Description

Recommendation: Short Student Transportation Inc ("STB") - Up/Base/Down Cases: $0/$2.2/$6.5

Quick Summary: Student Transportation Inc ("STB") is the third largest owner and operator of school buses in NA.  In short, the company has been over-earning since oil fell in 2014 and the dividend is unsustainable. Management justifies the dividend with highly misleading assumptions but the true economic earning power of the business does not support a dividend at all and to date the dividend has been financed through serial equity and junior debt issuances. We believe the company’s financial position is unstable and a reversal of recent fuel price tailwinds will cause STB to re-rate.

• Unsustainable Dividend: STB hasn't generated enough net income over the last decade to cover a single year of dividends and has financed the dividend through serial equity and debt issuances. STB pays an unsustainable dividend of $0.44 per share while earning only $0.10 of adjusted FY16 EPS.  In 2016, despite only $29mm of adjusted EBIT, STB paid dividends of $38mm and had $15mm of interest expense.

• Expensive Poor Quality Growth: Management focuses investors on consistent revenue and EBITDA growth, which masks the capital intensive nature of the business and the poor unit economics.

• Over-earning from Fuel Price Drop: Temporary benefits from customer contract resets lagging behind benefits from un-hedged fuel exposure have contributed ~360bps to operating margin since 2014 and accounted for virtually all of the earnings growth since 2014

• Trades at Significant Premium to Competitors: STB trades at 28x EBIT versus its closest competitors, Firstgroup PLC ("FGP") and National Express Group PLC ("NEX"), which trade at 11x and 15x respectively, despite STB having worse operating metrics, ROIC, and scale

Company and Market Description:  There are approximately 510k school buses operated in North America. Approximately 66% are owned and operated by school districts. The other 34% of buses are operated by private companies. There are over four thousand of these private operators in NA. STB owns and operates a fleet of ~13k buses and is the third largest operator behind FGP and NEX, which operate fleets of ~48k and ~28k respectively. After those three, average fleet size drops to fewer than three thousand buses.

School districts that outsource run competitive bidding processes and award three to eight year contracts. There are usually provisions for CPI like price increases and in many cases the district offers fuel price protections.  While there were some public to private conversions during the recession as school budgets were squeezed, most of STB's growth has come from acquiring smaller operators and winning share from other private operators.

STB typically has ~30% of annual fuel spend purchased by the school, ~30% mitigated in some form by schools (e.g., price collars) and then STB will hedge another ~20% of fuel requirements one year out using futures. The last ~20% of fuel requirements are left unhedged.

Adjusted financials and per bus economics below. Note the contribution to earnings from fuel cost declines.

Detailed Thesis:

1. Unsustainable Dividend:

While it may appear obvious from the tables presented above that the dividend isn't sustainable, management obfuscates this fact well and the dividend yield and consistency is a sticking point with bulls so this is a somewhat exhaustive look at the dividend coverage. In any case, we believe that without further support from exceedingly generous capital markets, the dividend is not supported by the economics of the business.

Background on STB's CapEx: The crux of the issue with the dividend is what real maintenance capital expenditures should be. With that in mind according to the latest annual filing, the average cost of a bus in FY 2016 was $73.6k and the useful life is 7 - 11 years. STB leases 31% of its fleet and school districts own 4% (8.5k wholly owned). The company favors operating leases which have 6 year terms and have purchase options for the residual values which tend to be 20% - 30% of the original value. We estimate the company sells a bus for $2,000 after its useful life.

How the Company Defends the Dividend

Here is a replication of a table presented in the company's latest annual filing designed to demonstrate the dividend coverage.

(note: the different between EBITDA presented by management and EBITDA in the summary P&L table is due to SBC)

The fundamental problem here is the "replacement capital spending".  We estimate annual maintenance capex should be ~$55mm ([$73.6k avg. bus cost-$2k residual value]/11 year useful life * 8.5k wholly owned buses). That's ~$7mm higher than the $48mm of depreciation listed on the P&L. That $7mm difference is likely due to inflation in bus prices over the 11 years since the bus was purchased (implies reasonable inflation of 1.25%/year).  In any case, it's fair to say the GAAP depreciation figure is a conservative approximation of real maintenance capital expenditures.

