14 Feb 2013
One of the earliest stock market bubbles was in railway companies in the 1830s and 1840s. At the time, rail was the new technology replacing canals and it is not difficult to understand why people with capital to invest were excited. As with all predictable technology-driven changes, it took much longer than its early supporters expected. (I will briefly digress on why this might be. My theory is that obvious technological change attracts opposition from “old-technology” incumbents. Stuff than comes from nowhere (YouTube, Facebook) happens with shocking speed. In the case of the English railways, canal operators lobbied aggressively against them. When roads in turn began to compete with railways in the 20th century, no doubt the rail companies behaved in the same way).
Many of the issues that mattered to the railways in the 1840s are still making news. New railways had to be approved by Acts of Parliament and landowners complained about plans to lay tracks over their property. Over the years, governments have veered between light touch regulation of transport infrastructure and complete nationalisation. British Rail was a state monopoly between 1948 and 1994 (from what I remember, these were not golden years of commuting) and was then clumsily privatised. Since then we seem to have been in a state of hybrid private ownership including the foolish listing and insalubrious de-listing of Railtrack. Operating franchises have proved hard to price correctly (to say the least) but we have more or less arrived at the point where trains and buses are mostly operated in the UK by five companies.
Arriva was acquired by Deutsche Bahn in 2010. The other four are all still listed; FirstGroup, National Express, Stagecoach (which owns 49% of Virgin Rail) and Go-Ahead.
I am not particularly interested in the operational details of running bus and train services but simple analysis of the four companies indicates that running buses is more profitable than running trains. Operating margins from bus services are typically +/- 10% whereas trains seem to struggle to hit 5%. One of the most basic ways to compare companies within the same sector is to look at the ratio of each company’s enterprise value to its revenues. Go-Ahead, which has the highest share of rail revenues (71%) is lowest valued at just 0.29x revenues while National Express, with a mere 13% rail share (following its loss of the East Coast franchise)is valued at a relatively rich 0.94x revenues. So it is plausible to say that there is a bias on behalf of investors for buses and against rail. Whether this is justifiable and proportionate is a key question.
Another headline differentiator is that two of these companies have invested heavily overseas. FirstGroup has 42% of its revenues in North America (it owns Greyhound, the bus franchise of my choice when I toured the East coast in 1980) and National Express has 32% in the US and 27% in Spain. Stagecoach has 14% of its revenues in North America. Go-Ahead is, as far as I can see, a purely domestic operation.
Foreign expansion invariably involves acquisition which in turn means debt. Utility-like services often attract managers who convince themselves that a business model that works can be replicated here there and everywhere (e.g. Enterprise Inns – see blog from 20 November 2012). As we all know now, gearing up aggressively in the last decade turned out to be a very bum idea. FirstGroup, in particular, remains dangerously financially constrained and the viability of its equity is far from assured.
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.
At 210p, National Express can be said to be sceptically regarded by the market. Its market capitalisation of £1070m exceeds its net debt (£810m) and its dividend yield of 4.6% is not far from a level that would be tempting for investors who were prepared to take a neutral view. (I’m just listening to Amy Rigby singing; “At the end of the day, I’ve got nothing good to say but you don’t suck, so I’m cynically yours”; that sums it up quite well and it’s Valentine’s day too; perfect).
I don’t believe that National Express is over-leveraged but I am not convinced by its strategy. It is a British company that overbid for the East Coast railway franchise and effectively defaulted on it. I suppose that this shows a degree of financial reality on behalf of management but given the mess it made in its domestic market, I cannot feel wholly comfortable with the fact that nearly 70% of operating profits come from Spain and North America. This stock is on my watch list for now.
At 297p, Stagecoach, with a market capitalisation of £1700m, looks the most expensive and presumably the most favoured by analysts. Operating cash flow is 12% of revenues (that’s good) and net debt of £735m (including pension liabilities) looks comfortable. Stagecoach’s regional UK bus operations achieve an operating margin of 18% (that’s very high). With a dividend yield of just 2.6%, it is valued like a “nobody does it better” company. As a value hound, I am not tempted to pay to join its fan club.
By contrast, Go-Ahead Group, at 1367p, makes me want to take a joyful canine walk in the park. With a market capitalisation of just £588m and very modest net debt of £114m, its enterprise value of £700m for revenues of £2400m and cash flow last year of >£150m just looks very cheap. Its dividend yield of 5.9% looks absolutely safe. On 11 December, in its pre-close update for the half year to December the company said:
Although we remain cautious about the wider economic outlook, we continue to see a robust performance across both divisions, therefore our expectations for the full year to 29 June 2013 remain unchanged. The Group remains in a good financial position with strong cash generation and a robust balance sheet, underpinning the dividend policy and allowing flexibility to pursue further value adding acquisitions.
What’s not to like (apart from the missing full stop after “divisions”)? This share just seems to be wrongly priced: and I say this in the knowledge that the full half year results will be released next week (21 February). The bus businesses look very sound. The main risk to the share price is likely to be the rail franchises, which achieved an operating margin of just 2.3% last year. As flagged earlier, this is the reason for the discount valuation; the bubble investment of 150 years ago remains the key sentiment factor; but cash flow and dividends are real and they will outlast sentiment. On the basis of what I can see, I would not sell this share at 2000p and that’s 46% above where I am buying it.