FirstGroup – watching with the wolves

FirstGroup – watching with the wolves

21 May 2013

Back on 14 February, when I wrote recommending Go-Ahead Group, I included summaries of my views on the other transport stocks, including this on FirstGroup:

At 189p, FirstGroup has a market capitalisation of £911m but an enterprise value of £3357m due to £2446m of net debt (including pension liabilities). Its historic dividend yield of 12.5% tells us that the market expects the company to cut or skip its dividend (decision due in May). This would be a speculative investment and is too dangerous for my taste. With revenues of £6500m, this business is not going to disappear but the risk is that it will end up being mostly owned by creditors rather than current owners of the equity.

And so, it came to pass, more or less. Yesterday equity owners were asked to put up a fresh £615m to defend the equity’s role in the company’s balance sheet against the creditor wolf pack: or as the rights issue press release coyly puts it – to “support the Group’s objective to remain investment grade”….Let’s hear it for investment grade! Yay!

The poor shares swooned yesterday – down by 30% to 156p. It’s strange how bad news seems harder to predict than good, no matter, apparently, how explicit the evidence of publicly available facts. It may be that the terms of the rights’ issue – 3 new shares for every 2 existing shares at 85p each – were pitched at such a low level that the odour of desperation was repellent. In passing, fees of £30m (nearly 5% of gross proceeds) for an issue that surely does not need to be underwritten demonstrate that there are still bankers out there whose skills surpass mortal understanding.
Never mind. It is not immoral to make a mistake, nor to be stupid, nor to wonder whether new investors might at some point take advantage of the pain of others.

At today’s cum-rights price of 156p, FirstGroup has a market cap of £750m and net debt (including pension liabilities) of £2280m for an enterprise value of £3030m, or 0.44x revenues. These ratios will change after 11 June, when the shares trade ex-dividend but, on the face of it, the value of the group (as measured by enterprise value) will not change. Shareholders will be putting in £600m and this will reduce net debt, regardless of how much of the cash is actually used to pay off debt. In theory, the enterprise value will remain at £3030m, but with the new market cap (£1340m) accounting for 44% rather than just 25% before.
One could argue that, with the creditor wolves driven backwards, the value of the group should grow. This is a tenuous argument that generally appeals to one-eyed equity investors, but which you can read today as the opinion of analysts. The truth is that FirstGroup needs to pay down debt through cash flow generation. If it can’t do that you can be sure that the value of the group will shrink and that the shrinkage will be manifested by a falling equity price.

The dividend has been understandably scrapped. If all goes well, a dividend of up to 4p a share might be paid in respect of the year ending in March 2014. This would imply a 3.6% yield on a theoretical ex-rights price of 111p. This offers no support now.

Free cash flow yield offers more hope. In FY 2012, free cash flow was £440m. In FY 2013 it fell to £260m. The FCF yield on FY ’12 results is nearly 15%: on FY ’13 it is 8.6%. It would be optimistic to assume that FCF will be better in 2014 than it was in FY 2013. Optimism is no use to us. I hope that it would be reasonable to assume that it might be unchanged. On that basis, the question is – what FCF yield should tempt in a new investor?

I will take 10% as a round and comfortingly double-digit number. It’s arbitrary but this is an art, not a science. Shockingly, without any reduction in net debt, the share price would have to fall to 75p to offer a FCF yield of 10%. On that basis, I will not be buying in at 111p – but I shall be watching closely. This company is where it is due to foolish acquisitions. It is crying out for disposals, particularly of capital intensive businesses. I cannot believe that there is not more news of this nature to come. The capital increase will improve the company’s bargaining position – it will be less of a forced seller. So like a hungry wolf, I shall keep watching.

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