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yale case 07-038 october 15, 2007

Air Canada
Selling the Company by the Slice
Jean W. Rosenthal 1 Francesco Bova2 Jacob Thomas3

Robert Milton had been fascinated by flying ever since childhood and dreamed of running an airline. But as he grew up and entered the industry, Milton came to see how poorly the major “legacy” airlines performed financially. The romance of flying could not obscure the difficulty of sustaining a profit in this industry. After a series of jobs in the airline industry, Milton came to Air Canada in 1992. While COO of the airline, he became convinced that the various parts of the airline operated separately could be worth more than the combined company. Milton proposed that the company examine its various functional areas to find unrealized value in divisions that could be stand-alone entities. Then, Air Canada could consider each business for carving out (separately incorporating each subsidiary and selling a fraction of the shares) or spinning off (divesting through a distribution of all the new company’s shares). When Milton became CEO in 1999, he moved to realize his idea. But before Milton set his plan in motion, a series of events rocked Air Canada. Just two weeks after Milton became CEO, Air Canada was the object of a hostile takeover bid that required an unplanned merger with Canadian Airlines, the country’s second largest airline, to resolve. The inability to integrate the two airlines quickly brought some infrastructure and labor inefficiencies in the short term. Then the collapse of the dot-com industries in 2000 curtailed business travel. Just as Air Canada was adjusting to this downturn, the September 11 U.S. terrorist attacks further reduced the number of passengers and required expenditures for security. Meanwhile, fuel prices began to climb precipitously. Then in 2003, SARS (Severe Acute Respiratory Syndrome) hit China and Canada, wiping out travel to the Far East and to Canada, particularly to Toronto, Air Canada’s hub. With declining passenger numbers and little liquidity, Air Canada filed for the Canadian equivalent of U.S. Chapter 11 bankruptcy. Bankruptcy provided a respite for the beleaguered airline and allowed Milton and his team to finalize the restructuring. Management streamlined operations and began breaking up the organization into subsidiaries. The company emerged from bankruptcy in October 2004 as a holding company, ACE Aviation Holdings Inc. (ACE), with ten wholly owned subsidiaries. By the summer of 2006, Milton was well into the test of his theory that the parts of the airline were worth more than the airline itself. The company had carved out Aeroplan, its frequent flier program, and Jazz, its regional airline, and had publicly discussed spinning off the maintenance unit. The one large asset remaining was the airline, Air Canada itself. A comparison of the ACE share price to “the sum of the parts” implied a negative value for Air Canada, but would carving out the airline capture additional value? What would be the costs and benefits? If Air Canada was sold, what should the structure be? When should the sale take place? And since selling the airline would mean that all the pieces of ACE were carved out, what would become of the holding company – and its CEO?

Airlines – An Unprofitable Romance
Robert Milton grew up wanting to run an airline. From his first view of a Boeing 747 as a 10-year old, he was obsessed with air travel. He was fascinated not only by the aircraft, but also by the operational intricacies of selecting routes and creating schedules. After an international childhood, Milton attended Georgia Tech, which he chose because it had both an airline program and proximity to a major airport. After graduation in 1983, he and a friend leased a small plane, hired a pilot, and used Milton’s graduation money and gasoline credit cards to start a small-package delivery service. When they sold the company five years later, Midnite Express had a fleet of 25 planes, a perfect safety record, and a reputation for reliability.4 After the sale of Midnite Express, Milton consulted for various companies, including British Aerospace. Milton then began work with fellow Georgia Tech alumnus Hollis Harris, the former president of both Delta Airlines and Continental Air Lines. Milton joined Harris in an endeavor to start up a low-cost airline called Air Eagle. In 1992, while Air Eagle was searching for financing, Harris was named CEO of Air Canada, and Milton followed him north.5 Air Canada had been privatized in 1988. By 1992 it was already facing serious difficulty, confronting the same problems faced by all legacy carriers. An airline’s major expenses were its fuel costs and employee salaries and benefits. Airlines could use hedging contracts to mitigate increases in fuel and foreign exchange rate shifts. However, these contracts tended to focus on price changes no more than one year ahead. As for employees, unionized legacy carriers typically negotiated collective bargaining agreements with their unions every three to five years, and Air Canada’s negotiations were no less tumultuous than those of other airlines. Indeed, Air Canada had less flexibility than most, given the government restrictions imposed first during the privatization and then following the merger with Canadian Airlines. Demand for air travel was uneven, rising and falling on the business cycle. Customers and competitors had instantaneous access to fare/pricing information, thereby fueling competition. Furthermore, the airline’s inventory was perishable – a seat cannot be sold once the plane closes its doors. Weather and airport congestion could bring sudden additional costs and/or cancellations. Air Canada’s home airports were especially vulnerable during Canada’s long, harsh winters. Airlines could hedge against certain operational risks, but not against catastrophe. As Jack McLean, Controller of both Air Canada and ACE following the restructuring, commented, “You can’t quickly mitigate the effects of catastrophic risk, for example, SARS or 9/11, because your revenues disappear overnight. You cannot get your costs out fast enough. Many of your costs are fixed, so there is always a lag between revenues disappearing and being able to reduce your costs.” Airlines required large capital investments, primarily for their fleet, accomplished through a mix of purchases and leases. Fleet ownership often required significant financing from banks, plane manufacturers, or specialized lending companies. On average, airlines owned 30 to 40 percent of their fleet. Air Canada typically funded its capital assets through a combination of debt, cash from operations, and higher interest, last resort or “backstop” financing from plane manufacturers. Historically, when liquidity became an issue, airlines transacted sale-leasebacks, selling their aircraft and leasing them back to generate cash to supplement cash flow from operations. Competitive pressures were intense. Although airlines remained highly regulated in many areas, price deregulation and privatization around the world in the 1980s and ‘90s had given consumers an overall decrease in prices and allowed new low-cost airlines to enter the field. These new airlines avoided “legacy costs” – those costs that build up over time in mature businesses. 6 Their employees had less seniority, lower salaries, and smaller, if any, pension plans. Their planes were newer and their fleets had fewer types of aircraft, reducing pilot training and maintenance costs. Their technology was new, work rules were 2 air canada

flexible, and route plans were rationally based on current market information rather than historic arrangements. Finally, their start-up costs were surprisingly small, meaning low barriers to entry. As Rupert Duchesne, CEO of Aeroplan and a former executive at Air Canada, said, “You could start up an airline with five 737s within 90 days of financing, using an average family home as collateral.” (See Exhibit 1 for summary statistics for legacy and low-cost airlines.) Milton understood the romance of air travel that drew in investors, but he also recognized that the financial history of the industry “was one of failure right from the beginning of commercial aviation.” Milton was not alone in this view. In a 2002 interview discussing USAir, one of his rare investment failures, Warren Buffett gave this perspective: The airline business has been extraordinary. It has eaten up capital over the past century like almost no other business, because people seem to keep coming back to it and putting fresh money in. You’ve got huge fixed costs, you’ve got strong labor unions and you’ve got commodity pricing. That is not a great recipe for success. I have an 800 number now that I call if I get the urge to buy an airline stock. I call at two in the morning and I say: “My name is Warren and I’m 7 an aeroholic.” And then they talk me down. For legacy airlines, both the long-distance airlines, called “trunklines,” and the regional airlines had experienced a wave of mergers, bankruptcies, and failures. In 2006, industry scholar (and former Yale SOM Dean) Michael Levine summarized the industry’s shaky financial history: Of eleven [U.S.] trunklines (legacy airlines) that existed at the time of airline deregulation, … only five of the eleven – American, Continental, Delta, Northwest, and United – are still flying. Delta and Northwest are now in bankruptcy reorganization, and United has recently emerged from one. Continental has been through bankruptcy reorganization twice, American seems likely ultimately to follow suit, and it is easy to imagine circumstances that will force those that have emerged to go through the process again. Of the ten regional airlines existing at the time of deregulation, two were liquidated, three were formed into a mainline operation (US Airways) that has emerged from bankruptcy reorganization for the second time, three more were first merged then absorbed by Northwest, and another was merged into a trunkline that was then liquidated (Ozark into TWA)…. Only Alaska has survived without bankruptcy reorganization.8

