“The Rarest Securities on Earth”

The folks at StreetAuthority are running a teaser along the same lines of several they’ve run in the past, one that touts the “rarest securities on earth” — these are Enhanced Income Securities, they are sold by different names but essentially are just stapled securities, a high-yield bond tacked on to a share of stock, designed, in their brief heyday, to compete with the high-yielding Canadian trusts. There are only three left, now (most have converted to plain old common stock), though Carla Pasternak and her group have been touting most of them since the days when there were six or eight or more to choose from.

I profiled one of these stocks last year for the Irregulars and wrote about them a few times, so since this ad is sending some questions my way again I thought I’d re-run an article I ran for the Friday File about three months ago. In this article I covered all three of the current securities at the time, and one former member that looked appealing … the stocks have moved around a little bit but are still near the prices they carried then. I haven’t re-checked all the details or updated the numbers below, but my basic opinion remains the same (two still sound appealing, including one that has converted to a regular stock, two others not so much).

So … without further ado, the following is an excerpt from the Friday File of February 26. No updates have been made for more recent numbers that are probably available, and my disclosure at the bottom is still accurate.

One of the most popular investment ideas that I’ve profiled in my “Idea of the Month” articles was New Flyer Industries, the bus manufacturer — and I’m guessing that it’s not because my analysis was wildly insightful, but because the pick has been a very lucrative one so far … so this particular stock has brought in more follow-up questions than most stocks I’ve written about. I can’t answer individual questions about stocks, since that falls into the realm of “financial adviser” and gets the SEC grumpy … so I thought I’d follow up on New Flyer and some of the similar types of “enhanced income” investments for you today in this Friday File.

If you haven’t seen the original commentary that I shared about New Flyer back in August, that can be found by clicking here. To refresh: New Flyer is the leading manufacturer of heavy-duty transit buses in North America, for municipalities and other customers, and their publicly traded “stock” is actually a hybrid high-yield security: part bond, part stock.

These securities are usually called Enhanced Income Securities, Income Participation Securities or Income Deposit Securities (or something similar), and they had a very brief window of popularity several years ago — at the time they were thought to be a useful way for small companies to raise money and create income-focused investments for folks who were, at the time, just beginning an obsession with the almost magically munificent Canadian Trusts. These investments generally had similarly high yields to trusts, but were not as restrictive in terms of taxation, were seen as a good fit for steady, capital intensive “old economy” businesses … and as it turns out, they also ended up having the virtue of not screwing up the Canadian budget like the burgeoning trust movement was feared to do, so they don’t face the big tax hike that the trusts do next year.

There’s no denying that these Frankenstein-creations were probably also briefly popular because they made more money for the investment bankers — who seem to love nothing more than having a way to make an investment or offering more complex. But in the end, what the surviving EIS investments have in common is that they effectively distribute most of their cash flow to investors as an above-average yield, they have steady businesses, and they have a stronger claim on the assets of the underlying company than do investors in typical stocks.

And, what do you know, most of them are also primarily listed in Canada, like New Flyer — though none are primarily Canadian businesses (New Flyer is actually the “most Canadian” since they’re headquartered and do their manufacturing in Winnipeg, but the vast majority of their sales are in the US … the others primarily own US assets and businesses).

These are the currently trading enhanced income securities that I’m aware of, in no particular order:

New Flyer Industries (NFI.UN in Toronto, NFYIF on the pink sheets)
Otelco (OTT — this is the only surviving US-listed one that I know of)
Medical Facilities Corp. (DR.UN in Toronto, MFCSF on the pink sheets)

Hmmm … lots of these guys have disappeared over the last year, or at least stopped actively being listed — I guess we won’t be seeing a lot of new Carla Pasternak teasers for these investments, now that the original eight EIS’s that we often saw mentioned are effectively down to three.

Let me give you a bit of an update on New Flyer, and then share some thoughts about the other available “enhanced” securities … and whether or not New Flyer is still my favorite of these little high-income Frankenstein’s Monsters.

