Few companies are as exposed to public-sector austerity as the 'Big Four' bus and rail groups. FirstGroup, Stagecoach, National Express and Go-Ahead all gained hugely from the largesse of the second and third Labour administrations, when public-transport subsidies grew steadily (see graph). But since the May election, fears that they stand to lose their place in the sun have sent the shares skidding.
The question now is whether those fears are overdone. Most 2011 earnings multiples are now in single-digit territory, while dividend yields in excess of 6 per cent are on offer from FirstGroup and Go-Ahead. And that's for companies that provide environmentally-friendly transport services most citizens can't do without - not the kind of thing governments can blithely cut. Is this a contrarian buy for those that can see through the short-term gloom?
Buy bye
On balance, we don't think so. It's true that the October spending review was less hard than feared on transport as a whole. Including capital spending, the Department for Transport needs to reduce its budget by only 6 per cent by 2014-15, in cash terms. And most of the cuts won't kick in until 2012, so the budget will actually rise next year. The government has also honoured its popular pledge to ring-fence the so-called free bus pass for the elderly and students, which has boosted passenger numbers noticably since it was introduced in April 2006.
But the spending review did target the more obscure Bus Service Operators Grant or Bsog, worth £436m last year, which will be trimmed by 20 per cent. And it cut the local-authority transport grants, which support commercially unviable yet socially sensitive bus routes, by a savage 28 per cent.
The bus operators boldly claim these measures will not affect profitability. "The Comprehensive Spending Review should have no direct impact on the group in the current financial year [to 30 Jun] and at this stage we believe that we can manage any impact on our results in following years through a combination of further cost savings and recovery through fares," said Go-Ahead's management in an October trading update.
This is credible for this year and possibly next - the cuts to Bsog only start from April 2012. But after that it's hard to believe the government will let private bus companies get away with their trademark double-digit operating margins. The Office of Fair Trading has already referred the local bus market to the Competition Commission for over-charging. The ensuing report by consultants LEK concluded that the bus industry in England earned returns above its cost of capital. Even if the Competition Commission does not find grounds to fine the bus companies - after all, buses have to compete fiercely with cars - LEK's observations will make it easy for the government to cut its subsides. And with fare increases weighing on an already stagnant market, passenger growth can't be expected to make up the difference.
Derailed
The immediate outlook for the rail industry is more positive, partly because it is more closely tied to the economic cycle than the bus industry. Passenger numbers should recover with output and employment next year. After that, however, the picture is darkened by the government's decision to lift its cap on prices. The maximum annual fare increase will be RPI plus 3 per cent in 2012 - up from RPI plus 1 per cent now. Such hefty price hikes are bound to dampen demand, and the extra revenues will not directly benefit the train operating companies as the DfT has already ring-fenced them for new rolling stock.
Yet the economics of rail travel matter less to the train-operating companies than the terms of the franchise agreements they sign with the DfT. At least on this point the news-flow should be positive. The Labour government realised the current system needed reforming when National Express handed back the loss-making East Coast franchise last year, and the coalition has continued with the process.
The DfT's new business plan, published last month, contained a commitment to stop "micromanaging train operating companies with unnecessarily prescriptive requirements". This has been the main bugbear of the rail companies ever since privatisation; they say having greater license over timetables and stations would allow them to operate more commercially and, eventually, more profitably. But it all depends on how the new franchise agreements look. And even in the most positive scenario investors won't feel the benefit for years.
IC View
The bus and rail groups face a tough period from 2012, with little scope for growth either in the UK or abroad, where budgetary pressures are pretty fierce, too. Unless they find innovative ways of adapting to the new climate, low share ratings look likely to stay low. Yet there are two solid reasons for holding transport stocks. First, is takeover hopes. The logic behind Deutsche Bahn's purchase of Arriva this year remains sound and its arch-rival SNCF, or the Dutch rail company Nederlanse Spoorwegen, might be interested in one of the other UK groups. Second, it's not everywhere you find a 6 per cent yield supported by such solid cash generation. Dividends should be secure for 2011, if not much beyond.
| Outsiders |
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| National Express axed its dividend in the downturn and its yield is now estimated at only 2.2 per cent for 2010. It's also trading at a premium to the sector, which looks undeserved even if you factor in dividend increases and the group's significant turnaround potential. Stagecoach, meanwhile, is the most profitable of the four groups, and therefore has most to lose if the government decides to get tough on margins, as seems likely. |
