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

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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
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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 government-
owned 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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of the smallest had been sold to the public. Opponents denounced the move as “a triumph of Conservative
ideology over good, common Canadian sense.”11

In order to gain political support, the Act of Parliament privatizing Air Canada placed a number of
restrictions on the airline. 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. In
addition, 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; the government retained the rest.12

Even after Air Canada was privatized, Canadians maintained a personal interest in the company. Every
decision was front-page news in the Canadian press and often the subject of political commentary. Sydney
Isaacs, strategist for Air Canada who became ACE’s Senior VP of Corporate Development and Chief Legal
Officer, joked, “Any change to the way we did business, be it a change of snack service from peanuts to
pretzels, was subject to a negative press headline.” Montie Brewer, CEO of the airline after 2004,
explained it this way: “Canadians identify with Air Canada. Americans think that all airlines have service
issues. Canadians think that only Air Canada has service issues, because that’s the only airline many have
*
ever flown.”

Defining a New Flight Path for Air Canada

Milton believed that dramatic changes were necessary for Air Canada to become profitable. As COO he
restructured operations, reworked schedules and fleet holdings, cut overhead costs, and focused on
shifting the organizational culture, while maintaining Air Canada’s reputation for safety. Milton took on
problems directly – he was described by both friends and detractors as “blunt and to the point.”13 The
sweeping operational changes and his direct approach led to clashes with the airlines’ union leaders, some
middle managers, and the occasional politician.14

A New Financial Strategy Plotted

Although Milton had focused on operations for most of his career, he recognized that it would take more
than smart scheduling and cost cutting to solve Air Canada’s problems. He believed that the airline’s value
was not reflected in the stock price and set about to “unlock the hidden value” for shareholders. (See
Exhibit 2 for Air Canada’s organizational outline and share prices before restructuring.) Milton put
together a strategy team in 1998 to review the company’s business structures, asking the group, “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. Air Canada did not own unrelated lines of
business, such as hotels. Even so, it became clear that portions of the business might be more profitable as
stand-alone entities. As Milton summarized it, “As much as I grew up loving airplanes and wanted to run
the airline, I realized that the airline was the worst business we had.” The team’s conclusion: The high-
risk and low-return profile of the airline business was masking the investment value of other segments.

One option following that conclusion was to divide the business and monetize each piece separately.
Duchesne remembered that by 1999 the group had identified three businesses that could potentially be
separated from Air Canada, in addition to the regional airline with its separate union agreements: ACTS,
the technical services group that handled major maintenance, repair and refurbishing of the fleet, the air
cargo business, and Aeroplan, the frequent flier program. However, identifying the business units created

*
Canadian radio and TV coverage of historic Air Canada events is archived on the CBC website at
http://archives.cbc.ca/300c.asp?id=1-73-1125.

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a new set of challenges. The new units had been considered cost centers rather than separate lines of
business, and there were no clear boundaries between the new entities and the rest of the airline.
Furthermore, the business units had none of the structures necessary for any type of public offering:
contractual definitions, financial statements, management and support systems.

Moreover, some of the businesses would not be familiar to the market. Several European airlines had
spun out their maintenance operations, including Aer Lingus and Swissair, and there were stand-alone
airfreight companies, but a stand-alone frequent flier program was a novel idea. Taking Aeroplan to
market would require a significant education effort to convey the business model to potential investors.
The process of creating subsidiaries and defining business relationships was expected to take months.

Running into Headwind

Milton’s success in operations led to his appointment as CEO in 1999. Less than three weeks later, Gerry
Schwartz, head of the Toronto-based private equity firm Onex, made a hostile offer for Air Canada as well
as the number-two Canadian carrier Canadian Airlines, with a plan to merge the two. Milton responded
with his own bid for Canadian and a legal challenge against Schwartz. The three-month battle was
followed closely in the press and in the government. Federal Transport Minister David Collenette defined
conditions for any resulting merger, noting, “The market alone will not decide what is in the best interest
of Canadians.” There were charges of political favoritism. 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.15

In the end, the courts decided in Air Canada’s favor, leading to the withdrawal of the Onex bid and
freeing Milton to pursue Canadian Airlines. When the takeover of Canadian Airlines was completed in
2000, Milton found himself in charge of the 10th largest airline in the world, with over C$10 billion in
revenues and some 45,000 employees (including regional carrier employees).16 The combined airline
controlled 80 percent of the air travel in Canada. The two airlines had duplicate routes and staffing that
had to be resolved, and voluntary buyouts and layoffs were planned, under regulatory restrictions.
Furthermore, the takeover required Air Canada and Canadian Airlines to merge systems for everything
from baggage handling to reservations to maintenance to accounting, leading to flight delays and lost
luggage. The thorny issue of merging the two company’s union seniority lists was also creating angst
among the labor groups.17

Although progress had slowed in the sturm und drang of the outside takeover bid and merger
implementation, the new restructuring model had not been forgotten. Milton remained optimistic. Air
Canada added a dozen new destinations, bought or leased 32 new aircraft, and announced plans for 100
more in the next five to seven years. In November 2000, Milton was quoted in the press as saying, “This
airline is growing in leaps and bounds. The world has been unlocked.”18

Major Turbulence

In spite of Milton’s optimism, Air Canada’s financial troubles continued into the new millennium. The
dot-com collapse and the end of Y2K-related consulting slashed demand for Air Canada’s profitable
business travel. (Milton joked that Air Canada had almost been a worldwide charter airline for Canadian-
based, high-tech company Nortel.) The September 11, 2001 terrorist attacks on New York and
Washington further reduced passengers and in Milton’s words, “destabilized the industry.” After 9/11, Air
Canada cut 5,000 jobs, reduced its schedule, and asked the government for C$4 billion in aid for the
Canadian airline industry. However, the Canadian government paid the entire industry only C$160
million, with two-thirds going to Air Canada. (This was in sharp contrast to the U.S. government that
provided US$5 billion in immediate assistance and US$10 billion in loan guarantees to U.S. airlines.19)
The run-up to the Iraq war brought further reductions in passengers and increased fuel costs.

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Air Canada was also facing increase competition from low-cost airlines, which it decided to combat head
on. In early 2001, Air Canada launched Tango, its low-cost brand. In January 2002 it relaunched Air
Canada Regional as Air Canada Jazz, and began Zip, a low-cost carrier serving western Canada.

In the months following 9/11, the drop in passengers and revenues challenged Air Canada’s liquidity.
Moreover, revenues available from one traditional source of capital for airlines, the sale and leaseback of
the fleet, was limited by the plummeting value of aircraft, dropping as all airlines were cutting back
simultaneously. In this period Air Canada sold and leased back 75 percent of its fleet, 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 2003.20

The final blow to Air Canada’s financial stability was the SARS scare in early 2003. SARS, a new, fatal
respiratory disease, was first seen in the Far East and then contracted by health workers in Toronto.
Travel plummeted to Toronto and then to all of Canada as well as the Far East, one of Air Canada’s most
lucrative markets. Many of Air Canada’s planes were flying with virtually no paying passengers.

