Description

FirstGroup PLC (FGP.L):  BUY

Summary/Thesis:

FirstGroup Plc is a transport operator in the UK and North America; it is listed in the UK but 62% (55% US and 7% Canada) of revenue and 74% of operating profit are from North America, through their FirstStudent (yellow School Buses), FirstTransit (public transit), and Greyhound (inter-city coach) segments.  The stock has traded down substantially recently due primarily to concerns over their FirstRail (UK Rail) segment and weakness in Greyhound. First Rail (23% of revenue and 15% of operating profit) has 3 UK rail franchises, but 2 of them are likely to fall short of revenue growth expectations in their bids and could experience significant losses (losses are capped though) and the segment could have negative value.  However, these concerns have driven the stock down too far and it now appears significantly undervalued. Their FirstStudent segment (31% percent of revenue and 46% of Operating Profit) is the largest provider of student transportation in North America (with 22% Market Share of outsourced market). A pure-play competitor to FirstStudent (Student Transportation Inc.) with 7% market share (#3) announced on 2/28/2018 that it was selling itself for $7.50/share which equates to 12.5x TTM EBITDA & 27.6x TTM EBITA (8.6x EV/EBITDA and 19.4x EV/EBITA if adjust for operating leases), while FirstGroup is trading for 4.1x EV/EBITDA and 8.8x EV/EBITDA (ex ring-fenced cash).  If you apply this 8.6x EBITDA multiple to FirstGroup's FirstStudent segment, you get a value of £2.9B (versus FirstGroup's current Enterprise Value of £2.9B), and this is if you completely exclude the remaining 53% of EBITDA. If you apply a 7.5-8.5x EBITDA to FirstStudent, -£84M to -£46M NPV for FirstRail (assuming the worst case), and 3.0-4.0x EBITDA on the remaining segments (Greyhound/FirstTransit/FirstBus) you get a value of £106-158 (29% to 92% upside).

A pure-play competitor (Student Transportation Inc.) to FirstGroup's student transportation segment (First Student) agreed to sell itself recently:

• On 2/28/2018 "Student Transportation Inc" (STB on NASDAQ or TSX) announced they agreed to sell themselves to a purchaser group sponsored by Caisse de depot et placement du Quebec (CDPQ) and Ullico Inc. (Ullico) for  $7.50/share in cash (a 27% premium to the 20 day vwavg price).
• The sale is at an implied 12.5x TTM EBITDA & 27.6x TTM EBITA (8.6x TTM EV/EBITDA and 19.4x TTM EV/EBITA if adjust EV, EBITDA and EBITA for operating leases).
• Just prior to the buyout STI was trading at 7.7x TTM EV/EBITDA and 17.3x EV/EBITA and had 4.2x Net Debt/EBITDA.
• First Student has 22% market share and 43K school buses in North America to 7% market share and 13.5K School Buses for STI.
• First Student has £1.8B GBP (~$2.4B USD) of TTM Revenue vs $660M USD for STI.
• First Student has EBITDA margin of 19.4% (18.5% if apply group costs proportionally to segments) and 9.4% EBITA margins to 13.1% and 5.9% respectively for STI if you don't adjust either for operating leases (as FS doesn't disclose operating lease by segment) but appear to be more-or-less inline if you adjust for operating leases.

The #2 student transportation company is also trading at a premium to First Group:

• National Express Group PLC is the #2 student transport operator in North America with ~half the market share of FirstGroup (11% share according to First Group).  42% of their revenue and 36.5% of their EBITA is from Student Transport with the remainder from UK Bus and Coach (24%; 29%), German Rail (3.4%; 0%) and Spain and Morocco Bus and Coach (28.6%; 40.0%).
• They have EBITA margins of 9.1% in North America Student Transport and 10.4% overall, with 2.4% Net Debt/EBITDA and 3.7% Dividend yield.
• They are currently trading at 7.7x TTM EV/EBITDA, 12.0x TTM EV/EBITA, 13.8x Adj PE, and 7.3% TTM FCF yield (8.2x TTM EV/EBITDA and 14.6x TTM EV/EBITA if adjust for operating leases).

