Jailbreak! A merchant kept a bird in a cage. He was going to India, the land from which the bird came, and asked it whether he could bring anything back for it. The bird asked for its freedom, but was refused. So he asked the merchant to visit a jungle in India and announce his captivity to the free birds who were there.
The merchant did so, and no sooner had he spoken when a wild bird, just like his own, fell senseless out of a tree onto the ground.
The merchant thought that this must be a relative of his own bird, and felt sad that he should have caused this death.
When he got home, the bird asked him whether he had brought good news from India.
“No,” said the merchant, “I fear that my news is bad. One of your relations collapsed and fell at my feet when I mentioned your captivity.”
As soon as these words were spoken, the merchant’s bird collapsed and fell to the bottom of the cage.
“The news of his kinsman’s death has killed him too,” thought the merchant. Sorrowfully he picked up the bird and put it on the window-sill. At once the bird revived and flew to a nearby tree.
“Now you know”, the bird said, “that what you thought was disaster was in fact good news for me. And how the message, the suggestion of how to behave in order to free myself, was transmitted to me through you, my captor.”
And he flew away, free at last.
The Indian Bird (
Rumi)
This particular tale highlights an important truth, that is, the great importance played by
indirect learning. The Indian bird
got the message, but not explicitly. Often we are bombarded with numbers, facts, opinions, often conflicting, about what to invest in, and what not to, so much so, that we fail to see the forest for the trees. Allegorical thinking can help put things into perspective and point us in the right direction. In 2012, when Air Canada shares traded for under a dollar, the airline was valued at the price of a new Boeing 777. If one was confident enough the Company would not re-enter CCAA, the valuation didn’t make sense. Even with a limited knowledge of the airline industry and Air Canada, it was a good leverage play if one understood the risk profile.
Many tales are structured in a certain manner, often with patterns (for example, A matter of design, and a design within a design) that occur in everyday life, often in business and certainly in investing. By reading these stories over and over again, so they become tacit knowledge, one will encounter a situation at some time in the future, where the same pattern of thought or behaviour is apparent and the person will react differently and more
wisely than would otherwise be the case.
The following are two posts about Aeroplan II.
On August 30
th, 2020: Aeroplan II – 2025 Valuation
https://stockhouse.com/companies/bullboard?symbol=t.ac&postid=31476884 On November 22, 2020: Aeroplan II, and the Rug Seller
https://stockhouse.com/companies/bullboard?symbol=t.ac&postid=31948677 The second post was an update to the first one, and captured valuation metrics from Delta and United when both airlines monetized their loyalty programs last year. Also learned was the methodology financial lending institutions employed to arrive at a valuation for airline loyalty programs.
Much has happened at Air Canada since these posts, and it’s time for an update.
Air Transat shareholders under a revised arrangement voted in favour of the merger, Air Canada announced a strategic partnership with JPMorgan as the exclusive issuer of the U.S. Aeroplan credit card, and in December, Air Canada announced an equity offering increasing the float to 335 million shares.
Note: For the revised valuations below I assume the EU will approve the merger between Air Canada and Air Transat (a high likelihood given the Canadian government has approved the deal).
In my August 30
th post, I estimated Aeroplan membership would grow to 8.85 million by end-2025 representing loyalty revenue of about $4.4 billion. This was based on Air Canada’s initial three-year target (2019 to 2021) to grow membership from 5 million to 7 million, representing a compounded annual growth rate of 12 percent. Beyond 2021, I assume loyalty membership will grow at a rate similar to what Qantas experienced between 2012 and 2019, about 6 percent annually. This is a conservative estimate. At the same time, Canada’s annual credit card spend is estimated to be $425 billion in 2025 (based on historical growth). With 8.85 million credit card holders, and assuming 31 million active cardholders in Canada, Aeroplan’s percentage of this total spend would be about 28 percent (8.85 million/31 million) of $425 billion, or $119 billion. A significant percentage of these 31 million cardholders, however, are individuals who use their cards less frequently, have much smaller annual spends and pay little, or no annual fees. Aeroplan cardholders, on the other hand, typically have high credit scores, use their cards for all purchases and pay their accounts in full every month. Moreover, Aeroplan offers a range of card options (including business cards) with annual fees up to $599. To account for this, the $119 billion was increased by a factor of 1.2 (it’s likely higher) so Aeroplan’s estimated annual credit card spend is revised up to $143 billion. Using Delta’s 3.7 percent ‘take’ as a proxy on the $143 billion, Air Canada’s estimated loyalty revenue in 2025 should be approximately $5.3 billion.
In terms of passengers carried, Air Transat carried about 5 million in 2019, about 10 percent of the passengers Air Canada flew the same year. Since this number also represents couples, families, etc., let’s assume the merger will add an additional 500,000 members to Aeroplan. (Air Canada flew just over 50 million passengers in 2019, and between 5 million and 6 million were Aeroplan members, so we should be in the same ballpark.) To be conservative, no growth in the Air Transat group between now and 2025 is assumed.