On April 1, 2003, Air Canada filed for CCAA protection, the Canadian equivalent of U.S. Chapter 11
bankruptcy. The airline would keep flying, but issues would be handled by the bankruptcy judge and
ultimately approved by creditors.

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, and by the time of the bankruptcy filing it could include the new structure into its planning.
Indeed, 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. However, Onex withdrew its offer early in the
CCAA process.

For Air Canada, CCAA protection allowed the company to shed costs and become more like a low-cost
airline. As Milton put it,

The low-cost carriers, Southwest, then JetBlue and AirTran, had new employees, new aircraft, no
debt, essentially a blank piece of paper. They were able to focus on growing an airline, not labor
issues. The legacy guys were all worrying about labor issues and couldn’t look out the front
window, because they were constantly bogged down by the labor stuff. With all these things, plus
the turbulence in the 9/11 aftermath, you had to have cataclysmic change, and it only became
possible because of the restructuring.

Restructuring Employee Relations

In its filing for CCAA protection, Air Canada argued, “Air Canada will not survive unless its labour
productivity and costs are brought in line primarily with domestic competitors. While a balance sheet
restructuring is required, no amount of balance sheet restructuring alone will make Air Canada a viable
airline given its current labour cost structure.”21

The impacts of SARS and the bankruptcy filing seemed to change the unions’ perceptions of the airline’s
problems, strengthening the likelihood of success in reaching new labor agreements. As Milton observed,
“Airline employees, many of whom had been flying virtually empty flights, had come to understand that
the problems were not simply Milton’s overreaction or a plot to reduce their salaries, but a reality.” Under
the bankruptcy, the unions negotiated settlements giving the airline some flexibility in work rules and
salary reductions. In addition, the new union contracts would remain in place until 2009, with one wage

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review set for in 2006, which did not allow the possibility of a strike. The stability for employees and
management would allow the company breathing space.

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. The company took steps to
create a slimmed down fleet with fewer aircraft types and an increasing reliance on cost-efficient, smaller
aircraft.22 As Brian Dunne, Executive VP and CFO of ACE, noted,

Even with an extremely aggressive management, the company could not have made money with its
existing fleet. Fleet drives fuel and maintenance costs, on-the-ground costs, and crewing costs.
Capital costs are extremely high. Even an aircraft operating lease is for five to seven years and the
commitment is very, very high. Bad things can happen if you don’t keep your finger on the pulse in
relation to fleet matters.

Management split the company’s existing aircraft between Jazz and Air Canada. Jazz got the Canadian-
made Bombardier jets and turbo-props. Management looked to make Air Canada’s fleet consistent by
ordering 18 777s (triple sevens, in industry lingo) and 14 787s as they became available from Boeing, to
replace Air Canada’s Boeing 767 and Airbus widebody fleet. Later, management increased its future
delivery orders with Boeing. These acquisitions would lead to higher capital expenditures in the future,
but would allow lower fuel and operating costs. 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.

In the first quarter following the restructuring, Air Canada added C$129 million of property and
equipment, of which C$86 million were progress payments on regional aircraft. It ended 2004 with assets
of C$9 billion and just over C$4 billion in net debt. Net debt prior to restructuring had been C$12 billion.
(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. Jack McLean
explained, “All major capital project decisions have the benefit of a discounted cash flow analysis using Air
Canada’s cost of capital. Although not all decisions are made strictly on the basis of discounted cash flows,
however, we certainly do a DCF for every project.” Management made roughly the following assumptions
concerning the cost of capital (COC): a cost of debt of 7.32 percent before tax (4.89 after tax, with a tax
rate of 33 percent), a cost of equity of 12.12 percent, and a debt/equity ratio of 74/26. Based on these
assumptions, the Air Canada COC would be 8.6 percent before-tax, or 6.8 percent after-tax. Air Canada
often used a slightly higher hurdle rate in their DCF analyses of 10 percent, just to set the bar a little
higher.

In addition to streamlining its fleet, the bankruptcy period gave Air Canada the opportunity to restructure
its balance sheet. To emerge from the bankruptcy period, the company raised C$1.6 billion, including a
C$540 million exit facility and loan from GE, a C$850 million equity rights offering back-stopped by
Deutsche Bank, and a C$250 million convertible preferred share subscription from Cerberus, a U.S.
private equity firm, in an agreement that gave Cerberus three seats on the ACE board.

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. Milton noted, “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, it had been transformed into a holding

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company, ACE Aviation Holdings, Inc., that held 10 stand-alone sister companies, one of which was Air
Canada. (See Exhibit 4 for the new subsidiaries under the ACE structure.)

With the subsidiaries defined, Milton and his strategy team focused on improving each subsidiary to
maximize the value of the holding company. The team worked closely and quickly with the newly
constituted board and conferred with the management of the new subsidiaries. Brewer remembered,
“Since we all knew what we wanted to do and needed to do, we only had to meet as the whole group once
or twice in the whole period. We worked fast.”

The team had to decide in which order to carve out the subsidiaries and how much of each to make
available to outside investors. It also had to determine market timing to maximize shareholder value over
the long term. Each step needed to be a success, to further enhance the value of those that followed.
Moreover, the cyclical nature of the airline sector meant that missing a positive moment in the market
could exact a financial penalty. Sydney Isaacs described the approach as “opportunistic, 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. As Isaacs noted, the company was rebuilding its credibility and creating a track record.

As the team evaluated the subsidiaries, it had to keep in mind that the newly formed companies had
varying degrees of experience with independence; in the language of annual reports, ACE’s subsidiaries
were “at varying stages of their corporate development.”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. 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. (See Exhibit 5 for a summary of ACE’s equity market entries before its decision on Air
Canada.)

First to Fly: The ACE Financing re- IPO

On its emergence from CCAA, ACE had issued 100 million shares at C$20 per share, provided to
Cerberus and to debt holders in resolving the bankruptcy. These began trading in October of 2004. ACE’s
share price climbed steadily, and management recognized an opportunity to raise more equity, thereby
strengthening ACE’s financial foundation before testing its desire to monetize other parts of the business.
Before carving out any subsidiaries, ACE would enter the equity markets for itself. The price in the new
share offering was set at C$37.00 per share, yielding gross proceeds of approximately C$462 million
(C$442 million, net of fees). In the same period, ACE also issued convertible senior notes, with net
proceeds of C$319 million.

ACE used C$557 million of the offerings’ proceeds to repay its high interest loans with General Electric
Canadian Capital. The rest of proceeds were used to purchase planes for Jazz and Air Canada and
modernize systems. In additional to the direct financial benefits, the equity offering gave ACE a chance to
test the waters. The successful takeoff gave the financial community a better picture of the reconstituted
company and its business model.

Second in Line: the Aeroplan Carve-Out

On June 28, 2005, ACE made its first carve-out. It sold 14 percent of its subsidiary, Aeroplan – the loyalty
rewards program. This was unprecedented; no airline had ever spun off a loyalty program. Rupert
Duchesne, Aeroplan’s CEO, explained Aeroplan’s business model:

If you fly today or you spend $100 on your CIBC Aerogold Visa, you get 100 Aeroplan miles. The
airline or credit card company buys those 100 miles from Aeroplan on day 1. Thirty days later, we
receive the cash for 100 miles – approximately $1.25 if you assume our average yield. We put that
dollar and a quarter into our pockets, and we deposit the 100 miles in your account. Then,
typically 30 months later, which is how long an average mile lasts, you come to redeem it. Let’s

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 say you decide to fly to Vancouver and buy an MP3 player. You spend 25,000 miles on your flight,
and 12,000 miles on the MP3 player to listen to on the trip. On that day, 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.

