My logic surrounding the purchase was as follows:
- I had analyzed the company's historical financial statements going back 5 years. My observation at the time was that the company had sufficient liquidity to redeem its debt up until 2020. I was buying a 2019 obligation which shouldn't be affected if anything untoward resulted from its negotiations with Air Canada with respect to the 2020 Aeoroplan loyalty contract. There were only two series of bonds in the capital structure and an unused credit facility.
- I used management's adjusted EBITDA from their annual reports in order to determine interest coverage after deducting depreciation and amortization but not amortization of accumulation partner's contracts, customer relationships and technology (as a rough proxy for EBIT). My thoughts were that interest was covered approximately 5.5x in 2016. My rationale for not deducting amortization of accumulation partner's contracts, customer relationships and technology was due to my concluding that this line was a result of a restructuring of the overall business back in 2013 and wouldn't likely be repeated, therefore, this line was non-cash. Management's own interest coverage determination was 8.73x based on their MD&A (this should have been a warning sign to me).
- At the time, I couldn't foresee a major liquidity problem, given that cash on hand at the end of 2016 amounted to $293M, short term investments amounted to $80.4M, and long term investments (comprised of marketable securities) amounted to $342M, which in aggregate, were more than enough to redeem $448M of both series of secured bonds. If anything, the common and perpetual dividends would be cut before the company missed a coupon payment.
- Shoring up my logic, the company reported free cash flow of $234M, $202M and $287M between 2016 & 2014 before dividends, and $96M, $61M and $144M after dividends. The bonds should have therefore been redeemed using a combination of liquidity on hand, available credit, and net free cash flow if needed.
Well, around two weeks ago, Air Canada announced that they were going it on their own post 2020, and Aimia common dropped almost 70%, as the market decided that Aimia was a dead duck without Air Canada. In order to salvage some modicum of confidence, Aimia announced that they would redeem the 2018 bonds early (which I owned), but the 2019 bonds got hit, trading down to near $.80 recently.
Here's a chart:
So what happened? Why did the 2019 bonds get hit when the contract (and resulting impact on future cash flows) isn't set to expire until 2020?
I have an idea, and this is just an idea at this point.
This isn't just about the company having sufficient liquidity as presented on the balance sheet. This is about everything off-balance sheet. What I mean by this is, what happens if there's a crisis of confidence in Aimia's ability to meet an avalanche of loyalty reward redemption requests all within a short period of time (as a result of loyalty plan holders deciding that maybe now is a good time to redeem their un-redeemed loyalty rewards)?
Heck, if you were an Aeroplan loyalty reward plan member, and you got news that Air Canada has walked away from the Aeoroplan contract post 2020, would you wait until 2020 to redeem your rewards balance?
In this case, Aimia would need to tap into its cash, marketable securities and long term investments in order to meet any influx of redemption requests. Here's a description of how their Cost of Rewards works from their 2016 annual report:
Cost of Rewards, Direct Costs and Operating Expenses
Cost of rewards consists of the cost to purchase airline seats or other products or services from Redemption Partners in order to deliver rewards chosen by members upon redemption of their Loyalty Units. At that time, the costs of the chosen rewards are incurred and recognized. The total cost of rewards varies with the number of Loyalty Units redeemed and the cost of the individual rewards purchased in connection with such redeemed Loyalty Units.
The Average Cost of Rewards per Loyalty Unit redeemed is an important measurement metric since a small fluctuation may have a significant impact on overall costs due to the high volume of Loyalty Units redeemed.
In its 2016 annual report, the company discloses a redemption reserve amount of $410.2M included in both short and long term investments, "held to comply with a contractual covenant with a major Accumulation Partner...representing 18.5% of the consolidated Future Redemption Cost liability"(assuming the major Accumulation Partner is Air Canada here).
The company also discloses an unused general redemption reserve amount of $300M, and I can either assume that the $300M is already included in the $410.2M Accumulation Partner reserve above, or I can assume that $300M is in addition to the Accumulation Partner reserve.
Let's assume that $300M is already included in the the $410.2M Accumulation Partner reserve above.
In this case, the company seems to be hinting at a full Future Redemption Cost liability of $410.2M / .185 = $2.2B. This is pretty close to the disclosed purchase obligation under the CPSA commitment of $1,986B (off-balance sheet), and I suppose that the accepted conventional wisdom has always been that although this obligation exists, it would be fulfilled by virtue of future cash flows resulting from future gross billings under the existing (and to be extended) Air Canada contract. All of this depends on Aimia remaining a going concern.
In this case, if there were to be a run on unredeemed loyalty rewards all within a short period of time, the company would need to somehow find a way to make good on making its members whole.
My hypothesis, therefore, is that the market is somehow anticipating a rush of member redemptions in advance of 2020. Why else would the 2019 bonds have collapsed one full year before the contract is set to expire?
In any case, I exited the strips I paid $.87 for back in July 2016 for $.72 and took my lumps, predicated on my re-analysis of the situation per above.
Truth be told, this risk was always there, I just didn't see it (and by virtue of a 70% drop in the common neither did most other participants, i.e., Muppets).
I have a number of concluding thoughts on this situation, in no particular order:
- What made me an authority on Aimia bonds in the first place? Why was I smug (or stupid) enough to have risked $7,976 (5% of consolidated capital at the time) on an issuer of which I really knew nothing about, and which had a gaping hole in its business model which I chose to ignore (i.e., 100% economic dependence on an unrelated 3rd party for its entire business model)? Although I got lucky on the 2018 bonds, I wasn't so lucky on the 2019 strips.
- The above point brings to question, just what am I an authority on when it comes to evaluation of credit? The answer: NOTHING. For the same capital at risk, I could have spent the same time researching who the best active bond fund manager is in Canada and bought $7,796 of units in his/her fund. Now, I know this comment ventures into the whole active vs. passive vs. do it yourself argument, and I know that do it your-selfers just abhor paying management fees, but I believe that there is a price to participate in excellent and consistent management, and when it comes to evaluation of credit, this is definitely not my playground, and I paid for it.
- Following this, I therefore believe that an honest evaluation of one's own capabilities is absolutely necessary in participating in a particular asset class, whether that class be fixed income or equities or whatever else we choose to invest in. There are professionals out there who's entire focus is to evaluate credit, daily. For the same effort it took me to develop initial expectations (which ultimately proved incorrect) surrounding purchasing Aimia credit in the first place, I could have made a short list of the best active bond fund managers and whittled that list down to one or two candidates.
- Ok, let's say you do consider yourself an expert in credit and you are a do it your-selfer at the same time. Minimum bond purchases at most dealers are $5K face. Achieving proper diversification across both ratings classes and durations must be a function of account size. On $150K in assets under management, I could really only buy 30 different bonds, which I don't believe is anywhere near enough in order to diversify issuer credit risk, not to mention geographic risk, duration/interest rate risk, etc. And even if I bought 30 different bonds, I'd be 100% fixed income! Not too intelligent.
PS, there is a silver lining to all of this. I just redeemed $1,000 of un-redeemed Aeroplan loyalty rewards for two $500 Best Western gift cards which I intend to use in a month during a family stay in Orlando Florida. My rationale? Why wait?