Aeroplan II, and the Rug Seller A man, having looted a city, tried to sell one of his spoils, an exquisite rug. “Who will give me a 100 gold pieces for this rug? he cried throughout the town. After the sale was completed, a comrade approached the seller, and asked, “Why did you not ask more for that precious rug?”
“Is there any number higher than 100?” asked the seller.
It is easy, all too easy, to be smug about the rug seller, but we are like him.
This ancient, Eastern tale — a teaching story intended as a means of conveying wisdom from old to young — is about our assumed limitations, those deep-rooted assumptions that we are largely unaware of and that keep us from achieving what is possible in various aspects of our lives. In the realm of investing, these limiting assumptions can be costly especially when it comes to creating wealth over the long-term.
In my February 26, 2020 post Planes, Trains and… (Free Cash Flow), I included the following comments with respect to CN’s 1995 IPO:
Many investors, including institutional investors, did not consider CN to be a viable/worthy investment. For most, CN was not even on their radar. For those who did invest, and stayed invested, significant wealth creation occurred. Today, almost 25 years later, one original share of CN Rail has turned into 12 shares with a February 26, 2020 closing price of $118.44. (CN typically splits its shares when the price reaches $100 USD.)
However, it wasn’t an easy ride up for investors. CN’s first non-recessionary decline came four years into its ‘turnaround’. Between June 30, 1999 and December 31, 1999, CN’s market cap dropped from $10,715 million to $6,849 million, a 36 percent decline. Its market cap slowly began climbing again and by December 2000, its market cap had surpassed its previous high. In December 2005, CN’s market cap reached an all-time high of $28,967 million, only to fall to $23,731 million six months later, an 18 percent decline. Again, within the next six months, market cap had climbed back up to $28,000 million. By December 2014, CN’s market cap had reached $68,267 million only to fall to $58,716 over the next year, a decline of 14 percent. Today, CN’s market cap is $84,235 million, about $8,000 million off its all-time high of $91 million in April 2019.
How many retail investors who bought CN early in its turnaround stayed with their investment? Probably not many. Some would have sold after the share price rose 50 percent, for sure many after the shares doubled in price (how could it go any higher?), and most certainly in the three non-recessionary setbacks mentioned above. While I only have institutional shareholder information dating back to 2004, the top two institutional holdings are the same then as they are today, and both are based in the United States. These U.S. institutional investors understood the U.S. rail industry, saw the upside to CN, and were not influenced by the Canadian ‘negativity’ surrounding CN Rail. They understood the perceived risk was much higher than actual risk.
The following are excerpts from two Financial Times articles in September 2020:
The collapse in global travel has forced airlines to finally pull back the curtains on their crown jewels. Having mortgaged planes and flight routes to secure new financing, US carriers have had to turn to their own loyalty programmes. The revelations suggest the entire sector deserves a re-evaluation once the pandemic is over.
Presentations submitted to investors have revealed in minute details just how lucrative the programmes can be. Delta’s SkyMiles programme, for example, generated $6.1bn in cash sales in 2019. That works out to 13 per cent of total group revenue. In terms of profits, the scheme carries even more weight. The $2.5bn in net profit it recorded accounted for more than half of Delta’s total net income last year.
Valuations recently put on the loyalty schemes have exceeded the market capitalisations for the airlines themselves — implying that investors value the business of flying passengers at less than zero. MileagePlus was valued at just under $22bn in bond documents, while United’s stock market capitalisation is just $10.6bn. Appraisers pegged American Airlines’ programme at a valuation between $18bn and $30bn, versus its equity market cap of less than $7bn. Delta Air Lines did not offer a valuation but in January, On Point Loyalty, a consultancy specialising in frequent flyer programmes, independently valued SkyMiles at almost $26bn, making it the most valuable programme of its kind in the world. Delta’s market cap totals $20.7bn.
Loyalty programmes are especially profitable in the US, where fees on credit card transactions are not capped like in Europe, giving card issuers more money — and more incentive — to pay up for miles. The programmes are also growing. Delta told investors last year that it expected to double revenue from American Express by 2023 to almost $7bn. For contrast, the entire 2019 revenue of the UK-based European budget airline easyJet was less than $8bn.
Big airlines have long treated the economics of their frequent-flyer programmes as a closely guarded secret. Now that Delta, American and United have been compelled to open up, their valuations should rise too.
Click on the link below for a review my August 30th post, Aeroplan II – 2025 Valuation.
