Description

With the recent announcement by I Squared of a takeover offer for FirstGroup plc (please refer to RoyalDutch's writeup for further detail), I feel it is timely to post my VIC membership application idea. 

All figures above and below are in british pounds (£).

I am recommending a long position in the ordinary shares of the Go-Ahead Group plc (LSE:GOG), a London-listed, UK based provider of public bus and rail transport services with an estimated low-risk return profile of 1.6 - 2x MOIC in 12-24 months, excluding dividends, with a target price range of £16-£21. 

At the current market price, I believe Go-Ahead offers an attractive entry point for a tangible asset-backed, old economy, inflation-protected, free cash flow generator. At a share price of £10.10, the company trades at an undemanding 2022E EV/EBITDA of 2.9x, even though:

1. Go-Ahead has generated EBITDA averaging £180mm since 2010 versus an enterprise value of approximately £600mm today and is on track for EBITDA of approximately £200mm for the financial year ending 30 June 2022.

2. Public transport demand in the UK is already at ~80% of pre-Covid levels and is poised for continued long-term growth, despite a material portion of the professional work force working from home. 

3. The board recently committed to re-instating the dividend, which could yield 12% at the current market capitalization. 

4. An experienced CEO ex Transdev and Deutsche Bahn with a fresh medium-term business plan to return the business to growth has recently been appointed. 

5. The company has a robust balance sheet with a significant portfolio of blue-chip London bus depots, plus £400mm of cash. 

Further, it is worth noting that two UK-based value-orientated investment managers recently took advantage of the low valuation, filing holding statements in March showing material purchases of Go-Ahead stock. Jupiter Fund Management increased its holding from 5% to 10% with a purchase of an additional 2mm shares. In addition, Aberforth Partners bought 2mm shares, initiating a 5% stake. 

What happened/why is the valuation low?

(Skip to the middle of the write up for a business description)

In its 2020 accounts, Go-Ahead flagged a contingent liability of £8mm relating to their 65%-owned LSER subsidiary (London & South Eastern Railway), jointly owned with France’s Keolis. The LSER subsidiary operated London’s Southeastern railway line. The contingent liability was for having potentially calculated the Department for Transport’s (DfT) share of the railway’s operating profits between October 2014 and June 2019 incorrectly. Go-Ahead was accused of retaining more than their fair share. 

In FY21, Go-Ahead identified further errors: £27mm was owed to the DfT due to overpayments from the DfT to LSER for track and depot access for the 2014-2020 period, and £17mm was owed to the DfT due to subsidy overpayments from the DfT to LSER between 2006-2020. Further, Go-Ahead owed £7mm in interest on these charges, resulting in total charges just shy of £60mm when including the contingent liability of £8mm. 

In the first half of 2022, the DfT notified Go-Ahead of an incoming financial penalty and the company accordingly earmarked a £30mm provision in the FY21 accounts which, at the time, were yet to be published. The CFO resigned shortly thereafter. In September 2021, the Southeastern rail contract was stripped from LSER, resulting in a loss of 20% of Go-Ahead’s operating profit and a quarter of the company’s revenue (2021: £4,059, 2022E: £3,300 – based on 9 months of LSER revenue). All of the issues at LSER have since been settled with the DfT, except the financial penalty of £23.5mm (provisioned at £30mm) which will be paid in the second half of FY22.

As a result of the errors identified by Go-Ahead and the resulting important quantification of the complex contingent liability, Deloitte could not complete their audit on time, and hence the publication of the YE 3 July 2021 accounts was delayed. Initially delayed to the end of September, then again to December, the accounts were finally published on the 24th of February 2022. Due to this delay, the company breached the UK Financial Conduct Authority’s 6-month publication time limit. This forced Go-Ahead to suspend trading of their shares and bonds from the 3rd of January to the 24th of February 2022. Consequently, Moody’s withdrew there Baa3 credit rating of the bonds (which has since been reinstated). The market did not appreciate the uncertainty and the stock traded down to a low of £5.40 in early March, although has since had a strong rebound to current levels. 

