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Aimia’s 'breakage' model may need fixing

Aimia Inc. may have changed its name and expanded globally in recent years, but the loyalty management company is still driven by the performance of its core Aeroplan business. Specifically, Aimia's relationships with Canadian Imperial Bank of Commerce and American Express, which offer Aeroplan-branded cards, are the source of much of its strength. A weakening economy has put a crimp on Aimia's growth this year, and investors should watch for a number of other worrying developments that could affect the Aeroplan business in the years ahead.

When holders of Aeroplan-branded credit cards spend, they rack up points, which partners such as Imperial Oil have to buy from Aimia. Those sales, which account for 30 per cent of Aimia's total billings, bring cash in the door, but don't get booked as revenue until members cash in the points (at which point Aimia books the expense of buying the rewards, mainly Air Canada tickets).

That is, with one important exception. Some points are considered "broken" – typically 16 per cent to 21 per cent are never cashed in – and recognized as revenue immediately, flowing straight to the bottom line. The impact is enormous: "Breakage" revenue in the third quarter was $46.3-million, or half of adjusted operating profits.

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Points drive revenue, breakage drives profits. Now, consider the three impending changes facing Aimia:

Expiring points Aeroplan members will start to see long-untouched points expire at the end of 2013. Aimia says it's prepared, but if the impending deadline causes a heavier redemption of points than expected, it could result in the redemption of broken points the company never expected would be redeemed. That would force down breakage estimates and, in turn, profits, says Industrial Alliance analyst Neil Linsdell.

Credit card upheaval An upcoming ruling by Canada's Competition Tribunal could end long-standing rules imposed by Visa and Mastercard on merchants. If the ruling follows precedents elsewhere, merchants will be free to pass on to customers the cost of "interchange fees" they are charged by card issuers, which they can't do now.

The change would translate into sticker shock at the cash register. Card issuers would likely compensate for lost interchange fees by increasing card membership fees and clawing back rewards. That would discourage card use – as happened in Australia after regulators removed the no-surcharge rule and capped interchange fees in 2003.

A similar outcome could reduce Aeroplan's gross billings by $100-million (8 per cent) by 2016, cutting $2.50 off Aimia's stock value (equal to one-sixth its current share price) in the worst case scenario, says Veritas Investment Research analyst Kathleen Wong.

CIBC: Frenemy? The CIBC Aerogold Visa has long been Aeroplan's golden goose, but the contract is up for renewal at the end of 2013, and Aimia CEO Rupert Duchesne is lukewarm on the state of discussions. "We hope that we can renew with CIBC," he said this month. "In the event that this proves not to be possible, we're very confident that we have other good options available to us."

Duchesne's guarded language could be because the Competition Tribunal's expected ruling likely hangs over negotiations. But CIBC is also heavily promoting its CIBC Aventura World MasterCard, which allows members to earn points that can be used on any airline, not just Air Canada. Aeroplan only gets the points Aventura members book for trips on Air Canada flights, and presumably few of those points would be broken. Any broken points would be CIBC's to cash in.

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See any reason for CIBC not to grow this business at the expense of Aeroplan? We didn't think so. Mr. Linsdell figures the cannibalization could translate into an impact of up to $2.25 on Aimia's share price over time.

Frequent flyer programs in general are a disappointment. Flight taxes, surcharges and seat restrictions curtail the benefits of points. It's only a matter of time before airlines switch to straight cash-rebate programs. No wonder Aimia has expanded its rewards beyond air travel, and is diversifying to the U.K., Mexico and the Middle East. The company can only hope this gives it enough lift off to compensate for any deterioration in its core business in the years ahead.

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