A Path Forward? The Shopkeeper
There is a Sufi story about a man who went into a shop and asked the shopkeeper,
“Do you have leather? “Yes” said the shopkeeper.
“Nails?” “Yes”
“Thread?” “Yes”
“Needles?” “Yes”
“Then why don’t you make yourself a pair of boots?”
The Shopkeeper represents a mindset that dominates most business thinking today. The story is intended to pinpoint the failure of company leadership to consider integration, the crucial function in any design activity.
Recall from an earlier post (January 8, 2021), the story about the design of the Douglas DC-3: the crucial design function, without which the DC-3 would never have succeeded, involved integrating the five component technologies. Designing the engine specifications required an understanding of the variable pitch propellers and the effect it would have on the wings and fuselage; the wing flaps and its effect on the wing and overall performance; the retractable landing gear and its effect on the wing and overall weight of the aircraft; the wing and body design and its dependence on the engine's thrust; and the stress characteristics of the new monocoque body. Integrating the component technologies was more critical to the success of the DC-3 then the task of designing any single component. The essence of design, then, is ‘seeing’ how it all fits together to perform as a whole.
Implicit in the task of integration – whether designing an airplane, an organization, or a pair of boots – are the notions of reliability and security, two aspects normally transparent to us, but ones that investors should be attuned to.
Air Canada Enterprises (ACE) 2
In view of Air Canada’s future free cash flow generating capabilities, the increasing earnings contributions of Aeroplan II and Air Canada Cargo in the coming years – estimated at over 50 percent – the greater valuation multiples these businesses typically get, and an ability to pursue other business opportunities, a more effective way to manage these activities and unlock intrinsic value might be to create a holding company and separate non-core but related business assets from the core airline business, setting them up as standalone companies.
A similar kind of structure was established exiting CCAA (bankruptcy protection) in 2003. At the time, ACE became a holding company for Air Canada, Jazz (later Chorus Aviation), Aeroplan (later Aimia) and Air Canada Technical Services (later Aveos). Most of the ACE shareholders were former debt holders looking to monetize the standalone business units and eventually sell them off. This would not be the case in an ACE 2 scenario.
As a holding company, ACE 2’s primary roles would be to develop capital allocation strategies and establish financial targets for each business unit. In this scenario, one Air Canada share would be converted into one ACE 2 share. ACE 2 would still be subject to foreign ownership restrictions; however, an immediate benefit would be non-core businesses – such as Aeroplan, Air Canada Cargo, Air Canada Vacations, Air Canada Maintenance, and other business units – would not be. (The assumption for Cargo is that Air Canada would operate the cargo freighters, and Air Canada Cargo would buy space on those aircraft.) The core business units – Air Canada Mainline, Air Canada Rouge (and Jazz if acquired) – would still be subject to foreign ownership rules.
Aeroplan II Valuation
Metanoia (Greek) – a fundamental shift or movement of mind
Joe DeNardi, an analyst with Stifel, says his thesis on the industry is that airlines are not really airlines, they aremarketing companies, they put their logo on the corner of a credit card, and clip 2 percent of the spend, on the portfolio, and the market is kind of valuing that like a low quality industrial….he says Delta has an incredibly lucrative partnership with AMEX….we are hopeful over time airlines like Delta can better educate the market and help them see that not all of the earnings come from running a capital intensive airline, that essentially Delta is a company like Marriott and is valued that way….he thinks Delta should sell 20 percent for $7 billion and that would increase the DAL value by 40 percent. (Transformational Value, CNBC Interview)
DeNardi has long argued frequent flyer programs are the most profitable piece of every airline, with profit margins approaching 50 percent. Yet few airlines break out detail on their programs, with many viewing them as secret. DeNardi on Wednesday again pushed Delta to offer more transparency, noting that $7 billion is impressive revenue and should be reported separately. Bastian said Delta may offer more details. “As we grow our loyalty program, you’re right, there will be a question of disclosure in terms of providing better insight from an ownership perspective and a governance perspective into the drivers of our profitability into the future and whether that’s in a segment or whatever disclosure format,” Bastian said.
In a research note, DeNardi suggested Delta’s stock could be worth more if investors had greater detail on the American Express relationship. “There continues to be a significant disconnect between the fundamentals of Delta’s marketing company and Delta’s valuation,’ he said. In an earlier note, Jamie Baker of JP Morgan, made a similar argument. “Quite simply, the heft and breadth of Delta’s relationship with Amex argues for a multiple premium to United and American, in our view, assuming said competitors are unable to replicate Delta’s success with their partners,” Baker said. (Breaking Out the Business, Skift Magazine, April 2019)
Air Canada’s loyalty program is as good as and most likely better than Delta’s given the former has arrangements with multiple financial institutions on both sides of the border. Until Covid, airlines were secretive about the revenue generated by their loyalty programs, but as programs are now used as collateral by some airlines, financial information is publicly available. Like its U.S. counterparts, Air Canada should be able to release financial information for reporting and valuation purposes without violating agreements with their financial partners. Given Air Canada’s partnership with several banks and credit card companies, respective revenue streams become obscured. Like Aimia, Aeroplan II would become a standalone entity under ACE 2, and could acquire other loyalty programs, or other loyalty-related businesses.
From Slide 123, Investor Day, February 28, 2019 (Speeches and Presentations):
Air Canada’s annual repeat customers is 28% vs 16% average for the US carriers.
