What to Buy: Student Transportation Inc (TSX: STB, NSDQ: STB)

Why to Buy Now: Student Transportation is pursuing a consolidation strategy in the highly fragmented North American school busing market. This recession-resistant industry has a considerable tailwind, as budget-strapped school districts increasingly look to outsource their transportation services.

Though Student Transportation is still relatively tiny, it’s committed to a substantial monthly payout of CAD0.046, for a current yield of 8.5 percent. And it’s maintained its payout at this level since late 2006.

Shares of Student Transportation’s stock currently trade near CAD6.55, down 5.3 percent from their 52-week high, but up 6.8 percent on a year-to-date basis. The stock has essentially been in a trading range between CAD6 and CAD7 for the past two years, as investors wait to see whether the company’s roll-up strategy translates into long-term growth.

As such, our near- to medium-term expectation is for a relatively stable share price, with the potential for some modest appreciation. In other words, this stock is suitable for investors who are more interested in a high level of current income than heady growth, though the latter may be possible over the long term.

Student Transportation is a buy below USD7. However, it should be noted that this stock’s CAD579 million market capitalization is toward the lower end of the small-cap spectrum, which means trading volume can be fairly light some days. As such, it would be prudent to set a buy limit near the market price to ensure the order fills at a favorable price.

Ari: As the third-largest school bus transportation provider in North America, Student Transportation Inc (TSX: STB, NSDQ: STB) has an intriguing story and an enticing 8.5 percent yield that has attracted substantial support from income-hungry retail investors.

The company is pursuing a consolidation strategy in a highly fragmented industry, with a tailwind from an era of tighter government budgets, where cash-strapped school districts are anxious to save money by outsourcing their transportation services. Student Transportation currently operates in 16 states, plus the Canadian province of Ontario. As a result, the vast majority of its revenue is derived from operations in the US, with Canada accounting for just 17.2 percent of sales.

Student Transportation is also attractive because it operates in a recession-resistant industry, as school districts will always have a need for its services, regardless of how the overall economy is faring.

Much of its revenue is contracted, typically for the standard 180-day school year, so its operations have a fair amount of predictability. At the same time, its earnings cycle is affected by the school year’s seasonality, with the calendar third quarter typically weak, since it encompasses part of the summer months when school is out.

Khoa: I noticed its market cap is just CAD579 million, which puts it toward the lower-end of the small-cap range. It seems odd for a company so small to offer such a sizable payout.

Ari: It might make a bit more sense after reviewing the history of this security. The company was founded in 1997, but didn’t go public until late 2004. At the time of its initial public offering (IPO), the stock was actually a hybrid of common shares plus subordinated notes, otherwise known as an income-participating security. It converted to a common-share structure five year later, in late 2009.

Given Student Transportation’s origin as an income-oriented security, management clearly decided they should maintain that attribute, even after its structure changed. And the company has been the very model of dividend consistency, paying a monthly dividend for 105 consecutive months, since February 2005. And it’s maintained its current monthly payout of CAD0.04636833 since late 2006.

When employing the standard payout ratio (total annual payout compared to annual earnings per share), dividend coverage appears to be a concern, since the annual payout of CAD0.56 per share is multiples of the firm’s EPS. But when adding back non-cash charges, such as depreciation and amortization, to net income, the payout ratio appears to be a more manageable 69.1 percent.

The company’s fleet of 9,600 school buses results in a significant non-cash depreciation expense, which totaled USD41.9 million in fiscal 2013 (ended June 30). In their earnings call, management cited a payout ratio of around 79 percent, though I haven’t been able to locate their methodology for arriving at that figure.

To be sure, the latter payout ratio is toward the high end of our comfort zone as far as the sustainability of the payout, but management said they’re working toward reducing it, though over the past year it’s only come down by a single percentage point.

However, CEO Denis Gallagher said he expects greater fiscal prudence along with new sales initiatives should bring the payout ratio substantially lower over the coming year.

