Interactive Investor

Is FirstGroup's slump a buying opportunity?

1st June 2017 13:43

David Brenchley from interactive investor

Jeremy Corbyn's Labour party has made significant gains in recent polls as it attempts to bridge what, at one point in the election campaign, seemed an impossible Conservative lead. A poll Thursday, after last night's BBC election debate, puts Labour just three points behind the Tories, meaning the incumbent party would lose its current 17-seat majority.

Of course, we don't take these polls at face value – remember what happened in the run up to the EU referendum and US presidential elections – but if Corbyn is handed the keys to Number 10, renationalisation of rail services will be high up on his "to do" list.

That's bad news for the likes of FirstGroup and Stagecoach. And, although most still believe Labour stands no chance on June 8th, talk of a "mixed trading environment" and "continued economic uncertainty in the UK" caused a rush for the exit Thursday.

That's despite forecast-beating final results, led by an improving North American business where margins surged in the 12 months to 31 March.

Group revenue of £5.65 billion matched expectations, while operating profit adjusted for one-off items of £339 million – up 13% – was almost 3% ahead of consensus. Adjusted pre-tax profit of £207 million was up 23% year-on-year, giving earnings per share (EPS) of 12.4p, up by a fifth.

We mentioned last year that broker Goldman Sachs pointed to margin recovery being the priority for FirstGroup. Mission accomplished, it seems. Overall, margin ticked up 20 basis points to 6%.

FirstGroup runs the iconic yellow school buses in the States that ferry over six million kids to and from school per day. It operates in more than 500 locations across the US and Canada.

Its First Student division was the key driver of those margin improvements, delivering 250-basis point growth to 9.6%. Cost cutting helped, explained boss Tim O'Toole, as did successful execution of recruitment plans in the face of "ongoing driver shortage challenges".

First Student's "excellent performance" was offset by First Rail margin, rebased under new contract terms, and higher fuel costs for UK businesses due to the strong dollar.

First Transit is also mainly North America-focused, and chiefs see "opportunities for steady progress" across the pond, in contrast to the economic uncertainty in the UK.

The company has been making headway over here, though, and the award of the South West Trains franchise – which had been run by rival Stagecoach for the past two decades – helped the share price recovery. FirstGroup, which has teamed up with Hong Long firm MTR, takes over the franchise in August.

It adds to the Great Western Railway and Trans-Pennine Express (franchises running until 2020 and 2023 respectively) in its First Rail division, which saw like-for-like passenger revenue up 1.3%, "reflecting industry-wide slowdown and infrastructure upgrades" on its network.

The derailment of a FirstGroup-operated tram in Croydon in November added a sombre backdrop to results. Investigations are ongoing.

And UK bus performance disappointed.

Cash generation has been good, with free cash flow seeing a "significant improvement" from £30 million in 2016 to £126 million in 2017.

Overall, more of the same is expected by both the company and analysts. FirstGroup expects rail margin to reduce again and to improve cash generation.

FirstGroup shares, glued to the 100p level late last year and into 2017, have been on a strong run, surging 21% since the award of the South West Trains franchise. However, they plunged 10% Thursday to a low of 134p before bargain hunters chased them back up above 140p.

But is this pullback a buying opportunity?

Consensus is, no, though broker Liberum does think FirstGroup trades on an "undemanding" forecast 2018 price/earnings (PE) ratio of 10.4 times and an EV/EBIDTA of 4.1 times.

While the dividend was off the table last year, the firm says it remains committed to reinstating a "sustainable dividend at the appropriate time". Liberum and Canaccord both expect this to be in the full-year 2018.

Others are more cautious, with UBS 'neutral' and Canaccord's Gert Zonneveld points to a PE of 11.6 on his forecasts, a 24% premium to its five-year average.

A price target of 125p suggests the stock has done enough, though there looks to be a measure of support around 136p, matching UBS's price target to the penny.

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.

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