In my view, the DfT and wider government used Go-Ahead as a scapegoat for the wrongdoings at LSER. The public-private contracts that govern these franchise arrangements are typically extremely complicated and call for large amounts of subjective interpretation. In addition, it seems reasonable to expect the DfT to admit at least some fault for the miscalculations that took place since 2006. Not doing so seems equivalent to a creditor in the private market receiving less than contractually agreed interest receipts on a considerable portion of its loan book over the course of 15 years, and then placing all blame on the debtor for the mistake. The creditors CEO would be gone in a heartbeat and their internal controls would be questioned substantively. However, the DfT suffered no such consequences.

Ultimately, Go-Ahead has lost a quarter of its revenue with the loss of the LSER/Southeastern contract and has also tarnished its reputation in the process. This is undoubtedly a significant loss. However, given rail is such a low margin business, this contract only contributed around 20% of the company’s total operating profit. To put this into perspective, a 65% reduction in the 2021 operating losses of the German and Norwegian rail business would make up for this loss. The company has guided to a 30-50% reduction of these losses in FY22. In addition, if the levels of profitability for regional bus that we saw in FY2019 returned, this would result in a £30mm increase on FY21’s operating profit and the aforementioned loss would also be recovered in full. 

Go-Ahead having been awarded the GTR (Govia, Thameslink) contract in March, the countries largest railway network by passenger volume, reaffirms the company’s ability to operate rail and shows that the DfT still has confidence in Go-Ahead. An independent investigation was carried out alongside the DfT’s investigation, and both concluded that the missteps were confined to the LSER subsidiary. Go-Ahead’s earning power has not been materially impacted by the loss of the contract and I therefore believe the current low valuation is overstretched. 

In addition to the issues at the LSER subsidiary, Go-Ahead struggled with its new rail operations in Germany and Norway. Loss-making operations in Germany commenced in 2019 with rolling stock delivery and quality issues from the manufacturer (Stadler). In addition, operating issues with poor punctuality of services led to significant financial penalties. At around the same time, Go-Ahead entered the Norwegian market, a suboptimal time with Covid around the corner. Since this contract was exposed to passenger demand, losses mounted due to Norway’s Covid lockdowns and were only partially stemmed by government subsidies. As a result, Go-Ahead made onerous contract provisions for both the German and Norwegian operations totalling £67mm and £72mm in FY20 and FY21 respectively.

Moving forward

With the issues at LSER resolved and provisions booked, Go-Ahead can focus on the post-Covid return of travel demand. 

Refreshed CEO

In the first half of 2022, long-standing CEO David Brown retired after more than 10 years in the role. A new CEO, Christian Schreyer, was appointed and took over at the beginning of November 2021. Schreyer’s most recent role was CEO of Transdev’s North and Central Europe divisions, having previously been Chief Strategy and Performance Officer for the group. Prior to his 11 years at Transdev, Schreyer spent 15 years in senior management positions with the world’s second-largest public transport company, Deutsche Bahn. Interestingly, Deutsche Bahn owns and operates Arriva, a Go-Ahead competitor which maintains the third-largest market share in London bus (Go-Ahead has the largest market share). Arriva also holds the third-largest market share in regional bus transportation, ahead of Go-Ahead’s fourth place. Schreyer has significant experience in implementing strategic turnarounds, having implemented such programs in Poland with DB Schenker and in Germany with Transdev. 

At the beginning of April, Schreyer announced his comprehensive business review and strategy update. The strategy focusses on streamlining Go-Ahead’s operations with a view to re-focus on the company’s key operating divisions – UK bus and rail. In the medium term (approximately the next two years), Schreyer has targeted a return to annual revenues of £4 billion, operating profits of £150mm (2019: £121mm, 2021: £116mm), and the resumption of the group’s dividend policy of paying out 50-75% of earnings per share. He also announced the board will recommend a minimum FY22 final dividend of 50p (p, or pence is equivalent to cents), a yield of approximately 5%. The company will not look to grow international rail operations and will instead focus on stemming losses in these divisions. I don’t believe management has any intention on selling these divisions at this stage, however, may be an option down the line once the market has normalized. 

