Bus Electrification And London-Stirling Rail Route Will Improve Future Operations

Key Takeaways

• Electrification of the bus fleet, supported by partnerships and CapEx, aims to improve efficiency and margins long-term.
  
• Expansion in rail services and strategic growth initiatives are expected to drive revenue and diversify earnings potential.
  
• Government policy changes, reduced funding, inflationary pressures, and operational model transitions could challenge FirstGroup's revenue stability and profitability.

Catalysts

Provides public transport services in the United Kingdom.

• FirstGroup's focus on electrifying its bus fleet and depot infrastructure, alongside significant government co-funding and investment, is expected to enhance operational efficiency and reduce costs, positively impacting net margins in the long term.
  
• The company is expanding its open access rail services, notably with the recent acquisition of track access rights for a new route between London Euston and Stirling. This expansion is likely to drive revenue growth by increasing capacity and attracting more passengers over the coming years.
  
• FirstGroup's strategy of pursuing both organic and inorganic growth opportunities in both bus and rail, such as recent acquisitions and expansion into adjacent services, aims to diversify and increase earnings, contributing to overall revenue growth.
  
• The planned deployment of £125 million in CapEx for bus electrification and strategic partnerships like the one with Hitachi for battery technology are expected to enhance the company's capabilities, leading to better operational efficiencies and potentially improving net margins.
  
• The implementation of a £50 million share buyback program, combined with future opportunities for additional buybacks or dividends, is anticipated to improve earnings per share (EPS), thereby enhancing shareholder value over time.

FirstGroup Future Earnings and Revenue Growth

Assumptions

How have these above catalysts been quantified?

• Analysts are assuming FirstGroup's revenue will decrease by 23.9% annually over the next 3 years.
• Analysts assume that profit margins will increase from 2.6% today to 5.0% in 3 years time.
• Analysts expect earnings to reach £110.8 million (and earnings per share of £0.2) by about June 2029, down from £128.5 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the analysts, the company would need to trade at a PE ratio of 17.5x on those 2029 earnings, up from 7.4x today. This future PE is greater than the current PE for the GB Transportation industry at 9.8x.
• Analysts expect the number of shares outstanding to remain consistent over the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 12.5%, as per the Simply Wall St company report.

Risks

• The shift of train operating companies (TOCs) to public ownership as planned by government policy changes could lead to a decrease in FirstGroup's revenues and earnings derived from these contracts as they get nationalized. This transition represents a potential risk to the company's earnings stability during the transition period.
  
• Decreased government funding for bus operations and a potential reduction in contract profitability and net margins owing to increased government intervention or changes in subsidy schemes may impact future financial performance.
  
• Inflationary pressures, particularly in driver wages and engineering staff costs, could lead to increased costs which may not be fully offset by revenue increases, thereby potentially compressing net margins.
  
• The uncertainty and complexity of transitioning from a privately-operated asset ownership model to a franchising model in regional bus markets could pose risks to both capital-intensive investments and returns on capital employed.
  
• There could be potential delays and uncertainties in securing and launching new open access rail routes, such as the London Euston to Stirling service, which could result in delayed revenue contributions and earnings growth from these ventures.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The analysts have a consensus price target of £2.5 for FirstGroup based on their expectations of its future earnings growth, profit margins and other risk factors.
• In order for you to agree with the analysts, you'd need to believe that by 2029, revenues will be £2.2 billion, earnings will come to £110.8 million, and it would be trading on a PE ratio of 17.5x, assuming you use a discount rate of 12.5%.
• Given the current share price of £1.75, the analyst price target of £2.5 is 30.2% higher. Despite analysts expecting the underlying business to decline, they seem to believe it's more valuable than what the market thinks.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.