Orion and Westwind research on Discovery Air

I know not all of you want to read about our deals each and every day, but here is the summary notes from Orion Securities and Westwind Partners following the Discovery Air (DA.A:TSX) analyst tour of the Wellington Financial Fund II portfolio co. Top Aces “Bagotville facility”, which sounds like the Dept. of Defence military base CFB Bagotville (home of Canada’s eastern CF-18 squadron).

From Orion:

What Happened?

• Discovery Air hosted an analyst tour of its Top Aces facilities in Quebec.

Recall, Top Aces provides airborne training to military personnel under multi-year contracts with the Department of National Defence (DND). The company’s business tends to be seasonally brisk in the September – November and February – June timeframes, and, from what we took in during our visit to the Bagotville facility, we can vouch for the former.

What Does it Mean?

• Top Aces should have an immediate impact out of the gate. The acquisition closed on August 27, which means that two of the business’ stronger months (Sept. and Oct.) will be included in Discovery’s FQ3 results for the October-end quarter. We are looking for this segment to contribute about $7.0 million in revenue and $2.3 million in EBITDA in the quarter.

• Demand from the DND outstripping current capacity (and budget allocations). In an effort to be proactive on this front, Top Aces recently secured eight new Alpha Jets, which will be delivered over the next 12 months. This effectively doubles the size of the company’s existing, operational fleet and positions it to be able to meet any incremental demand that may materialize in the near term. Perhaps more importantly, it (i) gives the company the type of capacity required to replicate its model in other NATO countries looking to save on training costs and (ii) further solidifies the company’s position as it relates to winning a longer-term, more comprehensive contract with the DND once the current one expires in 2010.

• Discovery has only just begun to explore the benefits that Top Aces’ relationship with the DND may bring to the table. Establishing strong ties with an organization like the DND is no easy task, nor is building-out a comprehensive aviation business in the Arctic.

With Top Aces, Great Slave and Air Tindi now allied, Discovery has both the relationships and the infrastructure necessary to participate in the Federal government’s renewed commitment to arctic sovereignty and development in the North. This could include training, maintenance and/or service work with a variety of potential aircraft platforms.

What Is it Worth?

• We reiterate our DCF-based $2.60 target price. This corresponds to about 16x our F2009 EPS forecast (January year-end). The eight Alphas currently being added will not likely become significant contributors until the following year.

What to Do

• Still Overweight; buy on recent weakness. With more equipment on the way and new relationships to work with, we see ample opportunity for Top Aces to thrive within Discovery’s
growing platform. In the process, this should surface value for Discovery shareholders.”

And from Westwind:

Rating: BUY Target: $2.25
Mkt. Cap: $183 MM ‘09 EV/EBITDA: 5.7x Total Annual Ret.: 61%

Highlights from the Top Aces Site Visit

Insight or Development:

Yesterday, we participated in a site visit to Top Aces and toured their facilities in Bagotville, Quebec. The visit reaffirmed our belief that Top Aces is a well run business, which makes a good addition to Discovery Air’s portfolio. Discussions with the Top Aces management team have increased our confidence regarding the company’s strong growth potential.

Analysis:

The co-founders of Top Aces, Didier Toussaint, Paul Bouchard and Dave Jennings have built a successful niche aviation provider in a market with significant barriers to entry. As ex-fighter pilots, they have worked together throughout their professional lives and understand the needs of the Canadian armed forces. All of the approximately 30 Top Aces pilots are experienced CF-18 fighter pilots, with almost 80% being Top Gun graduates. Overall, the Top Aces combination of the versatile alpha jet, some of the most experienced fighter pilots in the industry and a successful working relationship with the Department of National Defence (DND) would be difficult for a new entrant to replicate.

The Discovery Air alliance should provide Top Aces with greater resources and the financial flexibility to compete for contracts from other NATO allies. Top Aces is familiar with the U.S. market, having flown on missions for the Canadian DND out of U.S. bases. Further, Top Aces will also gain access to Northern Canada, and will thereby be able to work with the DND on training missions in the region.

With almost all of the Top Aces revenue coming from one customer (DND), investors may be concerned about the risk of losing the current contract when it comes up for renewal. When the current standing offer expires in 2010, it is anticipated that the DND will invite bids for a 15 year, $750 MM contract. However, we are not aware of any other company that currently possesses the necessary expertise to submit competitive bids. Further, the current partnership has been a big success, as a result of which we believe will put Top Aces in a strong position to renew the DND contract in 2010.

Although the current DND budget supports the operation of eight alpha jets, Top Aces is not likely to have a problem obtaining business for the additional aircraft to be acquired. In addition to the opportunities available to expand internationally, the current demand for alpha jet services exceeds the supply, as a result of which we would expect utilization rates to be fairly high, even after the planned fleet expansion.

Conclusion:

Although our forecasts and $2.25 target price remain unchanged at this stage, any announcement of new contracts with NATO allies could provide upside from our forecasts. We continue to like Discovery Air’s growth potential and reiterate our BUY rating ahead of seasonal earnings strength as the company gears up to report Q3/08 results in December.

(All figures in C$, unless otherwise noted.)

John Grandy, (416) 815-3067 jgrandy@westwindpartners.ca ; Rahul Paul, (416) 815-3128 rpaul@westwindpartners.ca”

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 convertible debentures.)