The cash cycle is straightforward. At the end of that period, notionally from a cash point of view,
if we sold 100 miles for $1.25, we know that statistically 17 percent of the miles are never used. In
round numbers say 20 cents fall straight to the bottom line. We also bought the seat for cheaper
than we sold the miles, so we make another bit of margin on that. So at the end of the day, we
have three sources of profitability: First, 17 percent of miles are never used. Second is the
difference between the cost of goods sold vs. the sales price of miles. Third is the fact that we’ve
been sitting on your cash for 30 months – the float.

ACE decided to start with Aeroplan for several reasons. First, Aeroplan received roughly 70 percent of its
revenues from parties other than Air Canada, primarily from bank credit cards. This was the highest ratio
of third-party revenues among the ACE subsidiaries. Second, management and market analysts felt that
Aeroplan was worth the most of all the four major subsidiaries – perhaps C$2 billion, greater than the
value of the airline itself. Also, Aeroplan was the most stable of all the businesses. It generated revenue
from credit card providers and other parties outside the cyclicality in the airline industry. While the
loyalty program had had a poor reputation for the way it treated Air Canada customers, almost all the
service issues were now fixed, and employees were generally customer-oriented and responsive. Finally, it
was profitable; the bankruptcy judge had required Air Canada to renegotiate its contract with the issuing
bank for the credit cards, which had resulted in more revenue for Aeroplan.

ACE elected to use an income trust to carve out Aeroplan, as opposed to offering common equity stock.
Income trusts, a popular Canadian organizational structure, were comparable to high-dividend-paying
common stocks. At the time of the offering, income trusts held special tax advantages that typically
yielded higher after-tax returns than their dividend-paying counterparts. Firms opting for the income
trust structure had to have stable income streams, since missing or reducing periodic distributions
typically led to a substantial decrease in the income trust’s unit price. ACE felt that Aeroplan’s expected
earnings and cash flows could be predictable enough to support an income trust, and the market premium
in Canada for this structure made it an attractive option. (See Exhibit 6 for additional information on
income trusts.)

For the IPO, ACE and Aeroplan conducted 150 to 160 analyst and investor presentations. (See Exhibit 7
for a summary graphic from the presentation.) The presentations were important not only to explain
Aeroplan’s business model but also to walk analysts through Aeroplan’s complicated accounting.
According to the strictures of GAAP accounting, revenue cannot be recognized until service is delivered.
This had an interesting effect on Aeroplan’s financial statements. On average, point redemption occurred
30 months after point accumulation, so Aeroplan’s income statement reflected revenues and profits from
30 months previous. These matching issues also produced other financial statement oddities, such as a
current ratio for Aeroplan less than 1 (typically, a sign of poor fiscal health), even though the company
was flush with cash.

As they explained Aeroplan’s business model, ACE executives were hoping that the presentations would
help clarify the ACE structure as well. ACE executives were concerned that the market appeared to have
difficulty disentangling the economics of ACE’s structure. Robert Milton explained, “Look at the four
subsidiaries: Air Canada, Jazz, ACTS, and Aeroplan, and you have four sets of cash flows. Add them
together and you have one cash flow. And that cash flow is worth some multiple in the market. The
problem is, the market looks at it all as an airline cash flow, and assigns an airline multiple.” With the
Aeroplan offering, 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). At the IPO, the
market gave Aeroplan a C$2 billion market capitalization.

9 air canada
The carve-out also shifted Aeroplan’s corporate mindset. Management focused on both the cost of an
Aeroplan point and its value to consumers. Furthermore, Aeroplan reduced its identification with Air
Canada, removing the familiar red maple leaf roundel, which made the program more appealing to new
partners. Therefore, the company was able to add gasoline companies, telephone services, and retail stores
to its list of point providers. Points could be redeemed for flights, hotels, and merchandise.

A novel contracting arrangement between Aeroplan and the airline, first entered into in 2004 and then
expanded further in 2006, led to gains for both parties. As before, Aeroplan contracted for 8 percent of all
seats on Air Canada flights. Even though Aeroplan’s standard percentage of reserved seats was higher
than for most U.S. airline frequent flier plans, it could still be difficult for customers to find seats on the
flights they wanted. Aeroplan and Air Canada, now negotiating at arm’s length, developed a new
supplemental points system, in which Aeroplan members could have access to any unsold seat on any
flight, as long as they were willing to pay additional points equivalent to the market price of that seat.
Consequently, 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 arrangement made Aeroplan customers happy by increasing the utility of the points,
and Aeroplan management benefited from the margins on the points used and the ability to recognize the
revenue at a faster pace. Everyone agreed that this novel contracting would not have been developed had
Aeroplan continued as an airline cost center.

In March 2006, ACE made a second move with Aeroplan, reducing its holdings to 75.3 percent by
distributing approximately 10 percent of its Aeroplan Income Fund shares to ACE shareholders, with a
market value of C$251 million. (Due to regulatory restrictions, only Canadian shareholders received stock;
U.S. shareholders received cash.) Aeroplan’s stock had done well; the company had attained a higher
market capitalization than Continental Airlines. And since ACE as a Canadian corporation retained a
majority of Aeroplan stock, Aeroplan continued to meet the regulatory requirement for majority Canadian
ownership.

Next Up: Jazz

Air Canada Jazz had been created in 2001 as Air Canada Regional Inc., merging four regional airline
brands into a feeder airline for Air Canada, with the name change to Air Canada Jazz in 2002 reflecting the
completion of the merger. As a regional carrier with smaller planes and shorter routes, Jazz had lower
employee costs than legacy airlines. It had maintained separate books since its creation, so there were no
challenges in separating revenues and costs from other ACE subsidiaries.

ACE’s management team realized that ACE could offer Jazz as an income trust, the same market structure
used for Aeroplan, since Jazz’s cash flow streams were surprisingly stable for an airline. Milton observed,
“The volatility had been taken out of the company.” The long-term contract between Jazz and Air Canada,
negotiated during the bankruptcy restructuring, had reduced Jazz’s revenue fluctuations by guaranteeing
Jazz seat revenue. It reduced Jazz’s expense fluctuations by treating Jazz fuel costs as a pass-through to Air
Canada. In addition, in late 2005 and early 2006 Canadian investors were still paying a premium for
income trusts, so the timing was good.

The February 2, 2006, Jazz offering was a success. The company sold 23.5 million units at a price of C$10
per unit. The estimated net proceeds were C$218 million, with additional proceeds from an over-
allotment option bringing the aggregate net proceeds up to C$232 million. In total, ACE retained 79.7
percent of Jazz.24

Should ACTS Be Next to Taxi to the Runway?

