Interactive Investor

Stockwatch: Do director deals indicate long-term upside here?

9th June 2017 12:29

Edmond Jackson from interactive investor

Is an upgrade from 150p to 165p for FirstGroup worth chasing? Broker Liberum Capital has just raised its target for the FTSE 250 transport firm as its market price slips to 139p, having hit 153p around the 1 June prelims.

On a medium-term view the US and UK bus/rail group looks as if its operations are improving overall and its stock is trying to break out of a four-year trading range of about 90p to 140p.

Profit-taking was justifiable after it has had a good run from 102p this year, and there's still no meaningful yield as prop and plenty of questions about whether the UK – and even the US – economy might slow down. But FirstGroup has shown it can make progress in a sluggish growth environment and, if low interest rates persist, then the risk profile favours upside.

Better operating results and cash flow

The results are quite complex due to a boost from the strong dollar versus sterling, also amortisation charges on hefty intangible assets creating a statutory versus normalised profits split. Normalised pre-tax profit is up 23% to £207 million on revenue up 8.3% to £5.65 billion, although at constant currency the top line eased 0.5% and operating profit is up only 2.3%.

The normalised operating margin was 6% and 5% statutory, which is pretty good for the industry and affirms underlying improvements. Adjusted earnings per share (EPS) rose 20%, statutory by 24%, and net cash inflow has leapt from £36 million to £147 million, helping net debt ease 8.5% to £1.29 billion.

So, despite a question mark over intrinsic revenue growth (i.e. economic slowdown would more likely induce a fall), the package of numbers is pretty good for running buses and trains.

It supports forecasts that imply a prospective price/earnings (PE) ratio around 10 times, albeit an immaterial yield of about 2.5%, and the balance sheet groaning with goodwill/intangibles at 103% of net assets. Weighing the risk/reward profile therefore demands confidence the macro environment won't significantly worsen given this stock isn't well-buttressed.

On track with recovery plan, with US/UK contrasts

It's worth briefly recalling the rationale when I drew attention in September 2015 with the stock at its lower end of a 90p to 140p range: that despite debt having eroded shareholder value, analysts were projecting normalised earnings per share to double from about 6p.

Well, the results now show 12.4p (earnings having been diluted by a deeply-discounted, 3-for-2 rights issue at 83p in June 2013 to reduce some debt and maintain investment).

So, in a medium-term context, FirstGroup is delivering despite a somewhat mixed story: its US First Student business (cheaper bus travel) is doing particularly well with margins up to 9.6% on £1.78 billion equivalent revenue after improvement plans. It represents just over half of group operating profit. First Transit and Greyhound are also improving overall in the US, on margins of 7% and 6.2% respectively, and the outlook for both is good.

In the UK, however, industry conditions for First Bus remain challenging, hence further cost cuts are required after operating profit fell 29% to £37 million; and in First Rail management remains cautious on the rate of passenger growth and anticipates a lower margin than the 4.2% achieved, with profit down 26% to £53.8 million.

A silver lining to this cloud involves operating the South Western franchise from August. So, it could be said, the US and its strong dollar are supporting FirstGroup where otherwise its UK operations aren't yet what investors want to see; or more positively that a decent financial outcome has been achieved despite UK challenges.

Scope for a circa 4p per share dividend

Company boards usually respond to such a situation, likewise the stockmarket by way of pricing, by ensuring a dividend yield that compensates meaningfully for downside risks.

The board currently says it will "continue to review the appropriate timing for restarting dividend payments" against market expectations for about 3.3p per share in respect of the current financial year.

While that appears covered some four times by earnings, FirstGroup's cash flow statement shows rival demands on cash - with annual investment steady at about £405 million (disposals offsetting this by £40 million) and £118 million going out on financing issues such as loan repayments.

Thankfully, a 27% rise in net cash generated from operations to £520 million has accommodated this and more, enabling a £31 million rise in cash (before currency effects) such that year-end balance sheet cash rose 11% to £401 million.

So, despite the board's prudent caution at this early stage in the new financial year, a dividend initially at 4p per share looks manageable. Debt management needs are also in focus e.g. the accounts' note on net debt shows circa £300 million in bonds maturing annually for the next few years; an,d while these could end up refinanced, it might be optimal for shareholder value to redeem them (to what extent possible).

The income statement shows net finance costs swallowing nearly half of operating profit, hence cutting debt should weigh in priorities as a means to enhance value.

Complex financials if moving overall positively

FirstGroup, therefore, faces multiple uncertainties, hence its stock is unlikely to be a smooth ride. Will the US economy strengthen or roll over under a Trump administration and what next for the US dollar? So far, US exposure looks a virtue both for the group and its UK shareholders, than face complexities of owning US stocks directly.

Can UK prospects genuinely improve? Bus travel is rising in priority, e.g. by local councils, albeit a tough market, and demand for rail can be sensitive to the economy. Given a goodwill/debt-laden balance sheet and a circa 2.5% yield at best, for the foreseeable future, the stock is exposed to any profit warning.

All considered, and especially if summer stockmarkets are turning volatile, FirstGroup's stock fall could extend further. Yet the strong US bus operations, amid advantageous times for dollar-based acquirers, beg the question whether a more radical approach to tackle the debt may arise - by way of a disposal. It would remove a strong element of operations, but transform finances hence the group's risk profile.

'Buy', therefore, looks the long-term appropriate stance, as indicated by Liberum's upgrade; also a pattern of directors' shareholdings RNS releases since the results. Some (including senior managers) have exercised options and sold shares, albeit a majority only to pay tax arising.

That insiders are overall raising their stakes is encouraging. So are central banks, which remain glacially slow with any interest rate rises to manage the US and UK economies.

FirstGroup - financial summary           Consensus estimates 
year ended 31 Mar 2013 2014 2015 2016 2017 2018 2019
Turnover (£ million) 6901 6717 6051 5218 5653    
IFRS3 pre-tax profit (£m) -28.9 58.5 106 114 153    
Normalised pre-tax profit (£m) 50.7 32.2 106 116   235 278
Operating margin (%) 3.1 2.7 3.9 4.6      
IFRS3 earnings/share (p) -2.5 5.1 6.2 7.5 9.2    
Normalised earnings/share (p) 8.3 2.6 6.2 7.7 7.6 13.7 15.5
Earnings per share growth (%) -68.2 -68.3 138 23.9 -1.3 79.3 13.3
Price/earnings multiple (x)         18.3 10.1 9
Annual average historic P/E (x) 14.7 40.2 22.8 13.9 16.2    
Cash flow/share (p) 46.2 27.8 27.2 34.1      
Capex/share (p) 27.4 24.8 31.7 32.0      
Dividend per share (p) 6.2         3.3 4.2
Yield (%)           2.4 3.0
Covered by earnings (x) 0.5         4.2 3.7
Net tangible assets per share (p) -196 -42.8 -33.0 -24.0      
Source: Company REFS              

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