Good morning, ladies and gentlemen. Welcome to Exchange Income Corporation's conference call to discuss financial results for the three and six-month periods ending June 30th, 2016. The Corporation's results, including MD&A and financial statements, were issued on August 9th and are currently available via the company's website or SEDAR. Before turning the call over to management, listeners are cautioned that today's presentation and the responses to questions may contain forward-looking statements within the meaning of the safe harbor provisions of Canadian provincial securities laws. Forward-looking statements involve risks and uncertainties, and undue reliance should not be placed on such statements. Certain material factors or assumptions are applied in making forward-looking statements, and actual results may differ materially from those expressed or implied in such statements.
For additional information about factors that may cause actual results to differ materially from expectations and about material factors or assumptions applied in making forward-looking statements, please consult the MD&A for this quarter, the Risk Factors section of the annual information form, and Exchange's other filings with Canadian securities regulators. Except as required by Canadian securities laws, Exchange does not undertake to update any forward-looking statements. Such statements speak only as of the date made. Listeners are also reminded that today's call is being recorded and broadcast live via the internet for the benefit of individual shareholders, analysts, and other interested parties. I would now like to turn the meeting over to the CEO of Exchange Income Corporation, Mike Pyle. Please go ahead, Mr. Pyle.
Thank you, operator. Good morning, everyone. Also with me today are Carmele Peter, EIC's President, and Tammy Schock, our CFO, who will review our financial results in greater detail in a few moments. Following on the heels of our best ever first quarter in our 12, our performance in the second quarter was marked by record results across almost every major financial metric that we use to gauge the health of our operations. Most notably, consolidated revenue grew by 16% to CAD 226.9 million. EBITDA grew by 18% to CAD 56.9 million. Free cash flow, less maintenance CapEx, grew by 28% to CAD 25.5 million, and our payout ratio was a strong 54%. This was in spite of a per-share growth of the dividend of 14% and a 38% growth in the total dividends paid as a result of an increase in the number of shares.
Q2's results are proof that our strategy is working. Given the number of new followers to your story, I want to put some of Q2's results in perspective. We were able to generate record results without a single major catalyst against a backdrop of volatile commodity markets, a depressed manufacturing sector, and a fluctuating Canadian dollar. Our performance was, in fact, the culmination of a number of factors. Most notably, our growth came from the strong contributions made by Regional One, Provincial, and our Legacy Airlines, each of which took advantage of previous growth capital investments which we made to accelerate our growth. Ben Machine, which we acquired in July 2015, also contributed to our record results in Q2 and continued to fulfill our objective of diversifying our revenue streams across multiple entities and geographies.
The diversity of our operations was in fact a key driver of our record results, given the opportunities and challenges that each of our operating segments faced in the second quarter. Let's take a look at some of the factors driving our performance in more detail. During the second quarter, we invested CAD 33.5 million in growth capital expenditures. The most significant investments were CRJ and other turboprop aircraft purchased by Regional One to fuel their future growth, together with the purchase of a Eurocopter EC135 twin engine helicopter by Custom. Within the aerospace and aviation segment, Regional One experienced strong growth as a result of the ongoing success at monetizing its expanded portfolio of aircraft assets. In the second quarter, Regional One generated strong revenue and EBITDA growth that was driven by aircraft under lease and the sale of assets and parts.
These asset sales and leases were largely drawn from previous investments made in the acquisition of a fleet of CRJ700 planes from Lufthansa CityLine regional airline. In other words, our previous investments delivered a very healthy rate of return and helped to fuel our growth. Regional One's success with the CRJ700 has enabled it to acquire expertise and a strong reputation with carriers around the world. We are now prolonging this experience into the CRJ900 platform, a longer range and higher capacity plane with new investments to grow the number of assets in our portfolio. I will expand on growth CapEx and how we expect to capitalize on new market opportunities in my closing remarks. Also within the aerospace and aviation segment, Provincial made strong contributions in the second quarter.
Of particular note was the benefit from the five-year in-service support contracts signed with a Middle East customer late in November 2015. Provincial's diversity of operations, like EIC's, was a key to its success in the second quarter. Revenue and EBITDA contributions from its aerospace division were partially offset by unfavorable economic conditions in Newfoundland and Labrador. Austerity measures implemented by the provincial government, coupled with depressed oil and gas and mining sectors, are causing a drag on Provincial's aviation service performance. The impact was lower revenue and EBITDA contributions from its scheduled flight and cargo services. Our legacy airlines, in contrast, experienced continued growth in the second quarter. Their progress was largely due to the acquisition of First Air's Kivalliq non-aircraft assets and previous investments we made to streamline our fleet, optimize route schedules, and benefit from a more coordinated procurement activity across our aviation entities.
While our legacy airlines continued to benefit from lower fuel costs in the second quarter, these savings were partially offset by the lower value of the Canadian dollar. The declining value of the Canadian dollar negatively impacts legacy airlines and their EBITDA contributions in that replacement parts and flight training costs are generally paid in US currency. I should point out that the impact of these costs and the weak Canadian dollar are more than offset by the Regional One revenues and the balance of our U.S.-based entities. Turning briefly to our manufacturing segment. On a consolidated basis, the manufacturing segment grew revenue and EBITDA as a result of the acquisition of Ben Machine, which we completed in July of 2015. Ben Machine's contributions helped to offset the declines experienced by manufacturing segment entities, which continued to be challenged by weak and volatile markets.
