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A re-regulated route for the buses?

It might be a slow-moving piece of legislation, but investors in bus operators should be aware of the potential impact of the Buses Bill
November 20, 2015

Buses can be quite political. Local politicians are often campaigning to save bus routes or keep a lid on prices, so the chance to have greater control over their neighbourhood bus network could reap them political capital. And this is why investors in bus operators stocks need to pay attention to the Buses Bill announced in this year's Queen's Speech.

The Bill, if made law, would curtail the autonomy of commercial bus operators to select routes, the frequency of services and the price of tickets. The way would be open for local authorities to regain control of their bus networks. A detailed note by broker Liberum said there had been an assumption in the bus industry that last year's decision to pass franchising powers to Greater Manchester would be a one-off. But now Sheffield and Cornwall look set to receive similar powers, suggesting, the broker says, that commercial, deregulated operations are no longer the default option.

 

Heavier load

Bus services outside London are run on a commercial basis. This is beneficial for groups such as FirstGroup (FGP), Go-Ahead (GOG), National Express (NEX) and Stagecoach (SGC) as they call the shots about the type of services they run. This does mean that if passenger numbers fall, it hits them directly. In the capital, Transport for London (TfL) receives all passenger income and pays companies on a per mile basis. So if passenger numbers dip, TfL takes the hit, while bus companies' earnings are likely to remain the same as long as their costs don't change. There is, therefore, some protection here, but margins are lower.

If more local authorities decide to go down the regulated, franchised route, this could eat into bus companies' margins. In such a scenario, Stagecoach has the most to lose given that it has greater regional exposure, according to analyst research published by Liberum's Gerald Khoo. He favours First Group and National Express for their greater overseas exposure.

 

 

Alex Paterson, an analyst at Investec, acknowledges that it is "extremely difficult to say here are the risks and downside" without knowing what exactly will be in the Bill. But he notes that many regions are "envious of London", which has solid passenger numbers compared with the declining trend elsewhere. "There is political capital in increasing bus services," he says. "The concern is that regions will push towards franchising and, therefore, the margins achieved by bus operators in those areas - which are 12-14 per cent now - will be similar to London at 8-9 per cent." Mr Paterson said he suspected local authorities thought they could "capture some of the margins being generated by the private and particularly the listed operators" even though the history of the bus sector suggests otherwise.

 

 

Stumbling block

A total of 38 local authorities have applied for powers to run their own regulated bus franchise, but Mr Paterson expects that only seven or eight are likely to achieve success on a five-year view. The reason being that areas have to elect a Metro Mayor to be accountable for the system and form a Passenger Transport Executive - a regional version of TfL. Just seven transport executive bodies beyond TfL have been set up across the UK - six in England and one in Scotland. "Manchester has scheduled the election of a Metro Mayor for 2017 and we therefore suspect that the earliest that regional devolution of bus policy could take place is 2019," Mr Paterson adds.

Further proof of how slow the process is can be seen in the Tyne and Weir proposal. This was submitted in June 2013 but was only rejected this month (November 2015). The decision by the independent board tasked with reviewing the proposal was welcomed by both Stagecoach and Go-Ahead in stock market announcements, arguably showing their relief. Stagecoach Group chief executive Martin Griffiths said: "We welcome the review board's confirmation that the core franchising proposal was unaffordable, inflexible, high risk and not in the public interest." The company and its rivals will be hoping other proposals fall flat, too, especially if the Bill does not make provision for compensation should a company lose out in a revamped system.

 

Silver lining

While the Buses Bill seems to indicate that the status quo will not be the default, Andrew Jones MP, Parliamentary Under secretary of state at the Department for Transport, did say in a recent speech that franchising was "not the only thing on the table" and that he had "real ambitions to improve public transport in areas that do not wish to pursue re-regulation of the bus network".

Mr Jones said he was also keen to develop partnerships between local authorities and bus companies. This was something highlighted by FirstGroup's chief executive, Tim O'Toole, who said working with councils in places such as Sheffield, Bristol and Cornwall had led to improvements in the bus network far more quickly than would be likely under a regulated model.

Investec's Mr Paterson said such a partnership could involve a council requesting a certain route or smart ticketing - similar to London's Oyster card - from a bus group if the authority agrees to build a bus lane, for instance.

 

Other political impacts

A more immediate political impact could be a cut in the Bus Service Operator's Grant (BSOG), a fuel rebate recovered by bus and rail companies. Investec's Mr Paterson says total BSOG recovered in the UK was £300m for the year to March 2015 thanks to the 34.57p companies can claim back out of the 57.95p duty levy on fuel. But with the government keen to tackle its budget deficit, he thought the BSOG could be on the chopping block. "While we think it is far from certain, it is possible that BSOG could be cut on 1 April 2016, and that this will be announced in the Autumn Statement (around 5 December 2015)," he says. "We anticipate the magnitude of any BSOG cut would be around 20-25 per cent, meaning operators would then be able to claim back between 25.93p and 27.66p." He estimates that the impact would be most keenly felt at Stagecoach.

All these potential hurdles for bus services in the UK mean investors might want to investigate the overseas exposure of the bus groups. But, as ever in investing, this is not a panacea, merely diversification. For example, although FirstGroup has significant operations in the US, the low prevailing fuel price across the Atlantic acts as a disincentive against public transport in favour of private motoring.

 

 

 

IC VIEW: It might be a long-term issue, but the Buses Bill undoubtedly needs to be watched by investors - especially as the legislation has not been finalised yet. Even if its impact is limited to a few regions and is slow moving, investors need to understand the potential impact it could have on the transport stocks in their portfolios.

 

BROKER VIEW:

On the face of it, forthcoming changes in regulation and devolution of transport powers via the Buses Bill has the potential to reshape the bus industry landscape. The concern is that allowing local authorities to set their own transport routes, with the major UK bus operators then having to bid for the right to run them, would lead to a loss of market share and erode profitability.

One factor to consider is the political will of central government to support devolution, and while that remains, sector valuations could remain under pressure. Some local councils have expressed an interest in refranchising their own routes for some time, arguing that they would be able to offer better/cheaper services. But is bus refranchising the answer? Who would pay for the buses and the infrastructure required to support the bidding process under this new model? Currently the four listed UK operators annually commit hundreds of millions of pounds for bus purchasing. At a time when the public purse remains stretched, how wise would it be to jeopardise this?

A major factor will be the will of the local authority to enact this change. Considering this, private operators would do well to implement the aspirations of local authorities, such as WiFi, multi operator or transport mode agnostic ticketing options. One of the best defences against franchising in the long run may be effective partnerships with local authorities.

What proportion of the country would actually sign up for bus franchising? Could there be a critical mass of bus routes required to make it effective? We estimate that outside of central London less than 25 per cent of the UK population live in cities. So perhaps only a fraction of bus businesses would see their profitability eroded.

The next point is around quantifying regional franchised bus margins. Currently, the only franchised bus system exists in London, where profit margins are around one-third lower than regional non-franchised operations. However, could operators use incumbency as an advantage when bidding, particularly in the early stages of franchising, to keep margins higher than this? The final element of consequence is time as presumably it would take a number of years for even any of the UK to implement this route.

- Jolyon Wellington at JPMorgan Cazenove