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Gamble of the week: Britain's biggest rail operator
This British operator of trains and buses has more than its share of problems. But the bad news is already in the price, says Phil Oakley.
FirstGroup is in big trouble. It is paying the price for overextending itself during the last decade. A borrowing binge has seen it become the biggest school bus operator in the US, while an aggressive bidding strategy has made it the UK's biggest rail operator.
Now, profits are falling in its UK bus and rail divisions, and a big dividend cut looms. The company's bid to win the West Coast rail franchise was an act of desperation to keep funding a dividend that it could not afford to pay. It arguably threatened the solvency of the business.
The company's finances look horrible. Net debt is more than £2bn and it is not coming down quickly. Interest payments are covered barely twice by its trading profits. The recent half-year dividend payment was not even covered by profits. It's no wonder the City has taken fright. Very few analysts recommend the shares, which are now trading at a 52-week low.
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Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.
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Dividends will have to be slashed. If dividends were based on paying out half the bus profits as is the case with rival National Express then the current 23.7p payout would have to come down to around 10p. Given the very high levels of debt, shareholders may be asked to stump up more money as well.
So why would anyone consider buying shares? The main reason is that FirstGroup has some very good quality bus assets they are just not being run very well and are financed with too much borrowed money. Nonetheless, school buses are a very reliable source of income, and there's a good long-term growth opportunity in this market.
Most buses are run by schools, but they cost a lot of money. With school boards under pressure to balance their books, more of their buses look set to be run by private firms like FirstGroup. Elsewhere, rising congestion should push more people on to buses. All FirstGroup needs to do is run its business better. This could be done by the present management team, or the business could be taken over.
A lot of bad news looks to be baked in to the share price. Based on City analysts' forecasts, the shares trade on just 6.3 times March 2013 earnings. If the dividend was slashed to 10p, the shares would still yield 5.4%. FirstGroup is risky, but worth a punt at current prices.
VERDICT: SPECULATIVE BUY AT 182p
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