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With the odds of a recession rising, now might be the right time to own a solid business that should do better in bad times than in good. A further attraction is a yield near 11%.  People seem to have forgotten, but the stocks of recession proof companies get a premium when times are tough, so there could be some decent appreciation as well as yield.

THE COMPANY:  Student Transportation of America is one of the bigger companies providing school bus services in the US and Canada.  It was previously written up at VIC in 2005 by the prolific and persuasive Issambres839, and I recommend that report and thread.  A slide show presentation from the company at a conference last March is here: http://www.nbfinancial.com/webcast/ppt/Student%20Transport-NBF%20Conference%20-Mar28-07.pdf

STB is now the fourth largest provider of school bus services.  Its literature says fifth, but last week the merger of numbers one and two, Laidlaw and FirstGroup was completed, moving everyone else up one notch.  STB specializes in rural and suburban operations, where compared to urban markets the competition is less, margins higher, unionization risk lower, safety higher and the costs easier to control.  90% of its revenues come from normal school bus routes, with the rest coming from field trips, travel to athletic events, charter, summer camps and other.  Contracts with school boards typically run for three to eight years, and usually include various cost escalators.  Only rarely are contracts not renewed.

RECESSION RESISTANCE:  The contra-cyclical element mainly concerns labor costs, which are about half of total costs.  STB’s drivers mostly work part time, and are hard to recruit without wage increases when unemployment is low.  In a recession there are many more potential drivers available (e.g., it may be a necessary career choice now for ex mortgage and real estate brokers), keeping that expense down. Although concern about the impact of higher gasoline prices may be hurting the stock, in fact fuel is mostly covered by escalator clauses, and is a minor expense compared to labor.  Actually, high gas prices makes the school bus option much more attractive than driving the kids to and from school every day. If the buses fill up, then the school boards will have to pay STB to run more of them.  I’m not claiming that a recession is a godsend to STB, but it should help more than hurt, and very few companies are in that position.

GROWTH OPPORTUNITIES:  STB’s growth has come mainly from acquisitions and taking over operations previously run by the schools themselves.  There are still huge numbers of mom and pop operators in this field, and about 2/3 of the 450,000 school buses in operation in the US are owned and managed by the school districts, which lack the economies that a professional operator can provide.  With under 5000 buses to its name and revenues in the C$180M range, STB still has plenty of room to grow in a market estimated at $15B annually in North America.

STB’s acquisitions and proposals to take over operations run by school districts are not geographically random.  Rather, its focus is to increase density in an existing rural/suburban region, so that one maintenance facility can handle the buses in that area, and other economies can be realized that will give STB an edge in adding tuck-in acquisitions or school district conversions.  STB’s operations are currently in six regions, of which five are in the US and one in Canada.  STB has acquired more than 30 companies in the last ten years, and is experienced at integrating them.  Prices range from 3.5 to 5.5 times EBITDA.  STB keeps most of the acquired companies’ employees and business names, so it continues to be viewed as the local operator.

The Laidlaw-FirstGroup merger will result in some divestitures for anti-trust reasons, which might be of interest to STB.  At the very least it should make the largest buyer less aggressive for a while in competing for available companies, and could shake loose some experienced management and staff.

Contracts show a great deal of stability.  In STB’s ten years of existence, it reports that of 309 contracts that were up for renewal, it kept 293 of them.  Rural and suburban districts typically lack the staff or inclination to have a competitive re-bidding process.  That is why corporate growth is a lot easier by acquiring incumbents.

IPS UNITS VS. COMMON:  There are two related STB securities one can buy.  The company went public in December 2004 using the Income Participation Securities form, which are units consisting of one common share and one 14% subordinated note due in 2016 with an oddball par value of C$3.847.  These IPS units trade on the Toronto exchange as STB.un, with a Bloomberg symbol of STB-U.  They also trade in the US as SUDRF.  Not surprising given the coupon, the company wants eventually to eliminate the notes from its capital structure and have all trading be in the common, which also trades in Toronto as STB, with a Bloomberg symbol of STB CN.  To that end, last spring it had a private placement of common, and last summer it offered to exchange common shares for notes. Enough unit holders accepted that it was able to retire about half of the notes.  Even though there are now more detached common shares outstanding (~20.2M) than there are units (~11.4M), the units continue to have the more active market with the tighter bid-asked spread.

The notes are callable starting in December 2009 at a price of 105% of par.  If the company calls them then, as it has said it will probably do, then all the units will have the notes redeemed and will become identical to the common.  Even though the common trades lightly, one should always look at its price before buying the units; to the extent that one is paying more than 105% of C$3.847 (i.e., C$4.04) more for the units than what one must pay to buy the common, that overage is likely to be lost in two years, should the notes be called.

As of Friday’s close the units were the much better buy, since pricing was such that one was implicitly buying the 14% notes at a slight discount to par.  Given that half of them have been retired, and the notes are in a superior position to the common, they ought to be selling for a much lower yield than that, in my opinion.  But if the arithmetic works out that one is paying say $4.60 for the note portion of the unit, then I would be more interested in the common.

YIELD:  Dividends on the common are paid monthly at a C$0.04638 rate, a shade below 9% currently. The subordinated notes pay C$0.04488 in interest monthly, for a total of C$0.09125 per month to holders of the units.  Given that most of the company’s revenues come from the US, one could worry about the safety of the dividend as revenues from the US diminish relative to the Canadian dollar obligations.  But STB has been aware of this risk and has hedged 85% of its dividend needs through January 2009, and 60% of total anticipated dividends through 2012.  In addition, it has been expanding its operations in Canada at a faster rate than the US, providing more C$ cash flow.

While cash available for distributions has been rising faster than actual distributions, I wouldn’t expect much of an increase in the common dividend, if any, until the US dollar starts working its way back against the Canadian dollar.  I suspect that would happen if the world economy weakened enough to bring down the price of oil and other minerals, which has attracted currency speculators to the Canadian dollar.  On the other hand, a stronger US dollar would reduce the price in US dollars of the shares and units relative to the Canadian value, so I am not sure it makes any difference in the end.

STB’s balance sheet isn’t bad.  Besides the $45M of Subordinated Notes remaining after last summer’s stock for notes exchange offer, the main debt is $35M of Sr. Secured Notes due in 2012.  There remains substantial unused credit available for acquisitions.  If the company doesn’t clean up the subordinated notes with another stock exchange offer prior to the first call date in December 2009, I would expect that they would be refinanced at a rate a lot lower than the 14% coupon.

I won’t waste anyone’s time with detailed sales and cash flow estimates.  I expect steady modest growth in both.  Numbers for the September first fiscal quarter will be out this week, but with schools closed July and August they are the least important of the year..

In summary, the yield of the units is more than respectable, and should we be on the verge of a recession as appears plausible, investors will appreciate the characteristics of STB more than they do in good times.  Even assuming no dividend increases, a recession should lower interest rates generally, and STB’s steady results despite the economy could easily price the common to yield 7%.  Add in C$4.04, the 2009 call value of the notes, and you get a plausible target C$12 on the units, a 20% increase from here in addition to the 11% current yield. 

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