't book.

The advice we received is that we don't think any bankruptcy judge in Canada would allow the airline to abrogate the contracts in such a way that gave cash flow risk to the airline. Frankly, if it did happen, our view is that we've actually got a fairly strong argument for the airline not to do anything. Because if we were to take that customer base and that revenue flow and provide it immediately to their competitors, WestJet, OneWorld Alliance, et cetera, et cetera, it will be a crippling blow to them. So I think what you'll see happen is have a fairly logical argument with them about is the price we're paying for Classic seats compensating you fairly for the opportunity cost of those seats? And we've done that work fairly regularly and the answer to that is yes. Are we paying you a fair price for the MarketFare rewards? And we've just done that deal so you could argue that in a moderate time, like we're in today, the answer to that obviously is yes at this point. And therefore, is there any incentive for anybody really to do anything? I think the answer is no. There are much more important things to worry about in the restructuring than a contract that is net cash flow positive to you in a much higher degree than if you did it yourself, which is what this is.

So we were lucky to be able to prove that in 2009, and our position now having done – just done this new deal with the card partners is much stronger than it was even in 2009 because the total revenue pile coming from these because of the breakage reduction we're talking about a moment ago and the increased price being paid by the bank means that the net cash flow in favor of the airline is even higher than it was in 2009 and will continue to grow as we get closer to the renewal of that relationship and the increased price being paid by the bank means that the net cash flow in favor of the airline is even higher than it was in 2009 and will continue to grow as we get closer to the renewal of that relationship.”

Former CFO David Adams – “Yes, just 2 other data points to that: one is Air Canada is a little bit different than many other airlines because it is a national flag carrier. And when it was put to the test in 2009, the Canadian government through EDC came to -- participated in the out-of-court refinancing and bridge loan. So the international gates are viewed as a national asset. And so notwithstanding WestJet's growth in the Canadian marketplace, I still believe that when push comes to shove, the Canadian government will be there with the financial support. So in a disaster scenario, we shouldn't be thinking about would the airline evaporate because there's a very, very low probability to that outcome. And for those of you, because we're here in London, just a finer point of Canadian bankruptcy law, we're not Chapter 11, right? So don't think of us that we are U.S. Chapter 11. And the difference is, is that in the U.S. you can actually cherry-pick contracts, I mean you get a judge to abrogate certain terms or conditions. In Canada, you have to abrogate the agreement in total. So it's either you keep the agreement out or you have to abrogate it completely. So when you talk about the risk of renegotiation, risk of cash flows, it's much higher in that circumstance than it would be under Chapter 11.”

By the way, Aimia’s equity was previously written up on VIC by castor13 in 2011 (under the old name of “Groupe Aeroplan”) as well as by Ragnar0307 in 2013.  I’m not sure if the equity is cheap today, but in any case, I think the preferred shares offer at least as much upside with less risk.

Also, note that Aimia is one of those rare small-caps where IR (Karen Keyes) can answer most if not all of your questions.  Not that you shouldn’t talk to the CEO/CFO, but you might want to try her first.

[1] AC CEO Calin Rovinescu at a conference on 12/2/15 - “10 years ago, Air Canada spun out its loyalty program to create shareholder value at that point in time. With that came a fairly expensive commercial contract.  And we will be restructuring that contract in 2020 with Aeroplan, and that will create value at that point in time.”  At AC’s 2Q16 call on 6/29/16 - “there's no question the expectation will be that, anything that is a below market, the term will be brought to market [upon renewal of the CPSA]”

[2] CEO Rupert Duchesne on the 6/27/13 analyst call – “So in the worst-case outcome where we wouldn't reach agreement with Air Canada in 2020, which is I said, I think it's extremely unlikely, we would have a hugely successful and economically viable program even without them. And frankly, it would be a program that would have been -- would be a great interest to other participants in the travel business.”

[3] ACE was the holdco which owned AC at the time.

[4] There is some evidence that AC had thought about eventually spinning-off Aeroplan prior to the 2003 bankruptcy, but in any event, I think it’s obvious that AC never would have agreed to these terms in an arms-length deal.

[5] CEO Rupert Duchesne at Analyst Day on 10/1/13 - “when we did the spinoff, we very carefully analyzed the real cost of the airline of providing those 8% of seats and we pay that pretty precisely. "

[6] Technically, there’s some circularity here, as ClassicFares are a component of AC’s revenue.  But we can overlook this since they’re probably not much over 3% of the total, and since our final estimate of the worst case scenario suggests a big margins of safety.

[7] For what it’s worth, Aeroplan’s own margins on ClassicFare seats seem to be close to 20%.  Since 2004, the program has offered seats at prices closer to market levels for those times when ClassicFare flights aren’t available.  In recent years, these have grown to ~30% of flights, but in the early years of 2002-2007 these were likely just a small portion of total flights, meaning that the Aeroplan’s gross margin on ClassicFare flights was probably close to its overall gross margin on airfare.  The latter margin never went much higher than 20%.  But it’s possible that Aeroplan was passing some of its savings on to coalition partners (e.g. CIBC) during that time, so this number might understate the true gap between ClassicFare and market prices.

[8] After interest expense but before preferred and common dividends

[9] This depends on the price that coalition partners pay for points, which could be less than the market value of the airfare it can buy

[10] CEO Rupert Duchesne at CIBC conference on 9/21/16 – “we would hope that we would get an Air Canada deal done long before we get to the end maturity on any of this debt.”

[11] CEO Rupert Duchesne at CIBC conference on 9/21/16

[12] http://www.bloomberg.com/news/articles/2015-07-30/aeromexico-said-to-value-loyalty-program-at-1-billion-for-ipo

[13] Adjusted for aircraft leases

Catalyst

Good chance they renew the contract with Air Canada in 2017.