How can Go-Ahead grow operating profits to £150mm in the medium term?

£150mm of operating profit in the medium term does not seem like an onerous target. Operating profits reached £161mm in FY16 and £151mm in FY17. Average operating profits over the past five years have been £120mm, on operating margins of 3.25% and revenue of £3,700mm. Schreyer is basing this £150mm target on £4,000 of revenue, and 3.75% operating margins – not overly ambitious when put into perspective. 

To achieve the £150mm target, Schreyer is aiming to reduce the bus divisions operating costs by £40mm or 4%, again, this doesn’t seem onerous. £40mm in cost savings is the equivalent to the operating profit generated from £1,067mm of revenues at a 3.75% margin. The impact of these savings is likely to be felt before any top line growth is seen as Schreyer identified areas of improvement during his business review and stated in the accompanying conference call that they are already implementing these changes. The savings will come from a number of areas including fleet, energy, overheads, and maintenance costs. Schreyer has noted his commitment to have greater visibility on costs which will be driven by an improvement in the companies’ data and analytics capabilities. £40mm in cost savings will go a long way in bridging the gap to the £150mm target. 

With the issues at the company’s international rail operations in Germany and Norway, Schreyer has confirmed they will not be attempting to enter into any further railway markets abroad. However, they will look to grow through accretive M&A in the international bus markets. Most recently, Go-Ahead purchased a small bus operator in rural Sweden, Flexbus. The great thing about the franchised bus business is that it is a standardized operating model and can be implemented in most markets at minimal cost or risk, as the company has seen with successful bus operations in Ireland and Singapore. Schreyer has identified three key low risk markets of interest – France, Sweden, and Australia. 

International franchised bus contracts can often be more profitable than those seen in London as they generally have longer durations of 8-10 years, versus 5-7 years in London. So, operating efficiencies can be further developed, while plant can be depreciated over a longer depreciable life. Capital intensity can also be lower. As is the case in Singapore, buses are provided by the transport authority, saving Go-Ahead CAPEX spend and increasing return on invested capital. Furthermore, as another illustrative example, in the Netherlands, if an operator’s contract is not renewed, the incomer must purchase and use the previous operator’s plant, reducing risk of write-downs and providing a residual value floor. 

Inflation hedge

With inflation making a return across the globe, Go-Ahead’s cost-protected business model offers an attractive comfort blanket. Eighty percent of Go-Ahead’s revenue stems from private-public franchises with local transport authorities. These franchises are tendered for and awarded to the lowest-cost provider. The contracts are on a ‘cost-plus’ basis with a management fee and incentive bonus paid on top of operating costs. That is, Go-Ahead retains the upside potential while also having their downside protected. And thus, Go-Ahead’s (and their competitors’) profits are largely inflation protected. In the way a rising tide lifts all boats, this should mitigate contract tendering risk amongst the industry. 

Diesel is a material cost to the business (accounting for around 10% of the bus division’s operating costs) so Go-Ahead maintains a strict diesel hedging policy. Specifically, diesel for the next financial year has been fully hedged at 33p per litre, providing Go-Ahead with a considerable discount of 60% when compared to the current wholesale at-the-pump price of 87p per litre. With the hedge in place, Go-Ahead’s FY22 diesel cost should come in around £45mm (based on 135mm litres – the number of litres used in both FY20 and FY21). Without the hedge, the figure would be closer to £117mm. Diesel for the following two years has been hedged at 50% and 25%, respectively. 

Wage inflation is unlikely to be an issue as they have recently finalised collective labour agreements for the following year. Management believes when these agreements come up for negotiation in a years’ time, they can cover any increases with a combination of price increases and better utilization of their buses. Better utilization will now become easier to achieve with Schreyer’s focus on improving data and analytics and greater cost transparency. 

Lastly, past evidence suggests that public transport is a defensive industry during recessionary times. For example, if we look at bus travel as a percentage of total travel in the UK during the global financial crisis, we see an increase from 5% to 6% from 2009 to 2010. This value only decreased back to 5% in 2011 once the global economy was in recovery. Similarly, rail, as a percentage of total travel, increased from 7% to 8% over the same period. 

