One of my best mates is Harris Kupperman (Kuppy). You’ve probably heard of him before as I’ve recorded phone conversations for the podcast with him, featured some of his work on the blog, and we’ve traveled together to some weird places where some of you have met with both of us. Harris, aside from being a good friend, is just a phenomenal thinker and that thinking is directly correlated with his success as a hedge fund manager.
About a week ago, he sent the below write-up to me, and since I thought it really worth considering, I asked him if he’s OK with my sharing it with the Insider group. As he’s a fellow Insider member, he was more than happy to do so.
Below is courtesy of Kuppy. Three cheers to the man. And though I would never embarrass a friend (ok, maybe a little), a huge congrats on his sparkling new wife 🙂 May she nag you until you’re good and old, my friend.
Aimia Inc (AIM.CN)
Due to a focus on scary sounding headline news, instead of analyzing the actual facts, there is a growing business that currently trades at 1.5x cash flow with net cash on the balance sheet.
Of course, at this sort of valuation, it comes with some uncertainty, but it is mainly misconceptions about the future that lead to the current valuation. I intend to clear up those misconceptions and then talk about what I think fair value ought to be.
Of course, I’m talking about Aimia (AIM – Canada) owner and operator of various loyalty programs including Aeroplan. I thought a whole new write-up that puts all the facts together in one place was needed. In particular, I intend to focus this piece on the misconceptions related to the Air Canada agreement ending, which have led the shares to decline by 80% from already undervalued levels.
I think there’s a pretty good chance that the shares are worth many times today’s quote and not much chance that an investment can lead to any permanent loss of capital, as you’re buying into the company at about 40% of the value of the balance sheet EXCLUDING Aeroplan and the International Coalitions. Furthermore, the net cash position along with rapidly growing cash balances will add further protection to any investment in Aimia.
Misconception 1: There will be a “run on the bank” due to card holders cashing in their $2.2b deferred redemption liability
Reality: This liability should be thought of as “float” like at an insurance company. This float is the difference between points issued and points redeemed and is a natural part of any loyalty program due to the time it takes for card holders to earn enough points to redeem for what they want (many card holders never redeem). This float revolves over roughly a 2 year window (based on management guidance that the average cardholder redeems once every 2 years.
While the numbers aren’t precise due to a weighting towards frequent fliers, let’s assume that roughly 60% of the total deferred liability is revolving (0 months to 24 months vintage), based on 45% of deferred revenue being current portion and 55% being long-term deferred. This would mean that $1.3 billion is “short term float.”
The $900 million of remaining liability should be thought of as an IBNR reserve. Some will be realized over time, but much of it is created through conservative accounting in order to defer taxable income (almost indefinitely).
If there were to be a “run on the bank” it would have happened during Q2 after the news that Aeroplan was breaking with Air Canada.
Instead, there was a $9 million total increase in redemptions and by the end of the quarter, redemption rates had normalized to be in line with previous quarters (Q2 corporate presentation page 35). This is due to many reasons, but principally because card owners redeem points to get certain items that they want (usually travel). They don’t simply redeem to get gift certificates when they don’t have enough points for what they want. Human nature is based on saving up to reach a goal.
Even card holders who have sufficient points, will not redeem in a hurry as they do not know their near- term travel plans. Q2’s redemption levels have proven this beyond a doubt. There will be another small increase in redemptions in early 2020 when the relationship with Air Canada terminates, but I believe that will be a similar non-event in the overall scheme of things and by then, AIM will have signed on additional redemption partnerships along with having a whole lot more liquidity to fund any redemption costs—due to retained earnings.
Misconception 2: The business will die in 2020 when the Air Canada relationship ends
Reality: Loyalty programs do not simply end. They sometimes trail off over many years, but this is only due to gross mismanagement. In 2020, when the relationship with Air Canada ends, all that will end is about $250 million in billings from Air Canada and preferred redemption pricing on Air Canada flights.
