Portfolio rationalisation and a likely return to dividend payments indicate an ongoing turnaround, says our companies analyst.
Despite a 6% drop to 96p for FirstGroup (LSE:FGP) with yesterday’s interim results, it is interesting to note Aberforth Partners taking a near 7% stake in the £1.2 billion rail and bus operator.
It is not clear whether Aberforth weighed the consequences of more Covid restrictions with the emergence of the Omicron variant, but these would appear to be the chief reason for stock weakness, affecting demand for transport services when people are told to work from home.
Elements of a contrarian investment coming together
Looking well into 2022, however, FirstGroup’s risk/reward profile looks more robust than those of many overcooked growth stocks, should the Bank of England be forced into interest rate rises to curb inflation.
A current market price of 96p compares with end-September net tangible assets of 90.4p a share.
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While consensus looks only for around break-even in the current year to 27 March 2022, a forecast £70 million net profit in 2023 implies a prospective PE of around 14x. Beware comparisons with past years, as the business’s US bus operations have been divested.
FirstGroup has paid no dividends for some years, but the US disposals raised £3.1 billion and have given a much stronger balance sheet, and the board has hinted at resuming annual payouts. Whether or not guidance has been involved, consensus is looking for 2.7p a share in respect of 2023, implying a 2.8% yield.
Sub-5% is nothing exciting; but if it’s marking the start of a progressive payout policy, it could underline the fact that a turnaround is underway and help trigger ‘status change’ in market sentiment.
Proven transport boss is now in control
A fortuitous catalyst is the presence of the interim executive chairman. David Martin only stepped into the role in July after Coast Capital, an activist US hedge fund owning 15%, forced the exit of the CEO appointed in 2018. It argued that the sale of two US bus businesses were poorly timed at the peak of Covid-19 disruption.
Martin was formerly CEO of Arriva and responsible for transforming it ultimately into an acquisition target for Deutsche Bahn, a leading global passenger transport and logistics company. He initially became chairman in August 2018 after FirstGroup had made £425 million losses over two years, its CEO frustrated by the risks of running major rail franchises.
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The search for a replacement CEO continues. Make what you will of that – whether it indicates no-one wants the job or the board is justifiably being particular. One would hope Martin stays in an executive role for a while yet.
Industry context may already have flatlined
While Transport for London makes for an inexact comparison due to its involvement with the Underground, it said yesterday that its passenger numbers began to flatline at around 69% of pre-pandemic levels in the middle of November, pre-Omicron.
FirstGroup’s own outlook is quite as you would expect: confident in remedial action being taken and providing guidance for the year from March 2022, albeit with “some uncertainty around the pace of recovery in light of the evolving circumstances of the pandemic.”
Even so, management expects “to build operational momentum in the current financial year, providing a solid foundation for delivering financial framework objectives – including commencing regular dividends within the next 12 months.”
Substantial value still to come from portfolio rationalisation
This is quite a claim within the interim statement, implying usefully positive news flow versus Omicron's dampener.
Management also emphasises FirstGroup’s 20% UK share of bus operations, with strong positions in most local areas; and its status as the largest UK rail passenger operator providing 27% of revenue. Both are said to be at an inflection point for growth, in terms of helping to meet government climate objectives as well as rising economic and social activity once the pandemic subsides.
First Bus has seen a 54% rise in interim operating profit to £26.8 million, on revenue up 26% to £393 million. A spread of initiatives is helping it to a reported 10% operating margin, having operated on a broadly cash break-even basis with government support to last September.
Passenger volumes have increased to 71% of 2019 levels in recent weeks, affirming Transport for London’s overall message. Driver shortages and fuel price increases weigh, but management says it can absorb them due to the extent of wider savings.
First Rail has seen a 34% drop in adjusted operating profit to £39.2 million, on flat revenue of around £1.75 billion. Net income from train operating companies eased 14% to £17.5 million due to changes in contractual arrangements that affected the income received from the Department for Transport. This kind of shift is impossible to anticipate, being part of the political risk affecting transport. Longer-term earnings will be driven by fixed fees plus delivery against annual targets.
Group is currently in a £137 million net cash position
Last July, the sale of the US bus operations generated £2.4 billion equivalent of net disposal proceeds, paving the way for a £500 million return of capital in November. This was implemented by way of a tender offer for holders’ shares at 105p, above the 96p level at which they traded. The premium reflected “confidence in our future prospects, as well as the substantial further sums expected to be realised by the group over time from the disposals completed this year.”
Together with the £130 million sale of Greyhound Lines last October, the group is said now to be in a net cash position, excluding First Rail ring-fenced cash and also IFRS 16 lease liabilities from net debt.
This financial year is expected to end, however, with around £15 million net debt after addressing FirstGroup’s pension liabilities and with those of Greyhound being retained as a condition of the sale.
Overall, I believe, the company’s position affirms the ‘sum-of-parts’ case I made for FirstGroup at 83p in October 2018, moderating to a ‘hold’ stance in mid-2019. The stock did reach 133p by February 2020 before Covid’s disruption. Yet its asset-backing means that, just as it bounced back from March 2020 lows, investors can feel comfort even if Omicron impacts passenger demand.
FirstGroup - financial summary
Year end 27 Mar
|Turnover (£ million)||5,218||5,653||6,398||7,127||4,643||4,642|
|Operating margin (%)||4.7||5.0||-3.1||0.1||-4.6||4.8|
|Operating profit (£m)||246||284||-196||9.8||-215||224|
|Net profit (£m)||90.3||112||-296||-66.9||-327||78.4|
|Reported EPS (p)||7.5||9.2||-24.6||-5.6||-27.8||3.8|
|Normalised EPS (p)||7.7||10.7||-1.6||4.6||-15.6||-3.3|
|Return on total capital (%)||6.2||6.5||-5.6||0.2||-3.9||4.3|
|Operating cashflow/share (p)||33.8||42.8||52.9||46.7||79.0||97.8|
|Free cashflow/share (p)||0.4||9.6||17.8||11.1||51.7||66.2|
|Net debt (£m)||1,520||1,390||1,135||956||3,311||2,379|
|Net assets (£m)||1,609||2,055||1,481||1,555||1,210||1,178|
Source: historic company REFS and company accounts
Probably only one genuine fresh buyer among institutions
Don’t pay much heed to a string of ‘Holdings’ RNS announcements which suggest stake increases; I suspect these are percentage adjustments after the tender offer removed Coast Capital’s 15% holding.
But Aberforth Partners appeared on the register in early December with a 6.6% stake from zero, indicating a longer-term investment and belief in current value. Similarly, Dimensional Fund Advisors LP of Austin USA has recently declared a 6.9% stake, although its previous holding was unspecified.
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The £52 million interim operating profit – both adjusted and statutory – on continuing operations implies a 2.4% margin, which is about median for the group’s historic trend (see table). Some investors will regard this as insufficient relative to the political risks that can impact a transport group.
It would also be encouraging to see some genuine director buying now the company is out of the closed period before results. However, Director Shareholding announcements relate mainly to awards, apart from the purchase of 15,000 shares at 87p last August by a non-executive director.
Risk/reward profile still looks net favourable
Overall, I still recognise key elements of turnaround fitting together for a fundamentally cash-generative business – with scope for Omicron to offer a useful opportunity to pick up shares at below average. A capable new CEO could be another plus.
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Fair value targets, even the pre-Covid 130p level, are tricky given that passenger demand could remain subdued. Yet I judge the overall risk/reward on FirstGroup equity as favourable, hence: Buy.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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