Discovery Air quarterly research updates

Apologies for the delay. Here are the update reports from GMP Securities and Versant Partners regarding the recent quarter at Discovery Air (DA.A:TSX). Discovery acquired Wellington Financial Fund II portfolio co. Top Aces in August 2007:

From GMP Securities:

We are maintaining our BUY recommendation and lowering our target price to $1.00 per share
(previously $1.70). Our target price is based on an average of our F10 P/E (15x) and EV/EBITDA
(6.5x) valuations. We would consider an investment in Discovery Air for the following reasons:

– Over the last two years management has built a solid portfolio of rotary wing and fixed wing
companies. Discovery Air’s revenue grew from $47 mm in F07 to $121 mm in F08 and we are
forecasting that revenue will grow to $159 mm in F09.

– Discovery Air’s operational units have experienced management teams with proven track
records of strong operational performance.

– The market for the company’s services remains strong and the company is adding new aircraft to meet this demand. The company’s Top Aces division is expected to add 8 new Alpha Jets through the end of F09. These aircraft are capable of generating revenue of $3+ mm per aircraft. To be conservative, we are forecasting that only 3 of these aircraft will be operational in F10.

– We believe that management must execute on its business plan and demonstrate to the
market that it can deliver solid revenue and earnings growth before there can be meaningful
appreciation in the company’s share price.

Revenue for the quarter was $59.1 mm, which was in-line with our $59.8 mm estimate. The increase in revenue this quarter was primarily the result of acquisitions (Top Aces and DMS) and improved business mix. However, total flying hours decreased by 6.5% to 27,885 hours from 29,834 hours over the same period last year. EBITDA came in at $19.6 mm, which was 7% below our estimate of $20.9 mm. We view this as particularly disappointing given that we had already assumed a challenging quarter due to wet weather conditions (this impacted both H&L and GSHL). EBITDA increased compared to $18.7 mm last year as the result of the inclusion of Top Aces results. For the quarter, EBITDA margin came in at 33.2%, which
was 180bps lower than our 35% estimate. Discovery Air reported lower EBITDA margin in both of its operating segments, as the company was negatively impacted by wet weather conditions, lower demand from resource companies, and higher costs.

Discovery Air reported net earnings of $8.9 mm or $0.07/share. This compares to our estimate of $9.8 mm or $0.07/share. This miss in net earnings was largely attributable to lower EBITDA margin.

Overall, we consider this quarter disappointing due to lower than expected EBITDA margin at both operating segments. Discovery Air continues to be impacted by wet weather conditions, lower demand from early stage resource companies, and higher costs. We have made adjustments to our model to reflect the lower than expected results this quarter.

Top Aces’ David Jennings appointed new interim CEO

On Friday (September 12), Discovery Air announced that its Board of Directors terminated David Taylor as President and CEO of the company. David Taylor and Ian McLean also resigned from the Board of Directors. David Jennings was appointed interim President and CEO of Discovery Air. Mr. Jennings is co-CEO of Top Aces Inc., a subsidiary of Discovery Air. He is a former CF-18 fighter pilot and was one of the three founding partners of Top Aces in 2001. After graduating a Top Gun in his CF-18 Hornet conversion course, he was assigned to 425 Tactical Fighter Squadron at CFB Bagotville. Mr. Jennings was then selected for NATO Tactical Pilot Leadership training and the ACE Air to Surface Conventional Weaponeering Course in Europe. By the end of his nine-year military career, he was ranked a Multi-Role Mass Attack Lead, the highest combat readiness level. Mr. Jennings then consulted for CAE Systems, writing software for the CF-18, prior to founding Top Aces Consulting (now Top Aces Inc.) as Senior Vice-President and partner in 2001.

REVISING OUR F09 AND F10 ESTIMATES AND LOWERING OUR TARGET PRICE TO $1.00 (PREVIOUSLY $1.70)

We are lowering our revenue and earnings estimates for F09 and F10 to take into account a weaker than expected Q2 results. For F09 and F10, we are lowering our EBITDA margin assumptions to take into account the disappointing Q2 results and to reflect a more conservative outlook through our forecast periods. The company had been forecasting EBITDA margin of 30% for F09, however YTD they have only achieved 24.4%. Given that the second half of the year is typically weaker than the first half of the year, we are lowering our EBITDA assumptions to approximately 22% for F09. For F10, we are forecasting that EBITDA margin will improve to 23% due to higher forecasted revenue at Top Aces (this division generates EBITDA margin in excess of 30%).

From Versant Partners

BOTTOM LINE

We continue to like Discovery Air, but given the weaker than forecast results, some uncertainty over growth next year, and the recent changes in management, we are lowering our rating to SPECULATIVE BUY from BUY previously.

We previously valued the stock by applying a 14x multiple to our F2010 EPS forecast to arrive at a target of $1.80. To reflect lower stock valuations across the aviation sector, we are reducing our multiple to a more conservative 10x. Applying this to our new F2010 EPS forecast of $0.07 implies a new target of $0.70.

