UK rail and bus: back on track?

Specifically, the allocation of the new Thameslink, Southern and Greater Northern rail franchise has grabbed investors' attention. The Department for Transport's (DfT) decision to award the high-profile franchise to a Go-Ahead (GOG) subsidiary Govia - passing over rivals FirstGroup (FGP) and Stagecoach (SGC) - is a real boon for the company. Govia, which is 65 per cent owned by Go-Ahead, will take over the Thameslink franchise this September, when it merges with the existing Southern network.

Go-Ahead’s rivals undoubtedly mourned the lost opportunity, especially as Stagecoach and FirstGroup insisted they submitted ‘quality bids’ for the contract. But within weeks of the Thameslink revelation, Stagecoach won back investors’ confidence with a successful extension to the West Coast franchise, which it runs through a joint venture with Sir Richard Branson's Virgin Group. The new contract means Virgin will manage the running of the line until April 2017.

After 15 years as operator, Virgin lost the contract in 2012 to rival company FirstGroup but mounted a headline-grabbing legal challenge against the decision, claiming there had been problems with the bidding process. After the government conceded that mistakes were made, it reinstated Virgin as the operator for 23 months and temporarily suspended three DfT employees. The public relations aftermath was not pretty and prompted a loss of confidence in the sector, which has now dragged on for nearly two years. Come April 2017, the West Coast franchise will have been in ‘temporary hands’ for nearly five years, and the government will be forced to make a firm decision as to who will run the line long-term. In the meantime, Virgin has promised to fund several improvements to the existing service, including a £2.5m interior refurbishment of its Pendolino trains, £2.8m on better catering facilities and £20m worth of station upgrades.

The Virgin extension marked the sixth contract to be re-allocated from the government’s new franchising schedule, announced last March. Transport Secretary Patrick McLoughlin revealed long-term plans designed to drive improvements to rail services, deliver on major infrastructure projects, and ‘put passengers at the heart of a revitalised rail franchising system’. As far as Britain’s transport companies are concerned, the new approach is paying off. Bidding for new franchises is as tough as ever - and the share price performance of the bidders is largely dependent on such awards - but there is confidence that a repeat of the 2012 debacle and the subsequent impact on the FirstGroup share price, is unlikely.

FirstGroup's share price is up by 37 per cent over the past 12 months, but its near-term performance could be undermined by external issues. The difficulties are in large part down to a troublesome activist investor – Tom Sandell – who is urging the company to separate from its underperforming US business. Under the auspice of his US fund Sandell Asset Management – which owns 3.1 per cent of FirstGroup – the Swedish billionaire is urging the board to sell off its Greyhound intercity US coach service and spin off its school bus division. But FirstGroup chairman John McFarlane says there was ‘no financial logic’ to the sell-off plan and shareholder support for Mr Sandell’s recommendations are lacking. Furthermore, he insists shareholders must realise any improvement in the US business will ‘take time’ and that there is ‘no alternative’.

But controversy for FirstGroup is likely to continue. It has missed out on the Thameslink contract and the new Docklands Light Railway contract (which went to a joint venture between French transport group Keolis and infrastructure provider Amey, part of Spanish multinational Ferrovial) but still intends to double the pay package of chief executive Tim O’Toole to £1.2m. The motion – which will be put to a vote at the group’s annual meeting in Aberdeen this week – was announced after a £50m cash return to shareholders was scrapped. Many FirstGroup shareholders have made clear their lack of support for Mr Sandell’s position, but this hasn't stopped them from voicing their own concerns over the progress of the group's turnaround plan.

Even National Express (NXP) which has long had problems in its rail business is pulling ahead of the competition by retaining its Essex Thameside rail franchise – branded as C2C - until 2029. The deal is the group’s only rail franchise but represents a crucial hold in the UK rail market. Unsuccessful bidders for the line, which runs from London to the Essex coast, spanned as wide as Dutch group Abellio, Hong Kong metro operator MTR and – you guessed it – London-listed FirstGroup.

But while most attention goes to operators' rail divisions, one shouldn’t ignore the management of the UK bus market. Bus routes are facing an ever-changing regulatory climate and while Stagecoach said its regional bus division drove pre-tax profits 2 per cent higher to £181m for the year to April, changes in the North East of England pose a real threat for operators there. Local bus services outside of London were privatised and deregulated in 1986. Since then, private sector operators have had considerable freedom to run commercial operations. But subsequent legislation has made it possible for a local authority to re-regulate bus services within their given region. Now, an ongoing attempt by NEXUS – the passenger transport authority for North East England – to impose a regulated system of bus contracts could threaten competition in the market. If successful, a move to re-regulate bus services in one region could be followed by others and dramatically altar the financial dynamics of the industry. In that event, Stagecoach could have the most to lose given it runs numerous operations across the region.

IC View:

We’ve remained fairly neutral across many of the companies in the sector as the effects of 2012 played out over the last two years. Now, momentum has returned for many stocks, especially Go-Ahead, which is trading at a five-year high. In terms of buying opportunities, National Express has suffered recent weakness, making a forward PE ratio of 12 more attractive than FirstGroup or Go-Ahead. The bidding war for franchises is back to full health and with the government keen to avoid a repeat of the West Coast debacle, one assumes the terms are fairer. Longer-term contracts should also prove beneficial for operators.

Favourites

We’ve maintained a neutral stance on the sector for some time given the uncertainty over several high-profile franchises and the public relations crisis facing the sector after 2012. Now, however, prospects look improved and National Express (NXP) is the most attractive company based on the forward PE ratio alone. It’s putting a sluggish performance in Spain behind it and proving its worth in the British rail market. The quality business is clearly Go-Ahead (GOG), particularly now it has added the Thameslink franchise to its portfolio, but investors should remember the shares are priced at record levels.

Outsiders

The weak link in our opinion is still FirstGroup (FGP) - but this isn’t down to a lack of progress in the turnaround plan. On the contrary, there are inklings of improvement across its existing network but a lack of new franchise wins and continued clashes between the board and high-profile shareholders is off-putting. The strategy to return to full growth remains unclear, the shares don’t offer a compelling valuation and it’s the only one of Britain’s ‘big four’ to have scrapped its dividend. In short, it has the most work left to do comapred to its competitors.