The market has fallen out with transport company FirstGroup (FGP).
A profit warning at the end of last month has shattered the confidence of many investors. With lots of debt, a weak UK bus division and the prospect of losing some or all of its rail franchises, the market seems to have made its mind up: FirstGroup's juicy dividend is not sustainable. A big cut is on the cards.
As a result, the share price has fallen to distressed levels. The shares trade on just five times March 2012 earnings. The company's debt is now almost twice its market value.
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But could this be a great time to buy for contrarian investors? Let's take a look.
Why is FirstGroup in such a mess?
Until recently, FirstGroup had been a great performer for its shareholders. The company has more than doubled its dividend payouts during the last decade. And even now, it is still promising shareholders a 7% increase in dividends for the year to March 2012.
However, last year it ran into problems with its US school bus business. And next year, profits from its UK bus business are expected to fall sharply. Add in the fact that a quarter of its profits come from UK rail franchises that start expiring in 2013, and you can see why people think that FirstGroup's dividend is unsustainable.
FirstGroup's main problem can be summed up in one word: debt. After taking on loads of debt by buying those American bus companies during 2007 and 2008, the company was left with a weak balance sheet. Things have not improved since. The company has not generated enough surplus cash flow to pay down debt to sensible levels.
In fact its finances are beginning to look more like those of a water or electricity utility, but with less secure profits. This debt needs to be cut. But it's not easy to do this with falling profits and a big dividend.
Unlike its peers National Express and Stagecoach, who can comfortably pay dividends from their bus earnings, this is not the case for FirstGroup.
This should worry investors (and clearly does). Rail profits are arguably temporary, as you may not retain the franchise forever. Paying regular dividends from them is probably not a good idea.
Looking at FirstGroup's profits
Have a look at the table below. It gives a rolling one-year profit and loss (P&L) account for the company. Usually you are given two P&Ls per year a half-year and full year one.
But you can use the half-year accounts to work out the profits for the second half of last year. You then add them to the first half of this year to get the most recent one-year profit performance.
This is a really useful thing to do as it gives you a reality check on progress. You can also cross check with analysts' forecasts to see if they are reasonable.
FirstGroup income account (£m)
Swipe to scroll horizontally
First Student
105.8
5.5
128.3
100.3
28
First Transit
58.4
27.2
57.2
31.2
26
Greyhound
45.1
30.5
40.2
14.6
25.6
UK Bus
152.8
59.4
148.8
93.4
55.4
UK Rail
116
55.7
108.7
60.3
48.4
Central costs
-28.8
-15.3
-26.5
-13.5
-13
Operating profit
449.3
163
456.7
286.3
170.4
Finance Income
2
0.8
1.9
1.2
0.7
Finance costs
-169.7
-79.3
-184
-90.4
-93.6
Pre-tax profit
281.6
84.5
274.6
197.1
77.5
Tax
-59.5
-18.8
-60
-40.7
-19.3
Tax rate
21.1%
22.2%
21.8%
20.6%
24.9%
Profit for the period
222.1
65.7
214.6
156.4
58.2
Minority Interests
-21
-11.9
-17.2
-9.1
-8.1
Profit for shareholders
201.1
53.8
197.4
147.3
50.1
eps (p)
41.74
11.2
41.2
30.7
10.5
dps (p)
22.62
7.62
22.12
15
7.12
Dividend cover
1.85
Row 17 - Cell 2
Row 17 - Cell 3
Row 17 - Cell 4
Row 17 - Cell 5
Interest cover
2.7
Row 18 - Cell 2
Row 18 - Cell 3
Row 18 - Cell 4
Row 18 - Cell 5
Interest cover (ex-rail)
2
Row 19 - Cell 2
Row 19 - Cell 3
Row 19 - Cell 4
Row 19 - Cell 5
Dividend cover (ex-rail)
1.2
Row 20 - Cell 2
Row 20 - Cell 3
Row 20 - Cell 4
Row 20 - Cell 5
Three things are quite striking here:
Profits aren't really growing.
Rail accounts for nearly one quarter of group operating profits.
Without rail profits, the dividend cover isn't very high.
Based on its last 12 months' profits, we reckon that FirstGroup's bus profits covered dividend payments around 1.2 times. In contrast National Express' dividend cover is based on two times non-rail profits.
Last month's UK bus profit warning means that there is a good chance that it won't be possible to pay dividends from bus profits in 2012/13.
So unless FirstGroup can retain a large chunk of its current rail profits, big dividend cut is probably on the cards. And this might be very hard to achieve. Two of its rail franchises First Great Western and First Capital Connect expire in 2013. Competition for these franchises is tough, with lots of foreign interest. It is unlikely that current profit levels can be maintained even if its franchises are retained.
The market has clearly already assumed a dividend cut. The dividend yield of 12% is more of a warning than a sign of a bargain. Given that competitors are not experiencing its bus problems, questions of management competence have to be asked.
So how much will the dividend be cut by?
City analysts expect FirstGroup to pay a dividend of 23.8p per share for the year to March 2012. With nearly 482 million shares in issue this gives an annual cost of around £115m.
If the dividend was halved, this would only save £57m from a debt pile of £1.8bn. A further £100m or so is expected to be raised from selling some of its poorly-performing bus assets in the UK. This might be just enough to give a sustainable dividend which is not reliant on rail profits.
However, if bus profits don't start growing again, FirstGroup's ability to pay its interest bills might still be a little to thin for comfort. Under this scenario, shareholders could be asked to cough up more cash to shore up the company's finances.
A buy for the brave
With the dividend cut in half, the shares would still yield 6%. The possibility of a takeover must also be considered. Given that a lot of FirstGroup's problems seem to be self-inflicted, it raises the question whether another management team could do a better job. The company has some good assets that could see the company broken up and sold off.
Adding it all up, then at these levels, FirstGroup might just be a buy for the brave.
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Phil spent 13 years as an investment analyst for both stockbroking and fund management companies.
After graduating with a MSc in International Banking, Economics & Finance from Liverpool Business School in 1996, Phil went to work for BWD Rensburg, a Liverpool based investment manager. In 2001, he joined ABN AMRO as a transport analyst. After a brief spell as a food retail analyst, he spent five years with ABN's very successful UK Smaller Companies team where he covered engineering, transport and support services stocks.
In 2007, Phil joined Halbis Capital Management as a European equities analyst. He began writing for MoneyWeek in 2010.
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