If Aeroplan were dying, you wouldn’t have a 1.0% increase in miles accumulated, a 3% increase in overall spend and a continued increase in the number of cardholders over the prior year.
In fact, Aeroplan is CURRENTLY GROWING. It is hard to say exactly what will happen after 2020, but it seems likely that the program will continue to diversify redemption options while offering card holders the ability to redeem on Air Canada.
Misconception 3: In order to maintain its active users, Aeroplan will have to pay between $150 million and $250 million in added costs (based on a number of research analyst reports) to Air Canada in order to continue buying seats at current discounted prices.
Reality: Point devaluation is part of the life cycle of a loyalty program. If a flight from city A to B costs 45,000 points today, and it costs 50,000 points in 2021, will anyone notice the difference? I have frequent flier points through quite a few airline alliances. I do not know how much it costs to go from one place to another. I just know that every so often, I cash in my frequent flier points for a free flight. I use however many points it takes to get me where I need to go.
If Aeroplan card holders were financially sophisticated, they would be using a credit card with cash back in the first place. The fact that they agree to receive these Aeroplan points, means that they’re already not that focused on the absolute value that they can earn with their spending, and instead treat points as a gift that can be spent haphazardly.
At the same time, with hundreds of millions of dollars in spending power, I have to assume that Aeroplan will be able to drive attractive bargains to buy seats in bulk from whatever airlines it partners with, including likely purchasing seats from Air Canada.
Additionally, while Air Canada is experiencing strong yield factors today, the history of airlines tends to show that airlines are terrible businesses and current yield factors are not sustainable—meaning that by 2020, Air Canada may actually become quite desperate for the 1.9 million flight rewards that Aeroplan granted in 2016.
Misconception 4: Air Canada will steal all of Aeroplan’s customers
Reality: Having tried to grow a credit card loyalty program through a company I was involved with, I can tell you emphatically that it is easy to get people to sign up for a new card — it is nearly impossible to get them to actually put the new card in the “front of wallet” position for spending.
The average Aeroplan customer has been with the program for 10 years. Their default credit card for all online and recurring purchases is Aeroplan. It’s inconvenient to earn points through 2 programs as it is harder to ever earn enough to get rewards. No one wants to leave stranded rewards when switching cards and there are inconveniences in switching cards. Therefore, it’s likely that a sizable percentage of customers stay with Aeroplan. That’s not to say that there won’t be defections to Air Canada (there will be). It is just that the defections won’t be enough to matter at today’s valuation level.
Misconception 5: The banks will cancel their relationships with Aeroplan
Reality: Aeroplan represents 9% of all Canadian credit card purchases and Aeroplan customers tend to be more affluent, hence more profitable for the banks.
The banks spent hundreds or even thousands of dollars per customer to acquire these customers (someone has to pay for those miles that are given away when you get a new credit card). These customers are highly profitable for the banks.
Most importantly, if the banks were to cancel the relationship with Aeroplan and move these customers to some other loyalty program, the banks would then become liable for the deferred liability to their customers when they cancel the Aeroplan points. Do the banks want to pay twice for the points they’ve issued?
Think of the lawsuits if they refuse to issue new points? The banks are going nowhere.
General Notes on Loyalty Programs
- A loyalty program generally uses Ponzi math where money comes in as a deferred liability but tends to come back out much more slowly. Due to tax treatment, this deferred liability becomes functional earnings and is often earned at very low rates of cash taxes. This creates lots of “float” that can be used to pay dividends, buy back shares or buy other loyalty programs. When the money does come out, if it ever comes out too fast, there will be point devaluations and gating to ensure that there is never a “run on the bank.”
- Due to the fact that much of this “float” is really income, and that taxes can be deferred indefinitely, cash flow is the best way to measure the success and value of a loyalty program.
- When loyalty programs decline, they don’t experience a Ponzi-like collapse. Instead, billings and redemptions decline at a roughly constant rate and the float is left to the owner of the loyalty program.
Let’s start with the balance sheet.
