What to Buy: Exchange Income Corp (TSX: EIF, OTC: EIFZF)

Why to Buy Now: Exchange Income Corp is a small Canadian buyout firm that specializes in the aviation and specialty manufacturing sectors. Similar in philosophy to Warren Buffett, management has assembled its portfolio of 11 companies by looking for the right company in the right market at the right price with the right management team. And it’s willing to walk away from a deal that doesn’t meet its stringent criteria.

The stock hit an all-time high of CAD28.84 in March 2013, but currently trades near CAD22.70, or down about 21.3 percent. The stock fell as low as CAD17.99 in early October, when the company reported an unexpected CAD10 million rise in expenses at one of its subsidiaries. But management believes this will be a one-time item. The shares have since risen about 26.2 percent from that level, and yield 7.4 percent at current prices.

More important, the stock has strong analyst sentiment, with six “buys,” three “holds,” and one “sell.” After a somewhat dismal 2013, analysts forecast that adjusted earnings per share will jump 181 percent in 2014, to CAD1.44 from CAD0.51, on an 11 percent rise in revenue, to CAD1.14 billion from CAD1.03 billion. The consensus 12-month target price is CAD25.46, suggesting a potential return of 12.5 percent above the current share price.

In the short term, however, analysts forecast that earnings per share will continue to decline during fourth-quarter 2013, for which the company has yet to report, and first-quarter 2014. The rebound in earnings doesn’t get fully underway until the second half of the year. So if expectations regarding near-term earnings aren’t already reflected in the share price, then there could be additional downward volatility over the next few months, unless the company’s numbers surprise to the upside.

But the shares have demonstrated considerable upward momentum since their 52-week low, so it’s possible that the worst is over as far as the selloff goes. And over the long term, the company’s stock has rewarded investors handsomely as it’s grown via acquisition, gaining 20.3 percent annually in US dollar terms over the 10-year period from the end of 2003 through the end of 2013. Including the reinvestment of dividends, the stock gained 33 percent annually over that same period.

While the stock may not produce such stratospheric gains in the future now that it’s on the cusp of moving up to being a small-cap stock from a micro-cap stock, we believe the CAD470 million company is still capable of producing enviable long-term gains.

Buy EIF below USD22. Please note that this is technically a micro-cap stock, with relatively low trading volume–the average daily trading volume over the trailing three months for the TSX-listed shares was roughly 46,000. Over that same period, the average daily trading volume for the OTC-listed shares was just 755. As such, investors should opt for the TSX-listed shares, if possible.

Regardless, low volume means shares on either exchange may trade at wider bid/ask spreads than larger-cap fare. The share price could also spike if there’s a sudden influx of market orders. Therefore, investors should always employ limit orders set near or slightly below the market price to purchase shares, or near or just above the market price to sell shares.

Ari: Exchange Income Corp (TSX: EIF, OTC: EIFZF) is a Canadian buyout firm that specializes in the aviation and specialty manufacturing sectors.

The stock hit an all-time high of CAD28.84 in March 2013, but currently trades near CAD22.70, or down about 21.3 percent. The stock fell as low as CAD17.99 in early October, when the company reported an unexpected CAD10 million rise in expenses at one of its subsidiaries. But management believes this will be a one-time item. The shares have since risen about 26.2 percent from that level, and yield 7.4 percent at current prices.

More important, the stock has strong analyst sentiment, with six “buys,” three “holds,” and one “sell.” After a somewhat dismal 2013, analysts forecast that adjusted earnings per share will jump 181 percent in 2014, to CAD1.44 from CAD0.51, on an 11 percent rise in revenue, to CAD1.14 billion from CAD1.03 billion. The consensus 12-month target price is CAD25.46, suggesting a potential return of 12.5 percent above the current share price.

In the short term, however, analysts forecast that earnings per share will continue to decline during fourth-quarter 2013, for which the company has yet to report, and first-quarter 2014. The rebound in earnings doesn’t get fully underway until the second half of the year. So if these expectations aren’t already reflected in the share price, then there could be additional downward volatility over the next few months, unless the company’s numbers surprise to the upside.

But the shares have demonstrated considerable upward momentum since their 52-week low, so it’s possible that the worst is over as far as the selloff goes. And over the long term, the company’s stock has rewarded investors handsomely as it’s grown via acquisition, gaining 20.3 percent annually in US dollar terms over the 10-year period from the end of 2003 through the end of 2013. Including the reinvestment of dividends, the stock gained 33 percent annually over that same period.

While it may not produce such stratospheric gains in the future now that it’s on the cusp of moving up to being a small-cap stock from a micro-cap stock, we believe the CAD470 million company is still capable of producing enviable long-term gains.

Khoa: How does management pursue its buyout strategy?