If you value the student transportation segment (First Student) in-line with comps, FirstGroup is trading at a substantial discount to intrinsic value:

• First Group:
• First Student makes up 31% of revenue and 46% of Operating Income (41% and 54% ex rail).  They have 2x the market share of the #2 competitor and 3x the #3, with in-line or better margins, and thus should be valued at least in-line with comps.
• First Rail makes up 23% of revenue and 15% of operating profit.  Given the limited transparency I value it assuming 2 of the 3 franchises hit their max possible losses (£189M for Transpennine and £61M (70% of £88M) for Southwest Rail), Great Western Rail franchise continues profitably for 2-6 years, and their open access operation (Hull Trains) continues through 2029 (when agreement expires).
• The remaining segments (First Transit/Greyhound/First Bus) make up 46% of revenue and 39% of Operating Profit (59% and 46% ex rail).  They are low-margin at 4.8% combined EBITA margin and deserve a fairly low valuation.
• £296.2M of Pension deficit; £109M in First Bus (UK), £186M in North America, and £2M in First Rail(UK).  They paid £43M above P&L impact in TTM at 9/30/2017 (£29M average in 5Y to 3/31/2017) and expect to pay a similar amount (or higher) in the next few years as they reduce the deficit.
• £429M GBP of cash, but £385M of this is Ring-fenced in the rail segment.  This represents pre-paid season ticket bond monies which is restricted cash; I exclude this from FirstGroups Cash and Net Debt calculations.
• £144M of capital leases.
• £1.535B of debt.
• 2.3x Net Debt/EBITDA (adjusted for ring-fenced cash) and 2.8x if exclude rail.
• No dividend (though likely to institute one in next year or two).
• £1.47B of operating leases; £230M ex rail if convert to debt equivalent.
• Estimate of Value:
• We value FirstStudent at 7.5-8.5x TTM EBITDA, First Rail at -£84M to -£46M and the remaining segments at 3.0-4.0x EBITDA (blended 5.6-6.6x EBITDA and 11.6-13.7x EV/EBITA) which yields a value of 106-158 GBp/share (28%-92% upside).
• At these target prices it would have a 5.4-8.1% FCF Yield (this estimate excludes rail and assumes capex = depreciation) and 9.3-11.5% FCF yield excluding the current pension payments above P&L expense.
• This doesn't include any benefit from recent re-fi of debt at lower rates which is expected to reduce interest expense by 14M in YE 3/31/2019, although Greyhound is experiencing weakness which will reduce FCF by a similar amount.
• Valuation (Spreading unallocated costs proportionally to segments):

Substantial opportunity to profitably grow the First Student segment through:

• Increased outsourcing by School Districts to reduce costs:
• Only ~38% of the student transportation market is currently outsourced to private operators like FirstStudent.  The rest is run internally by the school districts.
• Partnering with a transportation provider can save school districts an average of 10%-30% in transportation costs, according to the National School Transportation Association (NSTA).  The winning bids (and previous costs) are public for a number of school districts which seems to confirm this level of cost savings.
• Outsourcing has increased from ~26% in 2007-08 to ~38% in 2016/2017 and is likely to continue.
• First Student winning share from small operators and from rolling up the industry:
• The outsourced student transportation market is very fragmented.  Out of the outsourced market 40% share is from top 3, 3% from next 3, another 11 with >1000 buses, and then the remaining ~55% is made up of several thousand "mom-and-pops" (primarily with single district contracts).
• There are substantial economies of scale in the business through acquisition of buses and parts, maintenance, safety technology, hiring/training/payroll, route management, etc.  Small districts and mom-and-pop operators can't usually deliver the same level of service at the same cost as a large scale operator. Mom-and-pops can either bid irrationally and have little/no margin or lose to a large operator who can make a significantly higher margin at the same bid price.
• Cost is the main factor to win/maintain a contract.  The top operators have been bidding more rationally the past few years and have been able to push through significant price increases.  National Express has consistently had 9-10% EBITA margins in their student transportation segment, and FirstGroup has improved FirstStudent's EBITA margins from 6.4% in YE 3/31/2014 to 9.4% TTM as they executed on "up-or-out" bidding strategy the past 4 years to focus on profitability (bidding existing business and possible new business at higher price points where they could make a reasonable margin).  Their business has shrunk as a result, as they gave up low/no margin business, but this process should be largely complete and should grow from here as they win new business.
• FirstGroup says that “high quality, efficient providers have been able to achieve meaningful price increases during contract renewal in recent years, as customer service, security, and safety track records remain as important as price.” FirstStudent was able to push through 5.3% average price increases on 'at risk' business during summer bid season.  National Express had 7% price increase on contract up for bid last summer.
• The other very important factor is safety.  FirstStudent is twice as safe as the industry average (according to NSTA), has won several safety awards, and school districts have noted their safety (safety record and safety technology on the buses) as a reason they chose them over competitors.
• FirstGroup and the other top operators could also grow substantially by rolling up the industry.
• National Express (competitor) spent £105m on school bus/transit acquisitions in 2017 at 6x EBITDA and 15-20% ROIC and £82m in acquisitions in 2016 at 6x EBITDA and 15-20% ROIC.
• In recent years National Express was the only large operator that had been making acquisitions, as First Group & Student Transportation were over-levered but that has changed recently.  First Group is now in better shape financially and has indicated that they will likely make some small bolt-on acquisitions.
• Continued consolidation would help bidding be more rational and allow stable/improved margins for First Student.