Turning a National Monument into a Competitive Business
After joining Air Canada in 1992, Milton became Executive Vice President and Chief Operating Officer in 1996 and CEO in 1999. He quickly understood that in spite of its reputation for safe and efficient service, Air Canada combined legacy airlines costs, a corporate culture reflecting its history as a governmentowned Crown corporation, and an intense and often critical relationship with the Canadian public.9 For more than 50 years following its formation in 1937, Air Canada had been a Crown corporation, owned and operated by the Canadian government. State ownership of commercial enterprises in Canada was accepted under a belief that only the government had the money for airlines, railroads, electricity and telephone service, given Canada’s vast area, scattered population centers, and demanding climate. The state also stepped in to keep U.S. companies out. But by the late 1980s, the case for privatization had gained favor, given a more conservative government, an international movement toward deregulation, and growing concern about governance of state-owned entities. A 1986 government report had concluded that many government enterprises were being “flagrantly mismanaged.”10 Still, the proposed privatization of Air Canada created a political controversy. The company was one of the largest of Canada’s 170 government-owned businesses, and at the time of the privatization, only a few

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it became clear that portions of the business might be more profitable as stand-alone entities. Canadians think that only Air Canada has service issues. “As much as I grew up loving airplanes and wanted to run the airline.) Milton put together a strategy team in 1998 to review the company’s business structures. Americans think that all airlines have service issues.14 A New Financial Strategy Plotted Although Milton had focused on operations for most of his career. be it a change of snack service from peanuts to pretzels. Opponents denounced the move as “a triumph of Conservative ideology over good. and focused on shifting the organizational culture.” Defining a New Flight Path for Air Canada Milton believed that dramatic changes were necessary for Air Canada to become profitable. Sydney Isaacs. One option following that conclusion was to divide the business and monetize each piece separately. Every decision was front-page news in the Canadian press and often the subject of political commentary. “Any change to the way we did business. “How do we do something that will protect the employees and enable the shareholders to do well and the businesses to do well on a sustained basis?” The team looked at every facet of the airline and its operations. reworked schedules and fleet holdings. such as hotels. repair and refurbishing of the fleet. only C$226 million of the C$686 million raised in the two stock issues in 1988 and 1989 was used to capitalize the airline. Duchesne remembered that by 1999 the group had identified three businesses that could potentially be separated from Air Canada. the technical services group that handled major maintenance. He believed that the airline’s value was not reflected in the stock price and set about to “unlock the hidden value” for shareholders. joked. and Aeroplan.cbc. * 4 air canada .” Montie Brewer. As Milton summarized it. the air cargo business.12 Even after Air Canada was privatized. However. (See Exhibit 2 for Air Canada’s organizational outline and share prices before restructuring. in addition to the regional airline with its separate union agreements: ACTS. asking the group. As COO he restructured operations. strategist for Air Canada who became ACE’s Senior VP of Corporate Development and Chief Legal Officer. cut overhead costs. while maintaining Air Canada’s reputation for safety. some middle managers.” The team’s conclusion: The highrisk and low-return profile of the airline business was masking the investment value of other segments. the government retained the rest. The legislation mandated majority Canadian ownership as well as requiring the company to keep its head office in Montreal and operational centers in several cities across the country.of the smallest had been sold to the public. common Canadian sense. because that’s the only airline many have * ever flown. and the occasional politician. Milton took on problems directly – he was described by both friends and detractors as “blunt and to the point. In addition. Air Canada did not own unrelated lines of business. I realized that the airline was the worst business we had. Even so. was subject to a negative press headline.”11 In order to gain political support.ca/300c. the Act of Parliament privatizing Air Canada placed a number of restrictions on the airline. he recognized that it would take more than smart scheduling and cost cutting to solve Air Canada’s problems. the frequent flier program.”13 The sweeping operational changes and his direct approach led to clashes with the airlines’ union leaders.asp?id=1-73-1125. CEO of the airline after 2004. identifying the business units created Canadian radio and TV coverage of historic Air Canada events is archived on the CBC website at http://archives. explained it this way: “Canadians identify with Air Canada. Canadians maintained a personal interest in the company.

government that provided US$5 billion in immediate assistance and US$10 billion in loan guarantees to U. The process of creating subsidiaries and defining business relationships was expected to take months. leading to flight delays and lost luggage. the business units had none of the structures necessary for any type of public offering: contractual definitions. Milton found himself in charge of the 10th largest airline in the world. The new units had been considered cost centers rather than separate lines of business. 5 air canada .000 jobs. Air Canada’s financial troubles continued into the new millennium. with a plan to merge the two. Air Canada added a dozen new destinations. The three-month battle was followed closely in the press and in the government. “destabilized the industry. Less than three weeks later.15 In the end. Furthermore.S. high-tech company Nortel. (Milton joked that Air Canada had almost been a worldwide charter airline for Canadianbased. Milton was quoted in the press as saying. Gerry Schwartz. and announced plans for 100 more in the next five to seven years. The two airlines had duplicate routes and staffing that had to be resolved. with two-thirds going to Air Canada. and voluntary buyouts and layoffs were planned. In November 2000. the courts decided in Air Canada’s favor.17 Although progress had slowed in the sturm und drang of the outside takeover bid and merger implementation. Air Canada cut 5. reduced its schedule. made a hostile offer for Air Canada as well as the number-two Canadian carrier Canadian Airlines. Taking Aeroplan to market would require a significant education effort to convey the business model to potential investors. Milton responded with his own bid for Canadian and a legal challenge against Schwartz. The governing Liberal Party was accused of favoring Schwartz because of his role as a big party fundraiser and because of Collenette’s past clashes with Milton.19) The run-up to the Iraq war brought further reductions in passengers and increased fuel costs. airlines. with over C$10 billion in revenues and some 45.” After 9/11. When the takeover of Canadian Airlines was completed in 2000. the Canadian government paid the entire industry only C$160 million. but a stand-alone frequent flier program was a novel idea. noting. The thorny issue of merging the two company’s union seniority lists was also creating angst among the labor groups.16 The combined airline controlled 80 percent of the air travel in Canada. leading to the withdrawal of the Onex bid and freeing Milton to pursue Canadian Airlines. Running into Headwind Milton’s success in operations led to his appointment as CEO in 1999.a new set of challenges. Moreover. 2001 terrorist attacks on New York and Washington further reduced passengers and in Milton’s words. Furthermore. The world has been unlocked. Federal Transport Minister David Collenette defined conditions for any resulting merger.) The September 11. “This airline is growing in leaps and bounds.”18 Major Turbulence In spite of Milton’s optimism. head of the Toronto-based private equity firm Onex. Milton remained optimistic. and there were stand-alone airfreight companies. Several European airlines had spun out their maintenance operations. and asked the government for C$4 billion in aid for the Canadian airline industry. However. under regulatory restrictions. The dot-com collapse and the end of Y2K-related consulting slashed demand for Air Canada’s profitable business travel. bought or leased 32 new aircraft. financial statements.” There were charges of political favoritism. some of the businesses would not be familiar to the market. (This was in sharp contrast to the U. and there were no clear boundaries between the new entities and the rest of the airline. the new restructuring model had not been forgotten.000 employees (including regional carrier employees).S. management and support systems. including Aer Lingus and Swissair. “The market alone will not decide what is in the best interest of Canadians. the takeover required Air Canada and Canadian Airlines to merge systems for everything from baggage handling to reservations to maintenance to accounting.

Travel plummeted to Toronto and then to all of Canada as well as the Far East. had new employees. As Milton put it. However. CCAA Filing: An Opportunity to Look out the Front Window Air Canada had continued to flesh out Milton’s plan to create stand-alone subsidiaries in the early years of the decade. They were able to focus on growing an airline. which it decided to combat head on. Southwest. new aircraft. its low-cost brand. but issues would be handled by the bankruptcy judge and ultimately approved by creditors. Air Canada launched Tango. no debt. CCAA protection allowed the company to shed costs and become more like a low-cost airline. no amount of balance sheet restructuring alone will make Air Canada a viable airline given its current labour cost structure. the new union contracts would remain in place until 2009. dropping as all airlines were cutting back simultaneously. Air Canada filed for CCAA protection.20 The final blow to Air Canada’s financial stability was the SARS scare in early 2003. “Air Canada will not survive unless its labour productivity and costs are brought in line primarily with domestic competitors. a new. was first seen in the Far East and then contracted by health workers in Toronto. one of Air Canada’s most lucrative markets. a low-cost carrier serving western Canada. Many of Air Canada’s planes were flying with virtually no paying passengers. In the months following 9/11. and it only became possible because of the restructuring. In this period Air Canada sold and leased back 75 percent of its fleet. Air Canada argued. and began Zip. the unions negotiated settlements giving the airline some flexibility in work rules and salary reductions. Moreover. then JetBlue and AirTran. The legacy guys were all worrying about labor issues and couldn’t look out the front window. the drop in passengers and revenues challenged Air Canada’s liquidity. SARS. had come to understand that the problems were not simply Milton’s overreaction or a plot to reduce their salaries. In addition. you had to have cataclysmic change. The airline would keep flying. and by the time of the bankruptcy filing it could include the new structure into its planning. with one wage 6 air canada . the company had incorporated Aeroplan as a stand-alone entity and in January 2003 had arranged to sell 35 percent of Aeroplan to Onex for C$245 million. strengthening the likelihood of success in reaching new labor agreements.Air Canada was also facing increase competition from low-cost airlines. Restructuring Employee Relations In its filing for CCAA protection. With all these things. moving it from ownership of 47 percent of its fleet at year-end 1997 to owning just under 4 percent of the fleet by February 2003. On April 1. plus the turbulence in the 9/11 aftermath. the Canadian equivalent of U. In early 2001. essentially a blank piece of paper. In January 2002 it relaunched Air Canada Regional as Air Canada Jazz. The low-cost carriers.” Under the bankruptcy. As Milton observed. 2003. fatal respiratory disease. Chapter 11 bankruptcy.S. revenues available from one traditional source of capital for airlines. For Air Canada. “Airline employees. Indeed. was limited by the plummeting value of aircraft. but a reality. not labor issues.”21 The impacts of SARS and the bankruptcy filing seemed to change the unions’ perceptions of the airline’s problems. because they were constantly bogged down by the labor stuff. many of whom had been flying virtually empty flights. the sale and leaseback of the fleet. Onex withdrew its offer early in the CCAA process. While a balance sheet restructuring is required.

