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). 

Catalyst

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

·         FCF accreting to the business / capital returns