FirstGroup will continue to reduce interest expense (increase FCF) over time through re-fi's and debt paydown:

• The company has some high-interest-rate debt remaining from past periods of high-leverage & weaker performance; now that leverage is lower and the business is performing better they should be able to continue to re-fi over time at lower rates.
• On February 15 they issued $275M of long-dated USD denominated notes at a weighted average interest of 4.25% ($100m due in seven years at 4.17% and $175m in ten years at 4.29%).  They will use this issuance, cash on hand, and revolver to redeem (on 3/28) a £300M bond with interest of 8.125% with September 2018 maturity. This will reduce interest expense by £14m/year (make-whole cost of £11M to redeem £300M GBP bond).
• They have £350M of 8.75% notes maturing April 2021 which they will likely be able to re-fi in the 4's (or paydown with FCF).

The company will experience lower effective tax rates from US Tax cuts (but already paying minimal cash taxes):

• 55% of revenue and ~66% of operating profit are from the US.
• "As a consequence of the US tax legislation passed at the end of last year, we expect our blended P&L tax rate to reduce to the mid-20s for this financial year and beyond."
• "There will be no substantive impact on our expected cash tax payments." (They paid only £12M TTM in cash taxes).

What caused the recent drop in stock price?

• The company provided an update on February 21st for the period since 9/30/2017 which was worse than expected compared to 1H results ending 9/30/17 (YE is 3/31).
• There were two main issues:
• The Greyhound segment had like-for-like revenue decline of 2.8% in the period (versus down 0.4% YTD).  Strong growth in the shorter point-to-point markets accelerated in the period, but this was more than offset by intensifying challenges in the larger long-haul segment in the face of low-cost airline competition, which also resulted in a disappointing holiday season.  This segment has high fixed-costs so the drop in revenue is expected to cause a substantial drop in operating profit in 2H ending 3/31/2018 and in YE 3/31/2019.
• FirstRail like-for-like passenger revenue was only up 3.2%.  While on the surface a 3.2% rise increase seems ok, the Transpennine rail franchise assumes ~12% growth and Southwest Rail franchise assumes ~6.9% (bid assumptions aren't provided by First Group; they just say approximately similar to past 7 years of growth which implies those numbers).  These franchises are high fixed cost so any initial lag in growth expectations makes it difficult to catch up and be profitable (these 2 franchises are now viewed as likely to turn to a loss and hit max loss of £189M for Transpennine and £61M for SWR (70% share of £88M)). The Transpennine contract began in April 2016 but only had 5.9% growth in 2017 and 9.7% in 1H ending 9/30/2017 so is unlikely to meet the 12% annual growth rates.  SWR only began in August 2017 and they're adding ~47% more seat miles in this franchise, so, according the company, "it's only when those things come in (in 2019), that you can really, truly measure the impact against the bid model." So SWR may end up being profitable but there's no visibility into the bid model.

