Exchange Income Stock: A Steady Flight Path (EIFZF)

Exchange Income (TSX:EIF:CA) is a diversified aeronautical and manufacturing business with a focus on regional and specialty aviation. EIF is based in Winnipeg, Canada. In its 20-year history, EIF has grown from a single regional airline to reach a market capitalisation of CAD 2.2bn and provided its shareholders with a 19% CAGR of shareholder returns over the period.

Its successful strategy has been via a consistent track record of acquisition of adjacent and complementary businesses, a total of 31 acquisitions over the period.

As its name implies, Exchange Income has a focus on rewarding its shareholders with growing dividend income, which it has done with a 5% dividend CAGR for two decades. Current yield is 5.8%.

By virtue of its model of providing essential and specialised services via long-term contracts, EIF enjoys comparatively low volatility earnings for the aviation segment.

Recent diversification into other manufacturing segments offers further long-term growth.

Despite the long-term growth of the business, the stock is priced at a reasonable level, and is a great choice for low volatility income investors.

Shareholder alignment is strong, with 6% of shares being held by management.

Let’s have a good look at what they do.

Company profile

While EIF can be described as a regional aviation company, as a result of a string of acquisitions, it has steadily built itself from this base into a more diversified manufacturing and operational service provider.

The acquisition track record has been strong over this period, with a focus on acquiring businesses with strong management, good cash flows, and also segmental adjacencies that are complementary to the existing portfolio.

It would appear that some of the entities acquired have been merged, and possibly others divested, as the current portfolio of subsidiaries numbers 19 out of the 31 total acquisition count.

The operations can be viewed in two main segments, Aviation and Manufacturing, which each have diverse sub-segments.

Aviation

Essential Air Services

This is the original heart of the business, still accounting for 32% of revenues. Essential Air Services operates under a number of brand names, which provide fixed wing and rotary wing essential aviation services to remote communities in Northern and Regional Canada. As many of these communities are only accessible by air in winter, essential air services is aptly named. Services include medivac, passenger, freight, and charter services.

Many of the services are long-term contracts with regional governments, which provides a stable income stream. EIF’s businesses have a strong competitive position in these under-served markets.

Interestingly, Canada is the one of only two G7 countries where the regional population is growing, albeit at a modest rate of only 0.4% in the period 2016 to 2021, according to Statistics Canada. This is much lower than the 6.3% growth rate of the population as a whole over the period.

In my opinion, this growth rate is likely to increase over time, with climate change opening up more land uses further north, and low affordability of property in the urban areas. I see this as a double-edged sword, in that demand growth is unlikely to attract huge competition in the essential services segment. However, EIF needs to look elsewhere to continue to grow at historical rates.

Aerospace

This segment provides vertically integrated solutions highly tailored to special mission aircraft use. The client base is governmental, with long-term contracts for providing and operating specialised aircraft and training pilots. Typical use cases include intelligence surveillance and reconnaissance. With the increase in geopolitical tensions, demand for this segment should continue to be strong. Aerospace accounted for 14% of 2023 revenues.

Aircraft Sales and Leasing

ASL offers aftermarket aircraft engines and parts sales and leasing to the regional and specialised aircraft space. This part of the business is important for an integrated aviation company, as it allows EIF to generate income from its aircraft through their lifecycle, after for example, the owned and contracted aircraft have become obsolescent for use in specialised contracts or recycle its fleet. ASL generated 12% of revenues in 2023.

In total, Aviation provided 58% of 2023 revenues.

Manufacturing

The 42% of revenues remaining were spread across several businesses in the manufacturing segment.

Environmental Access Solutions

EAS accounted for 8% of the company’s 2023 revenues, offering bespoke solutions to allow access to construction and mining projects. The solutions provide temporary access to worksites over unstable or environmentally sensitive terrain. This is done by the provision of temporary bridges and heavy-duty mats to allow heavy machinery to operate in otherwise inaccessible areas. EIF claims that it is the largest operator in this industry and provides a ‘one-stop shop’ from planning, through operations, and site clearance.

With an increasing focus on sustainability and ESG in the mining and construction area, demand for these solutions can be expected to continue to be robust.

