Orion Securities on Discovery / Top Aces merger

Here is a note released yesterday by the Orion Securities research dept. regarding the pending acquisition of Wellington Financial Fund II portfolio company Top Aces Inc. by Discovery Air Inc. (DA.A:TSX).

12-Month Target: $2.40
Rating: Overweight
Potential Return: 71%

What Happened?

Discovery Air’s board of directors approved debt financing for its pending acquisition of Top Aces Inc.

• The company anticipates that the acquisition will close before the end of the month. Details on the terms of the financing may be released at that time.

What Does it Mean?

Positive.

• In light of considerable consternation in the credit markets, we believe that achieving approval on debt financing should be taken favourably. In our view, this was the last significant hurdle remaining in completing the transaction (originally announced on June 20, 2007).

• Recall, Top Aces is a private aviation company based out of Pointe-Claire, Quebec, which specializes in military airborne training.

• The purchase price was set at 20 million Discovery Air shares, $35 million in cash and the assumption of existing debt. All in, we put the total purchase price at about $75 million, plus or minus.

• As we outlined in our note on June 22, 2007, we believe that Top Aces currently generates annual revenue in the $30 million range at EBITDA margins broadly in line with Discovery Air’s current business. As such, the transaction is expected to be accretive to earnings once closed.

• From a strategic perspective the acquisition:

– Adds considerable scale (both geographically and financially);

– Opens up new end markets, specifically providing a well-established relationship with the Canadian Department of National Defence (DND); and

– Should help smooth out some of Discovery’s seasonality.

Transaction could add in the order of $0.02–$0.03 to EPS on an annualized basis once closed.

• In turn, this could be worth $0.15–$0.35 per share to our DCF-based valuation. We will wait until the transaction is closed before revisiting our forecast. Currently (ex. Top Aces) we are looking for EPS of $0.11 in F2008 (January Y/E) and $0.15 in F2009.

Recent market weakness has provided an attractive entry point – maintain Overweight rating.

• Excluding Top Aces, the stock is trading at 9.2x next year’s earnings and less than 5.5x EV/EBITDA. This compares with its peers at about 12.5x earnings and 6.5x EV/EBITDA.

• The stock also sits just slightly above book value of $1.37 per share.

MRM
(disclosure – Fund II and certain LPs/managers own warrants or shares in Top Aces; I’m a director of the Co.)