Although ACTS, the maintenance group, had been discussed as a potential carve-out since before the
bankruptcy, ACE had decided to delay it, and in mid-2006 ACTS remained in the holding company.

10 air canada
ACTS (Air Canada Technical Services) handled overhauls and major repairs; overnight fleet maintenance
had remained within the airline. ACTS had a good technical reputation for safety and operations. It had
developed contracts with Air Canada and was actively seeking to increase its third-party customer base,
taking advantage of moves by U.S. carriers to outsource maintenance repair and overhaul work.25
However, developing experience on the business side was taking time. Brian Dunne, looking back at the
Air Canada-ACTS division and similar reorganizations during his tenure at Aer Lingus, noted the
challenges faced by a maintenance group in transition to a separate company:

Maintenance is a division of the airline, so it’s driven by technical excellence, keeping the aircraft
flying, but doesn’t focus too much on costs. These businesses typically have management who
have successfully worked their way up from the floor, and have a technical excellence mindset.
These businesses have little financial capability and the financial information available to
managers is very, very limited. In a lot of cases, you bring in commercial people and they go out
and find themselves bidding on third-party contracts, without a lot of information on what their
costs are or what they need, whether they are making money or not. The necessary systems are
not yet in place, you don’t have sufficient financial people around, the commercial people may not
have the right cost information to handle the job properly, and the contract with the main airline
itself isn’t papered [clearly defined in a written document]. When you carve it out, you have a lot
of tension and emotion as they try to act separately.”

In early 2006, Milton and his ACE strategists realized that ACTS was not ready for an IPO. The story of
ACTS as a separate company in the maintenance-repair-and-overhaul sector was not well developed, and
there were information gaps. On the accounting side, the company had not yet developed the three years
of financial data that stock analysts desired. On the management side, ACE had brought in a new
executive team for ACTS to enhance its commercial, financial, and business sense, but the new group had
not established a track record. Therefore, ACE had two options: they could try a quick private sale of
ACTS, while the sector was still hot, or they could wait until 2008 or 2009, when they would have more
information for the financial markets.

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, but there were potential challenges.26 (See Exhibit 8 for financial data for ACE
and its major subsidiaries.) One of the direct benefits of the carve-outs was the access to additional capital.
Through its various offerings, ACE had already raised C$1.27 billion in equity markets. (In addition, in
2006, ACE also disposed of its 4.5 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.) Robert
Milton explained, “Our projected capital expenditures for the next two years alone total about C$3.4
billion. Most of this investment will go into acquiring new aircraft, giving us a vastly superior product to
most major North American airlines.”

Spinning off subsidiaries also had an important impact on transfer pricing between subsidiaries, making
the costs incurred obvious to both sides. Montie Brewer said, “Things that were once free now have
become an expense. Of course, there was always an expense, but it was invisible. We used to give miles
away for free to placate unhappy customers, because the costs weren’t recorded as expenses for a long
time thereafter. We are out of that game now.” So, for example, instead of automatically offering a large
number of points to customers who experienced major delays on the runway, Air Canada offered vouchers
toward the price of purchasing a seat on future flights.

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. It remained to be seen what impact these
partitions would have on various ACE stakeholder negotiations in the future.

11 air canada
A potential concern regarding the carve-outs was its effect on employee morale. Specifically, many
employees joined the company because they wanted to be part of an airline, a national company with a
long history, and identified with Air Canada and its maple leaf logo. In negotiations under the bankruptcy
proceeding, Aeroplan and ACTS employees had bargained to retain the pension plans and other benefits
that they had enjoyed as Air Canada employees, but it was proving hard for them to “give up the leaf.”
Brewer explained, “Jazz has always been separate and they haven’t had too many issues. But for others,
the transition may be hard. 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. I think emotionally it may take time to take ownership and pride in
the new company.” Others, like those at Aeroplan, liked the career stability of not being at an airline and
also liked being part of they considered a “winning” story.

Another concern of all the newly formed independent subsidiaries was the need to monitor each other,
creating additional overhead. For example, ACTS and Air Canada had to develop an arms length
relationship. In the past the maintenance group would take on “everything that needed doing” when a
plane came in for major overhaul, without consultation with other parts of the company. As Montie
Brewer described it, work orders had been decorated with new tasks “like stringing lights on a Christmas
tree.” Now, however, both sides had to learn a new process of proposals, approvals, and revised invoices.

ACE had unlocked value for its shareholders by spinning off its subsidiaries. (See Exhibit 9 for total
return to ACE shareholders.) But the perceived holding company discount remained, and it was
significant enough to keep Air Canada’s potential spin-off in the forefront of ACE’s strategic thinking.

Was It Time for ACE to Launch Air Canada?

In mid-2006, ACE still held complete ownership of the ground handling services (airport passenger and
aircraft services), Air Canada Cargo, and Air Canada Vacations (tour operations) in addition to Air
Canada and ACTS. As Milton saw it, the options were spending another year or two to spin out the
smaller pieces to eke out more value, or carving out Air Canada immediately, possibly folding in the
smaller units.

Looking back, Duchesne saw the spin-off of Air Canada as “the real fork in the road.… The key strategic
decision to me was not spinning off Aeroplan, because you’d be crazy not to once you had thought
through the business fundamentals. The really interesting decision point is, do you or do you not spin off
the airline, and if you do, what’s the eventual consequence of that.”

Brian Dunne remembered that time as a period of great internal debate. “We had over seven or eight
updates and strategy discussions with the board. We were not moving away from fundamental goals, but
moving toward real and action-oriented results. 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.”

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, it was clear
that an income trust would be inappropriate for Air Canada. Moreover, government discussions of
possible tax code changes had dampened the Canadian market’s enthusiasm for the trusts. The options
facing ACE, if it decided to carve out a portion of the airline, were a common stock IPO or a search for
private investors.

One major impact of a sale of Air Canada stock was obvious – it would be a source of capital for the
company. But it was not at all clear what the value of a stand-alone Air Canada stock in the market would
be. Along with the rest of the sector, Air Canada had continued to face challenges. As one example, Brewer
pointed out in an April 2006 video message to employees that fuel increases in 2005 had added C$500

12 air canada
million to the expense side, eating up a quarter of the C$2 billion savings that Air Canada had achieved in
its painful operational restructuring during the bankruptcy.

Since May 2005, ACE had raised C$1.27 billion in equity markets through the monetization of its
subsidiaries, including C$497 million through Aeroplan and Jazz trust issues. It had retained 75.3 percent
of Aeroplan and 79.7 percent of Jazz, which by 2006 had an estimated market capitalization of around
C$2.0 billion. The market value of the retained shares of these two subsidiaries was close to the entire
market capitalization of ACE.27 (See Exhibit 10 for ACE’s sum-of-the-parts evaluation and stock values for
ACE, Aeroplan, and Jazz, and a summary of ACE holdings.) As Brian Dunne noted, “Calculation of value
of ACE, less the imputed value of subsidiaries, led to a less-than-zero number.” In other words, if you
added up the sum of the parts, the airline was valued for nothing, or as Milton described it, “Buy ACE,
and get an airline for free.” Milton shared his frustration in the 2005 Annual Report:

Going forward, one of our major objectives is seeing our other assets, including Air Canada, the
world’s 14th largest airline, fully reflected in the share price. For the risk shareholders have taken,
for the capital they provided that is helping support fleet renewal, network expansion, strategic
28
investments and organic growth, shareholders should share in ACE’s success.