Go-Ahead’s performance over the course of the GFC was relatively sound. Net income from continuing operations reduced from £76mm in 2008 to £59mm in 2008 and £51mm in 2010, increasing back to £75mm in 2011. Of note, the company reported record operating profits in its bus division of £67mm in 2009 (2008: £66mm), equating to operating margins of 11%. EBITDA margins over the same period reduced from 9% to 8% and 7% respectively, before recovering back to 9%. It’s important to note that Go-Ahead did not reduce dividend payments during this period. 

Valuation

Go-Ahead’s shares trade at an undemanding FY22E EV/EBITDA multiple of 2.9x. This is compared to an average of 5.4x for the rest of the publicly listed ‘big-five’ UK public transport providers. This value discrepancy seems too great on both an absolute and relative basis to ignore. On a free cash flow basis, Go-Ahead is trading at a paltry 2.8x, or a forward free cash flow yield of 54%. This is in spite of the fact the board has committed to reinstating the dividend policy while Schreyer has guided to modest CAPEX requirements in line with previous spend, over the medium term. 

With the continued publication of operating results confirming that the miscalculations mentioned previously were contained to LSER and did not impact the wider Go-Ahead business, we are likely to see the market forgive the company for these errors. Therefore, in light of all that has been discussed above, I expect the market to re-rate Go-Ahead over the course of the next 12 months to an EV/EBITDA of 4-5x, for a share price of £16. Prior to the LSER issues, Go-Ahead was trading at an FY22E EV/EBITDA of 4x.  To be clear, in my opinion, Go-Ahead must simply steady the ship over the next 12 months for this re-rate to occur. That is, revenue and or earnings growth is not necessary. With one-off exceptional provisions already booked, Go-Ahead must show that no further provisions are required. These provisions cover the life of the contracts, so I don’t envisage further provisions likely. 

If Schreyer is able to execute on his new business strategy over the next two years, I would posit a conservative 24-month target share price of £21, based on a 5x EBITDA multiple on 2023E EBITDA of £218mm (£3,600mm revenue, 3.75% operating margins, D&A on assets of £92mm [excluding ROU assets], less £9mm of net income attributable to NCI). Of note, Go-Ahead’s 12-year historical average LTM EV/EBIDTA (FY10 – FY21 inclusive) is just north of 4x, while historical operating margins have averaged 3.75%. Schreyer is targeting a 3.75% margin in the medium-term which I see as conservative as the higher margin regional bus business contributed a smaller portion of the companies total operating profits at the beginning of the 12-year historical period mentioned above. The regional bus share of Go-Ahead’s operating profits was only 24% in FY10 versus 37% in FY19. This share will likely continue to grow as Schreyer targets a higher margin business mix. Thus, in my view, margins greater than 3.75% are likely and I see a 5x multiple as achievable. 

The company began accounting for leases under IFRS-16 during the 2020 financial year, although reports its net debt and free cash flow on a pre IFRS-16 basis. As such, I have elected to use EBITDA rather than EBITDAR in my analysis and have calculated enterprise value on a pre IFRS-16 basis. In my view, doing so also enables one to better understand the current and future operating results of Go-Ahead in comparison to historical and pre-Covid results. 

Capital Allocation 

Schreyer has stated that the company will resume their dividend policy of paying out 50-75% of earnings per share this year and will recommend a final dividend (payable around November 2022) of no less than 50p per share – a yield of 5%. Schreyer has recently been incentivised with the granting of 42,000 options that will vest over the next three years if certain KPI’s are met, one of those KPI’s being to resume appropriate returns to shareholders. A 50p per share dividend equates to less than a 1/3rd of my estimated FY22 diluted earnings per share of £1.59 (based on revenue of £3,300mm, operating margins of 3.75%, finance and tax expenses of £37mm). A 50% pay-out equates to an 8% yield, while 75% would equal £1.19 for a 12% yield. If we look beyond FY22 to 1H23 and consider an interim dividend, a 25% pay-out of my estimated FY23 earnings per share of £1.82 would equal 46p (based on revenue of £3,600mm, operating margins of 3.75%, finance and tax expense unchanged at £37mm). If we add this to the 50p minimum that the board will recommend, the total of 96p equates to a 10% yield at today’s share price. In a rising rate environment, which should favour cash flow generating (and returning) value at the expense of non-profitable growth, I see this yield as yet another attractive facet of the Go-Ahead investment opportunity. 

