Stock to Watch: Stagecoach Group

Scouring for companies with genuine scope for earnings upgrades might seem an impossible task right now; yet public transport group Stagecoach Group has enjoyed this from one broker following a trading update; and the forecast's context looks modest enough that possibly others may follow.

While the company looks to be benefiting from fare increases of about 6% this year, more people seem to be using public transport now petrol costs so much for cars. This effect has helped offset Stagecoach's own fuel cost rises, although it will see a reduction in the bus service operators' grant from April 2012.

If a chronic recession follows, higher unemployment is likely to reduce fare take but the recent solid performance is a reminder this is an 'essential service' share.

A 1 November trading update has affirmed progress in line with expectations: UK Bus revenues up 2.2% for the 24 weeks ended 16 October, UK Rail up 8.7% and Virgin Rail up 9.7%. North American revenues rose 12.0% in the five months to end-September.

The bus division has enjoyed stronger than expected commercial revenue growth of about 5%, and London bus earnings should be helped by restructuring the East London bus operations. UK Rail is set to report a £7-8 million first-half loss due to heavy losses at East Midlands, although revenue in the second half (to end-October 2012) should see year-on-year progress in operating profit. The company is also shortlisted for the new West Coast rail franchise and there are another dozen or so rail franchise opportunities between 2012 and 2014.

In North America there are start-up losses linked to new Megabus hubs, albeit these are expected to boost future profitability. Strong and sustained revenue/profit growth is expected in the coming years, making this an operation to follow - despite the US representing a modest 12% of group revenue in the 2010/11 year.

After meeting with the company, broker Panmure Gordon edged up its earnings per share forecasts by 2% for the current year to end-April 2012 and for the next two years by 5% and 3% respectively - upgrading its target price from 230p to 280p and moving from 'hold' to 'buy'. If the fair value target is realistic then it implies about 20% upside from the current price of about 240p if you include a 3% yield.

This latest forecast is slightly ahead of the consensus published in Company REFS, so it will be interesting to watch if any more analysts upgrade. It comes in a fairly undemanding context of a price-earnings multiple of about 10 times the 2011/12 outlook, falling below nine times for 2012/13. The annual earnings per share growth expected is modest however: about 5% rising to 10%. At least the market is already taking a cautious view, which helps the shares' risk/reward profile.

Although the FTSE 250 shares are down about 15% from a 272p high this year, the overall chart has shown robust progress from a 106p low in March 2009. Admittedly the market price has plunged before amid fears of recession - from 332p during the 2008 financial crisis - but this was not immediately followed by a downturn in the company's financial results; indeed turnover continued to grow throughout, aided by modest acquisitions. Normalised pre-tax profit saw a dip in its growth trend, from £192 million to £152 million in the financial year to end-April 2010, then a recovery to £199 million.

Also in terms of the risk/reward profile, while the price-earnings multiple may be entertaining single figures the prospective dividend is only 3% or so - hence not a lot of support to cushion downside, if the economic situation worsens significantly, although projected cover relative to earnings is a strong three times.

And while the end-April balance sheet had only £119.5 million goodwill/intangibles versus £924.3 million property, plant and equipment, the £246.2 million net asset value worked out at 42.7p a share - so not a lot of support there either.

The balance sheet has recently been a moving feast with a one-off return of cash about £340 million (virtually all the cash that was accounted for, at end-April) just recently, said to create a more efficient capital structure. The market appears to have shrugged this off as it hasn't made any real difference to the share price and it could be seen as a curious move when a cash hoard might be useful for acquisitions in a recession.

Although the group had £358.3 million cash at end-April, long-term debt was a fat £592.1 million and short-term debt, £62.5 million. Finance costs near £40 million compared with 2010/11 operating profit of £225 million, mitigated by £5.4 million finance income - a manageable situation, if a bit of a drag on profit. So it is understandable that the market appears to be taking a "wait and see" approach, towards the claimed benefits of the recent capital return, relative to paying down debt.

The key issue of judgment surrounding Stagecoach shares remains public behavioural: how bus and train usage is likely to trend in a modestly recessionary scenario. If the company can continue to show resilient performance and outlook relative to other firms needing to warn on profit forecasts, then its shares can recover to 270p and better.

The main risk is a more serious recession that begs questions why the board did not use its cash hoard to more aggressively cut debt hence protect operating profit.

The next update is likely to be interim results in early December.

For more information see www.stagecoachbus.com.

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