Spinning off Air Canada should, at least in theory, require the market to place some value on the airline
and therefore increase the value of the holding company. Brian Dunne observed, “The question we were
asking then was, ‘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.”

Unlike many holding companies that had amalgamated unrelated businesses, ACE had started with one
company and teased out related entities. This history, along with the public visibility of Air Canada, at
times made the distinction between ACE and Air Canada difficult to convey. As Brewer said, “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.” Spinning off this major part of the company would clarify the
relationship. As Brewer pointed out, the airline would get its own market identity and its own credit
rating.

But separating Air Canada from ACE was not without its challenges. Dunne noted that a carve-out would
be time consuming and expensive. Adding another public company to the market would introduce a
greater degree of complexity. Most importantly, the process had many uncertainties. “We could not be
sure how the market would react to the Air Canada story.”

Analysts seemed divided on the wisdom of a carve-out as well. Some questioned whether Air Canada
could even be divested, given that the airline was ACE’s core operation and the business on which all of
ACE’s other subsidiaries were dependent. One analyst said, “It’s a great thing to muse about and it’s a
great way to get your stock up, but I’m not really sure how realistic this is.”29 Another observer questioned
whether there would be demand for a “pure-play Air Canada stock,” noting, “Despite its extensive
restructuring, Air Canada is still saddled with a higher cost structure than its main competitor, WestJet
Airlines Ltd., and is seeing its margins squeezed by record high fuel prices.”30

If a portion of the airline were spun off, investors would be able to buy stock in the holding company and
in almost all its holdings. This might create arbitrage opportunities. Brewer pointed out that hedge funds
or other investors could play games with different pieces. That could have already been true to some
degree before any Air Canada carve-out, but it would be even easier if the carve-out took place.

If ACE Decided to Launch Air Canada, When Should It Schedule the Takeoff?

Even if ACE were to decide to carve out Air Canada, it faced a question of timing. The fate of the
maintenance group was not finalized, and a number of smaller sister subsidiaries were still under ACE.

13 air canada
There could be additional value when issues from the maintenance division were resolved and when ACE
would monetize air cargo and other smaller divisions. If an Air Canada carve-out was the right choice,
should ACE wait until those sales were complete before spinning off Air Canada? If not, 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. Summer results were always
better than winter, and the financials would look their best after second quarter reports. Missing that
window in 2006 might require a delay until a similar period the following year.

A final argument for moving quickly was the positive mood of the Canadian market in mid 2006 – the
IPO market in Canada was hot. As Dunne observed, “The biggest factor saying ‘act more quickly’ was
how fast the market could change. If it looked good, we should do it.”

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. 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. Unions would be able to consider only Air
Canada’s revenue and profits when negotiating new contracts. In November 2005, two of Air Canada’s
major unions, flight attendants and ground crews, filed to oppose ACE’s announcement of future
distributions to shareholders of approximately C$300 million. The unions’ filing stated that ACE had
significantly underestimated its future finances during negotiations when the company was under
bankruptcy protection, and the distribution to shareholders was “oppressive, premature and imprudent,”
while Air Canada’s employee pension plan was not fully funded.31 The effort did not succeed, but the
unions had not given up.

A separation of Air Canada from other ACE subsidiaries would make similar arguments even more
difficult. As Brewer stated,

When we were all part of the mother ship, employees could look to the profits of other business
segments, and now they can’t. When pilots complain about Aeroplan’s profits, I say, American
Express buys a lot of tickets from us. Why aren’t you asking for their profits? We try to get our
share of the profits from everybody and so does everybody else. So now, Aeroplan has figured out
ways to make money, but it’s their money, not ours.

Although many of the effects of the carve-outs had already reached employees, carving out Air Canada
would be a strong signal of the total separation of the entities. As Brewer noted, “It’s difficult for
employees to get their heads around not being the same company any more.”

Where Should ACE Land?

Spinning off the airline would remove the last major subsidiary from the wholly owned category, other
than ACTS. If the airline was carved out and ACTS moved to private equity, the next question was, what
would happen to ACE. It could dissolve itself, gradually monetizing its remaining stock holdings or
distributing them directly to its shareholders, as it had done with a piece of Aeroplan in 2006. As an
alternative, ACE could take its experience in highlighting an airline’s shareholder value, along with its
industry and restructuring expertise into financial markets, to seek out investment opportunities, like its
US Airways deal.

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. But none had taken the

14 air canada
steps that Air Canada had. Brewer, thinking back on his experience at Air Canada and his prior work at
various U.S. airlines, outlined the challenges:

It is a very difficult industry. Margins are very thin and challenges are great. Noncontrollables are
high in number and great in impact. If you make a medium-sized mistake, you are dead, so no
one wants to try anything, even though they know that what they are doing is not working, or
will not work for the long term. It’s a slow, painful death, but it’s slow. With a big mistake, that
ten-year horizon moves to five, then to three, and then you’re gone. But issues in the industry
were well defined, and we felt that we should be able to figure out how to solve it.

Milton had taken the bold steps. He had succeeded in separating the various divisions of Air Canada into
sister companies under a holding company. 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;

(ii) align management, capital and human resource needs within each individual business;

(iii) facilitate the development of each business segment to its fullest individual potential
including, where appropriate, through the pursuit of third-party sources of business; and

(iv) maximize subsidiaries’ value that was not fully recognized when the business segments were
part of Air Canada.32

With the changes that had already taken place, Milton and other ACE officers were no longer involved in
day-to-day airline management. There were benefits: with his once-removed position, Milton was no
longer a target for unions and the press. (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, the pilots’ union had filed a grievance with the industrial relations board.33)

In realizing his concepts for redefining a legacy airline, Milton, an airline fanatic since childhood, had
gone from optimizing airplane schedules to optimizing the value of the company as a whole. In the
process, he had gone from running an airline to running a financial management firm. 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. Even though Milton could no longer
look out his window to see planes taking off, he believed he had taken the company in the right direction.

I really believe I understand this business…. You are sometimes reduced to playing with the cards
you are dealt. So much of what happens is beyond anybody running an airline’s control. 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. And I don’t care if people like it. And if I wind up blowing up or getting
kicked out the door so be it. But I’m not deviating from what I believe has to happen.

15 air canada
This case was developed with the cooperation of ACE Aviation Holdings, Air Canada, and Aeroplan. It has been developed for
pedagogical purposes and is not intended to furnish primary data, serve as an endorsement of the organization in question, or
illustrate either effective or ineffective management techniques or strategies.

Copyright 2007 © Yale University. All rights reserved. Reprinted with permission of Yale University School of Management. To
order copies of this material or to receive permission to reprint any or all of this document, please contact the Yale SOM Case
Study Research Team, 135 Prospect Street, PO Box 208200, New Haven, CT 06520.