the bankruptcy period gave Air Canada the opportunity to restructure its balance sheet. Management might not have made the moves without the benefit of a restructuring. as markets would have seen these moves as making the business riskier. Although not all decisions are made strictly on the basis of discounted cash flows. Even with an extremely aggressive management. however. the company could not have made money with its existing fleet. Air Canada often used a slightly higher hurdle rate in their DCF analyses of 10 percent. we certainly do a DCF for every project. to replace Air Canada’s Boeing 767 and Airbus widebody fleet. just to set the bar a little higher. which did not allow the possibility of a strike.6 percent before-tax. noted.22 As Brian Dunne. and a debt/equity ratio of 74/26. in an agreement that gave Cerberus three seats on the ACE board. To emerge from the bankruptcy period. a U. but would allow lower fuel and operating costs. Executive VP and CFO of ACE. Even an aircraft operating lease is for five to seven years and the commitment is very. Bad things can happen if you don’t keep your finger on the pulse in relation to fleet matters. management increased its future delivery orders with Boeing. in industry lingo) and 14 787s as they became available from Boeing. of which C$86 million were progress payments on regional aircraft. smaller aircraft.review set for in 2006. Management split the company’s existing aircraft between Jazz and Air Canada. or 6. a cost of equity of 12. “All major capital project decisions have the benefit of a discounted cash flow analysis using Air Canada’s cost of capital. It ended 2004 with assets of C$9 billion and just over C$4 billion in net debt. Management looked to make Air Canada’s fleet consistent by ordering 18 777s (triple sevens. with a tax rate of 33 percent). Fleet drives fuel and maintenance costs.” Management made roughly the following assumptions concerning the cost of capital (COC): a cost of debt of 7. very high. ACE Lines up Its Subsidiaries for Takeoff Establishing the Queue The management also used the CCAA period to fully implement Milton’s plan to divide the company into a number of subsidiaries. Air Canada added C$129 million of property and equipment. Jack McLean explained. it had been transformed into a holding 7 air canada . and a C$250 million convertible preferred share subscription from Cerberus. on-the-ground costs. Later.8 percent after-tax. a C$850 million equity rights offering back-stopped by Deutsche Bank. private equity firm. the company raised C$1. “ACE believes that there is significant value locked in its various business units that can emerge if they are allowed a greater level of independence in operations and financing.” When Air Canada emerged from bankruptcy. Milton noted.89 after tax.32 percent before tax (4. (See Exhibit 3 for Air Canada’s debt repayment schedule projected for the emergence from bankruptcy.) The company’s approach to capital budgeting remained consistent through the period. the Air Canada COC would be 8.6 billion. In addition to streamlining its fleet.S. In the first quarter following the restructuring. The stability for employees and management would allow the company breathing space. Net debt prior to restructuring had been C$12 billion. Capital costs are extremely high. Based on these assumptions. The company took steps to create a slimmed down fleet with fewer aircraft types and an increasing reliance on cost-efficient. Jazz got the Canadianmade Bombardier jets and turbo-props. and crewing costs. These acquisitions would lead to higher capital expenditures in the future.12 percent. Restructuring the Fleet and the Balance Sheet The bankruptcy also gave the airline the opportunity to reexamine its fleet in a way that had been impossible in the depressed airplane resale market following September 11. including a C$540 million exit facility and loan from GE.

The airline or credit card company buys those 100 miles from Aeroplan on day 1. As the team evaluated the subsidiaries. net of fees). the cyclical nature of the airline sector meant that missing a positive moment in the market could exact a financial penalty. to further enhance the value of those that followed. The rest of proceeds were used to purchase planes for Jazz and Air Canada and modernize systems. which is how long an average mile lasts. one of which was Air Canada. Each step needed to be a success. Sydney Isaacs described the approach as “opportunistic. provided to Cerberus and to debt holders in resolving the bankruptcy.IPO On its emergence from CCAA.company. typically 30 months later. ACE’s subsidiaries were “at varying stages of their corporate development. we only had to meet as the whole group once or twice in the whole period.) With the subsidiaries defined.) First to Fly: The ACE Financing re. ACE would enter the equity markets for itself. Moreover. with net proceeds of C$319 million. ACE had issued 100 million shares at C$20 per share. It sold 14 percent of its subsidiary. it had to keep in mind that the newly formed companies had varying degrees of experience with independence. Aeroplan – the loyalty rewards program. In additional to the direct financial benefits. you get 100 Aeroplan miles. As Isaacs noted. ACE also issued convertible senior notes. thereby strengthening ACE’s financial foundation before testing its desire to monetize other parts of the business. It also had to determine market timing to maximize shareholder value over the long term. In the same period. Second in Line: the Aeroplan Carve-Out On June 28. the equity offering gave ACE a chance to test the waters. Thirty days later. Milton and his strategy team focused on improving each subsidiary to maximize the value of the holding company. in a positive sense”: the group had to seize the moment and not analyze for so long that it would miss a window of opportunity. “Since we all knew what we wanted to do and needed to do. ACE’s share price climbed steadily. Let’s 8 air canada . ACE made its first carve-out. we receive the cash for 100 miles – approximately $1. no airline had ever spun off a loyalty program. in the language of annual reports. This was unprecedented. explained Aeroplan’s business model: If you fly today or you spend $100 on your CIBC Aerogold Visa. you come to redeem it. These began trading in October of 2004.. 2005. the company was rebuilding its credibility and creating a track record. There were many possibilities: a subsidiary with a shorter independent history and newer management might not be ready for a public offering but could still be attractive to a private investor.” The team had to decide in which order to carve out the subsidiaries and how much of each to make available to outside investors. and we deposit the 100 miles in your account. that held 10 stand-alone sister companies. Then.”23 An IPO of a subsidiary would require the market to evaluate whether the company’s management had sufficient experience and whether contractual relationships were clearly defined. and management recognized an opportunity to raise more equity. The price in the new share offering was set at C$37. We worked fast. Rupert Duchesne. ACE Aviation Holdings. (See Exhibit 4 for the new subsidiaries under the ACE structure. Brewer remembered. Aeroplan’s CEO.25 if you assume our average yield.00 per share. (See Exhibit 5 for a summary of ACE’s equity market entries before its decision on Air Canada. ACE used C$557 million of the offerings’ proceeds to repay its high interest loans with General Electric Canadian Capital. We put that dollar and a quarter into our pockets. yielding gross proceeds of approximately C$462 million (C$442 million. The team worked closely and quickly with the newly constituted board and conferred with the management of the new subsidiaries. Inc. Before carving out any subsidiaries. The successful takeoff gave the financial community a better picture of the reconstituted company and its business model.

