Stockwatch: Sell-off here is a buying opportunity

by Edmond Jackson from interactive investor |

This stock is a play on balance sheet de-risking, and it looks to have the substance to make it happen.

Is it worth buying into a current retreat in FirstGroup (LSE:FGP) shares, the mid-cap transport company that just fended off an attempted boardroom coup by US activist shareholder Coast Capital?

On 7 May, I suggested that within a long-term 'hold' stance, a parabolic 21% rise in its chart to 115p during April meant that, unless firm reasons emerged to justify this, it was liable to fall somewhat, hence "you might want to lock in some gains for prudent risk management". 

While FirstGroup's balance sheet is emerging from "zombie" status (where any profit is gobbled up by interest costs) it still groans.  The share price has retreated to 98p despite end-May prelims delivered in line with a February trading statement.

I believe this was due to a proxy battle by Coast Capital, a US hedge fund owning around 10% (and backed by Columbia Threadneedle and Schroders, the second and third-largest shareholders) not actually succeeding to replace key directors.

Opportunists who are smart (in parts)

Traders may have driven the stock up, partly on hopes of a thorough break-up, eventually to leave both the UK and US operations under new ownership, central costs eliminated and sum-of-parts value (reckoned well over 150p a share) returned to shareholders.

Call them corporate raiders (in the 1980's takeover boom) or hedge funds, it's a well-established tactic by sabre rattling New Yorkers. As is the use of extra debt partly to make share buybacks, which FirstGroup rejects as irresponsible.  

That rebel votes constituted 15% to 46% on key resolutions was significant however, given plenty institutional shareholders' default policy is to support incumbent boards and may not have fully considered the detail.  Legitimacy in the thrust of Coast Capital's proposals is shown firstly by FirstGroup's end-May strategy review, in which it proposed separating the UK and US operations, divesting the US Greyhound bus operation and effectively the UK bus/rail operations also, in due course and according to contracts being fulfilled.

The endgame will be to retain the two US bus operations, currently generating 60% of group operating profit.  It suggests FirstGroup's incumbent board has to go some way in respecting a more radical shake-up if they want to keep their jobs. 

Negotiations continue ahead of the AGM

The dispute is in the details of rationalisation, but despite FirstGroup's still risky status – its equity must be regarded as speculative, not investment grade - I think this attention by international investors (Coast follows Apollo Global Management's plans to bid in early 2018) implies useful upside between the current share price and the net present value of rationalising the group.

Financial sabre rattlers have a role, even if restricted to negotiating with a new interim chairman – who says he will meet them – in this process of unlocking value.  With the AGM due 25 July, it's likely that talks will continue, and the incumbent board will want to show in its update later this month that both operations and the new strategy are on course.

So, in "narrative" terms, FirstGroup shares are interesting again (I described a speculative 'buy' case last November at 83p) with a caveat about how the rail side appears prone to ugly details, managing through its contracts.

Clawing out of financial "zombie" status

Annual results to 31 March 2019 were pretty much in line with expectations: adjusted pre-tax profit of £226.3 million was shy of consensus for £231 million, although adjusted earnings per share (EPS) of 14.4p beat consensus for 13p.  So, I wouldn't worry overly about the table below showing expectations for a 7% drop in EPS this year, contradicted by a pre-tax profit advance.

I'd set forecasting specifics aside to focus on the key point about how management says the group's underlying trend is ahead of its expectations, which is what is needed to continue reducing debt.  Even if a no deal Brexit hits consumer discretionary spend, people still have to get about.

FirstGroup's income statement shows it moving from a £196.2 million operating loss to £9.8 million operating profit and, though swamped by £107.7 million net finance costs for a £97.9 million statutory pre-tax loss, it would appear group operations are overall improving.

Operating profit shorn of exceptionals is up 5% to £332.9 million and pre-tax profit by 15% to £226.3 million.  The US "First Student" school bus business has resumed growth and raised margins, while, in the UK, "First Bus" also delivered growth and higher margin.

UK "First Rail" has implicitly peaked after generating £331 million underlying profit in the last five years.  However, it looks as if a managed withdrawal is going to happen over time.  A formal sale for the US Greyhound bus operation is underway and ought to be value-accretive.

I wouldn't put faith in a 4p dividend forecast (see table) this year, instead I say the crux for valuation is ability to tackle debt and cut the interest charge.  The end-March balance sheet saw net debt down 15.6% to £956.5 million and, from the income statement, the net finance charge is down 18%, which likely lags the debt trend anyway.  Sale proceeds from Greyhound should also help in due course.

Coast reckons a more radical separation of the UK and US assets can generate £3 billion in capital for debt reduction, investment and the pension fund; which sounds more like a carve-up and liquidation sale. But, whatever the truth is in all such speculation, there’s ultimately a prize for shareholders here.  Coast wouldn't have accumulated 10% otherwise.

You can't identify any "margin of safety" in FirstGroup's accounts but, on a behavioural finance view, this company is attracting proactive investors (there has also been West Face Capital of Canada) which hints at value to unlock.

Admittedly, there's a speculative element here too, linked to comparative values achieved in business sales of other US bus operations.  However, FirstGroup's UK operations will also have value in the right hands.

I envisage a patient scenario where the current board prevails and adapts some of Coast's ideas like it has started to already.  Essentially, this stock is a play on balance sheet de-risking, and FirstGroup looks to have substance to make that happen despite risks of UK/US economic slowdown.

FirstGroup - financial summary             Estimates
year ended 31 Mar 2014 2015 2016 2017 2018 2019 2020
Turnover (£ million) 6717 6051 5218 5653 6398 7127  
IFRS3 pre-tax profit (£m) 58.5 106 114 153 -327 -97.9  
Normalised pre-tax profit (£m) 32.2 106 116 152 197 231 277
Operating margin (%) 2.7 3.9 4.6 4.9 5.0 4.7  
IFRS3 earnings/share (p) 5.1 6.2 7.5 9.2 -24.2    
Normalised earnings/share (p) 2.6 6.2 7.7 9.2 12.3 14.4 13.4
Earnings per share growth (%) -68.3 138 23.9 18.8 33.7 17.1 -6.9
Price/earnings multiple (x)           6.8 7.3
Annual average historic P/E (x) 40.2 22.8 13.9 13.5 11.3 7.2  
Cash flow/share (p) 27.8 27.2 34.1 43.3 52.1    
Capex/share (p) 24.8 31.7 32.0 30.0 31.5    
Dividend per share (p)             4.0
Yield (%)             4.1
Covered by earnings (x)             3.4
Net tangible assets per share (p) -42.8 -33.0 -24.0 -4.3 -8.7 -12.4  
Source: Company REFS              

Technical situation also looks more attractive

I see the stock retreat as justifying a renewed 'buy' stance on the basis that rationalisation plans are now better-honed as a result of the activists, and annual results suggest finances that are manageable and can continue to improve.

It's tricky to specify stock price or fair value targets, but my considered instinct - from fundamentals, the narrative and investor actions - is of FirstGroup's risk/reward favouring long-term upside.

A market technical risk could be my under-estimating Coast's impulsive behaviour; that if it can't get its way then it will instead place its stock and move on to other targets.  From the timing of its stake-building regulatory news statements, it would appear to be amply in profit, though dumping could be interpreted negatively by the market.

I also take heart from the "creative destruction" model of capitalism, advanced by economist Joseph Schumpeter. FirstGroup seems a prime example: put together with bold ambitions for a multinational transport group, nowadays being pulled apart.  Capitalism is dynamic, will make it happen.  Don't be swayed by the noise of disruption, take a view on the endgame.  Buy.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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