Endnotes

1
Case writer, Case Study Research Team, Yale School of Management.
2
SOM ‘05; Doctoral Candidate, Yale School of Management.
3
Williams Brothers Professor of Accounting and Finance, Yale School of Management.
4
Robert A. Milton, Straight from the Top: The Truth about Air Canada, with John Lawrence Reynolds,
Vancouver/Toronto, Greystone Books, 2004.
5
Ibid.
6
U.S. General Accounting Office, “Airline Deregulation: Changes in Airfares, Service Quality, and Barriers to
Entry,” GAO/RCED-99-92, (Washington, D.C.: Mar. 4, 1999).
7
Dominic Lawson and Grant Ringshaw, “The Sage of Omaha’s Trans-Atlantic Game,” The Age (Australia),
September 24 2002, http://www.theage.com.au/articles/2002/09/ 23/1032734111833.html
8
Michael E. Levine, “Regulation, the Market, and Interest Group Cohesion: Why Airlines Were Not Reregulated,”
New York University School of Law, New York University Law and Economics Working Paper No. 80, 2006.
9
Robert A. Milton, Straight from the Top: The Truth about Air Canada.
10
John F. Burns, “Furor over Air Canada Offering,” New York Times, May 2, 1988.
11
John F. Burns, “Furor over Air Canada Offering.”
12
Funding Universe, “Air Canada,” http://www.fundinguniverse.com/company-histories/Air-Canada-Company-
History.html.
13
Katherine Macklem, “Air Canada Chaos,” Maclean’s Magazine, November 6, 2000.
14
Robert A. Milton, Straight from the Top: The Truth about Air Canada.
15
Kimberley Noble, “Gerry Schwartz, “Maclean’s Magazine, October 11, 1999; Timothy Pritchard, “Deal-Making,
Canadian Style,” New York Times, March 12, 2000; Katherine Macklem, “Air Canada Chaos.”
16
Air Canada Annual Report, 1999; Katherine Macklem, “Air Canada Chaos.”
17
Katherine Macklem, “Air Canada Chaos”; Bernard, Simon, “Air Canada Sets Pay Cuts and Another 4,000
Layoffs, New York Times, August 2, 2001.
18
Katherine Macklem, “Air Canada Chaos.”
19
Notice of Initial Application for Air Canada under the Companies’ Creditors Arrangement Act, Ontario Superior
Court of Justice, April 1, 2003, p. 11.
20
Air Canada Bankruptcy News,” Bankruptcy Creditors’ Service, April 4, 2003.
21
Notice of Initial Application, p. 37.

16 air canada
22
Notice of Initial Application, p. 38.
23
ACE Aviation, 2005 Annual Report, Feb 2006, p 14.
24
ACE Aviation, 2006 Annual Report, p. 14.
25
ACE Aviation, 2005 Annual Report, p. 14.
26
An ACE market presentation is online at http://www.aceaviation.com/ en/investors/documents/ml-ace.pdf.
27
ACE Aviation, 2005 Annual Report, p. 2.
28
ACE Aviation, 2005 Annual Report.
29
Chris Sorensen, “ACE Takes Flight on Spinoff Talk: Investors Cheer Possible Air Canada IPO.”
30
Chris Sorensen, “ACE Takes Flight on Spinoff Talk: Investors Cheer Possible Air Canada IPO.”
31
David Paddon, “Air Canada Union Leaders Oppose Special Cash Distribution to Shareholders,” Canadian Press
NewsWire, October 31, 2005.
32
Air Canada 2004 Annual Report, “New Corporate Structure to Maximize the Value of Subsidiaries.”
33
Rick Westhead, “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,” Toronto Star, p. A.02, Feb 7, 2005.

17 air canada
Exhibit 1 Airline Industry Statistics
A. Number of Domestic Airline Passengers, US and Canada (in millions)

B. Average Domestic Airfare for U.S. and Canada (in 1983 U.S., Canadian dollars)

Source for A and B: Gautam Gowrisankaran, “Competition and Regulation in the Airline Industry,” FRBSF (Federal Reserve
Bank of San Francisco) Economic Letter, Number 2002-01, January 18, 2002, citing data from U.S. Bureau of Transportation
Studies, Canada Aviation Statistics Centre, U.S. Bureau of Transportation Studies, U.S. Bureau of Labor Statistics, Canada, Avia-
tion Statistics Centre, Bank of Canada Review.

18 air canada
Exhibit 1 (continued)

C. Market Share of U.S. Legacy and Low Cost Airlines, 1998 and 2003

1998 2003
8% Other Airlines 2%

23% 33%

Low Cost
Airlines

65%
69%

Legacy Airlines

D. U.S. Airline Profits and Losses, 1998 through 2003 (Billions of 2003 U.S. dollars)

10

8 7.3
6.2
6 4.9 legacy airlines
4 low-cost airlines

2 1.1 1.3 1.2 0.8

0.3 0.2
0
1998 1999 2000 2001 2002 2003
-2

-4 -4.8

-6

-8
-9.7 -9.8
-10

-12

Source for C and D: United States Government Accountability Office, “Commercial Aviation: Legacy Airlines Must Further Re-
duce Costs to Restore Profitability,” GAO-04-836, August 2004.

19 air canada
Exhibit 2 Air Canada Before Restructuring: Organizational Structure and Stock Price

AIR CANADA

Passenger Operations Cargo Operations Airline-Related Businesses

Division Division Division

Passenger Ops (Air Canada, Cargo Operations Air Canada Tech. Serv. (ACTS)
Tango, AC Jetz)

100% Jazz Air, Inc 100% Aeroplan Limited Partnership

100% Zip Air Inc. 100% Touram, Inc.

100% Wingo Leasing, Inc.

Corporate structure and percentage of equity-
controlled directly or indirectly by Air Canada
before implementation of the Plan. 100% Air Canada Capital, Ltd.

100% Destina.ca Inc.

(Canadian Dollars)

16.00

12.00

8.00

4.00

0.00

Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02

Source: ACE Prospectus, June 30, 2004; Toronto Stock Exchange.

20 air canada
Exhibit 3 Air Canada’s Projected Debt Repayment after Emergence from Bankruptcy

C$ in Millions 2005 2006 2007 2008 2009

Long-Term Debt and Capital Lease Obligations
Long-term debt principal obligations 75 33 128 181 160
Capital lease principal obligations 143 144 180 180 87
218 177 308 361 247
Operating Leases
Future minimum lease payments under existing
498 452 441 326 322
operating leases of aircraft
Future minimum lease payments under existing
96 57 48 46 33
leases for other property
594 509 489 372 355
Capital Expenditures
Projected committed aircraft expenditures 1,003 561 718 28 0
Projected aircraft financing (942) (477) (653) (28) 0
Projected committed aircraft expenditures,
61 84 65 0 0
net of aircraft financing

Planned and committed expenditures for aircraft

231 198 145 28 39
engines, inventory, modifications and refurbishments
Other planned and committed property and equipment
189 157 160 134 120
expenditures
Total planned and committed expenditures for aircraft en- 420 355 305 162 159
gines, inventory, modifications and refurbishments

Projected pension funding obligations 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.

Source: ACE Aviation, 2004 Annual Report, Source p. 21.

