Orion Securities on Discovery / Top Aces merger details

Here is this morning’s research note on Discovery Air (DA.A:TSX) from Orion Securities regarding Friday’s closing of Discovery’s acquisition of Wellington Financial Fund II portfolio co. Top Aces.

Discovery Air successfully closed its acquisition of Top Aces Inc. Recall, Top Aces is an aviation company based out of Pointe-Claire, Quebec that specializes in military training.

The purchase price was set at 20 million DA.A shares, $35 million in cash and the assumption of existing debt. In conjunction with closing, Discovery indicated that the cash portion of the deal has been financed by an interest-only term loan at 9.25% with Pacific & Western Bank of Canada (PWB). There is no prepayment penalty on the debt but Discovery has granted 1.25 million warrants for DA.A shares to PWB (x-price not disclosed) as part of the arrangement.

Further confirmation of Discovery’s ability to execute on its acquisition-based growth strategy. In our view, completion of the Top Aces transaction should work to erase any disappointment that may have lingered following Discovery’s decision to terminate its proposed acquisition of VIH Aviation Group earlier this year. We expect the Discovery team to continue exploring acquisition opportunities as they arise.

Top Aces is an exciting addition to Discovery’s growing aviation alliance. As we have
discussed in the past, Top Aces i) adds considerable scale, ii) opens up new end markets, and
iii) smoothes out some of Discovery’s seasonality. Perhaps the most intriguing aspect of the
deal, however, is the relationship that it brings with the Canadian Department of National
Defence. This could work to unlock opportunities for Discovery’s northern-based Great Slave and Air Tindi operations in light of growing concerns over, and interest in, Arctic sovereignty. It may also become an important channel for new pilot recruitment.

Transaction should be accretive to earnings in year one. We believe Top Aces is capable
of generating between $11 million and $12 million of EBITDA annually.

DCF-based target price lifted to $2.60. The $0.20 increase in our target is consistent with
the range we had suggested in our previous work and reflects the transaction’s bottom-line
accretion. Our F2009 EPS forecast goes to $0.17 from $0.15 (January Y/E). On this basis,
the stock is trading at 8.5x next year’s earnings relative to its peers at 12.5x.

Closing risk off the table; buy ahead of seasonal strength. Discovery’s business is highly
seasonal. This is not necessarily a bad thing – and it is something that the Top Aces acquisition addresses – but it does otherwise complicate gauging the earnings power of the business.

As we head into Discovery’s strongest two quarters, investors should begin to see the positive
side of the business’ operating leverage.

I will refrain from discussing the corporate governance issues raised by Orion’s research analyst in his note regarding what he referred to as the “non arms length” debt transaction between Pacific & Western Bank and Discovery; each of Pacific & Western and Discovery share many board members and senior executives.

MRM
(disclosure – Wellington Financial Fund II and certain managers/LPs own shares in DA.A as a result of the acquisition; about 2% of DA.A in total)