Also. ACE felt that Aeroplan’s expected earnings and cash flows could be predictable enough to support an income trust. It generated revenue from credit card providers and other parties outside the cyclicality in the airline industry. income trusts held special tax advantages that typically yielded higher after-tax returns than their dividend-paying counterparts. Robert Milton explained. So at the end of the day. This had an interesting effect on Aeroplan’s financial statements. According to the strictures of GAAP accounting. ACE decided to start with Aeroplan for several reasons. We also bought the seat for cheaper than we sold the miles. a popular Canadian organizational structure. we know that statistically 17 percent of the miles are never used. the sales price of miles. revenue cannot be recognized until service is delivered.000 miles on the MP3 player to listen to on the trip. At the IPO. and employees were generally customer-oriented and responsive. Finally. Income trusts. management and market analysts felt that Aeroplan was worth the most of all the four major subsidiaries – perhaps C$2 billion. Add them together and you have one cash flow. ACE elected to use an income trust to carve out Aeroplan. At the time of the offering. since missing or reducing periodic distributions typically led to a substantial decrease in the income trust’s unit price. we take the cash we’ve been sitting on for 30 months and buy the seat from Air Canada and the MP3 players from Future Shop.” With the Aeroplan offering. And that cash flow is worth some multiple in the market. were comparable to high-dividend-paying common stocks. the market looks at it all as an airline cash flow. The problem is. “Look at the four subsidiaries: Air Canada. and you have four sets of cash flows. point redemption occurred 30 months after point accumulation. On average. (See Exhibit 7 for a summary graphic from the presentation. and assigns an airline multiple. which had resulted in more revenue for Aeroplan. ACE and Aeroplan conducted 150 to 160 analyst and investor presentations. and 12.say you decide to fly to Vancouver and buy an MP3 player. Second is the difference between the cost of goods sold vs. This was the highest ratio of third-party revenues among the ACE subsidiaries. ACE executives were hoping that the presentations would help clarify the ACE structure as well. Aeroplan was the most stable of all the businesses. (See Exhibit 6 for additional information on income trusts. so Aeroplan’s income statement reflected revenues and profits from 30 months previous. These matching issues also produced other financial statement oddities. At the end of that period. so we make another bit of margin on that. the bankruptcy judge had required Air Canada to renegotiate its contract with the issuing bank for the credit cards. 17 percent of miles are never used. the market gave Aeroplan a C$2 billion market capitalization. 9 air canada . notionally from a cash point of view.) For the IPO. such as a current ratio for Aeroplan less than 1 (typically. primarily from bank credit cards. we have three sources of profitability: First.000 miles on your flight. ACE executives were concerned that the market appeared to have difficulty disentangling the economics of ACE’s structure. You spend 25. The cash cycle is straightforward. and the market premium in Canada for this structure made it an attractive option.) The presentations were important not only to explain Aeroplan’s business model but also to walk analysts through Aeroplan’s complicated accounting. Second. if we sold 100 miles for $1. even though the company was flush with cash. As they explained Aeroplan’s business model. In round numbers say 20 cents fall straight to the bottom line. it was profitable.25. and Aeroplan. First. Aeroplan received roughly 70 percent of its revenues from parties other than Air Canada. almost all the service issues were now fixed. ACTS. Third is the fact that we’ve been sitting on your cash for 30 months – the float. the market could understand the business of Aeroplan and value it at a multiple appropriate to a marketing or credit card firm (much higher than an airline multiple). Jazz. On that day. While the loyalty program had had a poor reputation for the way it treated Air Canada customers. Firms opting for the income trust structure had to have stable income streams. as opposed to offering common equity stock. a sign of poor fiscal health). greater than the value of the airline itself.

had reduced Jazz’s revenue fluctuations by guaranteeing Jazz seat revenue. In addition. negotiated during the bankruptcy restructuring. Management focused on both the cost of an Aeroplan point and its value to consumers. so there were no challenges in separating revenues and costs from other ACE subsidiaries.S. Next Up: Jazz Air Canada Jazz had been created in 2001 as Air Canada Regional Inc. hotels. and retail stores to its list of point providers. shareholders received cash. Aeroplan continued to meet the regulatory requirement for majority Canadian ownership. The arrangement made Aeroplan customers happy by increasing the utility of the points. Jazz had lower employee costs than legacy airlines.24 Should ACTS Be Next to Taxi to the Runway? Although ACTS. developed a new supplemental points system. which made the program more appealing to new partners. with additional proceeds from an overallotment option bringing the aggregate net proceeds up to C$232 million. merging four regional airline brands into a feeder airline for Air Canada. As before. U. since Jazz’s cash flow streams were surprisingly stable for an airline. now negotiating at arm’s length. Aeroplan reduced its identification with Air Canada. It reduced Jazz’s expense fluctuations by treating Jazz fuel costs as a pass-through to Air Canada. Everyone agreed that this novel contracting would not have been developed had Aeroplan continued as an airline cost center. As a regional carrier with smaller planes and shorter routes. The company sold 23.” The long-term contract between Jazz and Air Canada. (Due to regulatory restrictions. airline frequent flier plans. Even though Aeroplan’s standard percentage of reserved seats was higher than for most U. Consequently. In March 2006. Therefore. Aeroplan and Air Canada. with a market value of C$251 million. it could still be difficult for customers to find seats on the flights they wanted. 10 air canada . telephone services. had been discussed as a potential carve-out since before the bankruptcy. as long as they were willing to pay additional points equivalent to the market price of that seat. removing the familiar red maple leaf roundel. Aeroplan contracted for 8 percent of all seats on Air Canada flights. A novel contracting arrangement between Aeroplan and the airline.7 percent of Jazz. ACE made a second move with Aeroplan. 2006. only Canadian shareholders received stock. reducing its holdings to 75. so the timing was good. “The volatility had been taken out of the company.The carve-out also shifted Aeroplan’s corporate mindset.5 million units at a price of C$10 per unit. the same market structure used for Aeroplan..S. Air Canada saw an increase in revenues and in passenger load factors (the ratio of paying passengers to total available seats) when Aeroplan paid market prices for seats that might otherwise have not been sold. The estimated net proceeds were C$218 million. and in mid-2006 ACTS remained in the holding company. Furthermore. and Aeroplan management benefited from the margins on the points used and the ability to recognize the revenue at a faster pace.3 percent by distributing approximately 10 percent of its Aeroplan Income Fund shares to ACE shareholders. in late 2005 and early 2006 Canadian investors were still paying a premium for income trusts. and merchandise. In total. Milton observed. And since ACE as a Canadian corporation retained a majority of Aeroplan stock. ACE retained 79. the company was able to add gasoline companies. with the name change to Air Canada Jazz in 2002 reflecting the completion of the merger. ACE had decided to delay it. Jazz offering was a success. first entered into in 2004 and then expanded further in 2006. in which Aeroplan members could have access to any unsold seat on any flight. the company had attained a higher market capitalization than Continental Airlines. Points could be redeemed for flights. ACE’s management team realized that ACE could offer Jazz as an income trust. It had maintained separate books since its creation. the maintenance group. led to gains for both parties.) Aeroplan’s stock had done well. The February 2.

The story of ACTS as a separate company in the maintenance-repair-and-overhaul sector was not well developed. so it’s driven by technical excellence. Of course. and the contract with the main airline itself isn’t papered [clearly defined in a written document]. and there were information gaps. but there were potential challenges. “Our projected capital expenditures for the next two years alone total about C$3.27 billion in equity markets.4 billion. but the new group had not established a track record. very limited. Brian Dunne.” So.) One of the direct benefits of the carve-outs was the access to additional capital. ACE had brought in a new executive team for ACTS to enhance its commercial. looking back at the Air Canada-ACTS division and similar reorganizations during his tenure at Aer Lingus.) Robert Milton explained. carriers to outsource maintenance repair and overhaul work. The necessary systems are not yet in place. We are out of that game now. and business sense.” In early 2006.S. We used to give miles away for free to placate unhappy customers.” Spinning off subsidiaries also had an important impact on transfer pricing between subsidiaries. ACE also disposed of its 4. you bring in commercial people and they go out and find themselves bidding on third-party contracts. Most of this investment will go into acquiring new aircraft. Through its various offerings. Therefore. It remained to be seen what impact these partitions would have on various ACE stakeholder negotiations in the future. ACE had already raised C$1. because the costs weren’t recorded as expenses for a long time thereafter. Milton and his ACE strategists realized that ACTS was not ready for an IPO. ACE had two options: they could try a quick private sale of ACTS. making the costs incurred obvious to both sides. there was always an expense. An Interim Assessment of the Plan The financial strategy and the carve-outs of Jazz and Aeroplan had produced several notable benefits for ACE and its stakeholders. On the management side. the commercial people may not have the right cost information to handle the job properly. whether they are making money or not. Montie Brewer said. without a lot of information on what their costs are or what they need. and have a technical excellence mindset. taking advantage of moves by U. “Things that were once free now have become an expense. ACTS had a good technical reputation for safety and operations. When you carve it out. It had developed contracts with Air Canada and was actively seeking to increase its third-party customer base. Air Canada offered vouchers toward the price of purchasing a seat on future flights. the company had not yet developed the three years of financial data that stock analysts desired. for example. (In addition. giving us a vastly superior product to most major North American airlines. On the accounting side. when they would have more information for the financial markets.5 million shares of US Airways stock for net proceeds of C$232 million – a gain of C$152 million since its acquisition of the stock in 2005 during US Airways’ bankruptcy. developing experience on the business side was taking time. Another indirect effect of the carve-outs was that it insulated the income generated by each subsidiary from other ACE stakeholders – in particular the airline unions. while the sector was still hot. These businesses have little financial capability and the financial information available to managers is very. instead of automatically offering a large number of points to customers who experienced major delays on the runway.25 However. in 2006. These businesses typically have management who have successfully worked their way up from the floor.26 (See Exhibit 8 for financial data for ACE and its major subsidiaries. but doesn’t focus too much on costs. or they could wait until 2008 or 2009.ACTS (Air Canada Technical Services) handled overhauls and major repairs. 11 air canada . but it was invisible. keeping the aircraft flying. you have a lot of tension and emotion as they try to act separately. financial. In a lot of cases. overnight fleet maintenance had remained within the airline. you don’t have sufficient financial people around. noted the challenges faced by a maintenance group in transition to a separate company: Maintenance is a division of the airline.