At the current valuation, I would prefer buybacks or an accretive tender offer over dividends, however the board is conservative and unfortunately don’t have much incentive as they own very little stock. 

Bus depots 

Go-Ahead owns a significant portfolio of bus depots throughout the UK with the majority located in central London, totalling approximately 2.96 million square feet. As the company is not in the business of property development, the depots are conservatively accounted for on a historical cost basis. I estimate a risked valuation (taking the average recent market price per square foot across all of the London boroughs and also applying a 15% discount) of the companies UK freehold property at £92 per square foot for a total of £272mm or 1.2x the current reported book value of £222mm. This equates to a per share value of £6.33. Incorporating the market value of the property portfolio and excluding leases and right of use assets, I calculate a net tangible asset value per share of £5.06 (no allowance is made for the non-controlling interest here which represent the 35% stakes in the GTR and LSER subsidiaries owned by Keolis. GTR and LSER do not own any of the aforementioned bus depots). Once intangibles are added back, the net asset value becomes £7.95. At a share price of £10.10, the difference of £2.15 effectively values the earnings potential of the company at only £92mm. 

Market Consolidation

Go-Ahead could also be a potential takeover target from private equity or industry in the medium term. Being such a capital-intensive industry with high levels of fixed costs and small margins, consolidation in order to realize synergies makes sense assuming surmountable anti-competitive regulation can be worked through. Gaining strength in size would help take advantage of the companies operating leverage, driving incremental sales to the bottom line. 

Reuters recently reported that the “UK [is] for sale” with $45 billion having been spent in the first half of 2021 by private equity firms, almost 10% of the total $547 billion spent across the world. The UK offers an attractive hunting ground for buy-outs as the market’s valuations have generally lagged that of the US. The FTLC index of British focused companies trades at a forward earnings multiple of 13x vs the US midcap IDX index at 18x. Amongst a rising rate environment, bidders will want to ensure they are not over exposing themselves and will likely seek deals with targets that maintain tangible asset backed balance sheets which carry a low cost of capital and generate large streams of free cash flow that can service higher yielding debt.

In March, Stagecoach, arguably the leading operator in the industry, accepted an all-cash offer of 105p (£595mm) per share from the German asset manager DWS. This offer was on top of an initial bid by National Express, a Stagecoach competitor and the second largest member of the ‘big-five’ transport players. National Express’s bid was for total consideration of ~£470mm and they were targeting synergies of ~£45mm. The company was most likely targeting Stagecoach for its complimentary higher margin, market leading regional bus business. 

FirstGroup plc announced over the weekend that they were considering a bid from the industrial private equity fund, I Squared. Checkout RoyalDutch’s writeup for further detail. The bid values the equity at £1b or an implied 2022E EV/EBITDA of 7.2x on a pre IFRS 16 basis. 

With ESG headwinds and a likely bidder to have a strict ESG mandate, Go-Ahead is leading the charge in the industry. As of the end of FY21, the company had a total electric bus fleet of nearly 300, making Go-Ahead by far the largest operator of electric buses in the UK.  FirstGroup, the largest of Go-Ahead’s competitors, only has 52 low emission hydrogen and electric buses. Go-Ahead plan to be net zero by 2045. My analysis indicates this shift will largely be funded by government programs, so I do not believe the change will result in a material impact on capex spend. 

If we were to value Go-Ahead on the same basis as the DWS deal at a 4.3x multiple on 2022E EBITDA, this again brings us to a share price of £16. Although not a like-for-like comparison, DWS is taking advantage of temporarily depressed market valuations across the sector and with passenger numbers trending upwards, the DWS bid provides another floor to public transport valuations. 