Khoa: What do you make of the fact that a majority of the shareholders are retail investors?

Ari: On the one hand, it’s concerning, as I like to see a company have strong and growing support from institutional shareholders, such as mutual funds, pension funds, and other professional asset managers. At present, just 26.5 percent of Student Transportation’s publicly traded float is in the hands of institutions. At the same time, it’s not that unusual for a relatively small-cap stock, particularly one that’s domiciled in Canada, to have escaped the attention of the big boys.

Its two largest shareholders are SNCF Participations, the holding company of a major European railway operator, and Caisse de Depot et Placement du Quebec, a Canadian pension fund manager. The former holds 15.9 percent of total shares outstanding, while the latter holds 9.8 percent of total shares outstanding. And TD Asset Management and Scotia Capital hold 3.3 percent and 2 percent of total shares outstanding, respectively.

On the other hand, support for the stock’s share price is clearly coming from income-hungry investors such as ourselves. Management is surely aware that this is the case, and that reality means it can ill afford to skimp on its payout in the future. Fortunately, the CEO holds nearly 1 percent of total shares outstanding, which is not a huge stake, but still sufficient to keep him properly incentivized to maintain the payout, while growing the firm.

Khoa: Tell me more about the company’s consolidation strategy. Looks like it’s been on quite an acquisition spree over the past several years.

Ari: As part of its roll-up strategy, Student Transportation has steadily acquired local school bus operators–mostly in the US, where the Canadian firm derives the vast majority of its revenue–in an extended acquisition spree over the past several years, though the pace of its M&A has slowed more recently.

According to data provided by both the company and Bloomberg, Student Transportation has closed 31 acquisitions since 2004, including 23 since 2008 and eight in calendar-year 2011 alone. Included in this tally is the latest set of acquisitions, announced on Sept. 17, of two school bus companies, one in New Jersey and the other in Pennsylvania.

Khoa: How does it finance these acquisitions? Is shareholder dilution a concern?

Ari: In financing these acquisitions, Student Transportation has shrewdly taken advantage of the historically low interest rate environment, which has allowed it to issue debt relatively cheaply, as well as make successful secondary equity issuances to yield-starved investors. As of June 30, which marked the end of Student Transportation’s fiscal year, the company reported USD220.2 million in long-term debt on its balance sheet.

Long-term borrowings have nearly doubled over the past five fiscal years, with long-term debt jumping to 113.2 percent of shareholders’ equity at the end of June, compared to 65 percent back in 2008. However, the picture is somewhat less dramatic when viewed from the perspective of long-term debt as a percentage of total assets, which climbed to 42.9 percent from 33.2 percent in 2008.

At the same time, goodwill, which is the premium paid beyond book value for the intangible assets of acquired companies, accounts for a substantial 27 percent of Student Transportation’s assets.

Meanwhile, Student Transportation’s weighted average of non-diluted shares outstanding has more than doubled, to 79.4 million shares from 32.2 million shares five years ago. The share count has grown via secondary issuances of 1.7 million shares in 2008, 12 million shares in 2009, and 12.25 million shares in 2012. Still, management noted that low-cost debt has enabled the company to avoid making additional secondary issuances, since the last one in March 2012.

The company’s dividend reinvestment program (DRIP) has also added incrementally to the share count, including 1.3 million shares in fiscal-year 2012 and 1.5 million shares in fiscal-year 2013. Like DRIPs at other Canadian-domiciled firms, retail investors must be Canadian residents in order to be eligible to participate. Dividends are reinvested without commissions at a 3 percent discount to the average share price of the five trading days preceding the payment date.

Student Transportation has attempted to offset some of this potential dilution via a buyback program, which in Canada is referred to as a normal course issuer bid. Nevertheless, share repurchases have been relatively minimal over the past two fiscal years, at just 96,300 shares and 401,076 shares, respectively.

