FirstGroup on the right road

FirstGroup looks a nicely-balanced transport business that is better at transforming capital into cash than most of its rivals, including Arriva and Stagecoach. Historically, this has given its shares a premium rating to shares in other travel operators. Now, however, they're trading at a significant discount, which looks unfair. Although there's no immediate catalyst, we think it won't test too many investors' patience to wait for a re-rating.

True, the discount is there for a reason. It reflects worries that profit margins in the company's large and lucrative division that runs yellow school buses in the US will fall as pressure mounts on public spending. Cash-strapped state schools, investors fret, will not only stop taking school trips, which secure extra revenues for FirstGroup, they'll also renegotiate their contracts at lower levels.

This is a risk, certainly, but it's an outside one. Safety concerns put schools in a bad negotiating position for their basic student transport service. And chief executive Moir Lockhead said in March that ancillary revenues would "recover as the economy strengthens" - which now seems to be happening.

Besides, there's another side to the coin: if their budgets come under pressure, schools may cut their costs by outsourcing their bus service. The total yellow bus market is estimated at $22bn (£14.3bn) - only 36 per cent of which is contracted to independent operators. Winning a bigger share of the pie is a real growth opportunity.

With a leading 34 per cent share among the independents, who are otherwise highly fragmented, FirstGroup is in a strong position to benefit from this trend. This is why Geoff van Klaveren, an analyst at Deutsche Bank, forecasts a "bright future" for the division, which can use its "unmatched economies of scale" to consolidate a fast-growing market.

First Group is well balanced between these growth prospects and the cash cows of its UK bus and rail operations. The bus services it runs for various local councils are particularly rewarding, with a profit margin of 11.3 per cent last year. Its rail franchises are slightly less profitable but, as both political parties broadly support more investment in railways, there is some scope for expansion - albeit at a pace dictated by politicians.

Both UK businesses are highly cash generative and - crucially - that cash flow is supported by long-term contracts and government guarantees. Rail franchises proved the undoing of National Express last year, which was losing so much money on the once-profitable East Coast line that it decided to pull out, risking the ire of the Department for Transport. But FirstGroup's contracts were negotiated so long ago that they qualify for revenue support, insulating the company from the fall in commuting and leisure travel that hit its rival.

However, one FirstGroup business did suffer during the recession: Greyhound, which operates the iconic long-distance coach service in the US. The division's revenues fell 22 per cent in the first half of 2009-10. But the latest numbers are encouraging, with a 1.1 per cent year-on-year increase for the fourth quarter.

FirstGroup's ratio of debt to equity is also a concern. The company owes its US operations to the transformative - but expensive - acquisition of Laidlaw in early 2007, and it paid £179m in finance costs in 2008-09. Yet strong cash generation combined with low interest rates makes the payments easily affordable and, after two long-dated bond issues last year, FirstGroup's maturity profile isn't risky either, with an average duration of 6.4 years. Most likely, management could also sell Greyhound easily enough to raise cash - as was initially planned.