Go-Ahead hits the buffers

Logic dictates that transport companies should be among the more defensive stocks at times like these, thanks to guaranteed income, effective monopoly over services and rising passenger numbers. But the de-rating of transport shares has been savage over the past six months and the signs are that falling passenger numbers, high fixed costs and the risk of deflation hitting tickets prices will tear strips out of Go-Ahead's immediate profits, with the prospect of several years of stagnant growth beyond that.

Go-Ahead is a major bus operator - a business that produces wide profit margins and should recoup the effect of high fuel costs as diesel prices go into reverse. However, operating rail services generates about two-thirds of group profits, most of which stem from the valuable Southeastern franchise into London Bridge station. First-half results for 2008-09 showed a slightly higher operating profit for rail operations of £3.5m, due to a modest increase in passenger numbers. But the trend from now on will be down.

According to stockbroker Blue Oar Securities, passenger numbers from the peak to the trough of a recession have usually fallen by around 7 to 10 per cent, although 1980 was worst when the fall was nearer 17 per cent. Assuming a best-case scenario, where numbers fall by a benign - and optimistic - 4 per cent, Go-Ahead would still see earnings per share drop by 29 per cent, making it the second-biggest loser among travel companies after National Express. The broker's most bearish scenario is an 11 per cent fall, which would hit profits by 61 per cent.

The problem is that falls in passenger volumes are a lagging indicator of economic health, so passenger numbers stay depressed years after the end of a recession. Simultaneously, the industry's high fixed costs mean that Go-Ahead has little flexibility to protect its profits during this period without breaking its obligation to provide a minimum level of service. It has already announced some 300 redundancies, but there is unlikely to be scope for many more.

More share tips and updates...

Coupled with this is the ongoing uncertainty over the fate of its Southern rail franchise into Victoria Station. A new franchise will be awarded in June this year, after several delays, and Go-Ahead says it has submitted a bid that "reflects the economic climate".

While losing Southern would be detrimental to Go-Ahead, it is questionable whether it is worthwhile for transport operators to make the effort to keep franchises. That's because the recession has exposed serious flaws in the way the system works. Price increases in most tickets are restricted to retail price inflation (RPI) plus 1 per cent, which worked well when passenger numbers were growing. But, under this system, if the economy approaches a deflationary spiral, then tickets prices will barely rise, thus eroding the group's profits while taking no account of any increase in discretionary costs. Some travel companies are said to be lobbying for changes, but allowing rail companies to raise ticket prices well above the inflation rate, or passing them higher subsidies, would prove politically explosive.

Go-Ahead also needs to decide what to do with its troubled aviation services business. Performance is linked to the global aviation market, which has seen big falls in both freight and passenger numbers. In the first-half of 2008-09, aviation's operating losses increased to £1.7m. In addition, the group had to book a £38m non-cash charge against the falling value of this division's assets. Go-ahead is unlikely to sell into a depressed market so aviation services will continue to be a drag on overall profits.