Description

I recommend Bombardier’s 6.25% Series 4 preferred shares (BBD.PR.C on the TSX) trading at $17.95. There are many types of Canadian preferred shares, and they are generally owned by local retail investors seeking income. The most common types of Canadian preferreds are perpetuals and fixed resets. Perpetuals pay a fixed amount of dividends, while fixed resets change their dividends every 5 years based on the Canada 5-year government bond yields plus a premium. Today, BBD.PR.C offers a current yield of 8.7%, which is the highest of all perpetuals. 

The Bombardier story has greatly simplified in the last 3 years. It has sold its transportation business to Alstom, divested its interest in Airbus Canada, and exited its CRJ and Learjet programs. Today, Bombardier focuses on only two platforms - Global and Challenger, and dominates the business jet market with Gulfstream and Cessna. 

Bombardier currently has $15bn of backlog which is about 2 years of revenue. The company delivered 120 aircraft in 2022, and guides138 deliveries in 2023 and 150 in 2025. 

Bombardier has significantly expanded its after-market strategy, with the expansion or opening of 4 service centers in Singapore, Melbourne, Miami and London. Another new center in Abu Dhabi is scheduled to open in 2025. From 2020 to 2022, Bombardier grew aftermarket revenue by more than 50%, much faster than the 20% overall revenue growth. The higher margin and recurring nature of the service revenue stream should help counteract the cyclical nature of business jet sales. As the new service centers ramp up operations and capture more market share, the company targets $2bn service revenues in 2025, a $500mm increase from 2022.

The company expects to increase EBITDA margin from 13.5% in 2022 to 18% in 2023. The margin expansion would be mainly driven by the maturity of the Global 7500 (entered into service in 2018; 100th aircraft produced in March 2022), incremental deliveries and expansion of after-market business. 

Putting these together, the company targets $1.6bn EBITDA and $900mm free cash flow in 2025. It expects to reduce leverage from 4.6x in 2022 to 2.0~2.5x in 2025. The company ended 2022 with $4.3bn net debt. 2.25x leverage in 2025 suggests $700mm additional debt paydown, which is very achievable given the FCF generation between 2023 and 2025. In 2025, if everything goes according to plan, Bombardier would be close to investment grade.

Currently Bombardier’s interest expenses are run-rating at $400mm, and 2023 EBITDA guidance covers interest expenses by 2.8x. EBITDA/interest coverage would decrease to 6.5x on 2025 guidance numbers. Dividends on all 3 series of preferred shares are only ~$23mm annually on merely $400mm of face value, so I don’t think the company would touch the preferreds unless things really go south. For margin of safety, there’s ~$4bn of equity value beneath the preferreds, and we are creating the company at ~5x today and ~2.5x on 2025 numbers. It’s worth noting that BBD equity has almost doubled in the last 2 years, while the Series 4 preferreds have barely moved. 

Looking further than 2025, defense is an important growth driver for the company. Last year, Bombardier created Bombardier Defense and set up new headquarters in Wichita, KS to more aggressively pursue opportunities in defense. The company’s goal is to grow defense revenue to $1bn by the end of the decade. 

The Series 4 preferreds can be redeemed at C$25. They have been outstanding for more than 20 years and I doubt the company would redeem them. It’s more likely that the company starts paying dividends or repurchasing shares after it reaches its leverage target. The company could force the Series 4 shares to be converted to common shares by dividing C$25 by “by the greater of $2.00 Cdn and 95% of the weighted‑average trading price of such Class B Shares”. If the company goes into distress and its Class B shares trade below C$2, a conversion would be very injurious. Interestingly, the $2.00 Cdn language was from the original 2002 prospectus which didn’t stipulate that the $2.00 Cdn should adjust in the event of a share split/reverse split. So when BBD did a 25-for-1 reverse split in 2022, the $2.00 Cdn didn’t change, making it far less likely that a forced conversion would hurt Series 4 preferred shareholders.

It’s also worth noting that Canadian dividends (preferred or common) offer tax advantages to Canadian investors. For example, an Ontario household with $150k income pays 45% marginal tax rate on income (including interest income), but only 28% marginal tax rate on Canadian dividends. While the tax attributes are not relevant to US investors, it’s important to know given the typical shareholder base of Canadian preferred shares. The 8.7% current yield is even more attractive on an after-tax basis compared to the ~5% interest rate offered by GICs today. 

I anticipate that the way this works out is BBD maintains good performance in the next 2~3 years and Bank of Canada starts cutting rates, causing investors to chase yields again. If BBD delivers on its 2025 target and delevers 2.5x while interest rates start declining, it wouldn’t surprise me that the Series 4 preferreds would trade at par. 

The other two series - Series 2 and Series 3 pay dividends tied to prime rate and 5-year Government of Canada yields respectively, and have more complicated terms. For example, every 5 years, the company decides arbitrarily what multiple of the then 5-year GoC yield the Series 3 series would pay for the next 5 years. The two series are convertible into each other every 5 years. Series 2 currently has a current yield of 10% and pays dividends monthly tied to the prime rate. If you believe rates will stay higher for longer, the Series 2 is worth considering but I prefer the simpler Series 4. 

Catalyst

Achieving 2025 target

Rate cut in Canada