“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 Frontie