“Jazz has always been separate and they haven’t had too many issues. but moving toward real and action-oriented results. liked the career stability of not being at an airline and also liked being part of they considered a “winning” story. many employees joined the company because they wanted to be part of an airline. creating additional overhead. ACTS and Air Canada had to develop an arms length relationship. As Milton saw it. Looking back. or carving out Air Canada immediately.” Brewer explained. For example. “We had over seven or eight updates and strategy discussions with the board. But for others. As one example. The options facing ACE. the options were spending another year or two to spin out the smaller pieces to eke out more value. Air Canada had continued to face challenges. As Montie Brewer described it. There is a lot of quiet pride in the leaf and the fact that they will not be part of the leaf may be disturbing to some. like those at Aeroplan. Along with the rest of the sector. were a common stock IPO or a search for private investors. however.… The key strategic decision to me was not spinning off Aeroplan. Aeroplan and ACTS employees had bargained to retain the pension plans and other benefits that they had enjoyed as Air Canada employees. work orders had been decorated with new tasks “like stringing lights on a Christmas tree. Specifically. I think emotionally it may take time to take ownership and pride in the new company. both sides had to learn a new process of proposals. The really interesting decision point is. ACE had unlocked value for its shareholders by spinning off its subsidiaries.” Now. but it was proving hard for them to “give up the leaf.A potential concern regarding the carve-outs was its effect on employee morale. what’s the eventual consequence of that. Moreover. the transition may be hard. and it was significant enough to keep Air Canada’s potential spin-off in the forefront of ACE’s strategic thinking. In the past the maintenance group would take on “everything that needed doing” when a plane came in for major overhaul.” Brian Dunne remembered that time as a period of great internal debate. One major impact of a sale of Air Canada stock was obvious – it would be a source of capital for the company. government discussions of possible tax code changes had dampened the Canadian market’s enthusiasm for the trusts. Air Canada Cargo. approvals. Another concern of all the newly formed independent subsidiaries was the need to monitor each other. But it was not at all clear what the value of a stand-alone Air Canada stock in the market would be. if it decided to carve out a portion of the airline.” How Would the Market React to a Pure-Play Air Canada Stock? Given the volatility in airline stocks generally and the challenges remaining for Air Canada. and Air Canada Vacations (tour operations) in addition to Air Canada and ACTS. In negotiations under the bankruptcy proceeding.” Others. possibly folding in the smaller units. and if you do.) But the perceived holding company discount remained. and identified with Air Canada and its maple leaf logo. a national company with a long history. it was clear that an income trust would be inappropriate for Air Canada. Was It Time for ACE to Launch Air Canada? In mid-2006. without consultation with other parts of the company. Duchesne saw the spin-off of Air Canada as “the real fork in the road. Brewer pointed out in an April 2006 video message to employees that fuel increases in 2005 had added C$500 12 air canada . because you’d be crazy not to once you had thought through the business fundamentals. We were not moving away from fundamental goals. We had refined our thinking on the way and had to look at our options from that point and what they would be going forward. do you or do you not spin off the airline. (See Exhibit 9 for total return to ACE shareholders. ACE still held complete ownership of the ground handling services (airport passenger and aircraft services). and revised invoices.

ACE had started with one company and teased out related entities. if you added up the sum of the parts. Brian Dunne observed. Adding another public company to the market would introduce a greater degree of complexity.” Analysts seemed divided on the wisdom of a carve-out as well. It had retained 75. less the imputed value of subsidiaries. and a number of smaller sister subsidiaries were still under ACE.) As Brian Dunne noted. “Buy ACE. along with the public visibility of Air Canada. eating up a quarter of the C$2 billion savings that Air Canada had achieved in its painful operational restructuring during the bankruptcy. “It’s a great thing to muse about and it’s a great way to get your stock up.27 (See Exhibit 10 for ACE’s sum-of-the-parts evaluation and stock values for ACE. “The model was unique enough that it was hard for some investors and financers and labor to understand the difference between ACE and Air Canada. but it would be even easier if the carve-out took place. one of our major objectives is seeing our other assets. the airline was valued for nothing. For the risk shareholders have taken.3 percent of Aeroplan and 79. Most importantly. One analyst said.”29 Another observer questioned whether there would be demand for a “pure-play Air Canada stock.. This might create arbitrage opportunities.” Milton shared his frustration in the 2005 Annual Report: Going forward. at least in theory.7 percent of Jazz. As Brewer said. Brewer pointed out that hedge funds or other investors could play games with different pieces. but I’m not really sure how realistic this is.” Unlike many holding companies that had amalgamated unrelated businesses. Aeroplan. led to a less-than-zero number. it faced a question of timing. Some questioned whether Air Canada could even be divested. As Brewer pointed out. investors would be able to buy stock in the holding company and in almost all its holdings.0 billion. including Air Canada. But separating Air Canada from ACE was not without its challenges. shareholders should share in ACE’s success. and Jazz.”30 If a portion of the airline were spun off. If ACE Decided to Launch Air Canada. the airline would get its own market identity and its own credit rating. ‘What is the best approach to ensure that the market fully recognized the value of ACE’s underlying assets and also how do we eliminate the holding company discount?’ Asking the market to put a value on Air Canada would be a benefit to ACE shareholders. Air Canada is still saddled with a higher cost structure than its main competitor. “Calculation of value of ACE. and a summary of ACE holdings. “We could not be sure how the market would react to the Air Canada story. and get an airline for free. the world’s 14th largest airline. network expansion. at times made the distinction between ACE and Air Canada difficult to convey.” In other words. for the capital they provided that is helping support fleet renewal. fully reflected in the share price. Spinning off Air Canada should.27 billion in equity markets through the monetization of its subsidiaries. Since May 2005. including C$497 million through Aeroplan and Jazz trust issues. “The question we were asking then was. The market value of the retained shares of these two subsidiaries was close to the entire market capitalization of ACE. the process had many uncertainties. which by 2006 had an estimated market capitalization of around C$2.” Spinning off this major part of the company would clarify the relationship. That could have already been true to some degree before any Air Canada carve-out. This history. require the market to place some value on the airline and therefore increase the value of the holding company. strategic 28 investments and organic growth. WestJet Airlines Ltd. Dunne noted that a carve-out would be time consuming and expensive. When Should It Schedule the Takeoff? Even if ACE were to decide to carve out Air Canada. “Despite its extensive restructuring.” noting. and is seeing its margins squeezed by record high fuel prices. given that the airline was ACE’s core operation and the business on which all of ACE’s other subsidiaries were dependent. The fate of the maintenance group was not finalized.million to the expense side. or as Milton described it. 13 air canada . ACE had raised C$1.

