The Stock

What to Buy: New Flyer Industries (TSX: NFI-U, OTC: NFYIF) @ USD11

Why Now? Sales are practically mandated by law, and buyers are backed by the power to tax. Throw in concern about fuel costs and the fact that much of the North American fleet is aging rapidly and you have pretty compelling reasons for buyers to step up, even in an age of strained budgets. And New Flyer has expertise in almost every area of green buses, so it has an edge getting sales.

The Story

It’s mid-August, and the heat of the pennant drive is exposing contenders and pretenders alike. A night at the ballgame–even a steamy one, with the threat of looming thunderstorms and two second-division teams on the field–is always a pleasure.

And baseball’s languid pace certainly lends itself to quality conversation.

Surely the good Lords of Baseball have eavesdropped on many a stock-centered conversation between Roger Conrad and David Dittman, two seamheads who love a pitcher’s duel almost as much as they love a sustainable dividend.

Baseball is famous for hard-working minor-league lifers who one day beat the odds and bust out of the bus leagues after years of toil for the high-class accommodations of The Big Show. Well, on this hot, humid night–which included a strong performance from one young Washington Nationals hurler who hasn’t yet broken down–we struck upon another type of “bus league,” one our first target for Big Yield Hunting is making up as it goes along.

After a couple beers (one each), a sausage-and-peppers (Roger) and a chili-cheese-onion dog (David)…

David: Roger, I think I’ve found our first stock for Big Yield Hunting. It pays monthly dividends and has a yield of almost 11 percent. And it’s in a business that’s really booming now, bus manufacturing.

Roger: That sounds a lot like New Flyer Industries (TSX: NFI-U, OTC: NFYIF). I like the yield, but what kind of a business is bus manufacturing for a dividend-paying company?

You know, staying power is more important than raw yield. And when’s the last time you rode a bus anyway, Dave? Don’t you drive a BMW now?

David: It is New Flyer. It does have the numbers to back up that yield. And when’s the last time you left your CLK in the driveway to ride a bus?

Roger: You forget I took an eight-hour bus ride with 32 Boy Scouts and adults on the way to our canoe trip in Ontario this summer. I’m not sure if it was a New Flyer bus, though. What’s the coverage ratio for the dividend?

David: The key metric is distributable cash flow, and they increased it by 30.7 percent in the second quarter. The payout ratio based on distributable cash flow is 53.9 percent; that’s down from 72.2 percent a year ago.

Roger: That’s pretty solid coverage. I also see they had a really good quarter. Total adjusted cash flow–earnings before interest, taxes, depreciation and amortization–was up 41.4 percent. Actually, a couple of soft spots on the orders front, but they seem to be holding profit margins steady despite what has to be a pretty competitive industry.

David: They’re doing it by being greener than everyone else. Their buses save energy, and what fuels they do burn are clean.

Roger: Am I reading that right that clean propulsion vehicles are 63 percent of total order backlog?

David: Yep. They make 35-, 40- and 60-foot buses with clean diesel, diesel-electric hybrid, gasoline-electric hybrid and compressed natural gas propulsion systems. And the orders are coming in from all over North America. Last quarter, they got them from the City of Ottawa, Baltimore, Minneapolis and Winnipeg, among other places.

Roger: Why are so many governments buying buses these days, particularly in a recession?

David: Environmental mandates are a big reason. But that’s one thing that makes this business so strong. Sales are practically mandated by law and the buyers are backed by the power to tax. Throw in concern about fuel costs and the fact that much of the North American fleet is aging rapidly and you have pretty compelling reasons for buyers to step up, even in an age of strained budgets. And New Flyer has expertise in almost every area of green buses, so it has an edge getting sales.

Roger: You mentioned Balto as a buyer. Maybe we should take a field trip. It’s been awhile since I ate mussels at Bertha’s in Fells Point. Anyway, marketing ability probably counts more than technology as far as sustaining dividends, and they’ve definitely got it.

David: I know you’re a stickler for balance-sheet strength. I like the fact that New Flyer has no significant maturing debt until 2012. The one thing that concerned me was the fact that it’s an income deposit security, combining a debt portion with an equity portion. That might throw off some of our readers.

Roger: I think it’s the main reason New Flyer is trading so cheaply, with a yield of nearly 11 percent. Not only are investors afraid of complications these days but a lot of the brokers I talk to are also. In fact, until Atlantic Power Corp (TSX: ATP, NYSE: AT) converted to a pure equity and listed on the New York Stock Exchange, some brokers wouldn’t even fill orders for it.

David: Is that a disqualifier for this service?

Roger: It would be if the structure threatened the dividend in any way. But as you’ve pointed out, that’s definitely not the case. Distributable cash flow covers the distribution by nearly a 2-to-1 margin. Also, one thing you didn’t mention is that sales hardly missed a beat in 2008-09 and also covered the distribution handily. 

David: Well of the 9.75 cents per share monthly payment, 3.298 cents is equity dividend and 6.452 cents is debt interest. It’s all paid in Canadian dollars, a good thing I think.

Roger: You know I agree. The loonie has already had quite a ride against the US dollar over the past few years, but I think it’s going a lot higher. I’m kind of bugged that people always trade it as an oil proxy when Canada’s fundamentals are so much stronger than ours in the US. But either is a catalyst for going well beyond parity. And a rising Canadian dollar will increase the US dollar value of dividends paid by New Flyer, as well as the US dollar value of its share price.

David: The interest rate on the bond portion of the income deposit security is pretty high at 14 percent, and management hasn’t said what they’re going to do with the bond portion when it matures, which is in 2020. They could also divide the bond and equity portions as other income deposit securities have. And I think it’s the last of the breed, as all the other income deposit securities have converted to corporations. Does any of that bother you?

Roger: Again, the key question for me is whether or not the company can cover that distribution, no matter how it’s paid.

That high bond yield also means they’re getting a pretty hefty writeoff and sheltering a lot of cash. The record on income deposit securities converting is somewhat mixed. With Atlantic it was a home run because they converted the whole thing to equity and kept the same dividend.

Some of the others pretty much fell apart, but the difference was really the strength of the underlying business. Atlantic has it. But some of those companies really had no business paying out a big dividend. The business just didn’t support it.

David: I guess the worst that will happen is they’ll redeem the debt portion for cash and keep the equity portion trading. The debt portion would have to be paid off at CAD5.53 per income deposit security, which would leave the equity at CAD5.23.

Factoring in the annual yield of roughly 40 cents on the equity portion and that’s still a yield of 7.6 percent–pretty good for a bus company.

Roger: And if they go Atlantic’s route, they’ll keep paying at this rate.

Keep in mind they’d have to pay a premium to redeem the debt portion before 2017 in any case, 105 percent of the par value if they do it before 2013, 104 percent if in 2014, 102 percent in 2015, 101 percent in 2016.

Anyway, I notice they’re actually buying back income deposit securities in the open market. That’s always a good sign. And the share consolidation they did in the spring seems to indicate management still supports the IDS structure.

David: It really does all come down to the health of the underlying business. It always amazes me that so many people investing for income get so distracted by other issues and lose sight of that.

Roger: I guess the real question is would we put our publisher into this one, and I think the answer is yes.

David: With the caveat of course that New Flyer Industries should be part of a diversified income portfolio and that he shouldn’t pay more than USD11 for it.

Roger: How right you are.