Catalysts:

• Potential (though unlikely) sale or spinoff of the FirstStudent segment:
• 46% (54% Ex Rail) of FirstGroup's EBITA is from First Student (student transportation) segment.  If the value of this segment is realized in-line with comps through sale or spinoff it is worth the entire current enterprise value.
• The company doesn't currently seem open to selling/spinning this segment; they say the company is better off together.  However, if the stock price languishes at these levels for long and gets enough pressure from shareholders they could be forced to change their mind.  West Face Capital (a Canadian activist fund) had taken a 5% stake at significantly higher prices on June 1 and likely pushed for a break-up, but they reduced their stake to 3.5% in December.
• CEO on 6/1/2017 in regards to question about possibly splitting off the FirstStudent business:  "I think any business that has a divisional structure, this is a perennial question, and we look at it all the time, and we look at what will create best value.  All of our divisions benefit from working with each other. We definitely do see synergies. We definitely benefit from it. So there's great advantages we see in our current configuration.  However, we think it is, and the board thinks it is, an obligation to continually revisit every single piece and to see whether or not it is in the right shape and whether changes should be made. And as of right now, we continue to believe that the current structure makes sense, and we derive value from it."
• Debt reduction & re-fi at lower rates:
• They have reduced Net Debt / EBITDA from 3.0x at 3/31/2014 to 2.3x at 9/30/2017 (excluding ring-fenced cash), through  £130M increase in EBITDA and £124M reduction in net debt; it is 2.8x excluding rail EBITDA though.
• The company has some high-rate debt remaining from past issues; now that leverage is lower and the business performing better they should be able to continue to re-fi at lower rates.
• They recently issued $275M USD denominated notes at a weighted average interest of 4.25% ($100m due in seven years at 4.17% and $175m in ten years at 4.29%).  They used this issuance and cash on hand to redeem a £300m bond with interest of 8.125% that matured in September 2018. This will reduce interest expense by £14m/year (cost 11m above par to redeem 300m bond).
• They have $350M of 8.75% notes maturing April 2021 which they can replace with low-interest debt as it approaches maturity.    
• Initiation of Dividend or buybacks:
• They haven't paid dividends or done buybacks in the past few years due to a focus on debt paydown and turning around the business but they have discussed plans to institute a dividend once debt is at a reasonable level.  They are still focused on retaining cash for debt paydowns, but as leverage continued to be reduced they will likely institute a dividend (and possibly repurchases).
• Performance of Rail above pessimistic assumptions:
• I assume both Transpennine and Southwest Rail franchises will hit their max losses of £189 and £61M (70% of £88M) due to the limited visibility into the bid assumptions and initial growth below expectations.
• Southwest Rail is still early in the contract.  They could experience higher growth once substantial capacity (47% increase over the contract) is added in 2019.   They could hit their growth targets, and experience a positive value instead of the -61M I currently assume.

Risks:

• Revenue Shortfalls in UK Rail franchises:  First Group has 3 rail franchises including Southwest Rail which started in August.  Two of these franchises (Transpennine and Southwest Rail) appear to be growing revenue slower than what is suggested is built into the contracts (though the company hasn't provided detailed bid information).  These have high fixed costs so assuming they fall short even modestly on revenue they are likely to start experiencing losses and end up experience max losses; the max losses in the contract are £189M for Transpennine and £61M (70% share of £88M) for Southwest Rail.  I assume these hit their max losses and the 3rd franchise (Great Western Rail) continues running profitably for 4-6 years (when it will then likely to be put up for competitive bid).
• Pressure on Greyhound from Airline Competition:  Continued pressure on long-haul segment from low-cost airline competition.
• Wage Inflation in First Student:  The industry continues to suffer from driver shortages and wage inflation, as it's difficult to hire enough qualified drivers at low wages in an environment with low unemployment.
• Pension:   £296.2M of Pension deficit; £109M in First Bus (UK), £186M in North America, and £2M in First Rail(UK).  The FirstBus pension has £2.42B of Assets and £2.53B of Liabilities so could see an increase in the deficit if results or assumptions change.  They paid £43M above P&L impact in TTM at 9/30/2017 (£29M average in 5Y to 3/31/2017) and expect to pay a similar amount (or higher) in the next few years as they reduce the deficit.
• Management:  Management has increased performance in student transportation segment the past few years but they continue to bid on (likely unprofitable) rail franchises and seem unwilling to maximize value through sale or spinoff of student transportation segment.  The same CEO did a dilutive rights issue in 2013.
• Debt:  2.3x Net Debt/EBITDA (if exclude ring-fenced cash) but 2.8x if exclude rail EBITDA.  Fairly high for a low-margin business, but in-line with comps, and they plan to continue to reduce debt.

