Interactive Investor

Stockwatch: This 7.7% yield is excessively fearful

26th September 2017 08:31

Edmond Jackson from interactive investor


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Are things really so bad at transport group Stagecoach as its shares portray? Over two years the price has slumped from 420p to a recent low of 154p - currently 159.5p - which capitalises the company at £920 million and yields 7.7%, covered 1.7 times by forecast earnings in the year to April 2018.

Management said at prelims three months ago: "our expectation of 2017/18 earnings per share [EPS] is broadly unchanged". Of three independent brokers covering Stagecoach, Investec and Canaccord Genuity advise 'hold', while Liberum has upgraded to 'hold' from 'sell' due to "evenly balanced risks at the current valuation, our forecasts showing a dividend yield of 7.7% matching the [price/earnings (PE) ratio] of 7.7 times, with an unchanged sum-of-the-parts based target price of 155p."

Weak operations story, yet a rising dividend

It's a tempting if tricky situation as I explained when drawing attention last December at 215p, when Stagecoach offered a 5.65% yield twice covered by forecast earnings (now trimmed) and a cash flow profile roughly twice earnings.

The chart showed a bullish "bowl", yet on fundamentals I concluded the stock was more "wait and see", though a contrarian opportunity was being created. I noted that operations weren't improving, given little ability to raise bus prices and poor Network Rail performance amid higher operating costs and government payments; although a West Coast rail franchise was proving successful. Revenue and margin were also down in US bus (the US & Canada represent 12% of group revenue).

After interims with normalised operating profit down 19% on revenue 1.6% ahead, last June's full-year results were little changed. Normalised operating profit was down 15.7% to £193 million, on revenue up 1.8% to £3,941 million.

Adjusted EPS slipped 11.9% to 24.4p, but the dividend rose 4.4% to 11.9p, with management affirming earnings expectations for the current year.

The stock's continued drift therefore implies such a payout will get compromised and/or substantial further risks lurk.

East Coast franchise has hit sentiment

Stagecoach's East Coast franchise appears the nub of the reason why the stock has fallen from a 210p to 220p range that persisted from June-to-June.

Stagecoach's 90% interest in Virgin Trains East Coast is expected to be profitable from 2019, but has seen slower-than-anticipated revenue growth versus rising premium payments stipulated in the contract.

Discussions on amends continue with the Department for Transport, and the end-April 2017 accounts contained an £84.1 million onerous contract provision to cover a worse-case projection of operating losses over the next two years.

Thus, the income statement is supported (or doctored) so long as losses don't exceed this provision. That the market prices for a 7.7% yield suggests it may also be less confident about free cash flow cover, e.g. requiring the projected dividend to be part-funded with debt.

Over the last financial year, net debt edged up £10 million to £409 million (principally long-term), although net finance costs fell from £43.1 million to £35.6 million. This leaves net gearing close to 600% of net assets, which are depressed not by goodwill/intangibles but £848 million trade payables versus £449 million trade receivables, in addition to £693 million long-term debt.

Since this industry requires capital investment (£157 million in the last financial year) the market understandably worries that, should cash flow fall, then the balance sheet may not be strong enough to support the extent of dividends hoped for.

This could also happen with economic recession or serial terrorist strikes on the transport system, discouraging travel. So be aware of a scenario where the dividend can get compromised, albeit a worse-case one.

Analysts at Liberum don't appear discouraged by the balance sheet; they contend that even if it takes a further hit in relation to the East Coast contract, debt covenant terms should not be tested; hence the market's pricing for a 7.7% yield is overly fearful.

Capital upside therefore exists given the stock would rise to reduce yield, so for contrarians Stagecoach is all-round attractive in the short to medium term.

Much obviously depends how these negotiations pan out. Stagecoach's franchise bid assumed additional/enhanced capacity becoming available at East Coast from 2019, to drive revenues, thus requiring higher premiums paid to the Department for Transport.

With Network Rail (owned by the government) unable to deliver these infrastructure improvements, in principle there's justification to vary contract terms. In practice, the DfT may not want to be seen bailing out a private operator, but it will have to respect what's changed, and commercial reality. Thus, the cloud of black sentiment hanging over Stagecoach potentially has a silver lining.

Bullish future for public transport?

Once this awkward matter is out of the way, it's possible perception shifts to management's claim last December: "There is a large market opportunity for modal shift from cars to public transport against a backdrop of population growth, urbanisation, technological advancements, and increasing pressure to tackle road congestion and improve air quality."

Mind, that for the time being, bus revenue growth is challenging and further cost cuts could spur re-regulation, with Manchester feared taking such a lead. London involves competitive pressures on tender pricing and possible wage demands.

Rail passenger growth is also difficult while terrorist attacks discourage discretionary travel. But this scenario may be priced in, considering the 7.7% yield and 7.7x 12-month forward PE.

Looking further out, what future for private operators under a Corbyn/McDonnell, Labour government? Jeremy Corbyn's web page makes clear: "Transport is something which should be run as a public service for everyone's benefit. Instead, we're spending millions every year subsidising the profits of private companies, whilst all too often passengers are left frustrated as their local services are removed or not properly funded, fares keep going up, and staffing levels are cut."

There's a clear objective to bring railways into public ownership and give councils power to set up publicly run municipal bus companies.

Labour plans to "save £2.8 billion over the next decade which would otherwise have gone directly into dividends for private shareholders in private bus companies."

Interviewed around the current party conference, shadow chancellor John McDonnell has made plain, renationalisation would be at "market value determined by parliament." But unless Conservative Party divisions bring down Theresa May to mean another general election far sooner than May 2022, all this seems unlikely to worry the market.

Stagecoach Group - financial summary           Consensus estimates
year ended 30 Apr 2013 2014 2015 2016 2017 2018 2019
Turnover (£ million) 2,805 2,930 3,204 3,871 3,941    
IFRS3 pre-tax profit (£m) 154 158 165 104 17.9    
Normalised pre-tax profit (£m) 164 170 172 137 146 149 133
Operating margin (%) 6.5 6.9 5.6 4.6 3.7    
IFRS3 earnings/share (p) 21.7 22.9 24.1 17.0 5.5    
Normalised earnings/share (p) 23.3 23.9 25.2 21.8 27.2 21.2 18.6
Earnings per share growth (%) 3.6 2.5 5.6 -14.7 26.5 -21.9 -12.2
Price/earnings multiple (x)       9.8 5.9 7.6 8.6
Annual average historic P/E (x) 13.6 15.8 14.9 10.7 8.2    
Cash flow/share (p) 54.6 43.2 54.9 48.6 40.5    
Capex/share (p) 23.4 20.7 25.6 32.1 22.2    
Dividends per share (p) 8.0 8.9 9.8 10.8 11.7 12.3 12.4
Yield (%)         7.3 7.7 7.7
Covered by earnings (x) 3.0 2.7 2.6 2.0 2.3 1.7 1.5
Net tangible assets per share (p) -24.5 -11.9 -21.5 -8.6 -20.0    
Source: Company REFS              

Share price target requires some faith

While I haven't seen Liberum's rationale, on asset value the majority of investors seem likely to take their cue from the balance sheet, where respecting goodwill/intangibles you are only looking at about 12p per share.

Trusting a sum-of-parts valuation effectively requires a takeover for the group or an element thereof, so is speculative. Meanwhile, consensus for the 2019 year shows nothing to inspire about the earnings trend, hence the upside catalyst is a breakthrough on DfT talks reducing dividend risk.

Stagecoach is therefore a quite speculative, event-driven play - albeit with potential to lock in a very attractive yield and also seize upside. If commercial reality prevails, then it's time to buy.

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