carving out Air Canada would be a strong signal of the total separation of the entities. American Express buys a lot of tickets from us. ACE could take its experience in highlighting an airline’s shareholder value. As an alternative. gradually monetizing its remaining stock holdings or distributing them directly to its shareholders. As Dunne observed. two of Air Canada’s major unions.31 The effort did not succeed. A final argument for moving quickly was the positive mood of the Canadian market in mid 2006 – the IPO market in Canada was hot. Although many of the effects of the carve-outs had already reached employees. but it’s their money. “The biggest factor saying ‘act more quickly’ was how fast the market could change. Summer results were always better than winter. Almost all other North American legacy airlines had faced bankruptcy – several more than once – and all had taken the opportunity to restructure their balance sheets and shed employees. “It’s difficult for employees to get their heads around not being the same company any more. Why aren’t you asking for their profits? We try to get our share of the profits from everybody and so does everybody else.” while Air Canada’s employee pension plan was not fully funded. Missing that window in 2006 might require a delay until a similar period the following year. to seek out investment opportunities. other than ACTS. If the airline was carved out and ACTS moved to private equity. the next question was. It could dissolve itself. should the subsidiaries remain as independent entities under ACE or be folded back under Air Canada? One factor affecting the timing was the seasonality of Air Canada’s revenues. and now they can’t.” What Would the Impact of a Spinoff Be on ACE Employees? The creation of ACE and the carving out of subsidiaries had diminished the direct equity link between the subsidiaries. When we were all part of the mother ship. flight attendants and ground crews. as it had done with a piece of Aeroplan in 2006. premature and imprudent. Unions would be able to consider only Air Canada’s revenue and profits when negotiating new contracts.” Where Should ACE Land? Spinning off the airline would remove the last major subsidiary from the wholly owned category. But none had taken the 14 air canada . filed to oppose ACE’s announcement of future distributions to shareholders of approximately C$300 million. A separation of Air Canada from other ACE subsidiaries would make similar arguments even more difficult. what would happen to ACE. So now.There could be additional value when issues from the maintenance division were resolved and when ACE would monetize air cargo and other smaller divisions. along with its industry and restructuring expertise into financial markets. In November 2005. This change had the effect of limiting the ability of unions in Air Canada’s workforce to attempt to reach past the airline itself to justify wage increases. I say. like its US Airways deal. but the unions had not given up. As Brewer stated. not ours. employees could look to the profits of other business segments. we should do it. As Brewer noted. Aeroplan has figured out ways to make money. should ACE wait until those sales were complete before spinning off Air Canada? If not. The unions’ filing stated that ACE had significantly underestimated its future finances during negotiations when the company was under bankruptcy protection. If it looked good. If an Air Canada carve-out was the right choice. and the distribution to shareholders was “oppressive. and the financials would look their best after second quarter reports. When pilots complain about Aeroplan’s profits.

In the process. And if I wind up blowing up or getting kicked out the door so be it. And sometimes you just have to put your head down and try to drive through walls and just say I know what I’m doing. Milton was no longer a target for unions and the press. The restructuring and resulting shift to a holding company structure had led him to move his offices from the airline headquarters between runways of Montreal’s Pierre Elliott Trudeau International Airport to the former headquarters of Zellers Department Stores in suburban Montreal. With a big mistake. But issues in the industry were well defined. through the pursuit of third-party sources of business. that ten-year horizon moves to five. then to three. (ii) align management. Milton had taken the bold steps. painful death.33) In realizing his concepts for redefining a legacy airline. he believed he had taken the company in the right direction. so no one wants to try anything. you are dead. Milton and other ACE officers were no longer involved in day-to-day airline management. So much of what happens is beyond anybody running an airline’s control. and we felt that we should be able to figure out how to solve it. had gone from optimizing airplane schedules to optimizing the value of the company as a whole. Even though Milton could no longer look out his window to see planes taking off. the pilots’ union had filed a grievance with the industrial relations board. or will not work for the long term. outlined the challenges: It is a very difficult industry.S. capital and human resource needs within each individual business.32 With the changes that had already taken place. There were benefits: with his once-removed position. (One telling commentary on Milton’s relationship with his employees was that when Milton published his memoirs Straight From the Top: The Truth about Air Canada in 2005. And I don’t care if people like it. Margins are very thin and challenges are great. Brewer. He had succeeded in separating the various divisions of Air Canada into sister companies under a holding company.steps that Air Canada had. He had realized the goals described in the first annual report issued by ACE: (i) put in place separate management and business plans for each subsidiary to better focus their strategic direction and profit making efforts. But I’m not deviating from what I believe has to happen. he had gone from running an airline to running a financial management firm. and (iv) maximize subsidiaries’ value that was not fully recognized when the business segments were part of Air Canada. airlines. Milton. thinking back on his experience at Air Canada and his prior work at various U. an airline fanatic since childhood. I really believe I understand this business…. and then you’re gone. but it’s slow. If you make a medium-sized mistake. where appropriate. Noncontrollables are high in number and great in impact. You are sometimes reduced to playing with the cards you are dealt. (iii) facilitate the development of each business segment to its fullest individual potential including. 15 air canada . even though they know that what they are doing is not working. It’s a slow.

1999. Milton. 2000. November 6. Burns. Notice of Initial Application. 1988. “Deal-Making. Ontario Superior Court of Justice.” 16 17 Katherine Macklem.” Bankruptcy Creditors’ Service. 2004. with John Lawrence Reynolds. “Regulation. It has been developed for pedagogical purposes and is not intended to furnish primary data. Katherine Macklem. and Interest Group Cohesion: Why Airlines Were Not Reregulated.” New York University School of Law.theage. serve as an endorsement of the organization in question. “Air Canada Chaos. March 12.S. “Air Canada Sets Pay Cuts and Another 4. Copyright 2007 © Yale University. D. General Accounting Office. To order copies of this material or to receive permission to reprint any or all of this document. Timothy Pritchard. p. 13 14 15 Katherine Macklem. “Air Canada Chaos.au/articles/2002/09/ 23/1032734111833. 2001. “The Sage of Omaha’s Trans-Atlantic Game. Yale School of Management. “Air Canada Chaos. or illustrate either effective or ineffective management techniques or strategies. All rights reserved. Robert A.” The Age (Australia). New York University Law and Economics Working Paper No. Robert A. “Furor over Air Canada Offering. Doctoral Candidate. Milton. Ibid.com. 4. Case Study Research Team. 2003. CT 06520. Canadian Style.This case was developed with the cooperation of ACE Aviation Holdings.C.html 8 7 Michael E.: Mar. (Washington. 80. “Airline Deregulation: Changes in Airfares. 11. Service Quality.” New York Times.fundinguniverse. Katherine Macklem.” Maclean’s Magazine. October 11.” 9 10 11 12 Funding Universe. April 4. Yale School of Management. SOM ‘05. 2000.000 Layoffs.” http://www. 20 21 Air Canada Bankruptcy News. New York Times. 37.” New York Times. Greystone Books. Levine. New Haven. and Aeroplan. Simon. April 1. September 24 2002. Burns. Robert A. 2006. and Barriers to Entry. 5 6 U. “Air Canada.html. 1999. Straight from the Top: The Truth about Air Canada. Straight from the Top: The Truth about Air Canada. Kimberley Noble. 1999). Bernard. Milton. John F. Williams Brothers Professor of Accounting and Finance. p. May 2. Straight from the Top: The Truth about Air Canada. 18 19 Katherine Macklem.com/company-histories/Air-Canada-CompanyHistory. “Air Canada Chaos. Dominic Lawson and Grant Ringshaw. “Air Canada Chaos”. 16 air canada . Vancouver/Toronto. “Gerry Schwartz. the Market.” GAO/RCED-99-92. Yale School of Management. 2003. Endnotes 1 2 3 4 Case writer. Reprinted with permission of Yale University School of Management. “Furor over Air Canada Offering. Air Canada. “Maclean’s Magazine. please contact the Yale SOM Case Study Research Team.” Air Canada Annual Report. http://www. PO Box 208200. August 2. 135 Prospect Street. John F.” Notice of Initial Application for Air Canada under the Companies’ Creditors Arrangement Act.

2005 Annual Report.” David Paddon.22 23 24 25 26 27 28 29 30 Notice of Initial Application. ACE Aviation. 14. ACE Aviation.pdf. “ACE Takes Flight on Spinoff Talk: Investors Cheer Possible Air Canada IPO. 38. 32 33 Rick Westhead. ACE Aviation. 14. 2005.” Toronto Star. Chris Sorensen. Feb 7. p.aceaviation. p. ACE Aviation. 2005 Annual Report. p. 2005. “ACE Takes Flight on Spinoff Talk: Investors Cheer Possible Air Canada IPO. 2006 Annual Report. p. An ACE market presentation is online at http://www.” 31 NewsWire. Feb 2006.” Chris Sorensen. p. 17 air canada . 2005 Annual Report. p 14.” Canadian Press Air Canada 2004 Annual Report. 2005 Annual Report. A. ACE Aviation.com/ en/investors/documents/ml-ace. “New Corporate Structure to Maximize the Value of Subsidiaries. 2. “New PR Fiasco for Air Canada: Pilots’ Union Lodges Complaint over CEO’s ‘Malicious’ Book: Airline Says It Will Fight Charge if Regulator Hears Complaint. “Air Canada Union Leaders Oppose Special Cash Distribution to Shareholders.02. October 31.

18 air canada . Canada. “Competition and Regulation in the Airline Industry.Exhibit 1 Airline Industry Statistics A. Number of Domestic Airline Passengers. U. citing data from U.S. Bureau of Labor Statistics. Canadian dollars) Source for A and B: Gautam Gowrisankaran.” FRBSF (Federal Reserve Bank of San Francisco) Economic Letter. Average Domestic Airfare for U.S.S. Number 2002-01. Bank of Canada Review. Aviation Statistics Centre. Bureau of Transportation Studies.. Bureau of Transportation Studies.S. January 18. US and Canada (in millions) B. Canada Aviation Statistics Centre. 2002.S. and Canada (in 1983 U. U.

