Stockwatch: Hop on this contrarian recovery play

On a forward price/earnings (PE) ratio of as little as 8 times, does mid 250 transport operator FirstGroup now represent value at 98p? Chart-wise it is bumping along the bottom in a channel range of 90p to 140p, having de-rated from over 400p - a harsh reminder how high debts can compromise a business and erode equity value. But a transformation plan well underway means analysts project profits re-establishing nearer 2011/12 levels, with earnings per share doubling from 6.2p normalised in the last financial year ended March (see table).

The relatively modest EPS recovery is due to a deeply-discounted 3 for 2 rights issue at 83p in June 2013, to pay down debt and continue investment, as shown by relatively high capex figures relative to cash flow and earnings. The balance sheet remains goodwill-heavy and supports £1.5 billion net debt versus a current market cap near £2 billion, although credit ratings are improving.

Such a stock may not feature on "conviction buy" lists, but a lack of interest together with operational progress and trading updates "in line with expectations" can imply attractive risk/reward in its pricing. Despite a slowdown in growth in the UK bus business and ongoing decline in the US Greyhound operation, the group is on an overall improving financial trend - offering essential services with an aspect of market leadership.

Scope to restore dividend

Another reason the stock has languished can be explained by the dividend. Previously in the high teens' pence per share, the payout was suspended from May 2013 and is only expected to restore at 2-3p - currently implying a prospective yield of about 3%. This is insignificant for a mature industry somewhat lacking in growth prospects - the kind of situation where directors typically maintain a high dividend to attract income-seekers. Yet FirstGroup reckons sustainable cash generation will rise over the medium term (despite being broadly flat in the current year) as multi-year improvement plans kick in. It implies scope to raise the payout, and if forecasts are correct the 2016/17 dividend would be over six times covered by earnings.

Overall trading on improving trend

Prelims for the year ended March 2015 cited underlying revenue up 4.1% despite exceptional factors reducing the reported figure by 9.9%; adjusted operating profit up 13.3% and attributable profit by 48.2% following a transformation plan. Meanwhile, net finance costs fell 19.4% to £140 million versus £245.8 million operating profit. Geographic/currency exposure comprised 52% of revenue deriving from the UK, 41% from the US and 8% from Canada.

A mid-July trading update maintained this "in line with expectations" theme and Standard & Poor's upgraded its outlook to "stable" from "negative". Then a latest pre-close update for the six-months ended September has the chief executive heralding: "sustainable improvements despite a more challenging trading environment in some markets." Its operational review reads robustly (see the About FirstGroup web-page for divisional particulars) for a stock on a forward PE of about 8 times. First Student, the US bus business that is the group's largest, has grown margins while also retaining contracts, which should benefit the second half-year.

Meanwhile, First Transit, also in the US, has seen some reduction in demand due to lower shuttle activity with the Canadian oil sands, although further contract awards have mitigated this. Greyhound, the largest provider of intercity buses in the US with operations also in the UK South West, has seen muted demand especially for longer-haul US journeys, with revenues expected to fall by 6.2% in the first half, albeit with various improvements due this autumn.

The ongoing transformation of UK Bus meant revenues edged up 1.3% in the first half and cost efficiencies were achieved: selected depot closures mean a £7 million exceptional charge in this year's accounts but which will accelerate medium-term targets. UK Rail has seen further strong passenger growth, for like-for-like revenue growth in the order of 7%, with overall financial performance "toward the top of our range of expectations" Having previously lost several franchises, UK Rail has been shortlisted for East Anglia and the TransPennine Express. So altogether a "good in parts" review but at least the net trend is upwards and actions are being taken in weaker areas.

Off the naughty step

Admittedly, the balance sheet still looks quite awful with nearly £2 billion gross debt (93% long-term) at end-March, in context of nearly £1.5 billion net assets - wholly represented by £1.85 billion goodwill and intangibles. FirstGroup's debt has appeared stubbornly high versus free cash generation relatively low - and which is expected to be broadly flat in 2015/16. The chief risk is margin growth proving tougher than hoped-for, thereby compromising profit forecasts, hence this stock needing more patience. An interest rate rise would be another issue, together with sustainability of the UK/US recoveries.

Yet if management can meet its claim to grow cash flow and restore dividends then FirstGroup has scope to creep up over years - as contrarian stocks are prone to. While analysts at Panmure Gordon retain a "hold" stance, seeing few catalysts in the near term, Shore Capital advises "buy" - expecting a dividend in the current year, then for cash flow to build strongly in the 2016/16. "We believe it is only a matter of time before the market begins to take FirstGroup off the naughty step." Even Panmure targets 120p, while Investec look for 125p, likewise Nomura, with JP Morgan Cazenove more optimistic in targeting 162p, and Panmure 120p. Admittedly, recent price targeting has been down, but stances are affirmatively "hold/buy" with no sellers.

Such a moderately positive consensus around the current share price of 98p looks to imply longer-term upside if management delivers like it says. Interims are due Thursday 12 November.

For more information see firstgroup.com.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.