Our Alberta operations, in particular, continue to be adversely impacted by the ongoing slump in commodity prices. Unfavorable market conditions in the second quarter were further exacerbated by wildfires that raged in Fort McMurray and surrounding areas, causing considerable economic disruption and lowering of demand for our customized steel tanks, pressurized vessels, and field services. WesTower Communications, by contrast, experienced a modest recovery, growing revenue and EBITDA in the second quarter. As in the recent period, WesTower Communications has experienced a reduction in new cell tower construction activity but has benefited from a trend toward increased demand for higher, more labor-intensive equipment upgrade and service work. We anticipate this development to continue in the near term. I will provide more commentary on our outlook and prospects for growth in the future in my closing remarks.
I would now like to turn the call over to Tammy, who will review our Q2 financial performance in greater detail.
Thanks, Mike. Good morning, everyone. In the interest of time, I'm going to focus my remarks only on our second quarter results. I'd also like to point out that we have changed the name of one of our operating segments going forward. The aviation segment is now the aerospace and aviation segment, that name change was done with the intention of better reflecting the diversity of our operations and entities that are in that segment. I should also remind you that our Q2 2016 results include the contribution from Ben Machine, which we acquired in July of 2015. As a result, there is no contribution from Ben reflected in the comparative figures for last year. Turning to our income statement. Consolidated revenue for Q2 was CAD 226.9 million, up CAD 30.6 million or 16% from last year.
That growth was largely driven by the contributions from Provincial, Regional One and Calm Air. Our manufacturing segment also contributed to our revenue growth as a result of the addition of Ben Machine as well as increased revenue from WesTower. Our growth was tempered by the performance of other subsidiaries in the manufacturing segment. Our Alberta operations in particular, which continue to be impacted by the decline in commodity prices and the forest fires there. On a segmented basis, the aerospace and aviation segment generated CAD 177.1 million in revenue, that's up 18%. The manufacturing segment had revenue of CAD 49.7 million, that's up 7% from last year. That's largely Ben Machine and WesTower driving that, offset by the weakness in other businesses. The growth in aerospace and aviation segments revenue reflects our diversification.
To that end, significant growth capital investments have increased our revenue across a diverse number of products, services, and geographies within our operations. As a result, those operations are much broader than they appear. There's 13 subsidiaries doing business around the world and across a number of industries. Consolidated EBITDA was CAD 56.9 million, up 18% from last year. The growth was due to a number of factors. As we have noted, it was largely driven by the contributions from Regional One, Provincial, and Ben Machine. Our legacy airlines, which continued to benefit from lower fuel costs and previous efforts to streamline operations and profitability, also contributed to that EBITDA growth. EBITDA gains were offset slightly by performance of certain manufacturing segment entities as we've already noted. On a segmented basis for EBITDA, the aerospace and aviation segment generated CAD 54.5 million, and that's up 15%.
Its EBITDA margins were 30.8%, which is down slightly from 31.5%. The manufacturing segment generated EBITDA of CAD 6.7 million, which is up 32%, and its margins were 13.4%, which is up from 10.9%. We reported net earnings of CAD 17.2 million or CAD 0.62 basic per share. These compare to net earnings of CAD 13.4 million or CAD 0.58 per share last year. The improvement was driven by factors already cited including strong performance of Regional One, Provincial, and Legacy. On an adjusted basis, net earnings were CAD 20.4 million or CAD 0.74 basic per share for Q2 2016. These compare to CAD 16.5 million or CAD 0.71 for the comparative period. Free cash flow was CAD 42.7 million, which is up 13%. Free cash flow on a per share basis was CAD 1.54, down from CAD 1.63 per share last year.
The decline on a per share basis was due to the increase in the number of shares, largely resulting from the shares that we issued upon the conversion of the Series J debentures. Free cash flow less maintenance CapEx was CAD 25.5 million, or CAD 0.92 per share. These compare to CAD 19.9 million or CAD 0.86 last year. As our maintenance CapEx was relatively consistent with Q2 2015, the increase in free cash flow less maintenance CapEx was attributable to the increase in free cash flow. Our free cash flow totals exclude the growth capital expenditures that we made totaling CAD 33.5 million and, as Mike mentioned, those growth capital expenditures included the purchase of additional CRJ and turboprop aircraft and the twin engine helicopter that Custom bought. Our payout ratio for Q2 2016 was 54%. This compares to 51% last year.
I should also point out that the increase was due to a 38% growth in total dividends paid during the quarter as a result of the dividend increase and the growth in the number of shares outstanding. Our payout ratio in Q2 2016 was well within the range we used to determine the sustainability of our dividend and our ability to increase our dividends. On the balance sheet, we ended Q2 with a net cash position of CAD 15.5 million and net working capital of CAD 145.3 million, which results in a current ratio of 1.86:1. These compare to a net cash position of CAD 15.5 million last year, so very consistent, and net working capital of CAD 135.3 million and a current ratio 1.74:1 at the end of 2015.
The strength of our balance sheet was solidified when we completed a convertible debenture offering of CAD 69 million with a seven-year term late in Q2. The proceeds of that offering were used to reduce our credit facility and then to redeem the Series J debentures that were due to mature in the next two years. That offering provided a number of benefits. It essentially enabled us to reduce our average cost of borrowing, extend the term of our debt by five more years, and it increased our liquidity as almost half of the debenture holders opted to convert their coupons into shares at the record price of CAD 30.60. That concludes my review of our financial results, and I'll turn the call back to Mike.