New Flyer Industries
has had a good six months since I wrote about them, continuing to consistently pay their monthly distribution (which remains unchanged, as it has been for years) and recovering from the low prices over the Summer with about a 35% move in the share price. The dividend is 9.75 cents per share (Canadian) per month, which annualizes to C$1.17, a current yield of just a hair under 11% … not quite as compelling as the 14% yield you would be getting if you had bought in August, but still a very high yield.

New Flyer’s business still looks very solid — they generated C$308 million in orders in the fourth quarter, and still have a backlog of C$3.9 billion, of which more than 20% is firm orders (the rest is options). And their future is in cleaner buses, which are a growing priority for metropolitan transit fleets — compressed natural gas, fuel cell, hybrid diesel-electric or hybrid gas-electric — 20% of their most recent quarter’s orders are these “cleaner” buses, but they make up 69% of the backlog, and they sell for considerably more than the traditional diesel buses.

The company’s “distributable cash” is still significantly outpacing their dividend, with improvements thanks to increased sales and a better product mix last quarter, so that the payout ratio was just 71% for the first three quarters of 2009 — so they have some cushion, since they’ve said in the past that the ratio should be below 80%. Cash flow has been improving, and they have a credit facility available that remains untapped, and I’ve been pleased with the management’s ability to bounce back from the one difficult large order they had last year (buses with a design flaw that should by now have all been fixed and delivered properly), and from a large order of 140 expensive reticulated buses that was delayed and left a hole in their schedule.

Given their market-leading position in heavy buses, their innovative new clean energy products, and their successful performance in the past, I’d still be happy to own New Flyer at these prices, though there’s not likely to be a big snap-back rally like we had last Fall — I would buy with the expectation of a 10%+ yield that looks sustainable to me (remember, roughly 2/3 of the distribution is interest on the bond portion, which is C$5.53 of principal with a 14% coupon — the balance is a stock dividend that can theoretically be changed, though the distribution has been constant at this same rate since the Summer of 2007).

The other two “enhanced” securities, to be honest, I’m not too crazy about — there is one that I like, but it no longer has this odd structure (more on that in a moment). Here’s a brief look at each:

Otelco is a rural wireline telecom company, and the company’s EIS has had a nice recovery off the lows of last Spring, to the point that it is now, like New Flyer, trading at near the “right” price — the price when half of the value is the bond and half is the stock, since OTT’s underlying debt is $7.50 in principal of 13% notes. The company is not profitable and hasn’t been for quite a while, so the stock dividend portion of the distribution is treated as a return of capital. They pay a quarterly dividend, not monthly like some of these securities, and the current distribution is 42 cents, for an annualized yield of 10.8%, just about the same as New Flyer. To their credit, they have seen free cash flow (operating income minus capital investments) turn around nicely, but most of their incoming “cash” is from depreciation and amortization of their long-lived assets — and unfortunately, as a wireline telecom company, those are essentially wasting assets, they’re not going to grow organically when people are cutting off their landlines and businesses are dropping lines faster than broadband additions are adding to income.

By comparison, Frontier Communications (FTR), the much larger wireline telecom company that is buying a bunch of Verizon’s phone lines, is profitable and is, I think, still the highest dividend stock in the S&P 500 — they’re not perfect, of course, they pay out about twice as much in dividends as they report in earnings, which can’t last forever, but the are at least profitable.

If you tried to do something similar with the larger Frontier and manufacture your own “enhanced income” portfolio around the business, the stock yields 13% and the bonds with a maturity similar to OTT’s 2019 yield about 8%, so you can see that a mix of both would get you pretty close to OTT’s 10-11% yield. Frontier, by the way, trades at about 1.1X sales and 7X book value — OTT trades at 2.1X sales and 35X book value — those numbers aren’t necessarily critical for analyzing these businesses, but they do tell you that OTT isn’t necessarily cheap. I mostly mention Frontier to let you know that, unlike some of the other stocks that trade as EIS or high income securities, the competitors also trade at high yields. I personally own shares of Verizon (VZ) since I like the combination of 6% yield (especially because that dividend tends to grow), megacorp stability, and potential broadband, FiOS and wireless growth, but I’m not crazy about the wireline telephone business and I don’t have a particular interest in owning Otelco, Frontier or any of the others.

