Similar to the recent progress Australia has made toward negotiating free-trade agreements, which we’ve detailed in our sister publication Australian Edge, Canada made a significant move itself this week, signing a free-trade agreement (FTA) with South Korea after almost nine years of negotiations.

Given its dependence on the US, which absorbs roughly three-quarters of its exports, Canada hopes to diversify into other fast-growing emerging markets. Unlike many of its peers, Canada’s exports remain largely dependent on slow-growing developed-world countries, as the country’s exporters have had considerable difficulty penetrating emerging markets.

This deal is Canada’s first FTA in the Asia-Pacific region, and the government is currently working toward similar deals with Japan and India. Canada is also a part of the Trans-Pacific Partnership (TPP), a group of 12 nations that’s trying to create a pan-Pacific free-trade area. South Korea has yet to join the TPP, though it’s expressed interest in doing so.

Although South Korea is Asia’s fourth-largest economy, it accounts for less than 1 percent of Canadian exports, and the dollar value of this trade has slipped in recent years.

Indeed, Canada’s exports to South Korea have declined sharply since 2011, a year in which exports jumped 37.2 percent year over year, to CAD5.1 billion. The following year, exports fell 27.1 percent, to CAD3.7 billion, thanks in part to greater competition from the US, whose own FTA with South Korea came into force in early 2012. In 2013, Canada’s exports to South Korea dropped even lower, to CAD3.4 billion.

Although 2011 was an outlier, and the two years since then are more consistent with the value of exports over the five-year period that preceded that result, it’s a downward trend nonetheless.

Meanwhile, imports from South Korea, which tend to dwarf Canada’s exports to the country, rose to a high of CAD7.3 billion last year. Clearly, two-way trade between the two countries has been dominated by South Korea.

While South Korea stands to make further gains from this deal, the Canadian government also forecasts significant benefits for Canada. In particular, the FTA is projected to increase Canada’s exports to South Korea by 32 percent, or CAD1.7 billion. That means annual exports should eventually be restored to the record level achieved in 2011, assuming the agreement is ultimately ratified by each country’s parliament.

Upon taking force, the FTA will phase out 98 percent of all tariffs, over the course of a decade, on goods traded between the two countries. The trade pact is a considerable win for Canada’s agriculture sector, particularly beef farmers, as South Korea will phase out the 40 percent tariff on beef over the next 15 years.

On the other hand, Canada’s auto industry will see even greater competition from Korean imports, as the current 6.1 percent tariff on Korean cars gets phased out over the next three years. In fact, that was one of Canada’s key concessions, as it had earlier tried to negotiate a seven-year phase-out instead. And it offers an unfavorable contrast with the US deal with South Korea, which has a five-year phase-out, though presumably the US simply has greater bargaining power.

Interestingly, according to The Globe and Mail, automotive industry analysts say that a large increase in Korean auto imports has not occurred beyond the percentage gains in the overall US car market, while US auto shipments to South Korea have doubled, albeit off a tiny base. But with that as a precedent, the deal may not be as bad for Canada’s auto industry as some fear.

While cars account for about 40 percent of imports from South Korea, Canada’s resource sector holds a similar share of the country’s exports to South Korea, at 44.9 percent of total exports in 2012, including mineral fuels, oil, ores, slag, ash, aluminum and aluminum particles. Liquefied natural gas (LNG) is among the energy products that will see its border tax removed.

Canada’s timber industry is also a key exporter to South Korea, accounting for about 13.5 percent of 2012 exports, including wood, wood pulp, paper, and charcoal. Lumber is another good that will see tariffs removed.

Overall, this seems like a positive deal for Canada, with the current government aggressively pushing for more such deals in the future. While much of the country’s near-term growth hinges on a US rebound, Canada has taken a long-term perspective by seeking to reduce its dependence on its neighbor to the south.

Portfolio Update

The flurry of earnings releases over the past few weeks meant that our coverage of some Portfolio names in the recent issue was necessarily perfunctory. As such, we’re offering a more thorough analysis of one of our Portfolio Holdings below.

Despite the harsh winter weather and its attendant labor and maintenance costs, Student Transportation Inc (TSX: STB, NSDQ: STB) reported that fiscal 2014 first-half (ended Dec. 31) revenue grew 15.3 percent, to USD208.7 million. Though STB had to absorb the increase in expenses as a result of a colder-than-usual season, any revenue missed in the recent quarter due to school closings will be made up in its fiscal third and fourth quarters, since most of the company’s contracts specify 180 days of school service and that’s when schools typically make up for lost days.

Interestingly, management noted that the company’s reputation for reliability during such weather extremes could earn it two new contracts from school districts fed up with a contractor that underperformed during snow events. Indeed, this dependability has helped earn STB a high renewal rate on its contracts, typically around 97 percent.

Meanwhile, the CAD627 million company generated adjusted EBITDA (earnings before interest, taxation, depreciation and amortization) of USD29.5 million, up 18.2 percent, driven by two tuck-in acquisitions and nine contract wins. The nine new contracts added 1,000 vehicles to the company’s fleet, and included the company’s largest contract award to date.

As a side note, though STB is a Canadian company, it reports its financials in US dollars.