FOCUS POINTS

– Q2 revenue of $59M was slightly below our forecast of $62M while EPS of $0.07 was lower
than our $0.10 estimate.

– Results were substantially impacted by abnormally low fire-fighting activity in Ontario
and Quebec.

– Although it creates some uncertainty, we expect last week’s management change will ultimately be positive for the company.

– Our new F2009 EPS estimate is $0.04, down from $0.11 previously. Our new F2010 EPS
estimate is $0.07, down from $0.13 previously.

Fire-fighting activity at abnormally low levels

Although not really a surprise, a major contributor to lower than expected financial results and weaker year-over-year numbers was the unusually low level of fire fighting activity in Eastern Canada. Contrary to Environment Canada’s earlier prediction for a hot dry summer, the weather across much of Canada this summer was unusually wet.

Recall that the company’s Hicks & Lawrence subsidiary is primarily engaged in fire spotting/fighting activity in Northern Ontario so fewer fires means less flying, and a large portion of the subsidiary’s revenue is based on actual flying hours. In addition, short-term, high-margin helicopter contracts for fire fighting typically boost Great Slave Helicopter’s results in the summer months. GSHL saw higher fire-fighting activity in Western Canada this year, but significantly lower levels in Ontario and Quebec. Indeed, overall company fire-fighting flight
hours in Ontario and Quebec were down 72% from a year ago.

Northern Services results

The Northern Services segment saw its flight hours drop by 5% but revenues increase by 11% driven by higher rates, higher pass through fuel expenses, and a shift away from light helicopter usage to intermediate sized aircraft. As mentioned above, lower fire-fighting depressed activity levels. In addition, lower activity at smaller resources customers who are struggling to finance early-stage exploration programs also contributed to the decrease in hours flown. The segment EBITDA margin of 33.8% was below our 49.0% forecast and the
44.6% recorded a year ago as higher wages and maintenance costs increased expenses.

Government Services results

Government services saw lower flying hours driven by a 63% decrease in firefighting-
related hours at Hicks & Lawrence. Revenues in the segment rose to $14.5M from $4.1M last year on the strength of the inclusion to Top Aces this year. Top Aces generates very high revenue per flight hour relative to Discovery’s other operations. The segment EBITDA margin of 42.4% was well above our 30% forecast, but below the 51.1% recorded a year ago.

Financial position

At the end of the quarter the company was in compliance with all financial covenants. The company has used nearly $20M in free cash flow so far this year, but we note that historically the second half of the year sees working capital balances decline and free cash flow turn positive. The biggest concern financially is the $33M term debt that matures on February 1st, 2009.

Management indicates that it is in talks to refinance this debt, but we suspect this liability will weigh on the stock until it is refinanced.

MANAGEMENT CHANGES CREATE SOME UNCERTAINTY

David Taylor removed as CEO

Late last week, Discovery’s Board of Directors terminated the employment of President, CEO and company founder David Taylor. Mr. Taylor and another Board member subsequently resigned from the Board. We understand that this change, along other recent Board changes, was initiated by shareholders, including executive insiders at the various Discovery Air subsidiaries who control significant blocks of shares as a result of their companies’ purchase by
Discovery Air. The interim President and CEO is David Jennings, who is co-CEO and a founder of Discovery Air subsidiary Top Aces. We believe that the company is now actively searching for a new full-time CEO.

All-new Board

The removal of David Taylor as CEO and from the Board is a culmination of changes that has resulted in an all-new independent Board of Directors. Recall that David Taylor is also the CEO of Pacific & Western Bank and shareholders had been pushing to reduce the Board representation of Pacific & Western Bank. To that end, it was recently announced that Gil Bennett, who was formerly Chairman of Canadian Tire, is the new Chairman of Discovery Air.
Also joining the Board are former RBC Financial executive Alan Hibben, Joe Randall, the current CEO of regional airline Jazz Air, and Wayne Sales, former CEO of Canadian Tire. There are now no representatives of PW Bank on the Board.

Changes should be positive at the end of the day

While these significant changes to the senior leadership of Discovery Air have clearly created uncertainty about the future direction of the company, we view them as ultimately positive. Firstly, the moves make way for a full-time CEO, which we believe is necessary to manage what is already a large business and for future growth. We also believe that a fully independent Board will be perceived positively by investors.

ESTIMATES LOWERED

We have substantially reduced our estimates to reflect the weaker than expected Q2, an expected weaker Q3 due to lower expected fire-fighting activity, and reduced flying hours in F2010 to reflect what we believe is the potential for lower resources-related work next summer. Our new F2009 EPS estimate is therefore $0.04, down from $0.11 previously. Our new F2010 EPS estimate is $0.07, down from $0.13 previously.

MRM
(disclosure – our Fund II owns DA shares; I own DA shares and debs)