Multi Story Window Solutions

Contributing 19% of 2023 revenues, MSWS is the second-largest subsegment in the EIF stable. It manufactures and installs exterior windows and glass curtain walling for high-rise buildings, typically in mixed use commercial, residential buildings. With a high demand for new residential high rises in Canada, to house the rapidly expanding population, and in the US, this segment should enjoy strong demand into the future. I would expect this to be one of the faster growing segments in the EIF group.

Precision Manufacturing and Engineering

Operating across N America, this segment houses a diverse set of eight specialised manufacturing businesses. Products include wireless and wireline construction and maintenance, hydronic climate control equipment, heavy-duty pressure washing equipment, commercial water recycling, pressure vessels and electrical control systems.

This diverse sub-segment accounted for 15% of 2022 revenues and includes some of the recent acquisitions.

I think that some of these businesses have an interesting growth profile. Dry Air, for example, is newly purchased for CAD 60m during 2023. This is the hydronic climate control business. Hydronic climate control heats and cools buildings with maximum environmental friendliness. With the introduction of a carbon tax due in Canada, alongside further ESG governance, I believe that more companies will seek to improve their environmental performance using products like this.

Financial Performance and Outlook

EIF reported FY 2023 results recently, and published its annual report on Feb 22nd.

The news was pretty good across the board, with strong year-on-year comps.

• Revenues up 21.3% to CAD 2.5bn
• Revenue growth in Aviation segment was 13%, compared to 34% in manufacturing. This is reflecting of the anticipated re-balancing of the portfolio towards the manufacturing segment.
• Adjusted EBITDA up 21%
• Net Income up 12%
• Free cash flow grew by 17% – flat on a per share basis.
• The dividend was increased by 5%

Due to the significant growth in the business, and funding of acquisitions, an equity raising was carried out in 2023.

3.3m shares were issued in a prospectus offering at CAD 52.25 per share, representing 8% of the shares outstanding at the beginning of 2023.

In addition to this, the share count increased due to the dividend DRIP, and new stock issued as part of acquisitions. Total share issuance was 11% in the period.

2023 was a busy year for acquisitions, with three transactions.

BVG Glazing

The glazing business BVG was added to the stable in March with a cost of CAD 107m. The product range includes several new glazing solutions, expanding the EIF capabilities provided by Quest, an existing subsidiary. This expansion is both in the areas of product with curtain wall and railings added to the product mix, and geography, with enhanced capabilities in the US.

On a combined basis, the two brands have a current backlog of CAD 1bn, and a further CAD 2.5bn in pipeline, which they feel will be more successfully tapped with the combined capabilities.

Hansen Industries

In April, EIF acquired Hansen for CAD 44m. Hansen’s business is precision manufacturing of sheet metal and metals machining. This expands the capabilities of the existing EIF business – Overlanders.

Dry Air Manufacturing

Dry Air was added in October, for a price of CAD 66m. Dry Air adds a new business line in Hydroponic climate solutions to the EIF manufacturing profile.

The expectation is that the existing business will be able to further expand and develop its R&D with access to growth capital from EIF.

Much of the acquisition funding was via cash, with a smaller proportion of share issuance in each case. All are expected to be earnings accretive, and in all cases, the existing management team is retained, lowering execution risk.

It is not clear how much of an opportunity there is for cross marketing between these three companies and the other construction servicing businesses, but in my mind there has to be potential here. One example given is for Hansen to provide machined installation frames for BVG’s glazing solutions.

These examples clearly show the EIF strategy of pivoting from an Aviation-based business to a more balanced Aviation/manufacturing franchise, No guidance is given on the forward mix, but my expectation is to see the higher growth rate of the manufacturing business to result in a long-term portfolio rebalancing.

The business outlook is very positive, as presented in the annual report, and expanded on in the earnings conference call.