Business overview

The Go-Ahead Group was formed in 1987 upon the privatisation of the UK’s National Bus Company, subsequently IPO’ing on the LSE in 1994. Go-Ahead is the largest operator of London’s famous red busses, has a growing high margin regional bus business, operates the largest railway network in the UK, and also has operations in Ireland (bus), Singapore (bus), Germany (rail), and Norway (rail). Go-Ahead employs 27,000 staff members. 

Go-Ahead is considered part of the ‘big five’ UK public transport companies which include: National Express, FirstGroup, Stagecoach, and Arriva, all of whom were formed as part of the privatisation of the National Bus Company in 1987. 

Go-Ahead’s services are provided via a combination of public-private franchises with local transport authorities and ‘free market’ contracted services. The franchises are lower margin than the free market services with the transport authority assuming the revenue risk and guaranteeing margins on a cost-plus basis and providing incentive payments for operating performance. Under free market services, Go-Ahead has full authority over its routes and fares, however, is exposed to revenue risk in the form of passenger demand. 

Operating margins, with the exception of bus operations, are tight with total blended margins of 3%. The bus segment was achieving pre-Covid operating margins of ~10%, which are currently sitting at around 5%. 

London & International Bus

The company has been operating in the London bus market since inception and has grown to a market leading position with 25% market share. The segment is the stalwart of the companies’ operations, generating reliable operating margins and profits, backed by a portfolio of aforementioned blue-chip bus depots. The segment accounts for approximately 1/3rd of total revenues and ~60% of operating profits. Operating profit margins are typically around ~9%, which are the highest among Go-Aheads London peer group (Metroline, Arriva, Stagecoach, RATP, Abellio). 

The London contracts are operated on a franchise model whereby TfL (Transport for London), the local transport authority, delegates the operations to private companies such as Go-Ahead on a tender basis. Fares and routes are set by TfL with contracts operating on a gross cost basis where a margin on top of operating costs is guaranteed with quality incentive payments also available if certain KPI’s are met. Incentive payments account for roughly 20% of London’s operating profit. 

Go-Ahead has small bus operations in Ireland, with two five-year contracts that generated a combined £40mm in revenue in 2021. Singapore consists of one five-year contract which generated £55mm of revenue during the 2021 financial year. Both Ireland, and Singapore operate on a franchise system like London, and thus are considered low risk by the company. They generate margins of ~5%. 

The company recently settled on the purchase of the franchised Swedish bus business Flexbus in April for £12mm. 

Regional bus

Go-Ahead’s regional bus business is the only division within the company that operates on a ‘free-market basis’, independent of the local transport authority. Regional bus is a division that the company has seen as a strategic opportunity over the past few years due to the low level of competition from the other large players, and consequently higher margins that are easier to maintain compared to the franchise models of London, Singapore, and Ireland. In the regional bus business, Go-Ahead has full authority over the fares and routes it offers, however, is exposed to revenue risk in the form of passenger demand. In normal operating times results have been strong with pre-Covid operating margins of ~10%, however with the onset of Covid and lower passenger numbers, margins fell to 4.2% in FY21. Go-Ahead maintains an 11% market share in regional bus (Stagecoach: 26%, FirstGroup: 21%, Arriva: 14%).

Boris Johnson’s public-transport friendly Government recently released their National Bus Strategy, in which they are encouraging local regional authorities to offer franchise like operating models, similar to that of London. This is part of a wider goal of increasing passenger demand and reliability of services in the more rural regions of the UK. This change will have an impact on Go-Ahead’s operating margins going forward, albeit small. With significant pricing power in these markets, the company is targeting a return to operating margins of ~9% in the medium term. Schreyer mentioned in his business review and strategy update conference call that they are already working with the local regional authorities to further develop relationships and secure optimal contract arrangements. 

CAPEX spend from 2016 through to 2018 was materially higher than average as Go-Ahead built out and invested in the fleet for the regional bus business. As the fleet has now largely been built out, material future CAPEX here is unlikely. My projections are for normalized CAPEX across Go-Aheads business of £40mm per annum. Go-Ahead’s bus fleet has an average age of 7.9 years. The only competitor that reports the age of its fleet is FirstGroup at 9.9 years. As mentioned earlier, I don’t believe the companies net zero target will impact future capex. 

