A to B economics
Last week, I had the dubious pleasure* of taking a coach owned by the Stagecoach Group. For research purposes, of course, and in the hours spent rolling along dreary roads I got to thinking – as I suspect most investors do – about the economics of the box I was sitting in. It was reasonably well occupied. Even so, the fares charged by these transport companies – and we can easily extend this example to the low-cost airlines, too – still surprise people. My initial guess is that it has something to do with our economic history – we just haven’t quite got to grips the size and scale of the efficiencies these enormous companies can squeeze out of a relatively simple, commoditised service. Relentless focus on price and efficiency is, when you think about it, a relatively recent obsession.
Like any dutiful investor, then, I came home and fired up a few annual reports. Were they in line with my expectations? Did I understand the business? Perhaps more interestingly – is there any value there? To step back a second, I had expected an indebted (revenues seem stable and predictable, which encourages leverage) business earning probably relatively close to its cost of capital. It doesn’t sound too attractive at the moment, but the economics of the industry do appeal to me. It strikes me as being a stable sector. Players in transport tend to be big and entrenched, likely partly because of the dual benefit of being more efficient in a national market and navigating a sector which has strong links to the Government. I don’t think it’s too much of a stretch to pencil in at least some growth in the wider market, too – something seems likely to become a discouraging factor in oil use in the next couple of decades, whether it’s the rising baseline cost or climate related. Ways of efficiently getting a large number of people from A to B seem like one of the better economic bets I can make.
The low down
It turned out to a be a pretty decent guess. Stagecoach Group – which I should say now does far more than just the coach stuff I was specifically thinking of, including US operations, UK Rail operations and more local businesses – do mostly tick the first box. If we capitalise operating leases, which work out at about £1bn, and add on the £523m of net debt the company holds on its balance sheet, we get a not-insignificant figure relative to its profits/cashflow and assets. As I mentioned before, that isn’t necessarily a bad thing – there are good economic reasons for having a high level of debt if revenues and profits are predictable enough. On that note – they have been fairly predictable, as one would expect. Most of the deviations from trend in the graph are due to tax timings and the like.
It’s also fair to say, though, that they earn more than I expected. In a refreshing change from most of the small caps I look at, my estimate of returns on capital is quite consistent:
Note: I played with the working capital figures a bit. Usually I simply calculate year-by-year data; but given Stagecoach some years running enormous excess cash balances, which are then paid out to shareholders the following year (giving evidence to the prior assumption, that they are likely excess) I moved things around a bit to hopefully better represent the company’s operational needs.
If you run the DuPont formula on Stagecoach, which I sometimes do if I’m curious where improvements are coming from – it gives us a little more bite than saying they’re getting more ‘efficient’ – asset turnover has improved. Whether this is a mix issue, a shift from one segment to another, or is indicative of a general improvement is a more complicated question. Margins are noisy but also seem to be on an upward trend.
The overall feeling I get is a well-run company, managed in the interest of its shareholders. Returns are good, above any reasonable estimate of cost of capital for a company of this size and stability (though perhaps a gap that’ll narrow as the macroeconomic environment becomes a little less.. goofy) giving growth value here.
There’s the company – and the price? Well, that bit’s not quite as tempting. It’s not particularly cheap, given the levels of debt and effective debt; we have to pencil in some sort of growth if we want to arrive at the current value. I don’t doubt that’s likely – as I mentioned above – but it serves as a useful mental nudge that Stagecoach isn’t priced for underperformance. Their interims, as a note here, reported LFL revenue up 5.9% and profits up about 30%, driven mostly by improvements in the rail division. So, probably overpriced – but since I like the business, I don’t mind shortlisting it. I’ve also remember that I need to look at Rotala, which is a small, AIM listed bus and coach company. Perhaps that’ll offer better value.
*For the record, I should state here it was actually quite pleasant! Perhaps it was the relentless lowering of my expectations by public perception of them, but I thought it was reasonably punctual, clean and comfortable.