Medical Facilities Corp has these hybrid securities trading at DR.UN in Toronto and MFCSF on the pink sheets. They own controlling interests in four specialty surgical hospitals in Oklahoma and South Dakota, and two ambulatory surgical centers in California. Like the others, they’re really a US company but are officially Canadian and are designed to spin off income like a royalty trust — their current montly distribution is .0917 Canadian cents, and like New Flyer that amount has been steady for years — so from the current price of C$10.74 that gives an annualized yield of a hair above 10%. As you can see, most of these similar-structured securities usually end up trading pretty close to each other … all else being equal, which it ain’t always.

This is essentially like buying a medical properties REIT, of which there are many, so what you get with this small security is perhaps something that’s a bit below the radar, since it’s far, far smaller than almost all REITs, and perhaps something that could grow — but again, as with most of the companies that primarily trade as odd hybrid securities, it’s more complicated to raise new money than it is for traditional equities … and most companies that spin out effectively all of their cash to shareholders need to bring in new shareholder money in order to invest in growth.

Though the dividend is decent, most healthcare REITs also pay a good dividend — admittedly, not nearly as high as 10%, But several of them have yields approaching or above 7%, with more potential for dividend growth, and I can’t help but think that the economies of scale are going to work against these guys in terms of profitability — most of the big health REITs have hundreds of facilities, and this company has four. Admittedly, they aren’t just landlords so they can make more of a profit than a simple building owner, which some of the REITs are, but the risk is also appreciably higher with this kind of concentration. Given the availability of more diversified and more growth-oriented options with yields that can grow, I’d look to the healthcare REITS over this EIS. You can see the basics on a few of them, though it’s clearly a bit dated, from when I divulged the “Rabbi’s Secret” last May.

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And you might be thinking of some other EIS investments that I’ve mentioned over the years, mostly in response to teasers by Carla Pasternak — and yes, several of them that I’ve written about are no longer, though that’s not necessarily a bad thing.

Atlantic Power was one of the more stable EIS investments, not surprising for a company that essentially is a utility electricity generator (they own shares of power plants that sell wholesale electricity, along with some transmission assets, all around the U.S.) Like New Flyer, they’ve done well and now have a much lower effective yield than they did a year ago, for Atlantic Power it’s now C$1.09 per year, which translates to a yield of about 8.6%.

That’s not bad, and of this group Atlantic would be the only one I’d consider buying now in addition to New Flyer (I don’t own any of these securities personally right now). Atlantic Power converted to a corporation late last year, and said they will be able to continue the distribution at the same level — and more importantly, that this is now a “qualified dividend”, making it in some ways more valuable to taxable investors. Unlike a coupon payment they can change the dividend whenever they want, of course, but they have committed to keeping it constant for now and, also unlike a coupon interest payment, it might be taxed at a lower rate than your ordinary income. For investors in the highest U.S. tax bracket, a company presentation said that this has the end result of increasing the after-tax distribution by 16%. Atlantic Power says that they “Can maintain current dividend level into 2015 with no acquisitions or organic growth initiatives.”

And, perhaps more importantly, Atlantic Power is likely to have a NYSE listing by sometime next quarter — which could easily drive up shares a bit as it begins to get more comparisons to more traditional electrical utilities, most of which are also held by income-focused investors, and most of which yield considerably less than Atlantic’s 8%+ (6-7% is a high yield for an electric utility right now). That’s not to say that Atlantic Power is certain to climb, it has already had a nice run and they still carry quite a bit of debt, and distribute a very large portion of cash flow (83% for the first nine months of last year, according to a company presentation). Then again, like many utility-type companies they do have much of their business locked up in long term, predictable contracts with solid customers (with some relief if fuel prices rise), and their conversion of the EIS to a standard equity and listing on the NYSE means they will have a much easier time raising money to expand.

As for the others?

B&G Foods, which previously had an EIS trading (I wrote about that one over a year ago on the free site), no longer does — they redeemed part of the debt portion of that security back in October, which automatically resulted in a splitting of the EIS. This means that folks who held that EIS (ticker was BGF) got back about 60% of the cash from the bond and are left with the stock portion of the EIS (one share, ticker BGS — still a relatively high yielder at 7%) and a small share of debt that continues to have a strong yield to maturity in 2016, but which they would probably have a devil of a time selling since there’s not likely to be enough of that debt outstanding to make it really “tradeable,” especially for small investors. This is a worthwhile risk to consider, and one that I don’t think I mentioned for New Flyer — the terms of an EIS can allow for the security to be “split” into common stock and debt if certain conditions apply, like B&G’s decision to repay some of the debt, and investors don’t necessarily get a say in that decision.

