By Paul Tracy
Shares of ultra high-yield portfolio holding Student Transportation (NASDAQ:STB) dropped to a low this morning of $5.72 a share, down 17.3% from last Wednesday's close, due largely to a negative research piece by Prescience Investment Group, an investment firm that manages a hedge fund. The research piece was widely disseminated on the Internet and through a summary piece by Prescience's CEO, Eiad Asbahi, on Seeking Alpha.
Based in Ontario, Canada, Student Transportation is the third-largest provider of school bus transportation services in North America. About 80% of the school districts Student Transportation serves operate under multi-year contracts of varying lengths. In short, the report alleges that Student Transportation is unable to cover its current $0.56 per year dividend through operating cash flows and instead relies on new share issuances to fund the payout. The firm placed a target of C$2.00 on the stock, roughly 70% below where it was trading the day before the report was issued.
There are several reasons to immediately suspect the accuracy and motives of this report. First and foremost, as Prescience and Mr. Asbahi fully disclosed, the firm and others involved in writing the report hold short positions in Student Transportation and stand to realize gains in the event the stock falls in price. The disclaimer goes on to state that the opinions stated in the report should not be considered independent and the firm might decide to increase or decrease its short position.
|When hedge funds sell a dividend-paying stock such as Student Transportation short, those traders must make dividend payments to investors in lieu of the company. Since Student Transportation pays a $0.046 dividend per month, equivalent to a 9% annual yield at current prices, holding a short position in the stock for long is an expensive proposition.|
The hedge fund managers behind the report have a vested interest in seeing the stock price decline.
The best scenario for Prescience would be that the stock drops quickly so that it's able to cover its short position before being forced to make numerous monthly dividend distributions. The panicky sell-off in the stock catalyzed by Prescience's report fits the bill.
The timing of Prescience's analysis is also suspect. As Student Transportation stated in a press release on July 26, the company is in a so-called blackout period as it completes financial reports for the fiscal year ended June 30, 2012. That means that Student Transportation is legally restricted from providing updated financial information until it has completed its annual reports and filings. All Student Transportation was able to say in its press release to refute the claims in this piece was that there have been no material or adverse changes in the firm's operations. The timing of the Prescience report limits management's ability to refute the claims in it. And Student Transportation doesn't normally release its fourth quarter and full-year earnings until late September, nearly two months from now.
Student Transportation is also a convenient target for Prescience. It's a relatively small company with a current market capitalization of $443.5 million and a share count of around 63 million, so it doesn't take much selling pressure to push the stock sharply lower. In addition, Student Transportation is predominantly owned by retail investors rather than institutions; strong institutional support might help reduce volatility in a stock in response to stories of this nature.
Moreover, the company's small-cap status means that there are only six analysts covering the stock, primarily Canadian and regional U.S. brokerage firms. That means there are few influential analysts who could immediately publish reports refuting the claims in Prescience's 30-page release.
Prescience's lack of independence and the convenience of Student Transportation as a target for its negative report do not necessarily mean the contents of the report are incorrect or that the opinion is wrong. But they do call into question the motives Prescience had in releasing its report free of charge on the Internet and via posts on popular financial websites. The hedge fund certainly has a financial incentive to paint Student Transportation's fundamentals in a negative light as a drop in the share price would result in profits for Prescience.
To make matters worse, a look inside the report reveals several fundamental flaws with Prescience's bearish thesis. First, the report repeatedly discusses Student Transportation's earnings and earnings per share. In its 2011 fiscal year ended June 30, 2011, Student Transportation earned $0.03 per share, and in the year ended June 30, 2010 the firm earned $0.05 per share. Clearly, on an EPS basis, the company did not earn enough money to cover its roughly $0.56 annualized dividend in either year.
But earnings and earnings per share are accounting measures that include a number of non-cash charges. As such, they aren't relevant metrics in this case. One of the biggest non-cash charges included in earnings for Student Transportation is the depreciation it charges on its vast fleet of school buses, vans and related assets. But these charges do not represent the actual cost of these assets or the cost of maintaining them; depreciation is simply a way of accounting for the cost of an asset over time. Just because an asset has been fully depreciated does not mean that its market value is $0, nor does it mean that the useful life of that asset is over. In many cases, firms would want to maximize their depreciation charges to reduce their reported earnings and, therefore, their tax burden.
In the case of Student Transportation's fiscal 2011 results, the company reported net income used to calculate EPS of just $1.59 million, but that includes total depreciation charges of nearly $33.2 million. For some groups of companies, such as master limited partnerships (MLPs) owning oil and gas pipelines in the United States, analysts routinely add back non-cash charges such as depreciation to net income to produce a truer picture of a company's earnings power and dividend-paying ability. Such an adjustment for Student Transportation would boost the company's earnings per share to more than $0.60 in 2011.
In another obfuscation involving earnings, Prescience's report claims that CEO Denis Gallagher's total compensation package of $1.8 million in 2011 was excessive because he was paid more than the company earned for the year. Once again, this is only true if you focus on unadjusted earnings that include depreciation and other non-cash charges.
|A better measure of Student Transportation's profitability and performance is to look at cash flow measures that exclude non-cash charges. The company typically discusses cash flow metrics in evaluating its own performance, and analysts covering the stock focus on these measures over headline earnings figures.|
Many of the report's bearish claims don't stand up to even the most cursory scrutiny.
