Why FirstGroup’s problems were easy to spot

Risk is more important than returns.  When investors focus primarily on returns, they’re likely to get sucked into whatever has done well recently and ignore the central importance of risk management.  And that’s when a major risk crystallises and whacks them around the head.

That’s exactly what we’ve seen with FirstGroup.

If you look just at the returns from FirstGroup, then they’re pretty impressive.  Dividends have gone from around 11p in 2004 to almost 24p in 2012, and they went up every year.  Ditto for revenues.  And it was going that way for earnings, too, until the financial crisis.

Investors thought this was a safe, defensive company with a bright future of reliable growth stretching out into the distant future.

In reality, it was anything but.

The problem with risks is that they can often be ignored until they can’t.  They can sit dormant for many years, and the longer they sit there doing nothing, the easier they are to ignore.  Paradoxically, this risk ignorance will usually increase the size of the risk and, therefore, its impact when it does eventually turn from probability to reality.

One popular measure of debt manageability is interest cover.  Through most of the last decade, FirstGroup’s interest cover was around 4, and since 2009 it has been consistently below 3.

That means anything from 25% to more than 33% of operating profits were going straight out the window to lenders rather than shareholders.

Not only is that offensive to me as a shareholder (although, thankfully, not a shareholder of FirstGroup), but it’s also incredibly risky to have such massive obligations to lenders.

Investors should have known better.  The debts were not hidden; they were in plain sight for all to see.  Investors who bought into this company at more than 700p (while today the shares sit closer to 120p), with a dividend yield of just 2.5% and a PE ratio of almost 20, were taking on huge risks for very little potential return.

Those risks have now become real events, but for many, it is too late.

Investing is about taking on risk.  There is no other way to achieve rates of return above the “risk-free” rate, or above what you can get in a cash savings account.  But if investing is about taking risks, then investors must understand the risks they are taking, and for the most part, that begins with looking at a company’s financial obligations and, most obviously, its debt levels.

Most investment errors stem from a lack of understanding of risk, whether that’s operational risk from the underlying companies or price risk from elevated share prices.  In all cases, close attention to and deliberate management of risk is a must if an investor is to do consistently well over the long term.

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.

6 thoughts on “Why FirstGroup’s problems were easy to spot”

  1. A couple of years ago, the directors at one of their subsidiaries in Aberdeen did a “meet the customers” even on Union Street. Many thanks to the managers who must have been rather puzzled about me asking about the business itself rather than how come the buses are late/early crowded/empty.

    He explained that usually bus operators were insensitive to economic cycles, although we were not living in usual times. I can’t find my notes to recall what his reasoning was, but it was along the lines that people often took bus trips to the shops, and this was being curtailed.

    I don’t talk to directors or generally go to meetings, but I must say, if you do that, you’ll generally walk away knowing something you didn’t before.

    I see that gearing for FGP is a honking 250%, and their operating margins have been savaged lately. It is, perhaps, not surprising that they’ve lost 43% of their value over the last year. Taking a look at the prelims, I notice that they’ve chopped off the dividend, and are going to take their begging bowl to the market. Yikes.

    I love this little section: “Martin Gilbert has today announced his intention to stand down as Chairman … his vision and
    drive have led the transformation of the Group”. Yes, Martin, great showing. You’ve managed to “transform” the company into one that can no longer pay its dividend and needs to raise additional capital in the markets so that it doesn’t collpase. A transformation so glorious that you had to step down from the board. It’s criminal, really.

    1. Hi Mark, apparently the Chairman decided to step down a year ago, so it’s just coincidence…

      Having the opinion that bus operators are insensitive to the economic cycle (which they are, relatively) is I guess one major reason why they thought it was prudent to carry so much debt in the first place. However, in hindsight it appears somewhat cavalier (and some would say it looked cavalier without the benefit of hindsight).

  2. Some endemic cultural problems also I fear.

    A couple of weeks ago we flew back into Luton and tried to board the Firstbus back to our car. The driver however, suggested we get on the bus just ahead of his because it was free!

    On the way out it cost a couple of quid for 3 minutes. At the time I said to my wife this must be the most profitable journey in their entire business and I had been impressed by the revenue potential!

  3. There are some good businesses within First Group, unfortunately they paid too much for them in 2007 and used too much debt. In the US it looks the is big pressure on the margin for bus schools, as local authorities don’t have money to pay for them anymore.

    The fortune of this business could change dramatically and all depends on the frachises to be extended and eventualy winning the bids for them again. I am not a specialist in railway franchises so I will never invest in a company that has one.

    I like to invest in companies where it is easy to forecast what will happen in the next year or so. I don’t like suprises!

    1. I think the franchise system can be quite disruptive to these companies, which is partly why loading up on debt was such a bad idea in the first place. If only the West Coast franchise had gone through… perhaps this could all have been avoided. But then, effectively betting the company on the success of a single deal is high risk to say the least.

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