Stockwatch: One to buy on the dips

A disposal and debt cutting prospects at this mid-cap create a special situation, argues companies analyst Edmond Jackson. The risk/reward could tilt positively in 2019.  

Does a rebound in the mid-cap shares of public transport group Stagecoach affirm fundamentals' and chart upside, or was it mainly a boost for UK risk assets now a no-deal Brexit looks less likely?

Or possibly all three, in which case pay attention?

Debt is a hinge for perception of value

Stagecoach initially leapt about 15% to over 176p, currently around 170p, on better-than-expected interims that came the morning after parliament got a stronger grip on (what remains of) Brexit, to avert 'no deal'.

While lower as expected at headline levels, there was a higher profit contribution from rail plus the prospect of a (part) disposal of US bus operations which could usefully cut debt.  It has weighed on equity value this year, especially after a low point has passed in the interest rate cycle: the end-October balance sheet showing a 16.5% rise in net debt to £461.2 million since April, due mainly to negative working capital movements as the Virgin Trains East Coast franchise expired.

The debt profile barely changed - £618 million longer-term, £37.9 million short-term, though cash fell 19% to £193 million.  Being predominately long-term makes it manageable yet off-putting in financial statements' context: net finance costs absorbed 15.9% of interim operating profit, and since £179 million net assets are depressed e.g. by £106 million provisions for accidents incurred and a £153 million pension fund deficit, net gearing is 257%.

So long as the operations narrative can bumble along without major upsets - and it doesn't appear Mr Corbyn is due to enter No 10 - prospects for cutting debt can boost equity value.

Chart builds on a sentiment-driven, early 2018 drop

The debt rise partly relates to Stagecoach's update on rail franchising last February that cited £19 million cash required through debt, which coincided with the stock lurching down to 130p.  It may also have conflated with investors shunning any stocks exposed to a Labour government – pressure that has persisted on and off, this year.

Otherwise, the narrative has been sound: at end-March, modest revenue growth was cited, from 0.1% for regional bus to 4.3% for London bus, with rail growing around 3%.

This drop may have usefully established a low from which the stock is now seen building: its chart showing a third rebound since March that can be interpreted as a new trend following nearly three years of decline from 420p in 2015.

Source: Company REFS

Forecasts trimmed since September 2017

I drew attention tentatively at 160p on the basis of a 7.7% prospective yield matching the price/earnings (PE) of 7.7 times, assuming forecasts at the time, suggesting that, despite a mixed operations narrative, a contrarian play was in the offing.

Management proclaimed:

"a large market opportunity for modal shift from cars to public transport against a backdrop of population growth, urbanisation, technological advancements, and increasing pressure to tackle road congestion and improve air quality." 

The reality involved competitive/ cost pressures but the market rating appeared to discount them.

But the table shows a de-rating of dividends to 7.7p per share expected more recently, the interim dividend maintained at 3.8p – consistent with such a full-year outcome anyway.  A 7.7p payout would cost £44.2 million, which looks high enough anyway given the debt context.  

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I should own up how looking occasionally at stocks like this, also construction/public services group Kier – albeit with caveats! – shows the need for greater scepticism of dividends where rising debts are involved.  Whether the costs are exceptional e.g. project over-runs, or suppliers demanding better payment terms, the current environment can nudge up debt leaving forecasts exposed. 

Possibly, Stagecoach hasn't held over 170p in the short term, not just due to wider market volatility but a sense a 4.6% yield is anyway necessary in respect of risks, also referencing the sector.  Go-Ahead offers 6.3% albeit on lower cover, First Group 4.6% on higher cover, and National Express 4.0% albeit with a respectable record of capital growth.

US disposal could transform debt/dividend risks

Medium to longer-term however, the US coach operations constituted 20% of interim revenue at £246 million and 15.6% of operating profit (including joint ventures) on a 6.6% margin; hence scope for even part-sale on a modest multiple of annual sales could comprehensively de-risk the balance sheet, even lead to a special dividend.

Mind the driver for disposal is higher US competition also fuel and staff costs, such that like-for-like revenue has slipped 3% and is below budget, hence an £85.4 million non-cash goodwill impairment charge after revising internal forecasts.  Investment continues and there's the standard caveat about "no certainty of a sale at this time", although oil prices topping out – now in steep fall – could ease hesitation among potential buyers.

So, although Stagecoach's balance sheet presently offers no margin of safety and Jeremy Corbyn currently leads the ‘next UK prime minister' betting odds, such a corporate development prospect makes the stock an interesting tuck-away.

UK operations appear to have stabilised

A 31% slide in interim revenue to £1.2 billion relates to expiry/loss of the East Coast South West train franchises. However, Stagecoach is involved in short-listed bids for three new franchises and "good progress" has been made on negotiating a new direct-award franchise for East Midlands, through to at least August 2019.

All such things raise the possibility of useful news flow while keeping fingers crossed for a meaningful disposal.  UK rail constituted 27.2% of interim revenue and 11.1% of operating profit including joint ventures, its operating margin rising from 2.4% to 3.4% which bodes well.

UK regional bus continues to dominate revenue at 42.8% with its margin up from 12% to 12.4%, thus 63.1% of total operating profit.  Management cites "a range of commercial initiatives around marketing, ticketing, new revenue streams and on pricing."

Independent research shows customers regard as the best-value, major bus operator in Britain – with 13 accolades were won at the 2018 UK Bus Awards.  London bus was flat, reflecting strong competition and with the margin slipping from 5.1% to 4.7% as staff, operating lease and fuel costs weighed, albeit as a modest 10.4% of revenue and 5.9% of operating profit.

So, they don't appear likely to give a jolt in the way Crossrail/HS2 have made headlines, the worse-case scenario being recession from a no-deal Brexit – if you believe either scenario.

Tilts to a special situation, 'buy' case

It's speculative because more radical action on debt is needed now the credit cycle has turned, hence the stockmarket being liable to punish firms that accumulated it opportunistically.

Volatility of the last day or so looks set to continue in the short term, as perceived UK risk assets, especially those indebted, in industries Labour plans to nationalise.  Thus, enterprising investors might look to buy dips in the stock with an averaging approach, given risk/reward looks able to tilt positively in 2019.  Buy on weakness. 

*Horizontal lines on charts represent levels of previous technical support and resistance. Red represents trendlines.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.