Tom Konrad CFA
New Flyer is the largest of the five suppliers of heavy duty transit buses in North America. Unlike its competitors, New Flyer is focused solely on transit bus sales, parts, and service. The company has industry leading technology, offering a full range of bus styles and propulsion systems, including diesel, liquid or compressed natural gas, gas and diesel hybrids, electric trolley buses, and hydrogen. They are currently developing a pure electric version.
Transit buses are a cyclical industry which is currently in a downturn. Municipal transit agencies are the main customers, and bus manufactures’ sales move in line with transit agencies’ budgets.
Many transit agencies currently face budget cuts even as high gas prices stimulate demand. That’s because fare box collections typically only cover about a third of the costs of running a transit agency, the rest must come from local, state, and federal transfers.
Both New Flyer and their competitors have shed workers to better match their production capacity with lower demand, but the remaining capacity is still enough to keep the bidding for contracts very competitive.
The New Flyer income deposit security (“IDS”) consists of one common share and a C$5.53 principal 14% subordinated note. The monthly distribution currently consists of a C$0.03298 cash dividend and a C$0.06453 interest payment on the note, for a total monthly distribution of C$0.0975. At the closing share price $7.79 on June 10th, that’s a 15% yield.
Unfortunately, the increasingly competitive environment means the company will probably need to cut payments to IDS holders in the coming months. New Flyer has made significant progress cutting costs and improving operational efficiency, yet an increasing tax rate and lower selling prices have reduced distributable income. Distributable income has been roughly equal to IDS distributions over the last two quarters, while the long term average distribution was only 80% of distributable income. Since the company’s tax rate is set OT increase over the next year, and the competitive environment is unlikely to improve much before then, payouts will almost certainly need to be reduced.
New Flyer’s board is in the process of evaluating a number of strategic options, both to better cope with the cyclical nature of the industry and the unsustainable distributions. On the recent May 13 conference call (MP3) they stated that they expect to announce their new strategic plan “in the next couple of months.” I take that to mean by the end July. Including cutting the dividend, they are looking at acquisitions in adjacent industries with the intent of making their overall business less cyclical. I take this to mean other types of buses, perhaps light duty transit or intercity motor coaches, or the acquisition of a parts and maintenance company. Investor worries surrounding the upcoming decision seem to have driven the recent price drop from the C$11.50-12.00 range to the current price below C$8.
Any acquisition would put more pressure on company resources, so I consider it a certainty that the dividend will be cut. The interest payment, however, cannot be eliminated unless the notes are called. The first opportunity to call the notes will be in 2012, for 105, meaning that note holders would need to be paid C$5.8065 (which would have to be raised through other borrowing or the sale of stock), and IDS holders would still retain their equity interest in the form of a common share.
I can’t predict if the company will call the notes, but the Q1 2011 book value per share was US$2.36 or C$2.32, so the combined book and principal value of an IDS is C$7.85, above the current stock price. For a company that will almost certainly continue to pay the interest on the subordinated note until the notes are called, this seems like a bargain. The interest payment alone amounts to a 10% yield at C$7.79. New Flyer should be able to remain current with these interest payments even if income falls another 30%, which I consider unlikely.
Past and Future Trades
I last took an in-depth look at New Flyer in October 2009, when the stock was trading around $9 because the Chicago Transit Authority had delayed a large order and thrown off production. I expected the company to work though these problems, and advocated buying at that price.
Since then the stock rose as high as C$12 this February. I began reducing my holdings when the price exceeded $11 mainly for rebalancing, which left me with the capacity to purchase more as the stock has fallen since March, making purchases at $10.50, $9, and $8. I will probably make one more purchase if it falls as far as $7. Despite the fact that the current price seems extremely cheap for an income investment, the overall uncertainly and current general market decline might conspire to drive it that low again.
No matter what the structure, New Flyer is an excellent value company at the current price. I like the income security nature of the current structure, and would be happy to hold the New Flyer IDS at current prices even if the dividend is reduced to zero, but I’d also be comfortable if New Flyer converts to a more traditional equity structure. If the current IDS were somehow converted into straight equity trading at the same price (C$7.79), the P/E ratio would be about 8, after taking into account the reduced earnings due to the loss of the interest tax shelter. (This tax shelter arises because interest on the note is treated as an expense for tax purposes, while dividends would not be.)
Although I expect the price to recover only slowly from whatever low it finds, I don’t see any reason to delay my purchases until it is back on the upswing, since the current 15% yield seems an excellent compensation for my investment.
DISCLOSURE: Long NFYIF.
DISCLAIMER: Past performance is not a guarantee or a reliable indicator of future results. This article contains the current opinions of the author and such opinions are subject to change without notice. This article has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.