Fortunately, net income per share has improved to CAD0.05 in fiscal 2013 from a loss of CAD0.22 in fiscal 2008 (the company reports its results in US dollars, but per-share data is listed in Canadian dollars). The most recent result also marks a recovery from the dip to CAD0.03 in profits per share in 2011-12, after the company posted CAD0.05 in profits per share in 2010.

So from an earnings-per-share (EPS) standpoint, shareholder dilution appears to have been mostly kept in check, though it does show that the company’s roll-up strategy has yet to translate into sufficient growth in EPS to more than offset the rise in share count.

Once we finally enter a rising-rate environment, Student Transportation won’t be able to pursue acquisitions as aggressively, nor will it have the same level of support from income investors, as some will inevitably shift their attention toward fixed income.

As such, management will have to reorient their focus toward organic growth. They appear to have anticipated this eventuality and are already taking pains to improve their operational metrics, including greater fiscal discipline as well as attention to margins. We’ll continue to monitor whether the company’s scale has truly enabled it to not only support its payout, but also achieve enduring growth in earnings per share.

Khoa: How are these dividends taxed?

Ari: Before proceeding, it should be noted that we’re not tax professionals, and that subscribers should consult their accountant or tax advisor to confirm the treatment of these dividends.

Our understanding is that thanks to the tax treaty between the US and Canada, the Canadian government withholds just 15 percent of the payout (as opposed to the 25 percent rate that would prevail without the agreement). Depending on their individual tax situation, investors should be able to recover some or all of that amount in the form of a credit at tax time by filing Form 1116.

Once the amount withheld by the Canadian government is offset by a credit, most investors should just be liable for the US dividend tax rate of 15 percent. Of course, that rises to 20 percent if your taxable income exceeds $400,000 as an individual or $450,000 as a couple.

The Canadian Revenue Agency (CRA) implemented a new rule earlier this year that requires US investors to file Form NR301 through their brokers in order to receive the reduced rate of withholding. Follow this link to learn more about the form and its requirements.

Finally, since Student Transportation is organized as a corporation, individual retirement accounts (IRA) and other tax-advantaged retirement accounts should be exempt from the Canadian government’s withholding.

Student Transportation is a buy below USD7. However, it should be noted that this stock’s CAD579 million market capitalization is toward the lower end of the small-cap spectrum, which means trading volume can be fairly light some days. As such, it would be prudent to set a buy limit near the market price to ensure the order fills at a favorable price.

Portfolio Updates

Portfolio news is light this month, as we wait for our companies to report their calendar third-quarter earnings.

Lightstream Resources (TSX: LTS, OTC: LSTMF) announced third-quarter production increased 17 percent to about 45,100 barrels of oil equivalent per day (BOE/D). The company’s Cardium business was responsible for about 20,600 BOE/D, and its Bakken business produced 16,000 BOE/D. The company’s Saskatchewan business made up the rest.

On an energy equivalency scale, output was 78 percent light oil and natural gas liquids and 22 percent dry natural gas. Natural gas comprised a higher percentage of production, which remained relatively flat compared to the second quarter.

Lightstream drilled 13 wells and placed eight wells on production in Cardium during the quarter, bringing its total to 38 wells drilled and 42 wells on production year to date. The company expects to add 10 more wells in Cardium by the end of the year.

In Saskatchewan, Lightstream drilled 11 wells and placed eight wells on production, bringing its total for the year to 36 wells drilled and 32 wells on production.

Lightstream is targeting the lower end of its forecast 8 percent to 12 percent annual production growth by the end of the year. The company continues to target a dividend sustainability ratio of 100 percent. Lightstream’s capital budget of $700 million to $725 million remains unchanged. Lightstream remains a buy below USD10.

Aditya Birla Minterals Ltd (ASX: ABY, OTC: ABWAF) is planning to divest its Mt. Gordon copper assets in Queensland, Australia, due to high costs, low production and weak commodity prices, all of which are making the mine unviable.

The company’s other mine project, Nifty, in Western Australia, will remain in operation. Aditya Birla remains a Hold.