Description

DISCLAIMER: The author of this posting and related persons or entities ("Author") currently holds a long position in this security. The Author makes no representation that it will continue to hold positions in the securities of the issuer. The Author is likely to buy or sell long or short securities of this issuer and makes no representation or undertaking that Author will inform the reader or anyone else prior to or after making such transactions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note. The views expressed in this note are the only the opinion of the Author.  The reader agrees not to invest based on this note and to perform his or her own due diligence and research before taking a position in securities of this issuer. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the below note.

Stagecoach is a bus and rail operator with operations principally in the United Kingdom. The Company has a long track record as a leading operator with highest margins in its peer group as a result of its lean cost structure and strong network. The Company is led by an experienced team with the current CEO having spent over 19 years at the Company and one of the firm’s founders as Chairman. Beyond experience, insiders are heavily aligned with shareholders due to their 26% ownership of the Company and have a history of shareholder-friendly capital allocation decisions mainly in the form of regular dividends of excess capital (the stock currently yields 5.6%).

The business generates high returns and enjoys relative stability through economic cycles; however, the stock currently trades at 7x fiscal 2016 adjusted earnings and 8x fiscal 2017 expected earnings due to an overly pessimistic extrapolation of its short term challenges and Brexit impact. Below we discuss each segment in more detail.

UK Bus (excluding London) (GBP1,033M in revenue, GBP137M in operating profit):

SGC operates buses across the UK, both within and outside of London. Regions outside of London are deregulated, which allows private operators to dictate fares and schedules, and compete freely on each route. Perhaps counterintuitively, this system has resulted in regional monopolies/duopolies with minimal competition on routes, primarily due to the importance of network scale in cost management. At the UK level, 5 large players control ~70-80% of the market share, with Stagecoach being the largest and most efficient player.

Share of passenger use by bus company:

Due to its monopolistic nature, the business has historically enjoyed strong pricing power, and has been able to offset the slow decline in bus usage by increasing fares on its commercial tickets. During the last two decades, UK retail price index (RPI) increased by 3% p.a. while local bus fare increased by 5% p.a..

Historical pricing of UK buses outside of London:

Despite being a very high quality business, this segment has come under significant pressure in recent periods from short term reduction in demand and long term changes in regulation. UK has experienced a combination of severe weather and road congestion in certain regions and deterioration in provincial high streets in late 2015 and early 2016. These factors together have caused an unusually weak environment for passenger volume. We believe that many of these effects are short term in nature and will reverse over time. More importantly, SGC has outperformed the market in terms of passenger growth each year over the last decade (data below). This creates an additional layer of safety in the scenario that demand remains depressed over a longer period.

Passenger journey growth on local bus services vs SGC like-for-like passenger growth:

Separately, the UK parliament has recently passed a Buses Bill, which allows municipalities to gain greater control over bus operations. They will have the option to dictate routes, schedules and fares, while simply outsourcing bus operations in the form of management contracts. This is the format currently employed by the city of London. Under this model, operators typically generate a lower margin, due partially to a mix shift towards great portion of leased versus owned vehicles; in turn, they bear no risk from revenue declines. In order to adopt this system, local governments are required to establish an elected mayor, build an in-house bus management team, design the local bus network and manage its bidding system. Due to its complexity and financial commitment, this is not a rational or attractive option for most municipalities that simply do not have the resources to take on a project of this magnitude, especially if they have a currently satisfactory network in place. As a result, only ~25% of regions (based on SGC’s bus revenue) have indicated interest. We believe that the earliest possible start date for the first city (likely Manchester) is 2020, and a realistic number of cities to finally adopt this may be much lower than those initially anticipated. There continues to be significant uncertainty associated with the new bill, however based on the only precedent so far, we believe that municipalities may be required to prove a material increase in value to the system in order to employ the new model. In late 2014, the Tyne and Wear region submitted a proposal to franchise its bus system. One year later the proposal was rejected on the grounds that it did not satisfy the requirement that the gain in value outweighed the negative impact on existing operators and incremental costs/disruptions. Although it is too early to tell if the same rigor will be applied going forward, there will likely continue to be consideration for the impact on the overall ecosystem. We believe that while this is a negative change for SGC and existing large operators, its onset will be 2020+ and gradual, and the impact will be limited to a small number of regions.

London Bus (GBP267M in revenue, GBP20M in operating profit):

Unlike the rest of the UK, London Bus business has experienced stable underlying traffic demand coupled with low digit price increases each year. As mentioned earlier, London already operates under the franchise model where typically 3-4 operators bid on each franchise, and the winner gains rights to operate buses on designated routes for 1-3 years. SGC has grown this business steadily and we expect them to continue to do so in the future.

