Clarus and Orion research teams on Top Aces growth plans

As a former director of Top Aces it wasn’t unexpected news, but Discovery Air (DA.A:TSX) announced today that the Top Gun team in Montreal had secured an additional two Alpha Jets — taking the current fleet to 12. Although some equity research analysts seem to think these aircraft were acquired for prospective customer reasons, my sense is that they are being put in place to accomodate training demands from their current customer(s). It may take a few months for these two new planes to be put to work, as upgraded ejector seats and canopy fragmenters will likely be required. And that work gets done in Texas as I recall. But these two plane acquisitions speak to the confidence the ultra conservative (and that’s a good thing when taking your eye off the horizon puts you into a stand of trees at 700 mph) Top Aces management team has in the near term revenue opportunities. Recall that in April 2005 they had just one Alpha Jet.

On last week’s results conference call, there appeared to be some concern on the part of research analysts about how many other Alphas are “out there” (i.e., available for purchase and bringing commensurate revenue growth). My recollection is that there are several airworthy Alphas sitting in crates (ready to assemble) in various European countries: Germany and Portugal, I believe. Crates in Germany and hangers in Portugal perhaps. But Top Aces Co-CEO Capt. (Ret’d.) Paul Bouchard knows where to find them….

And if they can’t source any Alphas, there’s always the supersonic Hawk, for example. More money than an Alpha, but more versatile as well. And with $1 million of cash flow a month, the division’s capex needs are largely self-financing, unless they want an SU-27 or MIG.

This from the Clarus Securities research dept.:

Yesterday AMC (after-market-close), Discovery Air announced the addition of two Alpha-Jet fighter class aircraft to its Top Aces subsidiary that trains the Canadian Air Force for combat
preparedness, bringing its aggregate fleet of aircraft to 16. This is part of Top Aces commitment to purchase a total of eight additional Alpha-Jets, which we expect to occur over the next year. We estimate the cost to Discovery Air, inclusive of retrofitting and associated spare parts to be approximately $1.5 million each and that the purchases will be internally financed.

Despite its strong pricing power and expanding margins, we are encouraged by the Company’s growing diversification away from the northern Canadian, resource-focused market and believe the acquisition of these aircraft provide a strong signal to investors that Discovery management will be able to expand Top Aces’ business from its current $30-$35 million per year. Management had indicated that it intended on purchasing additional aircraft should business expansion possibilities warrant the move.

In our forecasts, we have not assumed any expansion to Top Aces’ business before FY10 (January YE) where we have already arbitrarily added $10 million to our revenue expectation for that year to reflect new business wins. With the purchase of the aircraft, it appears incremental Top Aces revenue might occur earlier than expected, either in the form of expanded contracts with the Canadian military or through new contracts with other NATO governments. We are not changing our estimates at this time, however, the announcement provides us with increased confidence in our forecasts as well as potential near-term upside to our estimates.

We continue to believe that Discovery’s market-leading position in the Canadian North will result in continued pricing power, organic and external volume growth and ultimately higher margins for the Company going forward. Meanwhile, Top Aces should help diversify Discovery’s natural resource risk, reduce seasonality of Discovery’s spring summer-focused revenue and provide exposure to the growing niche market of outsourced air combat training estimated to be worth $1.5 billion across NATO countries (excluding the United States). We maintain our BUY recommendation and 12-month target price of $2.30 per share.

Here’s the research note from Orion Securities:

What Happened?

Top Aces lays out growth plans; Alpha-Jet fleet to expand from 10 to 18.

• Discovery Air’s newest subsidiary – Top Aces Inc. – announced that it received delivery of two incremental Alpha-Jets on Monday, September 17. The additions are part of an agreement that will see Discovery purchase a total of eight additional Alphas over an undisclosed period of time (we’re estimating about twelve months).

• Once delivered, these aircraft need to be refurbished and upgraded with new avionics packages.

What Does it Mean?

Positive.

• Business scaling-up faster than anticipated. Management had suggested on its Q2 conference call that it was in negotiations to add aggressively to its Alpha-Jet fleet in order to keep up with Canadian demand and/or enter international markets. Looks like talks wrapped up rather quickly… By spacing out the aircraft deliveries, Discovery should be able to pay for the new equipment out of internally generated cash flow and credit lines.

• Substantial fleet expansion should accelerate earnings growth over the next year or two. Once operational, we believe every two to three Alpha-Jets should conservatively add about a penny to EPS on an annual basis (we await the Top Aces business acquisition report for more clarity on margins). Recall, this is a highly profitable business from a ROIC perspective due to (i) the unique skill set(s) required to effectively perform airborne training for the military and (ii) the limited availability of this particular aircraft platform.

• Positive first steps for Top Aces within the Discovery fold; more to come. With Discovery having now secured the better part of the remaining global supply of Alpha-Jets (we had estimated that there were less than a dozen available prior to yesterday’s announcement), we expect management to begin evaluating the economics of other airborne training aircrafts – possibly even at the supersonic level. Moreover, we are excited about the potential for Discovery to build on Top Aces’ relationship with the Canadian Department of National Defence as it relates to opportunities in the Arctic via Great Slave Helicopters and Air Tindi (see note from September 14).

• We will revisit our financial forecast in due course. We would like to get further clarity on the Alpha-Jet delivery schedule and examine whether this expansion will require additional infrastructure outside of Canada before we make adjustments. As a reference point, we have previously suggested that Top Aces’ base business, which consists of ten Alpha Jets (two of which are carried as parts) and four Westwinds, is capable of generating $30 million – $35 million in revenue and $11 million – $12 million in EBITDA annually.

• We maintain our Overweight recommendation. We believe the stock represents excellent value given its growth profile (9.3x next year’s P/E; 5.7x next year’s EV/EBITDA). These metrics are exclusive of this Top Aces expansion.

MRM
(disclosure – Wellington Financial Fund II and certain managers/LPs own shares in DA.A as a result of the acquisition of portfolio co. Top Aces. I also own some DA.DB conv. debs.)