With that in mind, to claim that replacement capital spending it ~$6mm is a bit ridiculous. They were able to spend only $6mm in cash maintenance capex in 2016 because they continue rolling greater proportions of their fleet into operating leases. This defers the cash outlays but doesn't eliminate them-- the fundamentals of the business still need to be able to cover the maintenance expense, regardless of how it's financed.

Here is a simple case that adjusts the dividend coverage calculation for what should be average maintenance capital expenditures using depreciation as a proxy and assuming the percentage of the fleet leased remains constant.

Management would quickly point out that they did only spend $6mm on replacement capex. Putting aside how you delineate growth versus maintenance capex, that's a fair point for any given year. But on average the company will need to pay that depreciation. If they choose to lease instead of buy, the costs are still the same, just spread over a longer period plus interest. Management can defer capital spending but not eliminate it with leases. The economics of the business still need to cover the capital requirements of operating it.

Another reasonable critique of the case above that management would likely point out is that since leases, in effect, bake in accelerated depreciation in the annual lease cost, the leases overstate the capital spending relative to straight line depreciation used for GAAP. In addition, management indicates in calls they're able to get an extra year of useful life out of leased buses (on calls management discusses six year leases and another six years of useful life afterwards). So to normalize for the impact of financing but still give STB the extra one year of useful life, the table below calculates a depreciation figure assuming all buses are purchased outright and have useful lives of 12 years.

Regardless of how you look at it, the dividend doesn't appear covered.

Another way to check that GAAP depreciation approximates true cash maintenance costs of the wholly owned fleet is the company's non-GAAP capital expenditure table which breaks out total capital expenditures that were funded with cash versus operating leases:

In 2016, STB financed $58mm of capital expenditures with operating leases. The majority of those leases (estimate ~$48mm) were from continuing to shift the fleet from owned to leased and the remaining leases (estimate $11mm) were leases rolled from leases expiring six years prior. Thus the "true" maintenance capital expenditures for the wholly owned fleet for the period should be roughly $55mm (i.e. "new" leases of $48mm plus cash capex of $8mm). Doing the same process for the previous year and taking the average puts the calculated maintenance capex of the owned fleet at $47mm, right on top of the GAAP depreciation for the owned fleet, confirming that the depreciation is a reasonable approximation for go-forward maintenance capital expenditure requirements.

The company can continue to convert the owned fleet to operating leases to keep the cash maintenance capex low, however, eventually the operating leases will approximate the depreciation calculated in Case 2, plus interest.

From our perspective, it doesn't matter how you cut it: as it stands, the dividend is simply not covered by the economics of the business.

2. Poor Quality Growth and Management Focus on Wrong Metrics:

Management is quick to point to the consistent revenue and EBITDA growth. And indeed, revenue has approximately doubled over the last five years and EBITDAR (management reports EBITDA with operating leases added back) has increased from $60mm to $117mm. Management will also point to the fragmented industry as ripe for consolidation. STB has been acquisitive, spending ~$90mm on acquisitions over the past five years.

However, the attractiveness of this growth is dubious at best. ROE, with the exception of this past year, has averaged 2% (yet the dividend yields 8%). Management guides investors to look at EBITDA but this is a capital intensive business where depreciation is a very real and recurring cost. Further, the $260mm in acquisitions since 2006 don't appear to have added value. It's not as if management is scooping these businesses at or below equipment value either. There is ~$200mm of goodwill and intangibles on the books.

The easiest way to illustrate how little value has been created is looking at book value creation over the company's history.

As you can see in the first column, over the last 10 years there has been virtually no contribution to book value from operations. The dividend and book value growth that has occurred has been almost exclusively funded by raising capital.

It's Not STB's Fault, It's a Tough Business

Limited Advantages to Scale: Our conclusion is that there are limited benefits to scale. STB's cost structure, on a per bus basis, has actually increased over the past five years as the number of buses has increased by over 50%. While there are some advantages to having route density around hubs and from consolidating route planning, purchasing, etc. the majority of the costs and overhead are directly tied to the bus or the regional hub in which the bus operates.

Highly Competitive: Based on interviews with bus fleet operators, it's an extremely competitive business and often irrational. There are over 4,000 regional operators and the barriers to entry aren't high. Our understanding is someone with a local political connection and a financial backer to show wherewithal to purchase a fleet can be in business. There are advantages to winning bids from having a history of safety and reliability like STB. However, local operators are scrappier, carrying minimum required insurance, performing maintenance themselves and often overlooking depreciation in their bid packages.