Student Transportation of America (was STB.UN, in Toronto and SUDRF on the pink sheets) has delisted its EIS from the Toronto exchange, though the underlying stock still trades and a little bit of the debt still exists — they essentially exchanged most of the oustanding debt portion of the EIS for new shares, so the company is basically left with the same shareholders and the same focus on paying a large dividend, without the underlying guarantee of a debt coupon. Currently the yield is about 11.5% for the common stock, which trades at the ticker STB in Toronto. I look at this and I can see how they manage to keep the distributions going, thanks to heavy depreciation on their fleet of school buses, but I can’t get excited about a stock that keeps paying out so much more than they make in earnings in a very tight margin business — they do use the “distributable cash” numbers that many income-oriented stocks do to give an idea of their capacity to pay dividends, but they also, for the last six months of 2009, distributed half again as much cash as they had available. That’s partly due to seasonality, and I have not researched this stock as closely as New Flyer or a couple of the others, but something about the stock’s filings just give me the sense of riding along a precipice — and when doing so, there are better vehicles to ride in than school buses.

Likewise, one of the most wounded “enhanced” securities disappeared last year. Primary Energy Recycling, which has cogeneration plants at some steel mills in Northern Indiana, among a couple other businesses, used to be largely traded as an EIS, but the company was in such dire straits that it had to recapitalize. A key part of that recapitalization was getting the holders of the subordinated notes, including the folks who held that debt as part of an EIS, to accept common stock in exchange for that debt. So that’s just a regular stock now (PRI in Canada, PENGF on the pink sheets), with a rebuilt debt facility and a fairly short leash from their new creditors … and, I imagine, no dividend for at least a while.

This was clearly telegraphed, the company was obviously in trouble last year and earlier, when the yield temporarily looked massive, 20-30% or more for a time, but just because a company trades as a part debt/part equity security doesn’t mean you automatically have a successful investment. If they can’t cover the distribution with free cash flow, and at least cover the debt portion of the interest payments fairly easily (most of them are allowed to adjust the equity dividend portion of their distribution, but not the debt interest payment), then there’s good reason to be concerned — just as there is with any other apparently high income investment that pays out more than it brings in. The first time I mentioned these guys last April the stock was three times higher and the yield a reported 28%, and even then I noted that the absurdly high yield “should frighten you.”

I’m not primarily an income-focused investor, though I do like stocks that return cash flow to investors instead of blowing it on empire building, and my general tendency would be to choose stocks that are likely to increase their dividend for my personal portfolio, rather than high current yielders (of course, both is lovely – if Seadrill is able to maintain their growing payout that’s about a 9.5% yield — $2.20 a year on a $23 share price — though it’s far less certain and stable than many dividends, and certainly not as rock-solid as the coupon portion of an EIS should be). Still, for high current income and a margin of some safety, I’m still a fan of New Flyer … and I think Atlantic Power, though no longer a hybrid security, might continue to rise on their large yield as investors become more familiar with them, and more comfortable with their new “regular” stock. The EIS is in some ways a silly gimmick, but it doesn’t mean that the right company can’t give you some stability and income — and possible growth — from inside this gimmick.

Full disclosure: I continue to own shares of Seadrill. I am not invested in any of the other stocks mentioned above, and will not trade in any stock mentioned for at least three days.



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May 22, 2010 4:31 am

Thanks for the writeup Travis. I own both NFI and ATP from 2009. I think NFI could do better with some more focus on international business by way of airport bus contracts. There are plenty of large airports that still need to bus travelers to and from planes.

May 22, 2010 4:41 am

I really appreciate the information that you provide for us Irregulars. Pertaining to this article on EIS – Atlantic Power. I found two symbols, ATP.TO and ATLIF on the pink sheets. Being a US citizen which