Adding 500,000 Air Transat members to the 8.85 million members above, Air Canada’s estimated 2025 loyalty revenue will increase from $5.3 billion to $5.66 billion (affluent skew factor 1.2 x $425 billion = $510 billion, 9.35 million/31 million = 30 percent, 30 percent of $510 billion = $153 billion, 3.7 percent of $153 billion = $5.66 billion).
Comparing Qantas ‘Actuals’ and Aeroplan’s Expected Membership Growth
From 2006 to 2019, Qantas loyalty membership increased from 4.6 million cardholders to 12.9 million, a compound annual growth rate of 8.8 percent. (The growth rate varied over this period, linked to economic activity, at times higher than the 13-year average, at other times, lower.) In 2006, Qantas card membership represented 22 percent of Australia’s population. Over the 13-year period, loyalty membership grew 280 percent at the same time the country’s population grew by 25 percent. By 2019, just under 13 million cardholders belonged to Qantas’ loyalty program representing about 50 percent of Australia’s population. Highly engaged with an affluent skew, Qantas cardholders capture about 35% of total credit card transactions in Australia.
Under Aimia, Aeroplan membership experienced little if any growth between 2014 and 2019. I was unable to find card membership data before 2014; however, suffice to say numerous class action lawsuits tarnished Aeroplan’s brand while under Aimia management stunting membership growth over the life of the third party arrangement.
Aeroplan’s membership in 2019 represented only 13.3 percent of the country’s population (14.1 percent in 2014) compared to Qantas’ 22 percent in 2006. Increasing Aeroplan’s membership from 5 million members in 2019 to the predicted 8.85 million members in 2025 represents an annual compound growth rate of 8.5 percent, slightly less than what Qantas achieved between 2006 and 2019. With the additional 500,000 Air Transat cardholders included – a total of 9.35 million members – Aeroplan membership in 2025 would still only represent 23.3 percent of Canada’s expected population of 40 million, a percentage just slightly more than Qantas’ 22 percent market capture back in 2006!
The JPM card will be introduced in the U.S. later this year and is expected to increase Aeroplan membership by about two million, likely over a 12- to 18-month period. If a conservative annual growth rate of six percent for 2024 and 2025 is assumed, then total card subscriptions at year-end 2025 should reach 2.25 million. To determine the loyalty revenue the U.S. card should generate in average annual credit card spend, I used the estimated average 2025 spend per person for the Canadian cards as a baseline. This works out to $16,360 (9.35 million/31 million x $510 billion = $153 billion, $153 billion/9.35 million = $16,360 average spend). American cardholders will have an affluent skew and currency will be in USDs. To arrive at a U.S. annual member spend, Canadian spend was increased by a factor of 1.2 ($16,360 x 1.2 = $19,632), and rounded down to $19,000 CDN. Total U.S. credit spend should be about $4.28 billion, of which Air Canada would earn 3.7 percent, or about $1.58 billion.
Therefore, the estimated total Aeroplan revenue in 2025 is $7.24 billion ($5.66 billion + $1.58 billion).
The following valuations use the methodology outlined in Delta’s Sept 14, 2020 Investor Day Presentation. 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 revenue. Applying Delta’s 2019 Skymiles percentages and margins to Aeroplan’s 2025 estimates (they should be similar), the following valuations are derived:
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, Amex and Master Card (JPM, USD): $7.24 bn
Sales to Air Canada (49 percent of $5.9 bn):
3.55 Total Revenue: $10.8 bn
EBITDA (39.3 percent) $4.24 bn
To derive the present value of Aeroplan in 2025, a 9 percent discount rate is used. The weighted average cost of capital for Amex is 7 percent; Visa, 7.4 percent; and Master Card, 9 percent. At the end of 2019, Air Canada’s weighted average cost of capital was 7 percent. It will be higher today, but in 2023, with an investment grade rating, the Airline’s WACC should be back at or below 7 percent, so using 9 percent as a discount rate is reasonable and conservative.
To account for share buybacks which in a previous post I predicted will be significant in 2024 and 2025, a five-year period was used for the purpose of discounting the future value of Aeroplan, from the end of 2025 to today. At 9 percent, the five-year discount factor will be 0.65. In other words, one dollar in December 2025 is worth 65 cents today.
Applying the 15x multiple used by private equity groups, the estimated 2025 intrinsic value for Aeroplan is $63 billion (15 x $4.24 bn). Using the 9 percent discount rate (see below), the value today is $41 billion. With 335 million shares outstanding, the present value of Aeroplan based on 2025 earnings is $122/share.
Applying the 12x multiple used by lending institutions, the estimated 2025 intrinsic value for Aeroplan is $51 billion (12 x $4.24 bn). Using the 9 percent discount rate, the value today is $33 billion. With 335 million shares outstanding, the present value of Aeroplan based on 2025 earnings is $98/share.
