One of the most notable trends in the UK stock market since Brexit has been the outperformance of companies with significant overseas earnings. This is due to the fall in the value of the pound against the dollar and the euro. Companies that earn their profits in dollars or euros have benefited from an upgrade when these profits are translated back into pounds, causing their share prices to rise. The stock market has been pretty efficient in this regard, especially amongst the large international blue-chip FTSE 100 companies, most of which have performed well post Brexit. However there are also some companies that have not performed as you might expect. Firstgroup is one such anomaly.
I had been intending to write a blog post on Firstgroup anyway because I think there is a really interesting investment proposition emerging here. That the shares are languishing 7% below their pre Brexit levels despite the company earning nearly two thirds of its profits from North America makes the situation even more interesting1.
Firsgroup’s business model is not especially complicated. The company operates bus services in the UK and the US. In the UK they have agreements with local authorities to provide local bus services, while in the US most of their business is with school districts where they provide school bus services. Firstgroup is responsible for investing in the bus fleet and providing a reliable service. Firstgroup also own the Greyhound business in the US and Canada, a transit business in the US and they have a small rail business in the UK.
Now I would be the first to admit that this is far from being the world’s highest quality business. It is relatively capital intensive (buses are expensive and they depreciate), it is competitive and some areas rely on Government subsidies which are prone to political meddling. However there are positives too. Transport is not especially cyclical and there is no structural threat about to destroy the business (Uber has proven that it can disrupt the taxi industry, but it is too early to say whether it can do the same for buses which have far lower unit costs than taxis).
What is more complicated is Firstgroup’s history. The company unwisely bought into the US market at the top of the market in 2007, paying a very high price and taking on a lot of debt in the process. Significant underinvestment followed as the management tried to sustain their unaffordable dividend. Profitability deteriorated, eventually resulting in a rights issue, dividend cut and a period of heavy catch-up investment as the new management attempted to restore the business to health. The lack of any dividend payment and this rather ugly history likely explains why this is still a share that most investors will not look at.
In my view, the investment proposition today looks better than ever. Here are the key points2:
– Firstgroup has spent £1,100m on capex over the past 3 years, mostly only new buses. Management have indicated that that this period of catch-up capex is over with the business now able to compete on even footing with competitors. Capex is unlikely to fall dramatically from here, but the important point is that Firstgroup is no longer an underinvested business.
– There is already evidence that this investment is having the desired effect. Margins in the UK bus business have recovered from 4.7% at the low point to 5.7% last year and further improvement is expected this year. It is a similar story in the US student bus business where margins have moved up from 6.8% to 7.8% last year. These margins are hardly high by historical or industry standards. Indeed Firstgroup management have ambitions to take margins up higher over the coming years.
– Firstgroup currently has a highly inefficient balance sheet. The debt used to fund the US acquisition in 2007 was fixed on long dated maturities such that the company is still paying an average 6.3% on its debts. It is interesting to note that the bond market sees very little risk in Firstgroup’s debt. The longest dated maturity is the 2024 6.9% bond. This currently trades at a 30% premium to par, which equates to a 2.8% yield to maturity3. If Firstgroup could refinance all their debt today at this interest rate, the equity free cash flow would rise by £68m, a nearly 60% increase on our estimates for the current year. Of course this won’t all happen at once, but Firstgroup have a number of maturities arising over the coming years, so this should prove a very positive tailwind for the company.
– Firstgroup is a beneficiary of the recent depreciation of the pound highlighted above. Compared to where they were pre June 23rd, the company’s profits should rise by at least 5% and potentially more than this if current rates are sustained.
– The valuation of Firstgroup shares in no way reflects these positives. We expect Firstgroup to earn £114m of equity free cash flow this year. This equates to a 10% yield on the current market capitalisation of £1150m. This is a very attractive valuation both in absolute terms and relative to the wider market.
Below is a graphical summary of the above, which illustrates the bull case for Firstgroup shares from here. If management hit their margin targets and the debt is all refinanced at current rates then the equity free cash flow would rise to £195m, representing a 17% yield.
The important point is the sizeable margin for error here. The refinancing opportunity alone provides a significant tailwind and this is mostly within management’s control, subject to prevailing market interest rates. Even if one or two of Firstgroup’s businesses fail to meet their margin targets, the shares will still represent attractive value. Once Firstgroup reinstates the dividend and the market wakes up to the refinancing opportunity, I expect the shares will re-rate strongly.
1. This is no recommendation to buy or sell any particular security.
2. All financial data in the following bullet points are sourced from company reports and Allianz Global Investors research estimates. NB – 2017 refers to the current fiscal year estimates as Firstgroup has a March year end.
3. Source: Bloomberg, 03/08/16