In this post, I applied United’s MileagePlus EBITDA margin of 34 percent to what I estimated would be Aeroplan’s 2025 credit card revenue ($4.4 billion). At the time, only limited loyalty information from United had been made public. In their most recent financial filings, all three U.S. legacy carriers have opened the books to their loyalty programs.
U.S. Creditors, in assigning a value to the airline loyalty programs, included other third-party revenue such as revenue from non-air partners (hotels, rental cars, etc.) and loyalty cardholders. Additionally, the appraisers included the revenue from the sale of points to the airline. These are the points that the airline awards its frequent flyers when they purchase a ticket on the airline. I did not include this source as revenue, so the net result of the earlier valuation is that the Aeroplan component of the airline was undervalued (and the airline component overvalued).
“Is there any number higher than 100?”
Now that we have more information from supporting documents submitted to the creditors, it makes sense to compare Air Canada with Delta, and not United. Both airlines’ agreements were signed within months of each other and both are considered industry leading; and as I mentioned in another post, United’s loyalty program is known to be inferior to the other two U.S. legacy carriers (De Nardi, Stifels).
I also assume that as Aeroplan grows its credit card subscriptions to 8.8 million by 2025 (a conservative estimate), its EBITDA margin should expand to at least where Delta’s SkyMiles EBITDA margin was in 2019. Delta’s loyalty 2019 EBITDA margin was 39.3 percent. Recall that as membership and credit card spend grow, loyalty margins expand.
In 2019, 97 percent of Delta’s loyalty redemptions were with the airline, representing about 49 percent of total credit card revenue, or about 33 percent of total loyalty revenue. Applying Delta’s 2019 SkyMiles’ percentages and margins to Aeroplan’s 2025 estimates we get the following:
Note: Other third-party revenue is not included in the Aeroplan calculation. In the case of Delta, this represents about four percent of additional loyalty revenue.
Sales to Visa and Amex: $4.40 bn
Sales to Air Canada (49% of $4.4 bn): 2.15
Total Revenue: $6.55 bn
EBITDA (39.3%) $2.57 bn
Applying a 12x multiple used by creditors in arriving at U.S. airline loyalty valuations, we get a market cap of $30.8 billion.
Assuming the current 297 million shares remain outstanding in 2025, the value of Aeroplan in 2025 would be ‘a number higher than 100’, about $103.70.
Aeroplan II – A Re-Rating Game Changer
According to the SkyMiles Investors Presentation on September 14, 2020, Delta saw its Amex contribution grow from $1.2 billion in 2009 to over $4 billion in 2019. Amex remuneration paid to Delta between 2014 and 2019 alone increased by 116 percent. Under Delta’s new arrangement, the airline expects its credit card revenue to increase from $4.1 billion in 2019 to $7 billion by 2023, a 75 percent increase. That’s about an 11 percent annual increase in credit card revenues.
Air Canada is playing catch-up, so expect even better growth trajectories in Aeroplan II revenues between 2020 and 2025 — and beyond — as the Airline aggressively pursues new memberships. With the repatriation of Aeroplan in 2019, an industry leading arrangement with its financial institutions, the dominant airline in Canada, recent enhancements to the program and a lucrative credit card market to exploit, Air Canada’s loyalty revenue capture is accelerating its climb to cruising altitude.
Here are quotes from three airline analysts in the same Financial Times’ articles:
“If the card programme is worth more, then the core airline operation is worth less,” Darryl Genovesi, Vertical Research Partners.
Traditionally, airline fortunes rise and fall with the wider economy, and the companies’ fleets present huge, profit-devouring fixed costs unless they are operating at close to full capacity. Loyalty programmes represent the opposite, with their steady growth, scalability and lack of assets, Mr de Boer said. That attracts a different type of investor, he said, one more interested in dividends than profiting from a changing stock price. Those investors “are willing to pay a lot more per dollar of profit for a loyalty business than they are for an airline business . . . They consider it a lot more stable.”
Mr DeNardi (Stifels Associates) estimated that in 2019, depending on the company, loyalty programmes contributed between 30 per cent and 50 per cent of profits for US airlines. “They’re manufacturing these miles for about a penny, and they’re selling them to their credit card partners for two pennies,” he said.
“There will never be a bigger airplane built.”
— A Boeing engineer, after the first flight of the Boeing 247, a twin engine airplane that held 10 people.