21 air canada
Exhibit 4 ACE Aviation Subsidiaries, 2004

Air Canada, including Tango (a low-fare airlines) and Jetz (charter services)
Zip (discount division, integrated into mainline operations December 2004)
Jazz (regional airline)
Aeroplan (frequent flier program)
Air Canada Technical Services (major maintenance facilities)
Destina.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, cover and p. 10.

22 air canada
Exhibit 5 ACE Aviation: Funds Sourced by Issuing Equity and Convertible Securities 2004-June 2006 (in Canadian dollars)

Announce- # of shares % of Company Initial Net C$

Offering Offering Date Type of Equity Other Comments
ment Date Offered Offered in Mkt Price equity

Settlement of
ACE reorganization plan Aug 17, 2004 Aug 23, 2004 Common shares 42.3 million NA NA NA
creditor claims
12.5 million
(convertible to To Cerberus for
Convertible $250 million
ACE reorganization plan Aug 17, 2004 Aug 23, 2004 9.3 million investment of $250
preferred shares before fees
common million
shares)
$37.00
ACE Classes A and B Q2 2005 Common shares 12.5 million $442 million
Net $92 million fees
ACE convertible Senior Convertible as equity; financial
Q2 2005 319 million NA NA $92 million
Notes Senior Notes liability $236
million
Creation of Aeroplan Income Trust Offered only in
May 20, 2005 June 2005 15% $267 million
Income Fund Units Canadian markets
Delayed due to
Income Trust
JAZZ Sep 30, 2005 Delayed None None none changes in trust
Units
market tax letters
Nov 28, 2005 Income Trust Before over-
JAZZ Feb 2, 2006 23.5 million 19.1% $10.00 $218 million
Prospectus Units allotment option
Nov 28, 2005 Income Trust Total after over-
JAZZ Feb 2, 2006 27.0 million 20.3% $10.00 $232
Prospectus filed Units allotment option
Reduced ACE
Aeroplan units to ACE Income Trust Distribution to ACE
March 3, 2006 28.75 million holdings to 75.3% $10.00 $251 million
shareholders Units shareholders
of Aeroplan
Sale of ACE holdings in Completed Q2 Gain of $152
US Airways shares Q3 2006 million

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Exhibit 6 Canadian Income Trusts

An income trust is an investment vehicle that holds income-producing assets to provide consistent cash
flows to investors. Its shares or “trust units” trade on exchanges as stocks do. Investors (unitholders) are
beneficiaries of the trust and receive income through quarterly or monthly distributions. Real estate
investment trusts (REITS) and energy trusts are not uncommon, and business trusts became a favored
market structure in Canada after the 2000 dot-com bust. In 2000, only 73 trusts were listed on the
Toronto stock exchange, with a market capitalization of C$21.97 billion. By 2004, the number had grown
to 175 listed trusts, with a market cap of C$118.66 billion. In 2004, C$38.4 billion in equity was raised by
income trusts on the Toronto Stock Exchange.

An income trust provides a more tax efficient transfer of wealth from a firm to its shareholders as
compared to common equity. Under Canadian law before October 2006, firms using the income trust
structure were not taxed at the corporate level. Untaxed proceeds flow through to shareholders, who were
then taxed at their individual marginal tax rates.

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, which attempts to mitigate the effect of
double taxation). However, shareholders could still net higher returns after tax, because the trust’s
income was taxed at the investor’s individual level, not the corporate level. The following table illustrates
the difference in net income, assuming an individual investor with a marginal tax rate of 46.4 percent:

Common
Comparative After-Tax Returns for Income Trusts Income Equity
versus Equities (before October 31, 2006) Trust (100%
payout)***
Earnings before taxes 100 100
Corporate tax (assume 35% of EBT) 0 35
Earnings 100 65
Distributions paid to unitholders 100
Dividend to shareholders - 65
Amount received by individual investor 100 65
Personal tax on distributions (46.4% tax rate*) 46
Personal tax on dividends (31.3% tax rate**) - 20
After-tax return to investor 54 45
Total tax paid 46 55

* Assumes no favorable tax treatment on distributions.

**Takes into account the dividend tax credit.
*** The full payout scenario is for illustrative purposes. Most firms do not pay out all their after-tax earnings.
Source: Scotia Capital

Income trusts are particularly attractive to investors under low interest rates and volatile markets,
providing stable income streams and moderate growth. Historically, income trusts have generated higher
after-tax returns than other investments in similar risk categories. Also, through their brief history they
1
have offered higher ex post returns with less variability than the S&P/TSX composite index.

While an income trust resembles a fixed income product due to its stable stream of income
disbursements, income trusts are equity and as such do not have a fixed maturity date for full principal
repayment. An income trust also faces additional risks related to changes in interest rates, on top of risks
typically faced by other equity products.

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A major influence on the unit prices of most income trusts is the level of interest rates. As the risk-free rate
of interest or yield on government bonds goes up, the corresponding risk-adjusted yields on other
interest-oriented securities generally follow suit, which leads to corresponding reductions in unit prices of
income trusts, all else equal. In general, the reverse is also true, with lower overall interest rates leading to
higher unit prices. The more stable the income trust’s income stream, the more the market treats the
2
income trust like a bond, and the more sensitive its unit value is to interest rates changes.

Government Concern and Response: Increased Tax Deferment

The increasing use of income trusts after 2000 painted the Canadian government into a tricky legislative
situation. Picture the following scenario: an income trust, which pays no corporate tax, disburses income
to a unitholder, who in turn holds the investment on a tax-deferred basis, for example, within a pension
plan or a Registered Retirement Savings Plan (a personal pension plan held directly in an individual’s
name, the Canadian version of an Individual Retirement Account). The distribution grows tax-deferred
until the pensioner retires and withdraws the funds. For young pension plan or RRSP participants, their
tax payments may be deferred for 40 years. Thus, the combination of tax-sheltered investment vehicles
and income trusts could deprive the government of tax dollars for an extended period. This was deemed a
potentially serious problem by the government, 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.

After several of Canada’s biggest companies announced their intent to switch from corporations to income
3
trusts, the Canadian government responded. The Canadian Revenue Agency announced on September
13, 2005, that given future legislative uncertainty it would no longer give advance tax rulings to help
companies become trusts. Within a week, investors slashed C$9 billion in market capitalization from
4
trusts, and new IPOs of trusts were reduced or delayed. The status of income trusts became a matter of
increasing discussion in financial and governmental circles and an issue in national elections.

The government announced the Tax Fairness Plan on October 31, 2006. The change was designed to
mitigate the economic distortion that could shift future tax burdens from corporations, trusts, and
business entities onto individuals. The Plan added a distribution tax on distributions of income paid from
publicly traded income trusts and limited partnerships. With this change, after-tax returns to Canadian
taxable investors were nearly identical under a high dividend-paying corporation and a distribution-
paying trust. On the day of the announcement, nearly all income trusts saw a second significant
devaluation of their unit prices.

1
ScotiaMcLeod.
2
Scotia Capital.
3
Telus Corp. and BCE, two of Canada’s biggest telecom operators, converted to income trusts in September and
October 2006, respectively. 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.
4
Derek Decloet, Steven Chase, and Sinclair Stewart, “All Eyes on Ottowa’s Next Move,” Globe and Mail, Oct 11,
2005, p. B6. http://www.globeinvestor.com/servlet/ArticleNews/trusts/GAM/20051011/RTRUSTMAIN11.