Thanks, Tammy. Our outlook remains very encouraging, and we're bullish about sustaining Q2's momentum through the second half of the year. In the short term, we expect continued opportunities for organic growth for our aerospace and aviation segment and in our legacy airlines. We anticipate similar opportunities for growth for Regional One as demand for its aftermarket parts is strong, since regional carriers around the world are taking advantage of lower fuel costs to keep older aircraft in operation longer. We also see growth opportunities within Provincial's aerospace operations, given its expanded services work in the UAE. Provincial's potential for growth were in fact strengthened with the acquisition of CarteNav Solutions that we announced on Monday for a purchase price of up to CAD 17 million. While the transaction value was small relative to the size of some of our recent acquisitions, we believe that CarteNav will deliver significant strategic value.
The company, which is based in Halifax, develops software solutions used for intelligence, surveillance, and reconnaissance activities by government and private sector customers around the world. Bundling its capabilities with Provincial's maritime surveillance solutions will deliver significant competitive advantage. As customers demand more sophisticated capabilities, the combination of two best-in-class solutions provides product differentiation and market leadership. The anticipated growth within the aerospace and aviation segment will help to offset some of the challenges that our manufacturing entities are experiencing due to decreased demand for products caused by low commodity prices. Excuse me. Q3 will not be without its challenges. An extremely wet summer in Manitoba and Northwestern Ontario has essentially eliminated the need for firefighting capability, which has a significant impact on Custom Helicopters. It is also expected to be a busier than normal quarter in terms of maintenance capital expenditures.
The nature of these capital expenditures is such that they vary significantly from quarter to quarter, and Q3 is anticipated to be higher than a typical period. I would point out, however, that there is no change in the average level of maintenance capital expenditures expected, but rather this is just a variance in the quarter-to-quarter amount. Before I open up the call to questions, I want to give some context about our recent focus on organic growth opportunities and take this opportunity to talk about our commitment to growth via acquisition. Since taking our company public in 2004, our ability to grow has largely come from the disciplined execution of an acquisition strategy. We have only acted on the best opportunities, paying fair price for companies that have helped us to diversify our operations and enter new geographic markets while complementing existing operations.
Increasingly, we are seeing a trend towards higher acquisition multiples for target companies, particularly in the U.S. This trend is due to an environment of low interest rates and improved access to capital that are driving private equity to pay prices which are, in our opinion, unsustainable. Target companies are using this access, this lower priced capital to fuel their own growth opportunity. Our acquisition team, which is headed by Adam Terwin, continues to actively evaluate a number of potential targets, and as you have heard, we just completed the transaction of CarteNav as a result of our team's effort. Our goal is not to make big deals just for the sake of growing. Especially as multiples climb, we're not prepared to buy at any price. Being disciplined has led to our success over the last 12 years. We're not prepared to change what has worked for us.
Unless acquisitions satisfy all of our criteria, including the need that the price will lend itself to an accretive return to our shareholders, we will walk away from deals. In fact, we're quite prepared to keep our powder dry until acquisition conditions improved. However, in response to conditions that are tempering our acquisition opportunities, we've recently focused our efforts on driving organic growth opportunities by using our deployable growth capital towards investment within our business. In Q2, we made a series of growth investments totaling CAD 33.5 million. We are particularly excited by the investments made towards Regional One's purchase or commitment to purchase 11 CRJ aircraft. It's a fleet acquisition which is made up of a combination of 200, 700, and 900 series aircraft, expand Regional One's portfolio of assets.
Consistent with the experience of the CRJ-700 acquired from Lufthansa CityLine, Regional One will focus on the monetization of these assets through the sale of full aircraft, parts, or leases. I want to make it clear that we anticipate some lumpiness to the EBITDA and revenue contributions of these aircraft in the future, as complete aircraft sales do not always happen in every quarter. We're also using our deployable capital towards the construction of a surveillance aircraft for our own inventory. This investment will allow Provincial to better demonstrate its capabilities to target customers. Just as important, the aircraft will be used in quick response situations for surveillance opportunities as they emerge around the globe. With the world becoming a more dangerous place, we anticipate increased demand for surveillance solutions by governments and international companies alike.
The addition of CarteNav's capabilities, Provincial's ability to capture market leadership has improved considerably. Another growth investment we made in the second quarter was the purchase of a twin-engine Eurocopter EC135 for our Custom Helicopters company. Thanks to its more sophisticated flight capabilities, longer flight range, higher lift capacity, and enhanced safety record, the acquisition will allow Custom to support a greater array of job types and with new customers. The EC135 is expected to go into service late in the second half of this year. Clearly, we are optimistic about our future prospects. Our strong balance sheet and access to approximately CAD 220 million in available capital makes us ideally positioned to act on an array of organic and acquisition growth opportunities in the quarters ahead.
As always, we remain focused on extending our track record, providing our shareholders with a dependable and growing income stream through the steady, disciplined execution of our strategy. I want to thank you very much for listening. We would now like to open the call to questions. Operator?
Ladies and gentlemen, if you'd like to ask a question, please press star followed by the number one on your telephone keypad. We do ask that you limit yourself to three questions to allow others time in queue. Your first question comes from the line of Trevor Johnson from National Bank. Your line is open.
Hey, good morning, folks.
Good morning, Trevor.