As of the end of Q2, there is $567m of cash and $450m of debt. (I’ll ignore the preferreds as they’re not paying cash dividends and are effectively perpetual equity). Therefore, you have $117 million in net cash. Now, add in the $51 million in proceeds, net of the highest estimated tax number, from the sale of Air miles and you have $168 million in net cash.
Now, add in the value of PLM, which is growing rapidly. At CDN $100 million in run- rate EBITDA, at a 10x multiple, PLM is worth $1 billion and AIM’s 48.9% stake is worth $489 million.
Why is 10x EBITDA the right value? I have no idea, but what would you pay for a rapidly growing high ROIC business with negative working capital, massive tax advantages, that continues to dividend its excess “float” and income to you?
If this were a publicly traded company, I think it would trade at well north of 10x EBITDA.
Other net working capital is basically zero (we’re ignoring the deferred points liability as it is basically recurring “float”). Therefore, you get net book value of $657 million or $4.31 a share, of which approximately $1.10 is in cash (compared with today’s share price of $1.84). Based on this valuation, you get everything else (Aeroplan and International Coalitions), producing about $200 million in cash flow for free.
So what are Aeroplan and the international coalition’s worth?
I really have no idea. No one knows how much billings will decline by after the Air Canada program ends. No one knows how the International Coalitions will do, though they seem to slowly atrophy.
All that I know for sure, is that with the shares at $1.84, unless these programs have a very large negative value (as in a huge redemption liability that becomes due in cash — even though that is almost impossible due to devaluations and gating), it almost doesn’t matter what these are worth, since you are getting the cash and PLM at about 40 cents on the dollar.
Management has guided to $220 million of cash flow in 2017 ($210 million after the sale of Air Miles). If you assume that they roughly hit this target for the next 3 years until the Air Canada relationship ends, you have $600 million of additional cash ($4.00 a share) before any accounting for $70 million in annual savings.
Therefore, in 2020, I would expect there to be about $800 million in net cash ($168 million today + $600 million in cash flow over 3 years + whatever cash savings is created + savings in interest expense + added interest income from the rapidly increasing cash balances – one time severance and cost reduction expense). That is about $5.25 in cash!!!
There will also be value from the stake in PLM, likely worth over $700 million in 2020, based on current growth rates or another $4.60 a share.
In summary, as long as Aeroplan doesn’t detonate the company, you get to almost $10.00 in hard value (I’m ignoring the preferreds here as they’re perpetual equity with a low interest expense and no cash expense today).
Finally, on top of that $10.00 in value, you get whatever value the residual Aeroplan and international loyalty divisions will be worth.
Even if you assume massive deterioration in those businesses, they should still be producing $100 million in cash flow + $70 million in corporate savings. Basically, they will still have a value greater than zero, potentially a whole lot greater than zero.
Imagine the scenario above, but instead of $170 million in cash flow, Aeroplan can shift the redemption basket into higher margin items. Could cash flow be over $200 million?
If Aeroplan is then growing at the rate of Canadian GDP (Aeroplan grew in Q2, which had the worst news flow that it could possibly deal with), is it crazy to value Aeroplan at 10x cash flow or $2 billion? Add in the $10 in hard book value and you could be looking at a valuation in the mid-$20’s.
Furthermore, with $800 million in net cash when the Air Canada partnership ends in 2020, Aeroplan will be able to more than absorb any increase in redemptions during that year.
Remember, those banks that everyone is worried about abandoning Aeroplan?
They have huge investments in their cardholders through customer acquisition costs that need to be amortized over many years of card usage. They’ll do all that they can to make sure that Aeroplan survives and prospers so that Aeroplan cards remain “front of wallet.” These banks have their own relationships with potential redemption partners, they have the ability to give up on some of the economics of their credit cards in order to subsidize the redemption options. They have their own marketing budgets.
Basically, what I’m saying is that Aeroplan isn’t on its own here. There are many groups who are incentivized to ensure that Aeroplan continues to chug along after 2020.