Ari: In identifying targets for acquisition, management takes a long-term perspective toward its investments by looking for profitable, well-established companies that generate strong, dependable cash flows that are immediately accretive and, therefore, support EIF’s payout.

Similar in philosophy to Warren Buffett, management likes to partner with companies that already have strong executive teams. And while EIF works with each company to help grow their business, its subsidiaries largely operate independently and retain their own branding.

Management’s disciplined approach to acquisitions is best summarized in its own words:

“Our approach to acquisitions is straightforward, but not easy. We look for the right company in the right market at the right price with the right management team.”

“That takes patience. It takes effort. It takes time. Everything has to add up just right. It’s why we sometimes walk away from deals.”

At the end of the third quarter, the company had about CAD160 million in liquidity to undertake future acquisitions. It also recently announced an offering of CAD40 million in 6 percent convertible debentures, with a CAD6 million over-allotment option, with issuance occurring on a “bought deal” basis.

Khoa: Tell me more about EIF’s portfolio of companies.

Ari: Since its initial public offering (IPO) in late 2002, EIF has built its portfolio by acquiring 11 companies, with six companies operating in the aviation sector and five in the manufacturing sector. Portfolio companies operate in niche markets across the US and Canada.

When most folks think of the airline industry, the long-term operating woes of many of the behemoths come to mind. But small, regional carriers that focus on underserved areas tend to be far more profitable. EIF’s aviation segment is comprised of four regional carriers that offer scheduled service to such areas in Canada, making it the country’s third-largest passenger fleet. Additionally, these airlines also provide charter flights, cargo flights, and medical transportation among their services.

In this segment, EIF also owns a helicopter company that caters to companies in the resource sector as well as government entities. Finally, in a move toward vertical integration for one of this segment’s major expenses, in April 2013 EIF acquired Regional One, a company that supplies regional airlines with aftermarket engines and other parts, in a USD94.9 million deal, its largest acquisition to date.

The five companies in the specialty manufacturing segment are a diverse set, including a firm that builds towers for wireless communications, a company that manufactures custom tanks for energy transportation, and a subsidiary that designs and manufactures pressure-washing equipment.

Based on 2012 numbers, the company derives nearly 65 percent of revenue from its manufacturing segment and 35 percent from its aviation segment.

In addition to the usual financial and legal professionals that one would expect at such a firm, EIF’s management team has a chief operating officer to oversee each segment, and each of these professionals had significant experience in their respective industries prior to joining EIF, including 18 years in manufacturing for one executive and 40 years in aviation for another.

Khoa: What about dividend growth?

Ari: Though the company has increased its dividend eight times since 2004, dividend growth has been modest, at just 2.2 percent annually over the past five years. The current monthly payout of CAD0.14 has been in place since late 2012, and as mentioned earlier, at current prices, the stock yields 7.4 percent.

EIF is dedicated to supporting its dividend. Management expects its normalized payout ratio for full-year 2013 to come in around 80 percent, but projects that the payout ratio will revert to historical levels of roughly 70 percent in 2014.

At quarter-end, EIF had about CAD405 million in long-term debt, but its maturities are reasonably well staggered through 2021, so its debt burden should be very manageable.

Khoa: What should investors expect with regard to taxation of dividends?

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 in early 2013 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.

It appears that the form must be filed for each company for which you’d like to receive the more favorable withholding rate. The forms expire after three years from the end of the calendar year in which the form is signed and dated, so if you’re still holding the security at that juncture, then you’ll have to renew the filing.

Finally, since EIF is organized as a corporation, individual retirement accounts (IRA) and other tax-advantaged retirement accounts should be exempt from the Canadian government’s withholding. It’s not entirely clear whether filing form NR301 is sufficient to qualify for this treatment or whether a letter of exemption must be obtained.

If the latter, the page at this link instructs you on how to proceed, and also provides a searchable database for entities that have already received the exemption (in case your tax-advantaged account happens to fall under one of those entities).

Buy EIF below USD22. Please note this is technically a micro-cap stock, with relatively low trading volume–the average daily trading volume over the trailing three months for the TSX-listed shares was roughly 46,000. Over that same period, the average daily trading volume for the OTC-listed shares was just 755. As such, investors should opt for the TSX-listed shares, if possible.

Regardless, low volume means shares on either exchange may trade at wider bid/ask spreads than larger-cap fare. The share price could also spike if there’s a sudden influx of market orders. Therefore, investors should always employ limit orders set near or slightly below the market price to purchase shares, or near or just above the market price to sell shares.

Portfolio Updates

We’re in the midst of the quiet period between the end of the calendar fourth quarter and when companies start releasing earnings en masse. We do have some company news to report, and we’ll issue these updates via email alert next week.