Revenue for the fiscal second-quarter (ended Dec. 31) rose 13.5 percent, to USD135.5 million, while adjusted EBITDA increased 8.7 percent, to USD30.9 million. Those with an attention to detail will note that STB’s calendar fourth-quarter EBITDA was slightly lower than the full six-month period. That’s attributable to the seasonality of the industry, as the calendar third quarter, includes two essentially idle months, July and August, prior to the beginning of the traditional school year.

Adjusted EBITDA offer a truer measure of operational cash flows, as STB incurs huge depreciation expenses from its massive bus fleet–USD13.4 million in its most recent quarter. Since these and other non-cash expenses don’t reduce the actual cash the company generates, it makes sense to add them back to net income to get a better sense of operations as well as dividend coverage. Based on adjusted EBITDA, the company’s payout ratio for the first half of fiscal 2014 was 59 percent.

STB has also made strides toward reducing its fuel expense, with that item decreasing as a percentage of revenue by six-tenths of a percentage point year over year, to 8.0 percent. The company has fuel-mitigation features in about 60 percent of its contracts with school districts, while it’s covered about 23 percent of its commodity exposure for fiscal-year 2014 via fixed-price contracts with fuel suppliers.

Management’s medium- to long-term goal is to pare fuel expense to a range of just 6 percent to 6.5 percent of total revenue, by adding more propane-fueled vehicles (roughly 10 percent of its fleet at present), as well as by negotiating customer-paid fuel contracts.

At quarter end, STB had USD3.3 million in cash and cash equivalents on its balance sheet, along with USD273.6 million in long-term debt, with maturities staggered over the next several years. In November, the company raised USD71.4 million from 6.25 percent convertible debentures due June 30, 2019.

On Bay Street, the current mix of analyst sentiment is two “buys,” three “holds,” and one “sell.” Analysts forecast the company’s full-year fiscal 2014 (ending June 30) earnings per share (EPS) will decline 8 percent, to USD0.05, on revenue growth of 15 percent, to USD485.8 million. But the following fiscal year, EPS is projected to jump 48 percent, to USD0.07, while revenue will climb 10 percent, to USD534.4 million.

The consensus 12-month target price is CAD7.48, which suggests potential price appreciation of 6.7 percent above the current share price.

STB still has substantial opportunity for growth by winning new contracts with school districts, as well as by pursuing a consolidation strategy. Roughly 66 percent of the more than 500,000 North American school buses are owned and operated by public school districts, while the private-sector industry that covers the balance is highly fragmented, with an estimated 4,000 companies.

In the US, about 70 percent of the total fleet of nearly 468,000 buses is owned and operated by school districts. Of the 30 percent handled by the private sector, the top 10 contractors account for about 72.5 percent of that total.

STB ranks third on this list, with its fleet of 9,500 buses nearly double that of its fourth-ranked competitor, Atlantic Express Transportation Corp, while it’s dwarfed by its two largest competitors, National Express Corp and First Student Inc, which own and operate 21,000 buses and 54,450 buses, respectively. STB’s operations in both the US and Canada now include 10,800 vehicles, of which leased and managed buses account for about 19 percent and 4 percent of the total fleet, respectively.

School budgets have been constrained in recent years, and that has helped prompt administrators to save money by contracting this service to third parties. As National Association of Pupil Transportation President Don Carnahan observed in a recent interview with School Bus Fleet, one of the industry’s leading trade publications, school districts have not only had to contend with higher fuel prices over the past decade, but also the higher cost to replace an aging fleet. Recent clean-air regulations, in particular, have substantially raised the cost of compliance, and bus manufacturers are passing that along to their customers.

According to School Bus Fleet, the average age of the US fleet is rising, and now stands at 9.3 years, with an average retirement age of 14.4 years for large school buses in areas where roads are salted and 19.3 years in areas with no salt.

One of the novel ways in which STB is addressing school districts’ aging fleets is with its municipal tax lease program, whereby it helps districts arrange lower-cost financing for new buses, while the company handles operating and managing the fleet.

However, this new fiscal austerity has also caused a decline in school bus services, as districts seek savings by making cuts in student eligibility for transportation services. Fortunately, based on the magazine’s survey data, only 8 percent of respondents expect cuts to service in the coming year, down sharply from 21 percent and 15 percent in 2011 and 2012, respectively.

Since quarter-end, STB has continued to win new contracts and acquire additional transportation assets. In early January, it entered into a management services agreement with the aforementioned Atlantic Express (AE), whereby STB subsidiary SchoolWeels Direct Inc would manage AE’s school transportation operations in California.

AE’s parent company had previously sought bankruptcy protection, and in early February, a month into the management agreement, the company’s debtors cleared STB to acquire the California assets it had only just begun managing. The deal includes 425 school vehicles, which generate USD26 million in annualized contracted revenue.

Then in late February, STB was awarded three new contracts in upstate New York. The contracts, which include customer-paid fuel, commence at the beginning of the next school year and will generate USD7 million in annualized revenue.

STB has held its monthly payout at an annualized rate of CAD0.56 since its first dividend declaration in October 2006. At recent prices, the shares yield 7.9 percent. Student Transportation is a buy below USD7 in the Conservative Portfolio.