UK Rail (GBP2,129M in revenue, GBP67M in operating profit):

UK rail is a low capital, low margin business with strong downside protection. Rail operators typically submit bids for contracts ranging 7-15 years long, with revenue targets and corresponding promise of annual premium to the government. The bidder with the highest premium adjusted for risk gains the rights to operate the franchise. Historically, most contracts operated under a revenue support model, where the government provides the difference between the forecasted revenue (submitted by the franchisee) and actual revenue beyond a threshold. This model provided significant downside protection, and set up rail franchises as a largely low-cost option for transport operators, with the only real investment as the GBP5-10M bidding cost each year. Since the 2012 reform, the franchise contract model switched to a GDP support model, where the government supports only the revenue difference arising from GDP fluctuations. At first glance, this appears to be significantly riskier for operators, particularly those who have recently bid with aggressive revenue growth targets. However, a closer look at the entire rail system reveals that while the premium in the contract is non-negotiable, many other elements of the cost structure is, including the payment to Network Rail. This means that in a scenario where the railway underperforms expectations, the operator will still be able to reduce its other corresponding costs in order to minimize material losses. We believe that despite reform changes, the downside of operating rail in the UK is still very much protected.

SGC operates 3 franchises today and has a 49% ownership in Virgin Rail, which operates a fourth franchise. Three of the four franchises are expected to end their contracts by fiscal 2018, and one (East Coast) is expected to end in fiscal 2023. East Coast is newly contracted under the GDP-sharing model and includes high single digit growth expectations. As discussed earlier, even in a worst case scenario, this contract will not depress the overall cash flow generated from other businesses in the Company. In the meantime, Stagecoach expects a 3% margin for the remainder of the franchise - there is substantial upside in earnings if performance follows expectations.

Going forward, there will be a robust pipeline of franchises available for bidding (9 upcoming franchises in the next 4 years). SGC is currently shortlisted as one of the two candidates for Southwestern and is expected to participate in more applications as they become available. While difficult to determine at this point, we think given the challenges recent franchises have come across and the uncertainty associated with Brexit, the bidding environment could be positioned towards greater conservatism, leading to longer term upside for operators.

North America (GBP431M in revenue, GBP19M in operating profit):

North America segment is composed of commercial intercity business and a series of chartered coach/bus businesses. The largest and most exciting part of the segment is the intercity Megabus group. Megabus boasts fares as low as $1 for travels between major cities in the United States and Canada. Unconventionally, Megabus caters to a younger, urban student audience rather than the typical lower economic status customers of long distance coach travel. It employs an ultra-low cost model of minimal fixed assets (by eliminating depots and ticket offices) while providing more value-add services like free onboard wifi and electric sockets. As a result of its unique value proposition and successful positioning, Megabus has single-handedly changed the intercity bus travel industry, reviving it from its preceding 50-year demise.

Intercity bus travel (YoY growth):

Since its beginning in 2006, Megabus has grown 22% p.a.. However, similar to the UK Bus business, Megabus has experienced strong headwinds in recent periods. Intercity bus business is very closely tied to the price of fuel. As fuel prices decrease, the cost of self-driving becomes significantly lower, consequently reducing demand for alternative modes of transportation. As a result, Megabus posted weak growth in North America over the last year and half. Although we do not have a view on long term fuel price, we expect that there is significant upside in a case where fuel returns to pre-late 2014 levels. If fuel stays at current levels, Stagecoach will likely have to terminate routes with insufficient demand, which will reduce the size of the business. The negative effect may be partially offset by improved margins, as there are a large number of newer and less attractive routes that are still in the investment phase.

To summarize, we think that Stagecoach is a high quality business that has been hit with many challenges across geographies in recent periods, most of which are short term in nature, making this an attractive entry point for investors. The market has extrapolated its current trading performance to the indefinite future and the stock consequently trades at a significant discount to the market as well as its historical record; its current share price is at the lowest level since 2009.

Valuation

We have a target price of GBP2.47 based on a DCF using a 10% discount rate and 2% terminal growth. Our bear case assumptions detail a scenario where passenger growth declines significantly greater than historical levels and SGC loses most of their existing rail franchises without replenishment. If you assume that they maintain a steady business in rail through successful bids/renewals going forward, there is 49% upside with a target price of GBP3.02.    

Brexit risk

While the referendum would likely introduce additional uncertainty in the Company’s near- to mid-term results, the negative impact of any decrease in UK GDP would be somewhat offset by reduced discretionary spending, leading to greater adoption of lower cost forms of transportation. In fact, the UK regional bus industry has historically performed well during recessions with traffic fairly uncorrelated to GDP. SGC in particular has managed to grow this core segment in recessionary environments. UK bus revenue increased by 22% and 12% in 2008 and 2009, respectively. SGC’s smaller rail business is more exposed to macroeconomic factors. The market seems particularly concerned about East Coast Trains due to the aggressive growth assumptions embedded in the Company’s bid. In our view, the contract is set up to protect the Company against negative deviations to GDP growth from SGC’s initial forecast, as much of the impact will be absorbed by the government. Furthermore, we have conservatively assumed a 0% margin over the course of the franchise. SGC’s maximum capital at risk in the franchise is less than 15% of its market cap, however, due to the structure of the private/public partnership and the importance of this railway, we believe that it’s highly unlikely that SGC will ever sustain losses anywhere near this amount as the contract would be restructured in extreme downside scenarios.

Catalyst

Time