Interactive Investor

Stockwatch: An undervalued 'zombie' mid-cap with realistic potential

16th November 2018 10:04

Edmond Jackson from interactive investor

Disciplined portfolio investors might dismiss this indebted business, but companies analyst Edmond Jackson spies early signs of a turnaround and clear break-up potential.

Is it becoming more likely that "zombie" transport company FirstGroup will get broken up to enable more focused management, and debt alleviated?

A zombie company is one so burdened by debts and operational challenges, it exists mainly to pay debt interest charges and pensions, provide customers with services, employees jobs, and if listed companies then bumper pay for bosses.

Not much in it for shareholders unless deft at trading volatility – at FirstGroup, in a sideways trading range of 80p to 150p in the last few years, with no dividends.  But if capitalism works effectively, "something has to give", at least a refinancing.  Could the time be approaching?

60% upside entertained by Cazenove

Capitalised at around £1 billion in the FTSE 250 index, shares in FirstGroup jumped from 82p to 88p in response to latest interims.  They're currently around 80p, though plenty of stocks are currently being hit amid fast-moving UK politics.

I'm interested to consider if this rise implies recognition of the stock's risk/reward profile turning more positive, down at this share price area and versus corporate developments.

Despite media reports taking a "worse losses" view based on statutory interim figures, the market appears to be looking deeper.

Analysts at Cazenove reckon a 133p target given potential for future years' upgrades, as road-related earnings increase albeit rail are reduced mainly due to the South West franchise.  

"We remain overweight FirstGroup given the material self-help story and medium-term refinancing potential," they say.  

Source: TradingView (*) Past performance is not a guide to future performance

Mind how JP Morgan Cazenove is one of FirstGroup's brokers, but such a view resonates with the couple of times I've wrestled with FirstGroup here: at 90p in September 2015 then 139p back in June 2017 – when brokers targeted 150p to 165p after improved operating results.

My last conclusion was the stock being liable to drift lower, albeit with the group having some worthwhile businesses to sell in order to cut debt.  That at some point events could together here.

Underlying progress within a complex story

Media reports have cited the interim pre-tax loss rising from £1.9 million to £4.6 million despite a 19.2% revenue rise to £3.3 billion; and earnings per share (EPS) of -0.6p versus consensus for 0.3p.

Moreover, the statutory income statement shows £46.3 million operating profit wiped out by £50.9 million net interest – as if "shock horror" for relying on projections, reinstated dividends will give rise to a reasonably supportive circa 5% yield.  There's no interim payout.

But strip out intangible asset amortisation and normalised pre-tax profit is up nearly 40% to £42.0 million or 63.4% at constant currency; the road division up 17.9% to £63.1 million.

Moreover, on such a "normalised" view of profits/earnings, the recent years' trend (see table) has been pretty good.

Management guides for "broadly stable" group operating earnings (at constant currency) and free cash generation, albeit a smaller rail contribution due to infrastructure and industrial relations issues.  

Haggling with the Department of Transport continues over contract amendments and revenue sharing.

At first sight even "adjusted" interim EPS of 2.9p compares with a consensus 12.1p for the full year, however, the second half is normally FirstGroup's stronger - interim EPS of 1.9p became 12.3p for the last year.  

There are small improvements in the large US school bus division, both passenger/margin growth in UK bus, and the Greyhound coach operation is implementing improvements to target at least mid-single digit margins.

FirstGroup - financial summary           Consensus estimates
year ended 31 Mar 2014 2015 2016 2017 2018 2019 2020
Turnover (£ million) 6717 6051 5218 5653 6398    
IFRS3 pre-tax profit (£m) 58.5 106 114 153 -291    
Normalised pre-tax profit (£m) 32.2 106 116 152 197 231 277
Operating margin (%) 2.7 3.9 4.6 4.9 5    
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 12.1 12.6
Earnings per share growth (%) -68.3 138 23.9 18.8 33.7   4.1
Price/earnings multiple (x)         6.7 6.9 6.6
Annual average historic P/E (x) 40.2 22.8 13.9 13.5 11.3    
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)           3.5 4.5
Yield (%)           4.2 5.4
Covered by earnings (x)           3.5 2.8
Net tangible assets per share (p) -42.8 -33.0 -24.0 -4.3 -8.7    

Source: Company REFS         Past performance is not a guide to future performance

Dividend commitments are in principle

Defining a support level for the stock is made difficult by the guessing game of dividends' reinstatement.  Forecasts' implying 3.5x earnings cover for a 3.5p payout can't be relied on given no payout in a similar EPS context last year, and the board is suitably vague saying it is "committed to reinstate dividends and will continue to review appropriate timing", however there is no interim dividend.

A 3.5p total payout would cost £42.3 million in context of £140 million free cash declared for last September, and the interim cash flow statement showing £228 million generated from operations (if down 20.6% on 2017) versus investment fairly stable around £180 million.  

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The board's caution likely relates to infrastructure investment and financing needs, where the interim cash flow statement is curious: financing issues are stated absorbing £7.5 million in a volatile context which doesn't specify £50 million-plus of interest costs cited in the income statement.

With the debt profile showing £1,351 million long-term liabilities (i.e. bonds) and £344.5 million short-term debt (down 20.3%) also a £280 million pension fund deficit, common sense implies wariness as to dividends resuming.  The raw figures can overwhelm but at least net debt is down 11.2% on an adjusted basis to £1,048 million, which could help pave the way towards a refinancing.

North American break-up interest

In the last few days, a top-10 shareholder – probably Canadian activist West Face Capital which has traded the stock quite actively - has gone vocal to the press; whether this reflects frustration with a fallen share price, hence entertaining bid prospects.

Yet there's already been two last April from Apollo US private equity, the board rebuffed on grounds of fundamentally undervaluing the group.  This complaining shareholder cites FirstGroup's UK rail arm as "extraordinarily destructive" of capital, with losses up to £106 million projected until the contract ends in 2023.  Encouragingly, a peer US school bus company has been acquired for an enterprise value of $1 billion (£770 million), implying that a pro rata basis such a disposal would fetch more FirstGroup's market cap.

Highly speculative that may be, and takeover rules pre-empt Apollo making another offer until next year; but it's not unusual for takeover targets to get serial approaches, and from a US perspective the chaos of Brexit is likely to present an advantageous exchange rate.

The chief impediment seems how UK rail can be satisfactorily be exited – to another private owner - while the prospect of a Corbyn government rises as the Tory party combusts.

But see from the table how FirstGroup's trend in cash flow per share is much stronger than earnings per share – roughly by a factor of at least four.  Despite high capital spending needs also, it's the kind of profile tending to attract private equity.  Not to get swayed by takeover speculation but it has logical elements.

Very much a 'special situation'

Debt (amounting to modestly negative net tangible assets), lack of dividends and the challenges for UK rail, put this stock off-limits for disciplined portfolio investors.

Yet a "special situation" case part-derives from this, the market potentially failing to recognise sum-of-parts value.  

Given there are some attractive operations within the group and, overall, they are tending to improvement, private equity is likely at least keep FirstGroup in the frame.  Speculative buy

*Horizontal lines on charts represent levels of previous technical support and resistance.

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

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