In speaking to NEX, the best operator in the business (based on segment EBIT margins), there's a reason NEX isn't growing: the growth opportunities for top line are not worth the cost.

3. STB Over-earning

We believe STB is over-earning as multi-year customer contracts that were priced when oil was higher have yet to roll off while actual fuel operating costs have dropped precipitously.

Between 2006 and 2014 before oil crashed, STB adjusted gross margins (excluding operating leases) averaged 29%. After oil dropped, STB's gross margins expanded from 28% to 30%. As contracts roll off that were priced before 2015 in a high oil environment and new contracts that are priced with the current oil environment roll in, the gross margins will likely revert to the historical average. Some of this is dependent on changes in the CPI, which most contracts are tied to for price escalators, but from our perspective the magnitude of the increase in gross margins from this fuel spread will weigh on margins even in an inflationary environment. How much exactly is hard to say, but something closer to the historical averages is probable. Looking at the highlighted row for fuel in the summary financials, fuel as a percent of revenue went from 8.9% to 5.3%, contributing over 360bps to margins.

Below is a chart illustrating this. Gross margins closely track the spread between average oil prices when contracts were awarded and current oil prices. And if oil stays where it is now, around $50, that spread will start rapidly collapsing and margins likely with it.

The green line - Gross Margin: is STB's gross margin

The red line - CPI %: Represents mid-year YoY CPI % change

The dotted blue line - Contract/Spot Oil Spread: Meant to approximate the spread between that average fuel price STB contracts were struck and the current average cost of fuel

Notes on fuel spread methodology: There is plenty to quibble with on the details of how to do this but we believe the figures above are directionally correct. Contract Fuel Price Est.: We chose a five year average oil price to estimate the average fuel price at which contracts were awarded since it's near the mid-point of STB's contract lengths of three to eight years. The series was lagged one year since contracts don't start immediately.

Current Fuel Price: We used the trailing two year average to approximate actual fuel costs since the company hedges half of its exposure that is not covered by the contracts through futures one year in advance and leaves the other half un-hedged.

Driver Wages: It's also worth noting that a number of news sources are reporting driver shortages and double digit wage increases. It's difficult to aggregate and measure the reports systematically or determine how much wage increases would be offset by the CPI price escalator, but this could prove to be another significant headwind in the near future.

Searching for school bus driver pay in google news yields a number of articles on the issue:

https://www.google.com/search?hl=en&gl=us&tbm=nws&authuser=0&q=school+bus+driver+pay&oq=school+bus+driver+pay

4. Valuation:

We looked at valuation in three different ways.

Bullish Case - $6.5/share: We view this as an extremely optimistic way to look at the business. We assume that STB can quickly rework the business to hit NEX's EBIT margins of ~10% (that 10% for NEX doesn't include corporate overhead, so believing STB can achieve that sort of company level EBIT margin is highly optimistic). Applying 10% EBIT margins to LTM revenue of $608mm yields $61mm of EBIT (versus FY16 of $29). Using NEX's LTM multiple of ~15x without any discount for the time it will take to achieve this or STB's overhead burden, it implies a price of $6.5 per share.

Base Case - $2.2/share: For a base case scenario we give STB the benefit of the doubt and assume that despite the fuel spread headwinds that are likely forthcoming, STB can maintain LTM EBIT of $31 through cost cuts. At NEX's multiple of 15x that implies a price of $1.6 per share. We further assume that STB can do a $100mm equity raise at the current valuation and use it to pay down debt, generating $0.6 of value for a share price of $2.2.

Downside Case - $0/share: STB gives back 175bps of the 360bps of gain from fuel tailwind and EBIT declines to $22mm. Senior lenders tighten credit creating liquidity issues, sending the share price lower and the yield into the double digits, making it difficult to issue more convertible debt. Applying a small 1x discount to NEX's 15x EBIT multiple (still well above FGP's 11x) for a forced sale scenario, it implies an equity value of zero. For a scenario to result in no equity value the capital markets would need to stop being exceedingly generous and financing operations and dividends.

Catalyst

• Fuel tailwind reversal

• Dividend cut from capital markets halting financing of dividend and operations