Highlights on the outlook

• New long-term contracts for Medevac services for BC and Manitoba. Upfront investment in refitting aircraft to be amortised by the end of 2024.
• Expansion of a regional Air Canada contract for eastern Canada.
• Netherlands Coast Guard contract.
• UK Government contract for 18 months deploying the Force Multiplier Aircraft in marine surveillance. The contract was a short-term solution and EIF have tendered for a larger, longer-term contract. As the incumbent emergency solution provider, the chances of securing the long-term contract are high.
• Adjusted 2024 EBITDA guidance of CAD 600 – 635m (8-14% increase.)
• Guidance with high confidence due to long-term contracts.
• YOY EBITDA growth in most segments.
• CAD 2bn of liquidity via line of credit.
• Active M&A pipeline.

All in all, a very positive outlook for a business which shows a disciplined and successful track record of long term M&A. I would have high confidence in the management outlook.

Balance Sheet

EIF does carry a significant amount of debt, being in a capital intensive business. CAD 1.85bn in debt, which is over 3 x EBITDA. About 23% of this is in convertible debentures. This gives a debt to equity ratio of 165%, with debt representing 50% of total assets.

The debt maturity schedule is quite short in duration, with all of the long-term debt due in 1-5 years. On the conference call, it was confirmed the first debt due is some convertible debentures in mid-2025. The positive news is that with the strong cash flow, interest payments are very well covered, with a TTM interest coverage of 2.42x, a current ratio of 1.87, and a quick ratio of 1.21.

Clearly, refinancing this debt is a key issue to watch. I take comfort in management’s continued expansionary posture, some of which is debt funded, that they feel in control of this. I find it telling that there were no questions on debt refinancing on the earnings call.

Share Price Performance

EIF has been a very good performer for shareholders over the long term, with a price appreciation of 128% over ten years, significantly beating the TSX, which produced 50%.

Given the fact that EIF is a dividend focused stock, total return is important here. EIF total return has been an impressive three times the market.

EIF valuation took a big hit during Covid, not surprising for an Aviation-based business. Its recovery over the last five years has been impressive, outperforming the TSX total return by 50% over the period.

Valuation

According to Seeking Alpha, EIF trades at a price to trailing earnings multiple of 17, and at 6x TTM cash flows. TSX currently trades at 20x earnings. This seems like a reasonable valuation for a growing business with strong cash flow generation.

How do analysts see EIF?

Firstly, as a Canadian stock, EIF is not covered by SA Quant.

According to SA, all ten Wall St analysts that cover EIF rate it as a buy, or strong buy.

The average price target is for a 40% upside to current levels.

My take on valuation

Clearly, the analyst community is very positive on EIF, with a strong consensus that it is currently undervalued, and also on price targets. The average price target of CAD 64 with an upside of 40% shows strong expectations. I think that management’s guidance for a mid-range of 12% increase in revenues is reasonable. I do note that the share count has increased by about this proportion.

I also took a look at the history of analysts’ price targets vs the actual stock price. This shows the analyst price targets have typically been in the region of 20% above current market prices.

The market price to analyst target is currently at its highest level since covid, with no obvious catalyst.

Earnings can be expected to increase by management’s mid-range guidance of 12% with a high degree of confidence. There is no catalyst for margin improvement.

I also see the price multiple as having some upside, say to a multiple of 18.5. This generates a price target of CAD55, being a 20% upside to today’s price.

One could argue that a company throwing off this much cash and growing at 2-3 times GDP should attract a higher multiple. This hasn’t been the case in the past, and I doubt that this will change in a hurry. Clearly there could be further upside in the stock price, but I feel comfortable that there is at least 20% upside.

Risks

EIF provides a comprehensive summary of risks that they have identified.

I see the key risks to the positive thesis as:

• Debt refinancing and interest rates
• Economic conditions – however, as discussed, a third of the business is involved in essential services, and in long term contracts
• Credit risk
• Commodity risk
• Acquisition execution risk – however, the track record is strong, key management are retained, and M&A size has been contained.
• Client and contract concentration risk.

Summary & My Position

• EIF is a mature and highly successful value compounder.
• Management is shareholder-friendly with aligned interests.
• The business has a strong growth track record, which is set to continue.
• The business mix is shifting towards a more diversified profile with recent acquisitions.
• Debt levels are significant, but strong cashflow and liquidity reduce the risk.
• The share price currently sits at an attractive level with a strong outlook.
• The dividend of 5.8% is likely to grow with the business.
• I will add to my position at these levels.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.