In my December 15, 2020 post, Air Canada + Air Transat, Delta and Frogs (see link below), I estimated free cash flow in 2024 and 2025 should be approximately $10.4 billion.
https://stockhouse.com/companies/bullboard?symbol=t.ac&postid=32109045 This free cash flow estimate does
not include additional loyalty free cash flow generated from the 20 percent bump-up (Aeroplan’s affluent skew) as well as Air Transat and JPMorgan Chase cardmembers. Assuming an average buyback share price of $100 in those two years, $9 billion of free cash flow would reduce shares outstanding to 245 million (335 million – 90 million).
With 245 million shares outstanding at end-2025, the intrinsic value of Aeroplan’s share price today, based on 2025 loyalty earnings, is as follows:
15 x EBITDA multiple: $167
12 x EBITDA multiple: $135
If these assumptions are not considered conservative enough, then cut and slash, and assume Aeroplan’s loyalty revenue in 2025 will only be $5.4 billion, 25 percent less revenue than what’s projected. Using the same methodology, total loyalty revenue would be $8 billion and EBITDA, $3.1 billion (39.3 percent). At a conservative 12x multiple, Aeroplan’s 2025 intrinsic value is still $37 billion. Discounted to today and using current shares outstanding, the intrinsic value is $24 billion or $72/share, considerably higher than today’s share price for the airline as a whole. With share buybacks, the discounted share price jumps to $97/share.
Does this valuation still appear too optimistic?
Delta’s growth in loyalty revenue occurred over three financial arrangements, each incrementally better than the previous one. Delta’s loyalty revenue doubled between 2011 and 2018 ($1.755 billion to $3.5 billion) and is expected to double again to $7 billion between 2019 and 2023.
Using the same valuation methodology, Delta’s Skymiles 2023 valuation is estimated to be between $49 and $62 billion depending on the EBITDA multiple used.
Sales to Amex, other non-air partners and to Skymiles members: $7.00 bn
Sales to Delta (49 percent of $7.0 bn):
3.43 Total Revenue: $10.43 bn
EBITDA (39.3 percent) $4.1 bn
Applying the 15x EBITDA multiple used by private equity groups, the estimated 2023 intrinsic value is $62 billion.
Applying the 12x EBITDA multiple used by lending institutions, the estimated 2023 intrinsic value is $49.2 billion.
One option available to Delta during the Covid-19 crisis was to raise capital by selling a minority interest (say 25 percent) in its loyalty program. Given the future value of Skymiles and the number of shares already outstanding (635 million) Delta took the more prudent course and borrowed against the program instead.
In the previous post (Air Canada + Air Transat, Delta and Frogs) Air Canada’s and Delta’s 2025 valuations were compared. Delta’s valuation was based on no share buybacks before 2025 given the high capex spend over the next five years, periodic elective pension contributions to address the airline’s shortfall, and high debt servicing costs (more than $1.4 billion annually).
Based on 635 million outstanding shares, the estimated share price in
2023 for its loyalty program alone is as follows:
12x multiple: $77
15x multiple: $97
To Summarize Aeroplan’s estimated 2025 revenue stream is as follows:
Canadian Cardholders: $5.30 bn
With Transat Cardholders: $5.66 bn
With JPMorgan Cardholders: $7.24 bn
Present Value (intrinsic) of
Aeroplan based on 2025 estimated earning, 335 million shares outstanding and a conservative 12x EBITDA multiple: $98/share.
Present Value (intrinsic) of
Aeroplan based on 2025 estimated earnings,
245 million shares outstanding and a conservative 12x EBITDA multiple: $135/share.
Investors should now be able to understand why private equity groups love airline loyalty programs, why Onex attempted to acquire a minority percentage of Aeroplan in the early 2000s when Air Canada was in financial distress, and why Onex now owns WestJet today. It’s
all about the loyalty program.
Of course, the question is, will markets recognize the intrinsic value of airline loyalty programs going forward by rewarding airlines with rich programs – such as Air Canada and Delta – higher EBITDA multiples more in line with other Industrials (8x to 9x)? I believe they will, eventually. High free cash flows and a low reinvestment rate beyond 2022 should be the catalysts for Air Canada.
Recall earlier in this post, when Air Canada shares were selling for under $1 in 2012, and a new Boeing B777 cost more than what you could buy Air Canada for. This is one of those moments. Today, buying Air Canada shares mean investors are buying at a significant discount what is essentially a financial institution – Aeroplan, and the Airline is thrown in for free.
“One, testing is getting more ubiquitous and two, people are getting vaccinated, and both of those combined will lead to what we are calling a Jailbreak in the summer months.” – Helane Becker, Managing Director and Senior Research Analyst, Cowen and Associates https://www.bnnbloomberg.ca/video/air-canada-is-well-positioned-for-an-airline-recovery-cowen-analyst~2119208