1998 and 2003 1998 8% 2003 Other Airlines 2% 23% 33% Low Cost Airlines 65% 69% Legacy Airlines D. Market Share of U.2 4.8 1998 1999 2000 2001 2002 2003 -4. U. Airline Profits and Losses. 1998 through 2003 (Billions of 2003 U. Legacy and Low Cost Airlines.3 1.2 0.3 0.S.S. 19 air canada . dollars) 10 8 6 4 2 0 -2 -4 -6 -8 -10 -12 -9.2 7.S. “Commercial Aviation: Legacy Airlines Must Further Reduce Costs to Restore Profitability. August 2004.3 6.8 Source for C and D: United States Government Accountability Office.Exhibit 1 (continued) C.” GAO-04-836.8 1.9 legacy airlines low-cost airlines 0.1 1.7 -9.

00 0.Exhibit 2 Air Canada Before Restructuring: Organizational Structure and Stock Price AIR CANADA Passenger Operations Division Cargo Operations Division Airline-Related Businesses Division Cargo Operations Air Canada Tech.00 4.00 12. 100% Destina. Wingo Leasing. (Canadian Dollars) 16. Inc 100% Aeroplan Limited Partnership 100% Zip Air Inc. Inc. June 30. Toronto Stock Exchange. 2004.00 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Source: ACE Prospectus. Ltd. 100% Air Canada Capital. 100% Touram. Inc. Tango. 20 air canada .ca Inc. Serv. AC Jetz) 100% Jazz Air. 100% Corporate structure and percentage of equitycontrolled directly or indirectly by Air Canada before implementation of the Plan. (ACTS) Passenger Ops (Air Canada.00 8.

inventory. Source p. Source: ACE Aviation. modifications and refurbishments Projected pension funding obligations 1. 2004 Annual Report. net of aircraft financing Planned and committed expenditures for aircraft engines. 21 air canada . 21. modifications and refurbishments Other planned and committed property and equipment expenditures Total planned and committed expenditures for aircraft engines.003 (942) 61 561 (477) 84 718 (653) 65 28 (28) 0 0 0 0 498 96 594 452 57 509 441 48 489 326 46 372 322 33 355 75 143 218 33 144 177 128 180 308 181 180 361 160 87 247 2005 2006 2007 2008 2009 231 189 420 198 157 355 145 160 305 28 134 162 39 120 159 259 336 340 329 308 Air Canada’s definition for long-term debt (LTD) obligations: LTD and capital leases plus operating lease obligations net of cash and short-term investments.Exhibit 3 Air Canada’s Projected Debt Repayment after Emergence from Bankruptcy C$ in Millions Long-Term Debt and Capital Lease Obligations Long-term debt principal obligations Capital lease principal obligations Operating Leases Future minimum lease payments under existing operating leases of aircraft Future minimum lease payments under existing leases for other property Capital Expenditures Projected committed aircraft expenditures Projected aircraft financing Projected committed aircraft expenditures. inventory.

cover and p. 2004 Air Canada. integrated into mainline operations December 2004) Jazz (regional airline) Aeroplan (frequent flier program) Air Canada Technical Services (major maintenance facilities) Destina. 22 air canada .Exhibit 4 ACE Aviation Subsidiaries. 10.ca (Air Canada’s online travel site) Touram (Air Canada Vacations) Air Canada Ground Handling (in airport services) Air Canada Cargo (package shipping) As pictured 2005 Source: ACE Aviation 2005 Annual Report. including Tango (a low-fare airlines) and Jetz (charter services) Zip (discount division.

2004 Convertible preferred shares $250 million before fees $37. 2004 Aug 23. 2005 Sep 30. financial liability $236 million Offered only in Canadian markets Delayed due to changes in trust market tax letters Before overallotment option Total after overallotment option Distribution to ACE shareholders Q2 2005 319 million NA NA $92 million June 2005 15% Delayed 23.3% Reduced ACE holdings to 75.5 million (convertible to 9.00 $10. 2004 Common shares 42.0 million 28. 2005 Nov 28.3 million 12.00 $267 million none $218 million $232 $251 million Gain of $152 million Feb 2.3% of Aeroplan None $10.00 ACE Classes A and B ACE convertible Senior Notes Creation of Aeroplan Income Fund JAZZ JAZZ JAZZ Aeroplan units to ACE shareholders Sale of ACE holdings in US Airways shares May 20.75 million None 19.3 million common shares) 12. 2005 Prospectus filed Q2 2005 Common shares Convertible Senior Notes Income Trust Units Income Trust Units $442 million Net $92 million fees as equity.5 million NA NA NA Settlement of creditor claims To Cerberus for investment of $250 million ACE reorganization plan Aug 17. 2006 March 3.1% 20. 2005 Prospectus Nov 28.00 $10. 2004 Aug 23. 2006 Completed Q2 Q3 2006 Income Trust Units Income Trust Units Income Trust Units 23 air canada .5 million 27.Exhibit 5 ACE Aviation: Funds Sourced by Issuing Equity and Convertible Securities 2004-June 2006 (in Canadian dollars) Offering Announcement Date Offering Date Type of Equity # of shares Offered % of Company Offered in Mkt Initial Price Net C$ equity Other Comments ACE reorganization plan Aug 17. 2006 Feb 2.

An income trust also faces additional risks related to changes in interest rates.Exhibit 6 Canadian Income Trusts An income trust is an investment vehicle that holds income-producing assets to provide consistent cash flows to investors. The following table illustrates the difference in net income. By 2004. **Takes into account the dividend tax credit. with a market cap of C$118. Untaxed proceeds flow through to shareholders. income trusts have generated higher after-tax returns than other investments in similar risk categories. not the corporate level. In 2004. and business trusts became a favored market structure in Canada after the 2000 dot-com bust. Most firms do not pay out all their after-tax earnings.4 billion in equity was raised by income trusts on the Toronto Stock Exchange. Investors (unitholders) are beneficiaries of the trust and receive income through quarterly or monthly distributions. *** The full payout scenario is for illustrative purposes. An income trust provides a more tax efficient transfer of wealth from a firm to its shareholders as compared to common equity. through their brief history they 1 have offered higher ex post returns with less variability than the S&P/TSX composite index. providing stable income streams and moderate growth. In 2000.4 percent: Comparative After-Tax Returns for Income Trusts versus Equities (before October 31.97 billion. Source: Scotia Capital Income trusts are particularly attractive to investors under low interest rates and volatile markets. income trusts are equity and as such do not have a fixed maturity date for full principal repayment. the number had grown to 175 listed trusts. which attempts to mitigate the effect of double taxation). Also. only 73 trusts were listed on the Toronto stock exchange. C$38. with a market capitalization of C$21. Historically. 24 air canada . shareholders could still net higher returns after tax.66 billion.3% tax rate**) After-tax return to investor Total tax paid Income Trust 100 0 100 100 100 46 54 46 Common Equity (100% payout)*** 100 35 65 65 65 20 45 55 * Assumes no favorable tax treatment on distributions. 2006) Earnings before taxes Corporate tax (assume 35% of EBT) Earnings Distributions paid to unitholders Dividend to shareholders Amount received by individual investor Personal tax on distributions (46. Real estate investment trusts (REITS) and energy trusts are not uncommon. because the trust’s income was taxed at the investor’s individual level.4% tax rate*) Personal tax on dividends (31. The shareholder tax rate on income trust disbursements might have been higher than the net tax rates applied to dividends (thanks to the Canadian dividend tax credit. While an income trust resembles a fixed income product due to its stable stream of income disbursements. who were then taxed at their individual marginal tax rates. However. firms using the income trust structure were not taxed at the corporate level. Under Canadian law before October 2006. on top of risks typically faced by other equity products. assuming an individual investor with a marginal tax rate of 46. Its shares or “trust units” trade on exchanges as stocks do.