As noted recently by management, regional bus passenger numbers are already at 82% of pre-Covid levels with Manchester above 90%.

UK Rail

With the loss of the Southeastern rail franchise, Go-Aheads UK rail operations now consist solely of the GTR franchise (Govia Thameslink Railway) which they have operated since 2014. The franchise is jointly owned 65% by Go-Ahead and 35% by Keolis, the French multi-national public transport company which also had a 35% share in LSER. GTR is the largest passenger rail contract in the UK and comprises the Southern, Gatwick Express, Great Northern and Thameslink lines, with 349 million passenger journeys annually. The GTR contract gives Go-Ahead the UK’s second largest rail market share of 23% (FirstGroup: 28%). The Rail business is Go-Ahead’s lowest margin business, with historical operating margins of 2%. 

Even though the company lost the Southeastern rail contract, they were awarded a new 3-year contract for GTR in March that includes a further optional 3-year extension. The management fee earned is low at 0.5% of GTR’s cost base or ~£8.8mm. However, performance fees of £23mm are also on offer, which if achieved will bring the margin back in line with historical performance at ~1.85%. 

International Rail

Go-Ahead’s fledgling international rail operations consist of franchise contracts in Germany and Norway. The business has been plagued with problems since operations began in Germany in mid-2019. When the company first embarked on pursuing the German and Norwegian markets, they had aimed to generate 15-20% of the groups operating profit from international operations by 2022. Instead, international operations have contributed operating losses of approximately £70mm. Christian’s new strategy is focused on strengthening their core operations in the UK and “stopping the bleeding” in international rail. The divisions large onerous contract provisions taken in FY21 totalling £72mm and a re-statement of the FY20 provision by £40mm are no doubt part of this strategy.

The German business operates on a contract basis similar to GTR, essentially a cost-plus model. They operate five contracts across the Bavaria and Baden Wurttemberg regions. Go-Ahead has been hit with financial penalties by the transport regulator for poor operational performance in Baden Wurttemberg from the get-go. Management have indicated they are simply out of their depth and underestimated the differences in the market compared to the UK. Management admit they should have partnered with a local business who knows the local market, just like they did when they entered the UK rail business with Keolis. Schreyer has vowed to only enter foreign markets in the future with a partner or via a local acquisition. Further to operational issues, the company had quality and deliverability problems with their initial rolling stock which has since been resolved with the company reaching a €10mm / £8mm settlement with their supplier, Stadler. 

The newly appointed CEO of the division, Fabian Amini, has been tasked with bringing the division to an operational break-even level and maintaining this level for the remaining 10 years of Baden Wurttemberg’s contractual life. Christian Schreyer wants to bury the hatchet on Germany and move on. 

The Norwegian operations began shortly after the German operations in December 2019 with the commencement of the Oslo South package of rail services which in total comprise 5.5 million train kilometres. The contract was hit heavily by Covid restrictions as it has exposure to passenger demand. The Norwegian Government provided support, albeit this did not cover Go-Aheads cost base, resulting in a £2.5mm operating loss in 2020 and ~£1mm in 2021. As with the German operations, it is clear that Christian Schreyer would also like to move on from the Norwegian market. At best, they will operate at breakeven for the remainder of the contract. A provision of £66mm was recorded in FY21 as post covid passenger demand through to the end of the contract will likely be depressed, Government support will also be reduced. A £10mm asset impairment charge was also recorded reflecting lower discounted fixed asset values.

Catalysts

1) Market re-gaining trust in Go-Ahead management. The publication of financial results over the coming 12 months should show the market that the LSER issues were contained and do not impact on the wider business. Having a new CEO and CFO on board with the appropriate incentives, along with the appointment of two new independent directors (both of which have financial backgrounds, one of which has significant audit experience) should assist in this regard. The company recently stated in their first half 2022 results that year-to-date trading has been strong and they anticipate a full year result ahead of previous guidance. 