Air Canada home country market share is significantly above its US counterparts:
Air Canada 47%
American Airlines 22%
Delta 21%
United 16%
Slide 123 also states the opportunity for Air Canada is to increase credit card penetration for elite members (currently at 38%, US carriers average is approx. 50%) and loyalty penetration of airline flyers (currently at 35%, US carriers average is approx. 52%).
The links below outlined my thinking on the valuation of Air Canada under its current structure:
To arrive at 2026 Aeroplan revenue a (conservative) flat six percent was added to the 2025 estimate contained in the above-mentioned posts. Total Canada and U.S. card memberships by year-end 2026 will more than double the 5 million membership level that existed in early 2019 when Aeroplan was acquired by Air Canada. Last year, card membership increased by 1.2 million (comment on last earnings call by Chief Commercial Officer).
From previous estimates outlined in these posts the intrinsic value of Aeroplan II should be as follows:
Sales to Visa, Amex, Master Card, Capital One: $7.30 bn
Sales to Air Canada (49 percent of $7.3 bn):
3.58 bn Total Revenue: $10.90 bn
EBITDA (39.3 percent) $4.30 bn
The above methodology was used by U.S. lending institutions last year to place a value on the loyalty program of two U.S. airlines. Lenders used a conservative 12x EBITDA multiple, but private equity groups use a 15x multiple to value airline loyalty programs. Using these multiples, the intrinsic value in 2025 is as follows:
12 EBITDA multiple: $51 billion ($4.3 billion x 12)
15 EBITDA multiple: $64 billion ($4.3 billion x 15)
“Loyalty programs are so valuable that private equity firms tend to value them at 15 times EBITDA as stand-alone companies.” Globe and Mail, Why Air Canada is abandoning Aeroplan (2017).
Note: Using this valuation methodology necessarily reduces the value of the airline component of the business, as more revenue is apportioned to the loyalty valuation, and less to the airline.
Air Canada Cargo Valuation Like Aeroplan II, Air Canada Cargo (ACC) set up as a separate entity under ACE 2 should also be assigned similar multiples.
Using TD’s estimates, the 12-month price target for Cargojet (CJT) is based on a forward 12x EBITDA multiple. Current forward (consensus) PE multiple is 27.5x. CJT’s five-year (2018 to 2023) annual compound revenue growth is tracking about 10 percent. EBITDA margin for 2021 was 46 percent while 2022 and 2023 estimated EBITDA margins are 35.4 percent and 37.7 percent respectively.
Air Canada’s 2021 cargo revenue was $1.495 billion. By end 2022, the airline expects to have four B767 freighters operating and all ‘cargo’ B777s and A330s re-configured to carry passengers. To arrive at a 2027 revenue estimate, it’s assumed revenue growth resumes only in 2024 when all eight freighters are in service. Based on a 7.5 percent annual growth rate, estimated 2027 revenue is $2.0 billion. Assuming a 35 percent margin, 2027 EBITDA is estimated at $700 million. Applying a forward 12x EBITDA multiple, the
2026 year-end estimated intrinsic value of Air Canada Cargo as a standalone business is $8.4 billion, more than the Air Canada’s equity value today.
Would ACE 2 Receive a Holding Company Valuation Discount? Prior to 2001, CP was a holding company comprising five disparate businesses: CP Rail, CP Ships, Fording Coal, Pan Canadian Energy and Fairmont Hotels. CP traded at a 30 percent discount to its net asset value. In 2001 CP reorganized, selling off the five businesses, removing the discount and unlocking significant shareholder value (in the ensuing years).
Holding companies owning two or more distinctive ‘pure plays’ trade between 15 percent and 35 percent less than the combined value of its assets. The holding company discount is a little-understood phenomenon in finance. Academics have tried to identify why holding companies frequently sell at a discount to their asset value. Reasons cited vary from uncertainty around break-up costs which could exceed gains from elimination of the discount to poor reputation – management stretched too thin or didn’t understand the business, or perverse incentives causing management to starve its best businesses to rescue failing ones. Private companies, if part of the holding company, is another reason cited because they are difficult to value.
In view of the above and with the Shopkeeper story in mind, a holding company comprised of
integrated business units should avoid a valuation discount. Today, investors who invest in airlines understand and can value the airline business but may not fully comprehend the evolving nature of the enterprise and the much higher intrinsic value that will come with it. In an ACE 2 scenario, standalone but integrated business units become fully visible but remain organically connected to the core airline. Originating synergies remain in place, are enhanced, and new synergies come into play. The value of each business and its relative contribution to the overall enterprise is
revealed (Aletheia) enabling investors to
grasp the extraordinary value in what might otherwise appear to be a very ordinary and risky investment.
A Free Cash Flow Generator Regardless
Oxford Dictionary
du·ra·ble
adjective
1. able to withstand wear, pressure, or damage; hard-wearing.
"a well-designed pair of boots are durable"
In this post, combining future EBITDA estimates for loyalty and cargo businesses alone and using it as a cash flow proxy, along with significant reductions in capex – annual maintenance capex of $1.0 to $1.2 billion – point to higher free cash flows for the overall enterprise than what has been estimated in previous posts.
Even if the Company continues in its current form, the evolving nature of its businesses over the next few years, from creating a durable economic moat, to reducing operating and financial leverage, to growing loyalty and cargo revenue along with their respective expanding margins – both independent of the airline economy – will translate into healthier, less volatile, and more sustainable ROICs, which in turn will drive higher P/E, EBITDA and FCF multiples, rewarding investors in the process.