With this change. 2005. the reverse is also true. This was deemed a potentially serious problem by the government. In general. Steven Chase. disburses income to a unitholder. The change was designed to mitigate the economic distortion that could shift future tax burdens from corporations. 2005. that given future legislative uncertainty it would no longer give advance tax rulings to help companies become trusts. and Sinclair Stewart. with lower overall interest rates leading to higher unit prices. the Canadian government responded. There were also rumblings that the Royal Bank of Canada – one of Canada’s largest firm in terms of market capitalization – was also discussing making the switch. the Canadian version of an Individual Retirement Account). 2006. The more stable the income trust’s income stream. p. Within a week. for example. their tax payments may be deferred for 40 years. As the risk-free rate of interest or yield on government bonds goes up. within a pension plan or a Registered Retirement Savings Plan (a personal pension plan held directly in an individual’s name. 4 25 air canada . Picture the following scenario: an income trust. and new IPOs of trusts were reduced or delayed. Scotia Capital.A major influence on the unit prices of most income trusts is the level of interest rates. B6.” Globe and Mail. nearly all income trusts saw a second significant devaluation of their unit prices. and business entities onto individuals. two of Canada’s biggest telecom operators. all else equal. “All Eyes on Ottowa’s Next Move. The Canadian Revenue Agency announced on September 13. On the day of the announcement. After several of Canada’s biggest companies announced their intent to switch from corporations to income 3 trusts. which leads to corresponding reductions in unit prices of income trusts. since it would shift present-day tax burdens from corporate entities and their investors to individuals and institutions with income sources such as salaries or rent that are not subject to preferential tax treatment. For young pension plan or RRSP participants.com/servlet/ArticleNews/trusts/GAM/20051011/RTRUSTMAIN11. The government announced the Tax Fairness Plan on October 31. The distribution grows tax-deferred until the pensioner retires and withdraws the funds. the corresponding risk-adjusted yields on other interest-oriented securities generally follow suit. after-tax returns to Canadian taxable investors were nearly identical under a high dividend-paying corporation and a distributionpaying trust. Government Concern and Response: Increased Tax Deferment The increasing use of income trusts after 2000 painted the Canadian government into a tricky legislative situation. converted to income trusts in September and October 2006. respectively. and the more sensitive its unit value is to interest rates changes. Thus. and BCE. 1 2 3 ScotiaMcLeod. trusts. The status of income trusts became a matter of increasing discussion in financial and governmental circles and an issue in national elections. The Plan added a distribution tax on distributions of income paid from publicly traded income trusts and limited partnerships. who in turn holds the investment on a tax-deferred basis. Derek Decloet. http://www. investors slashed C$9 billion in market capitalization from 4 trusts. which pays no corporate tax. Oct 11. the combination of tax-sheltered investment vehicles and income trusts could deprive the government of tax dollars for an extended period. the more the market treats the 2 income trust like a bond.globeinvestor. Telus Corp.

Exhibit 7 Aeroplan’s Business Model and Organization Structure Aeroplan Business Model Source: ACE Presentations Aeroplan's Organization Structure Source: Aeroplan 2005 Annual Report 26 air canada .

269 620 941 9.198 417 924 367 303 334 482 253 1. ACE Consolidated Statement of Operations (millions of Canadian dollars. except per share figures) Operating revenues Passenger Cargo Other Operating expenses Salaries. materials and supplies Communications and information technology Food.520 2.830 2.580 9. wages. beverages and supplies Depreciation. amortization and obsolescence Commissions Other Operating income (loss) before reorganization and restructuring items Reorganization and restructuring items Non-operating income (expense) Aeroplan dilution gain Interest income Interest expense Interest capitalized Loss on sale of and provisions on assets Other 2005 8.378 452 - 190 66 (315) 14 (28) (12) (85) 367 (24) 46 (131) 258 Income (loss) before the following items: Non-controlling interest Foreign exchange gain Recovery of (provision for) income taxes Income (loss) for the period 27 air canada .Exhibit 8 Financial Data for ACE and Its Subsidiary Aeroplan A. and benefits Aircraft fuel Aircraft rent Airport and navigation fees Aircraft maintenance.

154 203 1.011 3.847 Accompanying notes deleted.399 10.355 711 680 265 3.354 5.679 28 air canada .168 11. materials and supplies Prepaid expenses and other current assets December 31.543 148 221 2.462 392 11.565 616 2.847 Property and equipment Deferred charges Intangible assets Investments and other assets LIABILITIES Current Accounts payable and accrued liabilities Advance ticket sales Aeroplan deferred revenues Current portion of long-term debt and capital lease obligations (note 7) Long term debt and capital lease obligations Convertible preferred shares Future income taxes Pension and other benefit liabilities Non-controlling interest Other long-term liabilities Commitments Contingencies and Guarantees SHAREHOLDERS’ EQUITY Share capital and other equity Contributed surplus Retained earnings 747 6 415 1.181 86 637 325 125 3. 2005 1.EXHIBIT 8 (CONTINUED) B.494 145 2. 1. ACE 2005 Consolidated Statement of Financial Positions (millions of Canadian dollars) ASSETS Current Cash and cash equivalents Short-term investments Restricted cash Accounts receivable Spare parts.

6 1.9 941 (2) 100 674 12 15.001 849 1.026 174 Twelve months ended December 31.787) (1.9 110 (11) 118 504 16 12.259 9.787) ACE Consolidated 8. ACE 2005 Segment-Based Income Statement in millions of Canadian Dollars Transportation Services 8.269 620 117 9.013 1.2 79 (713) (6) (194) 258 11.378 452 (C$ millions) Passenger revenue Cargo revenue Other revenue External revenue Inter-segment revenue Total revenue Aircraft rent Amortization of capital assets Other operating expenses Total operating expenses Operating income Total non-operating income (expense).847 882 4.830 417 482 8.787) (6) (1. Aeroplan 627 627 13 640 8 530 538 102 Jazz 10 10 1.269 620 941 9. non-controlling interest.479 9. 2005 InterSegment Elimination (1. foreign exchange and income taxes Segment Results Total assets Additions to capital assets Operating margin % EBITDAR (1) Accompanying notes deleted.830 9.EXHIBIT 8 (CONTINUED) C.351 29 air canada .006 194 9.200 343 424 8.6 227 (14) 33 381 5 6.781) (1.023 80 18 796 894 129 ACTS 187 187 567 754 32 675 707 47 (167) 7 11.

666 44. marketing fees from Air Canada Other Revenues Cost of rewards Gross margin Operating expenses Selling. net Amortization of deferred financing charges Net earnings for the year Weighted average number of units Earnings per unit Basic 2005 582.491 140.883 12.042 242. general and administrative expenses Depreciation and amortization Operating income Interest on long-term debt Interest income. call centre management.727 0.909 (6.304 187.859 132.950 101.901 397.352 639.459 8.315) 5. except unit and per unit amounts OPERATING REVENUE Aeroplan Miles revenue Tier Management.649 (939) 100. 2005 Aeroplan Income Statement thousands of Canadian dollars.739.5343 30 air canada .EXHIBIT 8 (CONTINUED) D.

541 2.977 76.000 644.834 35.221 December 31.625 674. 2005 31 air canada .793 300.300 543. interest at 3.183 1. except unit and per unit amounts ASSETS Cash and cash equivalents Short term investments. 2005 Aeroplan Balance Sheet thousands of Canadian dollars.221 $ $ 365.672.714 16.671 86.976 (998.434 728.692 6.45% Accounts receivable Prepaid expenses & other Total current assets Deferred charges Capital assets Software Goodwill Total assets LIABILITIES AND PARTNERS’ DEFICIENCY Accounts payable and accrued liabilities Deferred revenue Distributed payable Total current liabilities Long-term debt Deferred revenue Partners’ deficiency Total liabilities $ $ 32.645 679.399 1.874 98.EXHIBIT 8 (CONTINUED) E.755) 674.

00 31. Value of AER units received is based on 0. 2006 Total Return analysis assumes ACE Shareholders retained 0.00 Cash Distribution Aeroplan Distribution Total = $20 20.00 20.00 0.80 0.04 2.72 Cash distributions received monthly from Aeroplan units distributed to ACE Shareholders 32 air canada .18 units per ACE share multiplied by Aeroplan closing price of $13.47 30.00 Sep 30.29 ACE Share Price 10.00 (2) Total = $33. 2004 Jun 30.18 Aeroplan units distributed to them Mar 06.Exhibit 9 ACE Total Return Analysis 40.

115 854 165 3. June 2006 ACE Aviation Sum of the Parts Evaluation.97 32. ACTS. http://www.618 484 Per ACE Share* 18.62 1.aceaviation.134 3. June 14. 2006. Cargo and Ground Handling * 112 million shares.pdf 33 air canada .47 27.30 4.Exhibit 10 ACE Aviation Data. Air Canada Vacations.88 7.33 Source: ACE Aviation Presents to Merrill Lynch.com/en/investors/documents/ml-ace. share prices and exchange rate June 6. 2006 2. June 2006 Equity Value C$ million Aeroplan Jazz ACE share of US Airways Total Current ACE share price Implied equity value of Remainder (Air Canada.

00 35.00 25.00 ACE Aeroplan 10.00 20.00 15.00 40.exhibit 10 (continued) Stock Prices for ACE and its Subsidiaries through June 2006 (in Canadian Dollars) 45.00 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 34 air canada .00 30.00 Jazz 5.