2) A return to pre-covid levels of passenger demand. The company recently stated passenger numbers across the board are at around 80% of pre-covid levels with regional bus numbers at around 82%. I see public transport as a key avenue for households wanting to reduce their living costs in the current ‘cost-crisis’ environment, which may persist for some time. Inter day travel in and around the city will make up for increased numbers of staff working from home, driven in large part by exorbitant traffic and car parking fares (£11 / $14 per hour). The return of tourism will also play a role. 

3) Resumption of dividends. As noted, the board will recommend a minimum 50p FY22 final dividend however I believe the actual dividend will be higher. 50p does not meet the minimum dividend policy threshold of paying out 50% of earnings per share, based on my estimate of earnings. Further, the payment of a FY23 interim dividend early next year would bring the annual dividend yield to attractive levels of ~10%. 

4) Further M&A activity in the sector. On the back of a bumper 2021 for M&A deals activity in the UK, the already attractive real-asset-backed takeover targets may become even more attractive within a rising rate environment. Lenders will be looking to reduce exposure to high-risk sectors and shore up their loan books. 

 
Risks

I see my targeted return profile as low risk; however, I see the following risks as pertinent: 

1) Slower return to pre-covid levels of passenger demand. A slower return would heavily impact Go-Ahead’s margins in the regional bus sector and reduce confidence in the sector overall, impacting valuations. 

Mitigant: 

The dynamic of future public transport use will be different to what was seen pre pandemic, although this does not necessarily mean that demand will be lower. For instance, bus demand in the UK is currently the highest amongst all public transport modes as it’s user base is predominantly school students, shoppers, and manual workers who cannot avoid travelling. London underground passenger demand is at around 75% of pre pandemic while bus demand is at just over 80%. It’s also important to note that Covid restrictions on public transport – mandatory mask wearing, guidance to work from home etc were only dropped completely in the UK at the end of January. 

In Bus, Go-Ahead has seen an increase in demand for shorter trips in and around suburbia and less commuting into the city. The average bus trip distance has fallen from 4.4km to 2.8km. Weekday demand has reduced along with rush hour demand, while demand for weekend trips has increased – again showing increased appetite for shorter trips. I would envisage shorter trips would be more profitable as well as Go-Ahead can price its fares with a minimum floor while on longer journeys, they can’t necessarily increase prices on an equivalent £ per kilometre basis – there will be a price limit where commuters will simply prefer to use their car.   

In terms of rail, the large investments of public funds over the last century (plus) to bring Britain’s railway infrastructure up to the standard seen to day can not simply be thrown away. Railway commuters do not travel as much as bus commuters for essential reasons such as work and shopping so demand will be slower to recover, however, if there is an underinvestment in rail, service operators will not provide as many routes and route frequency will also reduce, leading to a drop in passenger demand. Therefore, a minimum level of investment is required. The level of subsidy provided by the DfT to service providers due to Covid over the past two years will likely continue or even increase, replacing passenger revenue. 

Further, Transport for London is one of the highest fare funded public transport bodies in the world. Prior to the pandemic, 72% of their income came from fares. This is compared to New York at (38%), Singapore (21%), Beijing (22%), Tokyo (20%), Hong Kong (37%), Paris (38%) and Madrid (47%). It is widely held that public transport will play a critical role in the post pandemic growth of London and the wider UK, therefore public investment will be crucial and highly likely from Boris Johnsons public transport supporting government (see the Bus Back Better strategy and Integrated Rail Plan). 

2) Announcement of further issues with government franchises given the large number of complex public-private contracts Go-Ahead operates under. I see this as unlikely given the clean up taking place after the LSER issues and Go-Ahead’s relatively blemish free operating history. The bulk of Go-Ahead’s contracts are in their London bus division, and these are largely homogenous so risk there is low. This leaves the GTR contract, which was recently extended, so again, I don’t see high risk here. 

3) Poor strategy execution by the new CEO. The business is dependent on relationships with local government bodies. If Schreyer is not able to build these relationships accordingly, market share may be lost to competitors and Schreyer’s medium-term targets of £4,000mm in revenue and £150mm of operating profit will not be achieved. 

Catalyst

As above.