Just wondering about Regional One with the shift from the 700, which was very successful and has proved to generate a lot of IRR to the CRJ-900 strategy. Can you just maybe walk us through that shift and if there's any significant economic differences between the two that we can look to?
Thanks, Trevor. It's really the addition of the 900. We're still very interested in the 700 fleet. It's going to be flying for a long time, as evidenced by our CityLine acquisition. Most of those planes are under lease around the world, which frankly exceeded our expectations because we thought we would part out a number of them, the demand for them as operating aircraft is very strong. The 900 is a slightly newer plane, as such, the values are still higher of those aircraft. We're seeing the stage where some people are starting to trade out of them to upgrade into newer series of aircraft, we're slowly moving into that asset. It's a little bit different in that the prices of them are higher, we would anticipate them being leased for a longer period of time before they're parted out.
It's really just the beginning of the next wave of aircraft. We were in the 200s for a number of years, still are very active in that marketplace, moved into the 700s a few years ago, now are dipping our toe into the 900s. It's really just an extension of the strategy. To the extent the differences in finances is that they would tend to be more leased aircraft as opposed to part-out aircraft, you would see a growth in our lease portfolio.
Got you.
Trevor, Carmele. I might add that they have the exact same engines, and there's about 85% compatibility with respect to their parts.
Okay, great Newfoundland, obviously there's going to be some challenges there just going forward. You highlighted some that you're experiencing in terms of some of the demand drivers. Just wondering if there's any opportunity to respond with some cost savings there to maybe squeeze a bit of EBITDA out of that business while it goes through a bit of a rationalization?
Yes and no. They've been working with Regional One strongly, which has reduced our cost of our parts going in, and we've worked together with our other airlines to share fleets to give us access to aircraft when there's short-term opportunities for customer demand. While the economy in Newfoundland definitely is a detriment to that business, a significant part of our business in that area is under contract and services, things like the hydro dam construction and things which are somewhat less variable than the general economy. While it is a slightly more challenging environment, we aren't hit by it to the extent that most of the people are in Newfoundland.
Got you. Great. I got the other headwind you mentioned, the fire suppression work, weak in Q2. It seems like that's going to bleed into Q3. If you can't share this, I understand, but any sense of just size of an impact that we might be able to put a finger on?
I'm not sure that I want to give you a precise number, but I think if you were to look at the Q2 last year versus Q2 the year before, you'd get a pretty good idea, because I think we talked about it then. Last year was a, in quotation marks, typical Q3 versus two years ago. We've had two wet years. The two wettest years in the last 20 were this year and two years ago. It's not a massive impact, but it does cost us a couple million CAD.
Our next question comes from the line of Derek Spronck from RBC Capital Markets. Your line is open.
Okay, thanks for taking my questions. Any update on the Canadian fixed-wing search and rescue contract?
Slightly. The bids have been in, and they have done the testing of the aircraft for both of the lead bidders, and the government's now working on making their selection. It's our understanding that that's going well and that they're on target for their thought of a release of the winner late this year or early next year. We remain cautiously optimistic. We think that ours is the most cost-effective solution in our partnership with Airbus. If we didn't think it was the best quote, I think you'd have a problem. We'll wait and see what the government has to say later this year. We're optimistic.
Okay, great. Does the acquisition of CarteNav, would that provide any benefits should you win the contract?
It may. It's more for some of the other work we do where I think you'll see a more immediate impact if we upgrade the technology, for example, on our East Coast surveillance that we do. More and more governments aren't really interested in the flying you do for them, per se. They want the data flow. However you can get them the data stream the most cost effectively is what they're looking for. CarteNav is an industry leader in the technology in surveillance. By using them within our Provincial platform, it not only makes Provincial more competitive, it lets us upgrade our product faster and give us a competitive advantage. While CarteNav still stands on its own, it has its own revenues, third-party customers that make the deal accretive from a historical point of view.
It's exciting from our end in that we've brought an industry leader on, which will help our existing industry leader when they work together, but we'll also be able to provide a strong cash flow support to the company as a whole.
Yeah, that's great color.
There's also the opportunity to potentially use the CarteNav mission control system actually on the C295 Airbus aircraft, which we have bid for fixed wing SAR. It is a possibility.
Okay. Just from a trend perspective, are you seeing an increase in surveillance-based contract tendering opportunities? It's probably difficult to answer, but what would a typical size and margin profile of a surveillance contract be?
That's not difficult to answer. It's actually impossible to answer. The surveillance opportunities are growing, and they're growing from not just national security issues, like people worrying about terrorism or illegal immigration. They're also growing from health concerns with things like the Ebola crisis we went through a year ago, where smaller countries are petrified of sick people coming into the country and creating health crises that they can't deal with. We are in discussions in a number of places around the globe. It's really important to understand that our participation could really be in one of three ways. One is they could simply contract us to provide them with data flow or provide them with surveillance, where we'll buy our own plane, we'll fly it and provide them with the information they want. That's the highest margin work we do.
Alternatively, they could ask us to build the aircraft for them, and then they would operate it. That tends to be lumpier business because you build a project and then you're complete. Finally, you could do it where you build it and then maintain it for them, which is what's going on in the UAE now. Earlier, before we bought the company, it had delivered two very highly technical surveillance aircraft, and we've now taken over the maintenance of those aircraft for the government. In short, the margins are all over the place, and the size of the projects are all over the place, but the general market demand is growing.