Segments:

• First Student:   £1.82B (31%) of Revenue and  £172M (45%) of Operating Profit
• US-based School Bus transportation provider; the largest provider of student transportation in North America, with ~22% market share of outsourced market. They operate 43K school buses and had TTM £1.8B GBP (~$2.4B USD) of revenue.  They have more than 1,100 different contracts in 470 locations and transport >5M students every day.
• Industry:  38% of market is outsourced (remaining 62% is directly operated by school districts) according to FirstGroup.  There are ~14K school districts in North America which use ~530K buses. The total North American market is estimated to be worth around $25B per year.  The industry is highly fragmented; the top 3 have 40% share; the next 3 with 3% share, 11 additional operators with >1000 buses, and then several thousand small operators.  Most contracts are for 3-5 years. Most States/Districts award the contract to the "Lowest Responsible Bidder". Certain States/Districts have the option to award the contract to the "Best Value" bidder.
• FirstGroup has focused on profitability over total revenue within First Student the past few years and has improved operating margins from 6.4% in YE 3/31/2014 to 9.4% TTM at 9/30/2017.  Their margins are now in-line with #2 competitor (National Express N. America).
• ~Flat revenue the past 5 years while reducing the fleet by ~10% (44K vehicles in YE 3/31/2017 from 49K in YE 3/31/2014 and 60K in YE 3/31/2010).
• Fourth year of 'up or out' bidding strategy to deliver higher returning contract portfolio. Increased bid prices on low margin business at end of contracts, and either came to agreement at higher prices or exited.  5.3% average price increases on 'at risk' business during summer bid season. (National Express had 7% price increase on contract up for bid this summer). 83% retention rate on 'at risk' (up for renewal/bid) business (94% overall).
• FirstGroup said that “high quality, efficient providers have been able to achieve meaningful price increases during contract renewal in recent years, as customer service, security, and safety track records remain as important as price.”
• First Student claims they are twice as safe as the industry average.  They have won a few safety awards and certain districts have awarded them the contract over a competitor due to their better safety (safety numbers and safety technology on the buses) with the same bid price.
• Constant currency revenue up 0.3% versus down 0.9% YTD (3/31/17-1/31/18).  The segment was impacted by school days cancelled due to the severe snowstorms in early January.  This will negatively impact YE 3/31/2018, but many schools will make up the days at the end of the school year, which should be a boost to YE 3/31/2019 (usually around 50% is made up for).
• Significant bus driver shortages (increased costs for drivers) as a result of strong US employment market are a drag to results.
• First Transit:   £1.10B (19%) of Revenue and  £64M (17%) of Operating Profit
• One of the largest private sector providers of public transit management and contracting in North America.
• Customers include transit agencies, universities and state transportation departments. Their university shuttle bus portfolio is the largest in the USA, including partnering with several Ivy League colleges. They recently won new paratransit (non-emergency medical) contracts in Houston, Chicago and Minneapolis, new vehicle maintenance contracts in Florida and renewed key services in Portland, Denver, New Jersey, and Washington, DC.
• One of the largest providers of airport shuttle services in the US; have contracts at airports across the USA including Detroit, Houston and Dallas/Fort Worth.  Operated 335 contracts across North America. Carry around 350M passengers in YE 3/31/2017.
• The transit market is worth around $30B per year in North America, of which around 30% is outsourced.  Private providers manage, operate, maintain and organize transportation services for clients under contracts which typically last for three to five years or longer.  The market includes the provision of fixed route bus services (approximately $20B segment, of which more than 10% is outsourced), paratransit bus services (approximately $5B segment, three-quarters outsourced), private shuttle services (approximately $2B segment, around 90% outsourced) and vehicle maintenance services (approximately $3B segment, more than 30% outsourced).