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Exhibit 7 Aeroplan’s Business Model and Organization Structure
Aeroplan Business Model

Source: ACE Presentations

Aeroplan's Organization Structure

Source: Aeroplan 2005 Annual Report

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Exhibit 8 Financial Data for ACE and Its Subsidiary Aeroplan
A. ACE Consolidated Statement of Operations

(millions of Canadian dollars, except per share figures) 2005

Operating revenues
Passenger 8,269
Cargo 620
Other 941
9,830
Operating expenses
Salaries, wages, and benefits 2,520
Aircraft fuel 2,198
Aircraft rent 417
Airport and navigation fees 924
Aircraft maintenance, materials and supplies 367
Communications and information technology 303
Food, beverages and supplies 334
Depreciation, amortization and obsolescence 482
Commissions 253
Other 1,580
9,378
Operating income (loss) before reorganization and
restructuring items 452

Reorganization and restructuring items -

Non-operating income (expense)

Aeroplan dilution gain 190
Interest income 66
Interest expense (315)
Interest capitalized 14
Loss on sale of and provisions on assets (28)
Other (12)
(85)

Income (loss) before the following items: 367

Non-controlling interest (24)

Foreign exchange gain 46
Recovery of (provision for) income taxes (131)
Income (loss) for the period 258

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EXHIBIT 8 (CONTINUED)

B. ACE 2005 Consolidated Statement of Financial Positions

December 31,
(millions of Canadian dollars) 2005
ASSETS
Current
Cash and cash equivalents 1,565
Short-term investments 616
2,181
Restricted cash 86
Accounts receivable 637
Spare parts, materials and supplies 325
Prepaid expenses and other current assets 125
3,354

Property and equipment 5,494

Deferred charges 145
Intangible assets 2,462
Investments and other assets 392

11,847
LIABILITIES

Current
Accounts payable and accrued liabilities 1,355
Advance ticket sales 711
Aeroplan deferred revenues 680
Current portion of long-term debt and capital lease obligations (note 7) 265
3,011
Long term debt and capital lease obligations 3,543
Convertible preferred shares 148
Future income taxes 221
Pension and other benefit liabilities 2,154
Non-controlling interest 203
Other long-term liabilities 1,399
10,679
Commitments Contingencies and Guarantees
SHAREHOLDERS’ EQUITY
Share capital and other equity 747

Contributed surplus 6

Retained earnings 415

1,168

11,847

Accompanying notes deleted.

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EXHIBIT 8 (CONTINUED)

C. ACE 2005 Segment-Based Income Statement

in millions of Canadian Dollars Twelve months ended December 31, 2005

Inter-
Transportation Segment ACE
(C$ millions) Services Aeroplan Jazz ACTS Elimination Consolidated
Passenger revenue 8,269 - - - - 8,269
Cargo revenue 620 - - - - 620
Other revenue 117 627 10 187 - 941
External revenue 9,006 627 10 187 - 9,830
Inter-segment revenue 194 13 1,013 567 (1,787) -
Total revenue 9,200 640 1,023 754 (1,787) 9,830

Aircraft rent 343 - 80 - (6) 417

Amortization of capital assets 424 8 18 32 - 482
Other operating expenses 8,259 530 796 675 (1,781) 8,479
Total operating expenses 9,026 538 894 707 (1,787) 9,378

Operating income 174 102 129 47 - 452

Total non-operating income (ex-

pense), non-controlling interest,
foreign exchange and income
taxes (167) (2) (11) (14) - (194)
Segment Results 7 100 118 33 - 258

Total assets 11,001 674 504 381 (713) 11,847

Additions to capital assets 849 12 16 5 - 882
Operating margin % 1.9 15.9 12.6 6.2 - 4.6
EBITDAR (1) 941 110 227 79 (6) 1,351
Accompanying notes deleted.

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EXHIBIT 8 (CONTINUED)

D. 2005 Aeroplan Income Statement

thousands of Canadian dollars, except unit and per unit amounts 2005

OPERATING REVENUE
Aeroplan Miles revenue 582,883
Tier Management, call centre management,
marketing fees from Air Canada 12,666
Other Revenues 44,352
639,901
Cost of rewards 397,042
Gross margin 242,859
Operating expenses
Selling, general and administrative expenses 132,459
Depreciation and amortization 8,491
140,950
Operating income 101,909
Interest on long-term debt (6,315)
Interest income, net 5,649
Amortization of deferred financing charges (939)
Net earnings for the year 100,304

Weighted average number of units 187,739,727

Earnings per unit
Basic 0.5343

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EXHIBIT 8 (CONTINUED)

E. 2005 Aeroplan Balance Sheet

December 31,
thousands of Canadian dollars, except unit and per unit amounts 2005

ASSETS

Cash and cash equivalents $ 365,874

Short term investments, interest at 3.45% 98,977
Accounts receivable 76,541
Prepaid expenses & other 2,300
Total current assets 543,692

Deferred charges 6,399

Capital assets 1,834
Software 35,671
Goodwill 86,625

Total assets $ 674,221

LIABILITIES AND PARTNERS’ DEFICIENCY

Accounts payable and accrued liabilities $ 32,645

Deferred revenue 679,714
Distributed payable 16,434
Total current liabilities 728.793

Long-term debt 300,000

Deferred revenue 644,183
1,672,976
Partners’ deficiency (998,755)

Total liabilities $ 674,221

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Exhibit 9 ACE Total Return Analysis (2)

40.00

Total = $33.80
0.04 Cash Distribution
2.47
Aeroplan Distribution
30.00

Total = $20
20.00

31.29 ACE Share Price

10.00 20.00

0.00
Sep 30, 2004 Jun 30, 2006

Total Return analysis assumes ACE Shareholders retained 0.18 Aeroplan units distributed to them Mar 06.
Value of AER units received is based on 0.18 units per ACE share multiplied by Aeroplan closing price of $13.72
Cash distributions received monthly from Aeroplan units distributed to ACE Shareholders

32 air canada
Exhibit 10 ACE Aviation Data, June 2006

ACE Aviation Sum of the Parts Evaluation, June 2006

Equity Value Per ACE

C$ million Share*
Aeroplan 2,115 18.88
Jazz 854 7.62
ACE share of US Airways 165 1.47
Total 3,134 27.97
Current ACE share price 3,618 32.30
Implied equity value of Remainder 484 4.33
(Air Canada, ACTS, Air Canada
Vacations, Cargo and Ground Handling

* 112 million shares; share prices and

exchange rate June 6, 2006

Source: ACE Aviation Presents to Merrill Lynch, June 14, 2006.

http://www.aceaviation.com/en/investors/documents/ml-ace.pdf

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 exhibit 10 (continued)

Stock Prices for ACE and its Subsidiaries through June 2006 (in Canadian Dollars)

45.00

40.00

ACE
35.00

30.00

25.00

20.00

15.00
Aeroplan
10.00
Jazz
5.00

Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06

34 air canada