U.K.-based bus operator FirstGroup (OTCPK:FGROF) (OTCPK:FGROY) shocked the market earlier this year with its announcement that it might not be able to continue as a going concern. However, a trading statement at the annual general meeting affirms that the company is now in a better shape. I judge that it is likely to survive. Although the investment case is mixed and risks persist, the shares are cheap at their current price. However, given the risks, I don’t see this as a compelling buy.
The Company Believes It May Turn a Profit
Reporting on trading between the start of April and end of August, the company said that it had experienced stronger-than-expected financial performance. Adjusted operating profit and cash from operations have reportedly been ahead of its expectations. This was driven by better revenue recovery and strong cost control. Partly the company has benefitted from governments extending their financial assistance programmes to bus operators.
FirstGroup now expects to deliver a small adjusted operating profit for the first half of its financial year. This is ahead of its expectations several months ago. Shares are already up by about 50% since their July lows.
Business is Starting to Pick Up Again
The pandemic has severely damaged bus operators, even though in many markets they have benefitted from government subsidy schemes meant to tide them over.
FirstGroup has a particular challenge. It is exposed to passenger buses, which have continued during the lockdown to some extent in the company’s key markets such as the U.K. It also has exposure to school transportation, which has been affected by schools switching to home teaching. There was some encouraging news on this, with c.45% of its fleet operating home to school services in North America. Passenger numbers weren’t provided, but such contracts are often at a fixed price rather than being dependent on passenger numbers. Although the level of service remains well below normal, it is still a sign that the school bus business segment is gearing up again.
Even with the Canadian border closure ongoing, revenue at the Greyhound division is up to c.35-40% of pre-pandemic levels.
In the U.K. market, operated mileage is back to about 90% of pre-pandemic levels and passenger mileage has moved above 50% of its pre-pandemic levels. Interestingly, in line with the thesis that rail is recovering more slowly than the bus segment in the U.K., the company’s rail division, GWR, has around 90% of its services operating, but passenger numbers are only 30%. That said, I was on a couple of (non-GWR) trains in the U.K. recently and observe that while passenger numbers remain lower than usual, they are markedly up from where they were even a month ago. School and student transport explains part of this.
While none of these figures sound great, nonetheless I think that they are encouraging. People are getting back on the buses, more so over time. Ridership levels are now getting to the point where the services wouldn’t be obviously loss making as they were a few months ago with near-empty buses. Additionally, as the company relies not only on passenger revenue but also government funds in return for running certain specified services, the financial picture looks even better than suggested by improved passenger numbers.
The company noted that it “is now expecting to generate a small adjusted operating profit in the seasonally weaker first half of the financial year.” For a company which was teetering on the brink just a couple of months ago, that is good news, even with the thin level of detail provided (specifically about how significant the adjustments are in arriving at that profit). The survival of the business requires that the company manages its liquidity, turns a profit, turns free cash flows and divests the lossmaking businesses. The trading statement didn’t mention cash flow, but liquidity is up, profit is expected to return albeit on a small scale, and there is hope that the U.S. business, which is problematic but not always lossmaking, will be divested. I assess that although the company will continue to be vulnerable to the current unforeseen events such as a second wide-scale spike in infections and lockdown, aside from that, its survival looks likely.
Liquidity Has Improved
The company noted that its committed undrawn liquidity of c.£850m has improved since April. It also said that it expects comfortably to pass covenant tests due in recent days. EBITDA on the basis relevant for the bank test was expected to be around 2 times, well within covenant requirements of less than 3.75 times.
The North American Business Remains on the Block
I explained previously why FirstGroup was trying to exit its North American operations and how that would strengthen the investment case for the company in FirstGroup: A Way Back From The Abyss.
No deal has yet been announced, but the trading announcement confirmed that this is a key priority. It said that the company is “resolutely focused” on executing the portfolio rationalisation strategy through divestment of the North American businesses. It said that there has been significant interest from potential buyers, as I explained in my previous piece. As expounded in that previous piece, undoubtedly, the company can sell the North American business. The question is on what terms. It looks like a buyer’s market, with the company keen to get rid of the business and also no doubt keen to bolster its liquidity and balance sheet further. So while a full valuation would be welcome, based on a competitive bidding process, in reality, I think that there is a fair chance that the business will basically be sold on the cheap. That is never ideal, but in this case, I think that it is still positive for the investment case. Getting out of North America and getting more cash in the bank – even if it is less than might have been achieved in better days – improves First’s survival prospects and so will be a positive development.
How to Value FirstGroup
At this point, valuing the company is difficult because there are so many moving pieces. One needs to consider specifically the future likely demand for bus and rail demand in the U.K., the expected longevity and the sale price which might be attained for the U.S. business.
Although the first couple of these items remain unclear, the trajectory is clearly pointing to increased usage of public transport over the long term, subject to any more lockdowns. While it may plateau below pre-pandemic peaks, I don’t expect it to be far below. Some workers may work from home for years, but in general I expect many travel patterns to return broadly to their pre-pandemic levels, and where they do not, service and cost reduction to mitigate any revenue impact. So, I expect that the company can hobble on with some government support, and a couple of years from now, the U.K. public transport business will be similar to what it was pre-pandemic.
As for the U.S. sale, it’s clearly a fire sale, so the group won’t get the best price, but it will still be chunky and will also stop it bleeding red ink there.
That said, the U.S. sale could wipe out the debt. The company said in its statement last month that it is on course for leverage of around 2x on an EBITDA basis. So, even decent but not great U.S. proceeds could allow debt to be covered, and valuation then becomes a question of what the U.K. business is worth. In its most recent annual report, the U.K. bus and train businesses were responsible for around 37% of adjusted operating profit. The rump business may include some more of the North American business, and no two years are the same. Then again, profitability in the U.K. business will be down in the next couple of years while ridership recovers. But, if one says that, by say 2023, things will largely have recovered or at least rebalanced, a U.K. rump business at about 40% of group historical earnings before the U.S. divestiture would produce around 3-4.8p EPS, based on the best couple of years in the past five years using basic earnings. A multiple of around 15x, which seems generous but plausible if the company gets back into shape, could suggest a share price around 45-72p.
There is a lot of back-of-the-envelope reasoning in that assessment. But it suggests that, while the company – whose shares stand at 48p – may be undervalued for a recovery, they are not wildly undervalued. There are large unknowns and a lot of risk, which is reflected in the current price discount in my view.
Why I’m Not Getting into FirstGroup
Having said all that, it doesn’t mean that FirstGroup has a great investment case. I previously explained why I think Stagecoach (OTCPK:SAGKF) (OTC:SAGKY) is a better pick than First in this area, and even given that, my Stagecoach position is heavily underwater at this point.
Despite the improving passenger numbers, there remains substantial uncertainty about the short- to medium-term demand for bus services, and even more so for commuter-heavy rail services, which as per First’s numbers are recovering more slowly to date. There are also industry-wide issues. FirstGroup faces specific challenges such as getting a good sale price, fast if possible, for its North American business.
With so many moving parts, I think that there are more assured investment options elsewhere. However, if one has a high risk tolerance, it is worth looking into the FirstGroup situation more closely. After rumours of a U.S. sale surfaced, shares moved sharply upwards. But at today’s price of 48p, they remain priced for poor outcomes, almost two-thirds below where they were at the start of the year. For those willing to wait a year or two for a return, a U.S. sale and demand normalization could lead to a substantial upwards rerating on the name from today’s prices.
Disclosure: I am/we are long SAGKF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.