That's why we're building that inventory plane, where we're going to have our own one sitting there to be able to show people the surveillance capabilities, but also to be able to jump in when there's a requirement, whether it's a missing plane, a health crisis, you name it, in a given location, we'll have an inventory available to be able to move rapidly.
Our next question comes from the line of Mona Nazir from Laurentian Bank. Your line is open.
Good morning, and congratulations on a great quarter.
Thanks, Mona. Good morning.
Just a couple of questions from me. Turning to the margin on the manufacturing side, would you say that the 250 basis point improvement year-over-year is mostly driven by Ben Machine? If we were to strip out the acquisition, the legacy business would be down year-over-year?
Yes, the margin improvement is mostly driven by Ben Machine. That's correct. The second part of your question was about legacy?
The legacy manufacturing company.
Oh, okay. Sorry. Yeah.
Yeah, the legacy manufacturing company, the margins would be down as a percentage just because Alberta continues to suffer with the economy there. In the other places, there really hasn't been a material change in margins in our remaining-
Manufacturing
manufacturing entities. They've strengthened slightly at WesTower Communications with the move towards more higher value add work. The declines really are driven by Alberta.
You touched on the CarteNav acquisition. It's small, but can you speak about the complementary nature of the business, but really potential synergies. I saw that their customer base seems pretty broad, U.K., Australia, New Zealand. Do you expect some cross-selling opportunities on the customer side?
Yes, we do. I think the key thing, the main synergy, is the ability to improve the caliber of both companies' products by access to the other company. When Provincial is doing surveillance work, whether it's building custom aircraft, designing a system, or actually doing the flight ourselves, the information technology requirements change rapidly. Provincial has had an internal department of that, but it's not their core business. This is CarteNav's core business, and so what it's going to do, it's going to make us be able to move more quickly, more cost effectively, and be able to design things to meet our customer needs more rapidly. Then with CarteNav as part of our family, we're going to have access to the capital and the opportunities to let them take advantage of their own direct growth opportunities as we have with other subsidiaries.
I can also tell you, it's really the first deal in quite a while where the strategic impact is more exciting than the financial one. It's accretive on a standalone basis. It's a good profitable company. What's exciting to us is what it lets us do with our other companies by working in concert.
Mona, Carmele, there's also a potential of cross-selling each other's products, which would be helpful for each of the companies as well.
Okay. Just lastly from me before I step back. Looking forward, you spoke about acquisitions and how they must be accretive and meet your M&A criteria. Given strong performance from your current business model and the stability that it generates, would your preference be to make improvements in the current legacy business, investments in Regional One, internal efficiencies, or would your preference be to tap into a new vertical if the price and segment is right?
I think the priority for us is to make accretive investment, you've seen with the returns that we published and put out on Regional One and Provincial and the Legacy Airlines, where we're earning returns greater on those growth CapEx than we can possibly get in an acquisition in today's environment. Our first focus is making sure we're taking advantage of all the opportunities that are in front of our operating subsidiaries. Now, that's not to say we're not interested in acquisition, Adam and his team do a lot of working. You got to do a lot of prospecting to find the one diamond, the one unique company that drives growth. We've bought those in difficult acquisition environments before. We bought Provincial at a time when capital was low, and we were able to buy it at an accretive price.
I don't want to give the idea that we're not interested in acquisition. What we do know is the key to our success is if we don't overpay for anything, we're able to grow the company. When we're right on the acquisitions, it's really accretive. When we have a challenge, and everyone has challenges, you've got the flexibility to retool, fix up the problem and continue to grow your dividend. I think right now you'd see more of an emphasis on internal growth, but simply because the returns on internal growth are much higher than they are in acquisitions.
Our next question comes from the line of Tim James from TD Securities. Your line is open.
Thank you. Good morning. I'm just wondering, in Q1, you noted a significant improvement in small to mid-size field projects being bid at Stainless. Is that not, or is that expected to translate into revenue opportunities for the second half of the year? There wasn't any mention of that in the most recent outlook.
We've been a bit disappointed in Our bidding in the second quarter was very close to an all-time high at Stainless. The challenge is companies are deferring decisions, and the decision process is longer. I'm not sure what the uncertainty is in the marketplace that's causing that. With the number of quotes we have out there, our historical close rate is remarkably consistent. We would anticipate that as decisions are made on those, we're going to see our order book start to grow perhaps later in the third quarter into the fourth and see our revenue start to expand early in 2017. In all honesty, I thought that would have happened sooner. We've been surprised by how slow the capital expenditure market has been to actually let out the projects.
There's lots of people talking, lots of people getting us to bid things, but not a lot of work that's been let out.
Okay.
Just to echo that, we're not losing the work to competitors, it's just the closeout ratios just aren't happening.
Okay, thank you. Just a quick sort of housekeeping question here. The sequential increase in depreciation and amortization versus Q1, I think it was up about CAD 1.8 million or 8% sequentially. Just wondering if you could talk about what was the cause of that.
Go ahead, Tammy.
Well, the big driver of that is as we get a larger lease portfolio in Regional One, those planes have a depreciation associated with them. It's growth CapEx on planes that have not been parted out. They're flying around.
That sequential increase from the first quarter to the second quarter, primarily related to those aircraft? Okay.
Correct.
Almost entirely.
Yeah.
Okay.
We depreciate the aircraft once they go into service. As you can see in our numbers, the lease revenue grows at the same time as the depreciation does. One other thing I'd like to point out, just to make sure, there's always people who have questioned about what's a maintenance CapEx. One of the things we do to make sure we're absolutely conservative when we look at that lease portfolio is any amount that we experience in depreciation on our lease portfolio, we need to replace that asset value with purchases. The first, whatever amount we spend in Regional One up to our depreciation amount, we show as a maintenance CapEx.