So, what makes the market realize all of this? I think you need one or two more quarters where redemptions are stable. I think news about new redemption options should be announced soon, which will also alleviate investor fears. Investors need to stop fearing a “run on the bank” and start focusing on the big picture.
In summary, I don’t see why AIM isn’t a double-digit stock in a year or two. If Aeroplan doesn’t rapidly deteriorate, the shares could be trading a whole lot higher than that in 2021 when it becomes obvious that there is real residual value in the brand.
With the bonds back at 97, clearly the debt holders have already figured out that the balance sheet risk is negligible here. Now the equity holders need to figure that out.
So, all that really needs to happen is people get over their fear of a “run on the bank.”
As a certain percentage of people defect from Aeroplan and go to different programs, won’t they cash in their points leading up to 2020?
Well, what happened to Blue Chip Stamps as people transitioned into credit card programs and the Ponzi math at Blue Chip went into reverse.
Did Berkshire experience a “run on the bank” as more stamps were redeemed than issued? No. The float was used to purchase Wesco and the float was never claimed.
There are still billions worth of Blue Chip stamps out there unclaimed, despite $25,920 in stamp issuance in 2006 (the last year that there is data outstanding). In effect, all that outstanding “float” really was earnings in the end—much like Aeroplan’s “float” is not going to get redeemed.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer’s securities.
- New redemption partner signing
- Continued business growth without an increase in redemptions
Disclosure: The AOF fund has a position in Aimia at a price of $2.13. As of publishing, it’s trading at $2.38. We agree with Kuppy’s assessment and believe it can go much much higher.
Founder & Editor In Chief, Capitalist Exploits Independent Investment Research
Founder & Managing Partner, Asymmetric Opportunities Fund
Unauthorized Disclosure Prohibited
The information provided in this publication is private, privileged, and confidential information, licensed for your sole individual use as a subscriber. Capitalist Exploits reserves all rights to the content of this publication and related materials. Forwarding, copying, disseminating, or distributing this report in whole or in part, including substantial quotation of any portion of the publication or any release of specific investment recommendations, is strictly prohibited.
Participation in such activity is grounds for immediate termination of all subscriptions of registered subscribers deemed to be involved at Capitalist Exploits. Capitalist Exploits reserves the right to monitor the use of this publication without disclosure by any electronic means it deems necessary and may change those means without notice at any time. If you have received this publication and are not the intended subscriber, please contact firstname.lastname@example.org.
Capitalist Exploits website, World Out Of Whack, Insider, and any content published by Capitalist Exploits is obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. The information contained in such publications is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. The opinions expressed in such publications are those of the publisher and are subject to change without notice. The information in such publications may become outdated and there is no obligation to update any such information. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.
Capitalist Exploits and other entities in which it has an interest, employees, officers, family, and associates may from time to time have positions in the securities or commodities covered in publications or the website. Corporate policies are in effect that attempt to avoid potential conflicts of interest and resolve conflicts of interest should they arise, in a timely fashion.
Capitalist Exploits reserves the right to cancel any subscription at any time, and if it does so it will promptly refund to the subscriber the amount of the subscription payment previously received relating to the remaining subscription period. Cancellation of a subscription may result from any unauthorized use or reproduction or rebroadcast of any Capitalist Exploits paid publication/s, any infringement or misappropriation of Capitalist Exploits proprietary rights, or any other reason determined in the sole discretion of Capitalist Exploits.
Capitalist Exploits has affiliate agreements in place that may include fee sharing. If you have a website and would like to be considered for inclusion in the Capitalist Exploits affiliate program, please email email@example.com. Likewise, from time to time Capitalist Exploits may engage in affiliate programs covered by other companies, though corporate policy firmly dictates that such agreements will have no influence on any product or service recommendations, nor alter the pricing that would otherwise be available in absence of such an agreement. As always, it is important that you do your own due diligence before transacting any business with any firm, for any product or service.
© Copyright 2017 by Capitalist Exploits