Go-Ahead drives up yield

At first, the idea of buying shares in a government-subsidised sector, such as public transport, might seem fool-hardy in the current climate of cost-cutting. On reflection, the long-term rationale for buying bus and train operators is still secure, while a dividend yield of over 7 per cent on Go-Ahead's shares amply compensates for the short-term risk. After a dramatic share price slide over the past two months, the shares now look like a classic contrarian buy for value-orientated readers.

There are reasons for the recent weakness, of course. In late April Go-Ahead warned that profit margins on its London bus routes, which represent about a third of profits, had slipped 1.5 percentage points as contracts began to be renewed on tougher terms. Then last month it guided down profits expectations for the year to June 2011, citing reduced operating margins in its train division, which accounts for another third of profits.

The uncertainty surrounding the government's October spending review is adding to the gloom. A bus operator such as Go-Ahead gets state subsidies in two main ways. First, it receives money from local councils whenever passengers travel on concessionary schemes, such as the free bus pass for over 60s; second, the Department for Transport (DfT) rebates most fuel duty. Free bus passes have been ring-fenced, so the question is really whether the government will whittle away at the duty rebate.

Happily, radical reform looks unlikely. Go-Ahead and its rivals have made it clear they would have to raise prices and reduce networks if subsidies were dismantled - as they have the right to do in the unregulated market outside of London. This would reduce the value of any saving, as fuel duty receipts would be lower. And it would be politically costly. Buses are widely used, particularly by the vocal grey vote. With social inclusion and green issues second only to cuts on the coalition's agenda, public transport looks an unlikely victim.

Some profit erosion is to be expected as the government tinkers with the terms and conditions. But Go-Ahead's cash-generative business model looks intact. Crucially, this should allow it to maintain its dividend - the main reason for buying the shares. Even if the spending review is harsher than expected and the group's profits do take a dive, Paul Butler, an analyst at investment bank Macquarie, points out it could at a pinch borrow to fund the dividend. The balance sheet is strong, with net debt currently equivalent to only one year's operating profits.

Investors would be foolish to expect the dividend grow any time soon. The board will probably use any recovery in profits to rebuild cover rather than increase the payout - underlying earnings are currently only about 1.5 times dividends.

But, for those with a five-year investment horizon, Go-Ahead starts to look more like a growth story. That's partly because public transport is still growing at the expense of cars, particularly in the south east, where Go-Ahead is focused. And there is scope for acquisitions. The local bus market outside London remains fragmented, with a third of services run by councils or independent operators. On average, Go-Ahead has bought small players at the rate of three per year over the past five years and that should continue. The group prides itself on a decentralised, adaptable approach to running services, which appeals to local councils. It's also on decent terms with the DfT, which should help when new rail franchises come up for grabs. "Go-Ahead hasn't blotted its copy book once," says Paul Hickman at brokerage KBC Peel Hunt.