Yeah.
When you're leasing a plane, you're effectively using it up to a certain extent. We are very conservative in calculating what our maintenance capital investment is into that business.
Okay. Over what period are those, when you buy pre-owned RJs in this case, what period are those amortized over?
Well, the amortization is calculated differently on different components of the aircraft. It's designed to be over a period that matches the lease.
Oh, okay.
We're amortizing things like the engines have defined life, so those will be amortized at a greater rate than, say, something else like the airframe, which doesn't depreciate at nearly the same rate.
Right. Okay.
We'll calculate the amortization to bring it to what we believe the residual value is when it stops flying.
Right. Okay. All right. That's great. Thank you very much.
Yeah.
Your next question comes from the line of Konark Gupta from Macquarie. Your line is open.
Thanks, operators. Good morning. Congrats on a good quarter, guys.
Good morning, Konark. Thank you.
I have a few questions here. Let me start with the second quarter first. You probably benefited from the sold aircraft in the quarter, just like the first quarter. I'm also guessing maybe there was some impact of fire suppression and mix at Regional One on margins in aerospace and aviation?
The first part of the quarter was quite busy. The April, May period in the fire suppression business. For whatever reason, the hose came on, and the rain started, and it stopped very quickly. Those are bullish for margins, and anything, what time we increase our lease portfolio, it's very strong for margins because especially on an EBITDA basis, virtually all the expenses are depreciation.
I see. Okay.
The lease portfolio drives EBITDA. It's important to understand that the offset to that is when we look at free cash flow, is we're subtracting off that depreciation as a maintenance CapEx to get down to what's the pure economic return we've generated.
Okay. What was the EBITDA benefit from the aircraft sold in the quarter?
I'm not sure that I have that number. It wasn't an exceptional quarter. We sold some smaller aircraft, but we didn't sell any of the 700-900 aircraft.
Okay, I see. Thanks. Moving on to Regional One. Looks like the fleet has certainly grown a lot over the last couple of years here, and that probably would imply some more leasing revenue and some more part and full sale down the road. Obviously the mix kind of gets changed here as well because you have some CRJ 200s, I believe now, and some CRJ 900s. As we look forward on the Regional One, the growth rate has been pretty strong over the last few quarters here. How should we think about the business overall? Should we think it as a double-digit growth rate over the next at least few more quarters because of these initiatives? Or should we think the growth to kind of fall back to single-digit rate?
I'm not sure how to answer it in terms of digits. I can tell you that we continue to be very actively looking for investment opportunities, and there's a number of them. I would anticipate continued growth. From an analysis of our results point of view, the growth CapEx this quarter gives you a pretty good idea of what's going to happen three or four months out. When we get an aircraft, it doesn't immediately go into service. We might have to do some work to it, and we have to put it out on lease. With a certain drag, three months, four months, that's going to generate revenue on a go-forward basis. When you see strong growth CapEx numbers this quarter, it's reasonable to expect that a couple of quarters out, you're going to see continued growth as a result of that.
The only thing I would say is you need to keep looking at when we talk about, if we've sold a bunch of aircraft. When you sell them, you get a benefit once. When you lease it, you take it over a period of time. Right now, we've been selling more than leasing. I would anticipate further growth as a result of the CapEx we've made.
Yeah, as well, particularly for the 900s that we've acquired to date, there is a lag time between not only from the time we get them to lease them, but they're staggered acquisitions, they're not all coming at the same time. You'll see that spread out over the next balance of the quarter.
Our next question comes from the line of Steve Hansen from Raymond James. Your line is open.
Yeah, good morning, guys.
Morning, Steve.
Good results. It's hard to poke a lot of results here. I did want to ask you a little bit about the risk management that you're deploying here as it relates to Regional One. You're certainly putting a lot amount of capital into the business. Just trying to get a sense for, maybe just give us a broader perspective on the business as it's growing so quickly here, the visibility that you have going forward, the total lease package or lease term or tenure, I guess, that you're seeing in the portfolio as it stands today. Just how you think about what will rising oil prices might do to that business over time, if indeed they come back, and just get a broader sense for the risk management you're deploying here.
Yeah. It's really important to understand how we do the investments. Regional One are experts on the value of the component parts of those aircraft. We're looking at the expected number of shop visits in the future from operating aircraft. When are overhauls going to be required on engines? When are they coming back? We're looking at building our portfolio to make sure we're available to take advantage of needs for engines for other people. While low oil prices has helped, it keeps these planes in service longer. You would have to see a massive increase before that would dramatically impact the value of those aircraft. We're always looking to make sure, what's our exit strategy if the lease portfolio weakens? Can we part it out? Can we get our money back? Can we earn a suitable return?
Quite frankly, with the exception of the 900s, which are really flying aircraft, they're not quite at a part-out stage. That's why we're sort of dipping our toe in slowly. Most of the other aircraft, when we buy them, we know we could part them out and make a profit. If we can lease them out first, even better, it increases our rate of return. Again, we're looking at the demand portfolio of that type of aircraft. Understand, we can't do this for every type of aircraft. We don't have expertise in 737-400s, as an example, which are coming out of other airlines. We don't have the internal knowledge to be able to part those aircraft out, so you don't see us playing in those. But where we do know the aircraft, like the CRJ platform, Dash 8 platform, ATR platform, we're very active.
