Thoughts on the Non-Binding Acquisition In Calin Rovinescu’s retirement announcement on October 16, 2020, he was quoted as saying that “Our Covid-19 Mitigation and Recovery Plan is now nearly complete, and the remaining steps will be put in place prior to year-end.” Last Friday, Chorus Aviation issued the following statement in response to recent share price appreciation:
“Chorus Aviation Inc. confirmed today that it has received a preliminary, non-binding acquisition proposal from a third party that is subject to a number of significant conditions. There can be no assurance that any transaction will occur, or as to the timing, structure or terms of any transaction.”
There is a considerable amount of speculation about who this ‘third party’ could be. The Globe and Mail in a recent article reported that it is likely a financial investor, and not a rival airline. The Globe also reported that Air Canada is not the bidder for Chorus.
Is it possible, however, that one of Calin’s remaining steps to be put in place prior to year-end is somehow related to the Chorus announcement?
First, some history. As part of the monetization process during CCAA, the financial arrangements between Air Canada and each of Aeroplan (became Aimia in 2008), Air Canada Technical Services (became Aveos in 2008) and Jazz (became Chorus Aviation in 2010), favoured the smaller entities rather than Air Canada, all of which were owned by ACE Aviation Holdings upon exiting the CCAA process.
Following a failed arbitration (to change the cost-plus mark-up) with Chorus in 2013, Air Canada reached a new Capacity Purchase Agreement (CPA) with Chorus in 2015 that saw the relationship extended by five years to 2025, and approximately $550 million in ‘financial value’ given back to Air Canada in the ensuing six years. Of significance in the 2015 agreement was the modification of Jazz's CPA fee structure, moving from a "cost-plus" mark-up of 12.5 percent to a more industry standard fixed-fee compensation structure.
During the 2013 arbitration, the Chorus leadership realized that to be successful in retaining the CPA beyond 2020, it needed to address Jazz’s cost structure, foster a more effective partnership with Air Canada, and begin a process to become less reliant on one customer for the majority of its revenue. It was during this period that Jazz began transforming itself into a global aircraft leasing company.
In early 2019, a few days after Aeroplan came back under Air Canada’s umbrella – along with a cash infusion of $1.612 billion – Air Canada announced a new CPA with Chorus Aviation. In return for projected annual savings of $100 million over the first two years (2019 and 2020) and additional savings over the remaining life of the agreement, Air Canada agreed to extend the CPA for an additional ten years (2026 to 2035) and guaranteed Chorus approximately $2.5 billion in revenue comprising $1.6 billion in leasing costs and $860 million in fixed fees over the life of the agreement. Additionally, Air Canada made an equity investment of $97 million representing approximately 9.99 percent of the issued outstanding Class A variable voting shares and Class B voting shares.
The Chorus shares were issued to Air Canada at a price of $6.25, representing a 5% premium. The two companies entered into an investor rights agreement requiring Air Canada to hold the shares for a period of at least 60 months. Proceeds of this equity was to enable Chorus to purchase larger aircraft for the CPA fleet (60 percent of the investment) and acquire aircraft for the leasing business.
At the time, many analysts viewed the 10-year extension as the most important element in the new agreement as it reduced the potential ‘cliff-risk’ of an un-extended CPA. Others familiar with Air Canada and its relationship with Jazz (before and after CCAA) saw another possible outcome given the lengthy CPA extension to 2035 and the unusual move of Air Canada taking an equity position in Chorus at just under the threshold level of 10 percent.
By 2019, Chorus was clearly evolving into a successful global leasing company – more a finance company and less an airline. Air Canada’s equity investment would be one more push in helping Chorus continue that transformation. The equity investment was also an opportunity for Air Canada to participate in this value creating transformation, as the Company had now become the second largest regional aircraft lessor (portfolio value) in the world.
As was the case with Aeroplan, is it possible that this was the first step in a process that would also eventually see the airline component of Chorus come back under Air Canada’s umbrella?
After all, Chorus Aviation is the only large regional aircraft lessor that is also an operator. As the present value of the CPA declines – say over five years – the value of Air Canada’s equity position in Chorus should increase substantially as it continues to grow its global leasing revenues. Keep in mind that most of the value in the CPA is in the leases, which would remain in place after the airline unit was brought back under Air Canada’s umbrella.
The appropriate EBITDA valuation multiple for Chorus when it was solely a feeder airline for Air Canada varied between 2.3x and 4.0x. Leasing companies, with more stable and predictable earnings, enjoy much higher EBITDA multiples, closer to 10 times. Much like Air Canada has seen during its decades long transformation, Chorus was experiencing both an increase in earnings and a re-rating as a result of its transformation into a successful global leasing company. As EBITDA margins between 2012 and 2019 increased from 10.8 percent to 24.7 percent, the market rewarded Chorus with higher EBITDA multiples, increasing from 2.3x to 7.2x over the same period.
At the time of Air Canada’s equity injection in early 2019, the market cap for Chorus was just under $1.2 billion. By January of this year, before the Covid-19 crisis began, its market cap had increased to $1.25 billion with a share price of $7.95. Last week, before Friday’s announcement, Chorus shares were trading in the $2.30 range, yielding a market cap under $400 million.
Could the current crisis create another opportunity for Air Canada?
With the above thoughts in mind, who might be the potential buyer of Chorus shares?
An ideal acquirer for Chorus Aviation would be a large financial institution, well connected with the major banks, and with a strong reputation among institutional investors. In order for Chorus to continue to grow its leasing business, the company will need access to additional equity which it can then lever up at favourable terms to purchase additional aircraft. Combined with prudent management and sound execution Chorus will continue to grow its earnings and achieve even higher EBITDA multiples.
One financial company that would meet these criteria is Fairfax Financial Holdings. Many investors have already speculated that this is likely the company that is currently buying up Chorus shares. Fairfax already has a relationship with Chorus. The insurance company holds $200 million in debentures as well as exercisable warrants (albeit at $8.25/share).
Another possible buyer could be a global leasing company. GE Capital Aviation Services (GECAS) would be one candidate. GECAS is the second largest aircraft leasing company globally that also has a significant regional airline component, totalling about 75 percent of Chorus Aviation’s portfolio value.
Another possible buyer is one with Canadian connections. Seraph Aviation Group is an Irish based company with over $5 billion in assets. Seraph is owned by the Martello Finance Company, also based in Ireland. Seraph, formerly known as Stellwagen Group, acquired the commercial aviation advisory and asset management business from ECN Capital Corp (TSX:ECN) a few years ago. Almada Inc, a Toronto-based Private Equity firm with a small aircraft leasing arm, also has an ownership interest in Seraph.
Still, another possibility could be a consortium of smaller private equity groups/investors buying up the shares.
Closing Comments
In view of the current crisis, is it now possible to shorten the timeline to bring the regional airline operation back under Air Canada and could it be achieved at a much lower cost? ‘Jazz’ within Air Canada would not only serve to increase future free cash flow but also remove the inflexibilities associated with a third-party commercial arrangement.
And it is entirely possible that as part of his Covid-19 Mitigation and Recovery Plan, the CEO of Air Canada – with its almost 10 percent ownership interest in Chorus – sees this opportunity and could very well be the chief architect behind this acquisition proposal.