Interactive Investor

Stockwatch: what I’d do next with this successful share tip

He’s made a profit of over 90% on this tip and the valuation remains undemanding. But with the share price having dipped in recent days, equity analyst Edmond Jackson revisits the rationale to plan his next move.

24th November 2023 11:00

Edmond Jackson from interactive investor

When I rated mid-cap UK bus and rail operator FirstGroup (LSE:FGP) as a “buy” at 96p in December 2021, it was based on classic value/contrarian criteria. The business is well established in essential services as the second-largest regional bus operator in the UK and the largest rail operator.  

Yes, that involves challenges as to relations with government, although excellent subsidies are involved for older travellers and those on benefits. The train driver’s union remains awkward, but we should not forget how Arriva was acquired in 2010 for £2.3 billion by a German transport group.

That FirstGroup was trading only at a small premium to net tangible asset backing of over 90p a share offered scope to get lucky. 

I also made a “macro” pitch, about how FirstGroup’s risk/reward profile was attractive versus growth stocks that were over-inflated from monetary stimulus during Covid. Central banks would have to tackle incipient inflation, and higher interest rates prompt an aspect of portfolio rotation from “growth” to “value”. 

The prospective dividend yield back then – just like now – was not especially attractive at around 3%, although shareholders are also currently being teased with a 75 million share buyback programme as additional “return”. 

Capital upside also appealed by way of divestment of the US bus operations in July 2021 – with £3 billion proceeds transforming the balance sheet. There was also scope for further asset rationalisation. A fortuitous catalyst was appointing a proven transport boss as interim executive chair – intriguingly, the ex-CEO of Arriva, who honed that group into a takeover target. Aberforth Partners taking a near 7% stake underlined a classic sense of “event-driven value” in FirstGroup. 

Yet stock now dips on ‘strong’ interim results 

FirstGroup has enjoyed a strong run, especially this year, just recently testing 180p before the prospect of more rail strikes in December was raised. 

Yesterday, the shares closed down nearly 5% at around 167p and has eased to 165p this morning after interim revenue to 30 September was revealed flat at around £2.2 billion. Yet adjusted operating profit jumped 52% near £101 million and normalised earnings per share (EPS) nearly doubled to over 8p.  

Higher wages and other costs are being overcome by firm passenger numbers and ticket price rises, although it’s unclear quite what extent that benefits from government subsidising some travellers.  

Prospects for the full year to 31 March 2024 are re-affirmed, however, where consensus is for EPS of 12p, rising just over 15p in 2025, hence a forward price/earnings (PE) ratio of 14 times, easing to 11.5. That is hardly demanding. 

What grates with me about the profit adjustment is it relating to a £142 million charge for ending participation in two local government pension schemes – this to result in annualised cost savings of £2-3 million. So the upfront cost they prefer us not to recognise, but please do notice the net benefit in future years. I agree it probably is a sensible tidying up, albeit largely just re-arranges costs. 

It means a reported interim net loss of £51 million, although it’s unclear quite whether the market was guided for this or was bowled a googly, which partly hit sentiment. 

Passenger financial support will probably remain the same under any Labour government from next year; and while the party can sound radical at times, its leader affirmed public-private partnerships in his conference speech. Realities of the UK fiscal position mean re-nationalisation is a non-starter in my opinion. 

A chief risk would seem flat revenue may be as good as it gets – say if the UK economy does deteriorate under “higher interest rates for longer”, hence reduced spending on leisure travel, and also for work if unemployment rises. 

FirstGroup thus illustrates how a classic “value” play needs to follow through with growth legs once its valuation has re-rated to look broadly fair – unless its yield is sufficiently attractive for income investors. Otherwise, some holders start to sell and the stock retreats. 

Rail outcomes are more critical financially for the group 

Buses constitute 23% of the continuing operations’ revenue, albeit 36% of operating profit (disregarding the pensions’ exceptional cost). 

While First Bus is “clearly sensitive to broader consumer spending and inflation trends, we expect to make further progress against our expectations,” helped by efficiency improvements. Revenue advanced a respectable 18% to £5,605 million, helped by passenger volumes, price rises and better performance, offsetting a circa £19 million reduction in funding.  

Government policy has still helped and remains “extremely supportive,” with the Department for Transport declaring a further £700 million for service improvements in the North and £150 million in the Midlands. A £2 fare cap has also been extended to the end of 2024. 

First Rail revenue eased 3.5% to £1,722 million, its operations review detailing initiatives towards better operating performance and customer experience. At risk of my picking unduly on a negative, the nub issue is possibly the rail policy section citing “passenger numbers and revenues well below 2019 levels”.  

Management is in negotiation with government on this, where their “ask” could be explained better to investors than “for government to take steps in the short term to incentivise operators without requiring primary legislation.” It sounds like they want more subsidies albeit that’s unlikely now that the Conservatives will strain every sinew towards tax cuts in an election year. 

Expectations tempered

The table going back to 2016 suggests around £5 billion revenue might be a reasonable medium-term target, albeit 2018 and 2019 look exceptional. Operating margins will probably struggle to reach 5% again, not least because of question marks about whether a Labour government would provide support for a private operator to achieve that. Return on capital has lately recovered to around 6% to 7%.  

Given constraints of size/activity of the UK population (for revenue), also government and the trade union, it is hard to see what “gives” on these broad issues for FirstGroup to build – if even sustain – what growth credentials it has.  

FirstGroup - financial summary
Year-end 25 Mar

 20162017201820192020202120222023
Turnover (£ million)5,2185,6536,3987,1274,6434,3194,5914,755
Operating margin (%)4.75.0-3.10.1-4.64.02.73.2
Operating profit (£m)246284-1969.8-215171123154
Net profit (£m)90.3112-296-66.9-32778.463687.1
Reported EPS (p)7.59.2-24.6-5.6-27.80.8-1.110.3
Normalised EPS (p)7.710.7-1.64.6-15.6-13.2-4.919.8
Return on total capital (%)6.26.5-5.60.2-3.93.37.06.4
Operating cashflow/share (p)33.842.852.946.779.097.86.275.2
Capex/share (p)33.433.235.135.727.334.223.823.3
Free cashflow/share (p)0.49.617.811.151.763.6-17.651.9
Cash (£m)3604015566939691,439788791
Net debt (£m)1,5201,3901,1359563,3112,379 6261,276
Net assets (£m)1,6092,0551,4811,5551,2101,178877740

Source: historic company REFS and company accounts.

It’s positive how the interim adjusted operating margin on continuing operations is up from 2.6% to 4.5% - where First Bus raised its from 4.8% to 7.1% - but like I say, it’s unclear what extent this starts to benefit from re-arranging pension costs.  

In due respect, the adjusted margin for First Rail is up from 3.2% to 4.5%, but if revenues are consolidating, can margins seriously rise further to achieve profit growth? 

More positively, and if management continues to deliver on its rather impressive electrification, a public transport push by a future Labour government to get people out of vehicles, helping meet net zero targets, could benefit FirstGroup. 

During the first half-year, 166 electric buses were delivered, over 100 charger heads installed and also solar panels at 25 depots. But it’s not clear how many “green” funds exist nowadays or whether investors are so motivationally aligned to buy the stock for this reason.  

My concern is therefore flat revenue under slight pressure according to how the UK economy pans out, such that investors tilt to lock in gains with the price at 165p, following a circa 80% gain in two years including dividends.  

Market pricing might exact a higher yield – in other words, fall – to sustain interest. If you are pessimistic on the UK economy and are sceptical that a Labour government would co-operate well enough with private firms, lock in (some) gains. Broadly: Hold. 

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

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