One of the things we'd like to do in the future, quite frankly, is to increase the number of platforms that we participate in.
I see that's helpful. Just one on the acquisition side and the multiples that you're seeing certainly creep higher to make sense. What about looking back at the manufacturing side here with some of the depressed metrics you've been seeing throughout the space? Is there opportunity there where the multiples might still be lower or at least more appealing, or is it just not enough visibility in the space to give enough capital or enough to deploy capital?
That's a good question. We're actively looking in the depressed markets to see if there's something available that can augment our business. Alberta is a great example for us, is every time we've gone through this in Alberta, we've come back with a bigger market share. Because of our stability, we're able to maintain service through this and pick up customers and grow. This is the deepest trough we've ever experienced and the longest trough, we still love that business, were there opportunities to grow it and augment it in a downtime, we'd certainly be interested. We're still very interested in growing the stainless steel tank business in the U.S. In spite of the slowdown there really has been no appreciable downtick in the multiples people are looking for in that business. It's been kind of a double whammy in investing in that business.
The overall market is softer, the prices are higher.
Great. That's it from me, guys. Thanks.
Thanks.
Your next question comes from the line of Kevin Chiang from CIBC. Your line is open.
Hi, thanks for taking my questions here. Just a couple of, I guess, maybe more housekeeping questions. You had mentioned in your prepared remarks, maybe more of a focus on organic growth opportunities versus tuck-in acquisitions, given the multiples out there. Just wondering, when you look at the capital intensity of your business, it has started to creep lower as you've harvested the benefits of some of the growth CapEx in prior years. Would you naturally see some of that capital intensity increase as you focus more on growth CapEx versus, say, capital being deployed for acquisitions? Do you see that inching higher from here or
I don't think you'd see an inch higher, Kevin. I think it's really the stuff we're already doing that you see in our statement. The opportunities in Regional One and Provincial would be the main organic investment opportunities in front of us today. There may be an opportunity here and there within our airlines to grow, but we retooled those fleets a few years ago. A year and a half ago, we finished, and you see the margins growing in that business. We're very almost market locked. We have very high market share where we are. For us to go in, you'd have to see us move into a new marketplace, which would likely, other than playing around the edges, be done through an acquisition. We may move into Northwestern Ontario or a different part of Nunavut or something should the opportunity arise.
Generally speaking, the airlines are suitably capitalized, and I don't see a significant amount of capital going in there other than the ongoing maintenance investment, obviously, to maintain our fleet.
Right.
If we do have opportunities, we're earning returns in the high teens to low 20s in our investments in Regional One, and that's after maintenance CapEx. You can't come close to those returns, not remotely close in the acquisition world.
[inaudible]
To the extent that they uncover opportunities, we're going to be aggressively pursuing them. Having said that, in line with the question earlier and our challenge when we went through at WesTower Communications, where we had unbridled growth. We're going to make sure we're very comfortable with the markets for the planes and the parts before we go any further.
Okay. That's helpful. Yep.
Just another comment on organic growth. There's a lot of opportunities where there is no significant capital required, and let me give an example of that. As we announced in November of last year, Provincial was able to get the in-service support contract, the PBL contract, as we refer to it. Part of the component of that was inventory supply and management. What they did there is bring in Regional One to provide inventory and manage it as well. We were able to grow the Regional One business through a Provincial opportunity. That's just kind of an example of where we're able to grow organically without any capital requirement.
That's helpful. When you think of maybe the personnel you have and the executive team you put together, I think a lot of it's been around the strategy of these tuck-in acquisition growth. If the focus moves more towards organic growth opportunities and harvesting some of this low-hanging fruit, is there a sense that you have to build up the team further, or are you still leveraging the team on the ground, whether it's Regional One or PAL, just to find those opportunities for you?
We're very comfortable with the executive team we have in virtually every one of our entities. As you grow, obviously, you're going to add people, but not disproportionately to the growth of the business. One thing I just want to clarify, we're still very active in the tuck-in acquisition market. That part, because they tend to be smaller deals, they tend to be mom-and-pop companies. They tend to be people who care about how you're going to treat the staff. Price isn't the only criterion, and CarteNav would be an example of that. Those kinds of deals we're still fairly active in. Stuff on the smaller end of our range. It's the bigger deals that tend to be auctions with private equity that are the ones that are really hard to do.
The CAD 200 million transactions are the ones that we find ourselves not being prepared to pay. Where private equity is prepared to pay, we're just not prepared to swallow that kind of risk.
Okay.
We're still active in the smaller transactions. It's the bigger transactions at this point that we find ourselves not being prepared to pay market price.
Fair enough. The discipline is obviously very important here. Just last one for me. You mentioned these high multiples. Would that make you a potential seller of some of the assets you have if the multiple is high enough? Is that off the table because then you're forced to redeploy that capital into a high multiple world, so you end up holding onto what you have regardless of where the multiples are?
It's a really good question, actually. I think we're kind of agnostic about ownership in that everything is for sale at a certain price. We need to be able to redeploy the capital. I think if someone were redoing a roll-up of an industry that we're involved in, where they were prepared to pay a strategic value, whereas we're a financial owner, we would consider it. To date, we really haven't had many of those opportunities, although I guess WesTower Communications was that to an extent, in that we sold it to another industry player, turned a profit, and redeployed our capital. Generally speaking, unless someone's going to pay us a material premium to what we think it's worth, we like the businesses we're in now. I don't see that as a big part of our strategy.
