Stagecoach Group - Undervalued With A Few Moats

| About: Stagecoach Group (SAGKF)

I just bought approximately a 10% weight in Stagecoach. I think they are very good value at this price. To break down the business, they are a bus and train operator.

Income statement:

So 73% profit Regional + London bus 21%, rail 9.7% North America - less group costs/a few other bits.

Shares have fallen from a high of 420 in mid-2015 to 260 now - a near 40% fall. They have been particularly punished due to their December trading statement, which stated:

"We believe that revenue has been adversely affected by the terrorist attacks in Paris discouraging people from travelling to major cities. We currently anticipate a recovery in those revenue growth rates."

I guess it's possible some people will travel less due to the attacks - but like the post September 11th dip in travel, it will be temporary.

There are also concerns about a buses bill to be introduced later this year - this will make introducing some sort of franchising system easier (in some ways) for councils. As margins in London (where contracts are franchised) are lower than the rest of the UK where there is a free market in operation, then this obviously creates concern. What this view misses is that under a franchising arrangement much more risk lies with the council. They don't have the capability to take on or manage this risk.

The report on the denied franchising application in Newcastle is an interesting read (ish). What I believe it shows is the council being far out of its depth - and Newcastle is a big council with far more resources than other areas…. This is nothing to say what the inevitable judicial reviews/litigation will make of this.

Even after a buses bill, councils will have to work out what they want to do, consult, then implement it - this will take years - my guess being at least 3-4.

I also don't accept the current view that the introduction of franchising is necessarily a bad thing for the industry as a whole. London buses are the only region in the UK, which has seen sustained growth - despite being franchised.

It should be profitable to run more buses - demand should be there, particularly given the cost of parking, running and insuring a car. It's a co-ordination problem - people won't quit their cars if there is a poor bus service. In addition, a poor bus service can't get users it needs to become/sustain a better service without a period of initial investment.

I can see justification for some sort of contracts system to allow cross subsidy in the network to allow losses to be made on routes, incentivizing car users to give up their car, once routes are established using surplus generated to repeat the process.

Private operators should be doing this already - but I don't see them doing it - certainly where I live in Sheffield. What I see is the best routes being maintained - and short-term profit being extracted by running down less well-used routes.

Frequencies are cut/reliability is not maintained and in the short term, bus load factors increase as does profitability. In the longer term, it is cancerous - the more affluent will switch to cars - leading to a negative cycle.

The government whilst officially encouraging public transport, I think really are less inclined to encourage it than you might believe. Car users are a good source of revenue 60-70% of the petrol price is tax. To push this further, the income generated to buy this is also taxed - probably at 30-40%.

The government doesn't want cheap, high quality public transport - it lets people work less and retire earlier, in the meantime paying less tax. This may be attractive to people but isn't attractive to those who extract surplus value from them (my inner Marxist emerging).

This (and the fact we have a Tory government) leads me to believe any regulation will have little impact.

I think in the end, a sensible franchising system would probably lower the margin - London buses have a 7% EBIT margin vs. 11% for Regional, but you may start to see top line growth and as a result, profit could rise. In addition, the risk of running services may be cut - right now, Stagecoach is exposed to a slowdown in the economy.

Lots of profit is in the last few people getting on a given bus. If they lose their job, they don't need to travel for work and margins could be hit. This risk is mitigated a bit under franchising.

Despite these regulatory issues, I have wanted to own a bus business for ages - there are some barriers to entry in that bus depots (in common with everything else) are difficult to develop in the UK given our planning laws. There are natural network effects which are again a bit of a barrier to entry, it is also reasonably capital intensive.

Further, an established operator can drive out a new entrant without deep pockets. Competition is measured - big operators know where others are and don't impinge upon their turf.

Stagecoach is trading at a P/E of 10 and has a yield of almost 4.5%. Debt is a reasonable £391m. They don't have much in the way of tangible assets, so I am looking at this from a cash flow perspective.

Cash flow from operations for 2015 was £315.5m less £134.5 net CAPEX and £33.2m lease repayments. So a rough free cash flow was £147.8m - so at a market cap of about £1500m, we are at about 10X FCF.

This is about the upper limit of where I will invest. I still see it as a bit pricey - having said that the business is good quality, medium cap.

There is probably a reasonable probability of it getting taken out if it stays at these levels - attractive opportunity for a big European transport operator for example.

There are some growth opportunities. Coach travel is permitted to compete with the TGV in France for the first time and Megabus hopes to do well. I think there are opportunities for this in the UK given the high cost of UK rail travel. Having said that, they don't seem to be interested in expanding in the UK.

Megabus revenue grew 36% in the six months ending October 2015. They are not profitable yet - nevertheless, there are clear precedents for businesses like this becoming profitable. Difficult to put a number on it but I think it's at least possible for this to grow to be a significant element of Stagecoach's business.

If you were to split the current business out and put a value on it (an exceedingly difficult and imprecise thing to do, which I won't attempt), you might be surprised how much you could get - leaving the rump looking undervalued.

It is unlikely to get rich by investing in this, but medium/large caps can move more than one would expect and if you wait long enough, the compounding can be powerful. I hope this will become a core holding generating stable returns over many years, but time will tell.

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