• First Transit has around 15% of the outsourced market in North America, which accounts for approximately 30% of the total market.
• 14 new contracts and 94% retention rate in the 1H period ending 9/30/2017 (82% retention in YE 3/31/2017).  Growth was partially offset by impact of hurricanes especially on Puerto Rico and costs associated with driver shortages.   They said they expect to restore margins in the second half.
• Constant currency revenue down 0.1% in period 9/30/17-1/31/18 versus up 2.6% YTD (since 3/31/17).  Performance in the period reflected the timing of contract starts and completions, as well as further reductions in service volumes in the Canadian oil sands region.         
• Greyhound:   £710M (12%) of Revenue and  £40M (11%) of Operating Profit
• North America Based Greyhound Bus service.  Greyhound is the only national operator of scheduled intercity coaches in the US and Canada, serving 48 US States and 10 Canadian provinces and territories, with a unique nationwide network and iconic brand (also owns BoltBus).  4K destinations offering 55K city pair journey combinations. Transport 16M passengers per year and 5B passenger miles/year using a fleet of 1600 vehicles.
• Greyhound had like-for-like revenue decline of 2.8% in the period 9/30/2017-1/31/2018 (versus down 0.4% YTD).  Strong growth in the shorter point-to-point markets accelerated in the period, but this was more than offset by intensifying challenges in the larger long-haul segment in the face of low-cost airline competition, which also resulted in a disappointing holiday season.
• FirstBus:   £864M (15%) of Revenue and  £39M (10%) of Operating Profit
• FirstBus is one of the largest bus operators in the UK, transporting 1.6m passengers a day on 6K buses, with ~20% of the market outside London.  Serve 40 of the UK's largest towns and cities including 8 of the 11 most densely populated.
• The First Bus segment had like-for-like passenger revenue of +1.4% in 9/30/17-1/31/18 versus +0.9% YTD.
• First Rail:   £1.35B (23%) of Revenue and  £63M (17%) of Operating Profit
• One of the UK’s most experienced rail operators, carrying around 130m passengers using 1,200 vehicles across two of their franchises (Great Western Railway and Transpennine Express) and open access passenger rail service (Hull Trains) in YE 3/31/2017.
• On 3/27/2017 won bidding with partner MTR (70:30 split) for a third franchise (South Western rail) which started up in August 2017.
• Also operate the Tramlink service on behalf of Transport for London and the Heathrow Connect service with Heathrow Airport.
• Transpennine Express franchise contract runs until at least April 2023.  Contract began in April 2016 and bid assumes ~12% annualized revenue growth.  Only 5.9% growth in YE 3/31/2017 and 9.7% in H1 2018 (ending 9/30/2017). Max possible loss of £189M.
• South Western Railway franchise contract runs until at least August 2024.  Contract began August 2017 and bid assumes ~6.9% annualized revenue growth with 47% increase in capacity.  Had 0.6% in YE 3/31/2017 and 2.9% in H1 2018 (ending 9/30/2017). Max possible loss of £88M; 70:30 split though so only £61M max loss for FirstGroup.
• Great Western Railway franchise contract runs until at least April 2020 (with likely additional extension of 2-4 years soon) and carries >105M passengers per year.  Most of segment profits are from GWR and Hull, which should remain profitable. Max possible loss of £30M.
• Hull Trains open access passenger rail service agreement runs until 2029.
• LFL passenger revenue growth in rail segment increased to 3.2% in period 9/30/17-1/31/18.  This revenue growth implies that TPE and SWR are likely falling short of bid estimates, though substantial capacity will be added soon in SWR so could meet estimates (though minimal transparency).

Catalyst

Potential (though unlikely) sale or spinoff of the FirstStudent segment.

Debt reduction & re-fi at lower rates.

Initiation of Dividend or buybacks.

Performance of Rail above pessimistic assumptions.