Your next question comes from the line of Chris Murray from AltaCorp Capital. Your line is open.
Thanks, guys. Good morning.
Good morning, Chris.
Just back to acquisition strategy. One of the things historically, when you think about the way you've done acquisitions is part of the target has always been to take 100% of the companies. Any thought with maybe some opportunities out there to maybe take less than 100% of companies, maybe keeping management with a higher percentage than you normally would, or just looking at co-investments or joint ventures and stuff like that in order to accelerate the growth?
We actually regularly have looked at a couple of those. The trick is just structuring and making sure we have control because we want to make sure the funds flow the right way. In the right scenario, yes, we would take less than 100%. You never say never. I don't think we would take a minority position. I think we're always going to be in a position where we want control. Taking less than 100% absolutely is a possibility.
Okay, great. Just back to thinking about growth capital. Just I understand tuck-ins seem to be reasonably active. Just from your tone, maybe no big expectations on larger acquisitions, at least in the near term. Any kind of numbers you want to put around? Any thoughts around growth capital for at least the balance of the year at this point?
I think the kind of dollars, if you look over a number of quarters, is we're just sort of average what we're putting out is a reasonable barometer going forward. It's hard for me to answer it from quarter to quarter, Chris, simply because we may get an opportunity to buy three aircraft and it's $20 million US, or we may buy one. It kind of bumps around quarter to quarter. The kind of investments, the size of investments we're making on average, I think is something we see continuing. Our team at Regional One looks at a lot of opportunities. Not all of them are as accretive as others, and so we don't do everything. The ones we do, we've earned high returns on. I would continue to expect us to invest money in those businesses. The acquisition stuff, you're correct.
It's clearly more hit-and-miss. I don't want to come across as too negative because I'm reasonably positive on the stuff that's sort of under CAD 75 million. It's when we get into the bigger deals that the pricing is a bigger issue. Even in some of those where it's a unique market niche that other people may not understand the way we do, we're very competitive. Where we see most of the opportunity now would be in the smaller deals and in the organic investment in our core businesses.
Okay. No, that's great. Thanks, guys.
Our next question comes from the line of Raveel Afzaal from Canaccord Genuity. Your line is open.
Yes. Morning, guys. Thank you for hosting the call. I just had a follow-up question on what was just said. For Regional One, every quarter we add in the growth capital that you're investing, that bumps up our forecast for Regional One looking forward. I understand growth capital in this business is an acquisition, so difficult to forecast. Can you give us some visibility on Q3, how your growth capital is looking for this business now that we are pretty much in Q3?
We're continuing to close on planes. If you look in our MD&A, we talked about a total of 11 planes that we've purchased or committed to. There's a couple of those that will close this quarter, plus whatever we find as we shop around. We continue to invest, Raveel. I have some competitive issues about revealing too much here because we're in some negotiations on things that we may or may not ultimately decide to proceed with. We clearly have already made commitments for things that'll close in this quarter. You'll see continued growth CapEx in this quarter.
Okay. Just following up on the last question, I know we can't use a hard and fast rule, assuming something like CAD 30 million to CAD 40 million in growth capital for this business on an annual basis, you think that's a realistic assumption, at least looking into 2017? Is that too high, too low? I know you can't give a good number as guidance, just some color on that.
If you're looking for CAD 30 to CAD 40 as an annual number, I would say that's low based on what we see today. If you're looking at that on a quarterly basis, we'd have to find some bigger transactions to be able to meet that every quarter. I can't put a forward-looking number because we don't use budgets or targets for doing acquisitions or investments. We do it when they meet our criteria. I would anticipate continued growth. CAD 30 million would be on the low end on an annual basis.
Got it. With the Canadian Search and Rescue contract, could you give us some more color in terms of, just remind us what the size of this contract would look like, how quickly it could ramp up, what sort of resources it might require from you in order to execute on this project?
From a big picture point of view, Raveel, it may be awarded later this year or early next year. The delivery of the aircraft start a couple of years after that. Our role is not in the delivery of the aircraft. Our role would be in the maintenance and the oversight of the maintenance on an ongoing basis. The contract by its nature is, I think 25 or 26 years long, the maintenance on aircraft, clearly they have to fly for a while before you need to fix things. Our stuff would ramp up over the next five years, once a contract was awarded. I'm not prepared to put a dollar value on it because how it's being awarded hasn't been decided per se. We would be on the maintenance side, so we're not going to buy and sell.
As a result, we have very little, unlike the WesTower Communications transaction where there was significant working capital required to fund accounts receivable and inventory, this project would not be that way. The investment required would be minimal.
Just to give you a little bit more color maybe on the size, I can talk about the number of people that we'd have to add because it is primarily a labor-driven contract for us. We're talking about around 100 new positions. Mike's absolutely right. Very little capital expenditure required. There's a little bit of ground equipment we need and some consumable inventory, that would be primarily it.
That's it for me. Thank you, guys.
Thanks, Raveel.
This does conclude our Q&A session. I will now turn the call back over to Mr. Pyle for any closing remarks.
Well, given that there's no further questions, I'd like to thank everyone for participating in today's call, and we look forward to updating you on our progress in the quarters ahead. Thank you.
Ladies and gentlemen, this does conclude today's conference call. Thank you for joining us today. You may now all disconnect your lines.