But here again, Prescience's report claims that Student Transportation's operating cash flow and free cash flow are also insufficient to cover its dividend payout.
Much like the knock against EPS, these claims are questionable, at best. In 2011, Prescience calculates Student's operating cash flow per share to be $0.47, still below the $0.56 paid in dividends for the fiscal year. But to calculate this, the report uses the fully diluted share count rather than the basic share count.
In 2011, Student Transportation had a weighted average of about 57.76 million common shares outstanding. But the company has also issued several classes of convertible bonds; holders of these debentures have the right to convert their bonds into shares of common stock at a particular price. If all of the convertible debenture holders decided to convert their bonds into common shares, Student Transportation would have to issue an additional 15.85 million shares -- the fully diluted share count includes both actual shares and these 15.85 million that would be created if Student Transportation bonds are converted to shares.
But this represents a worst-case scenario -- it's highly unlikely that all of the company's convertible bonds would be converted to common shares in any given year. Convertible debentures are convertible into common stock at a predetermined ratio, so in many cases it's not profitable to convert a debenture because the conversion price would be more than the current value of the common stock. That was the case with Student Transportation in 2011 and remains so today.
The firm had three classes of convertible debentures trading as of the end of last fiscal year: $26.9 million principal amount of 7.5% convertible debentures convertible into 5.2 million common shares, $51.6 million principal amount of 6.75% convertible debentures convertible into 7.1 million common shares, and $59.4 million principal amount of 6.25% convertible debentures convertible into 6.3 million common shares. The 6.75% debentures are convertible into 137.931 shares of common stock per bond. Based on the par value of C$1,000, bondholders are getting a price of $7.25 per Student Transportation share at conversion. It would be illogical to convert a bond into common shares at $7.25 per share when one can simply buy the shares on the open market at around $6.00 as of this morning.
Only one class of Student Transportation debentures appeared to offer an attractive conversion option in 2011-- investors converted about C$25.7 million worth of the 7.5% convertible debentures into common shares at a price of C$5.15. This added fewer than five million new shares to Student Transportation's share count. With the exception of the roughly C$27 million worth of 7.5% convertible debentures still outstanding that can still be converted at a below-market price, investors are unlikely to convert their bonds unless the price of Student Transportation's common stock were to increase markedly. Therefore, it makes little sense to include the 15.85 million shares in the fully diluted share count in the company's total share count.
In fact, Student Transportation's annual report tells us that the company's debentures were antidilutive in fiscal year 2011, meaning that if all debenture holders did convert their bonds into stock it would serve to boost earnings because the value of retiring the debt is higher than the dilution caused by issuing new shares.
And the use of per-share numbers is an unnecessary complication Prescience appears to use to imply that Student Transportation's operating cash flow was not enough to cover dividends paid in fiscal year 2011, something that's demonstrably untrue. In 2011, Student Transportation generated a total of $36.3 million in cash flow from operations and paid just $25.4 million in dividends to common shareholders, covering its payout on an operating cash flow basis by 1.43 times.
Prescience also uses free cash flow and free cash flow per share to illustrate its point. The hedge fund's questionable use of the fully diluted share count presents the same problem for operating cash flow per share. But there's another problem with free cash flow as a metric in this case.
Free cash flow is defined as operating cash flow minus capital expenditures. CAPEX includes the money a company spends on new equipment and parts as well as property. The logic behind free cash flow is that it tells us how much cash a company generates after it has paid to invest and maintain its properties, plants and equipment.
In the case of Student Transportation, its free cash flow last year was $22.68 million, which is less than the $25.41 million it paid to common shareholders in dividends. However, this calculation of free cash flow is based on CAPEX spending of $13.7 million, and that amount is distorted by the company's acquisitions and bids on new contracts to manage school bus fleets. In particular, Student Transportation's annual report tells us that around $6.0 million in capital spending is replacement CAPEX, needed to keep its existing equipment in good working order and continue servicing its existing contracts. The remaining $7.7 million in CAPEX is related to new contracts it bid on in 2011; in other words, this is capital spending needed to fund growth.
When determining if Student Transportation's dividend is sustainable, what investors should care about is the firm's ability to generate cash after spending all the capital it needs to maintain and continue servicing its existing contracts with school districts. CAPEX used to buy equipment to serve new contracts might not generate much cash flow immediately but is intended to generate future cash flow. If we add back growth capital spending to the free cash flow figure, Student Transportation generated $30.38 million in sustainable free cash flow, more than enough to cover its $25.4 million in common dividends.
Bottom line -- Prescience Investment Group's 30-page report on Student Transportation is filled with figures and charts that claim to prove the company is dramatically overvalued and to present a scary picture of dividend stability. But the hedge fund managers behind the report clearly aren't independent analysts and have a vested interest in seeing the stock price decline. The timing of the report during Student's blackout period is also suspicious. And a closer examination of the report suggests that many of the report's bearish claims don't stand up to even the most cursory scrutiny.
The drop in STB is a result of Prescience Investment's flawed report offers investors an opportunity to buy a quality dividend stock yielding around 9% at an attractive price. Student Transportation remains a buy under C$7 and remains on my "Buy First" list.
Disclosure: I am long STB.