Investors, beware: the wheels might come off this sector

These businesses look defensive, but could burn unsuspecting income investors.

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Transport businesses can generate predictable cashflows due to the frequent, repeat nature of a commuter-based service combined with monopolised routes. This could be a boon for dividend investors. However, I worry that the franchise-bidding nature of Firstgroup (LSE: FGP) and Stagecoach (LSE: SGC) leaves them vulnerable to sudden losses of business. 

First falling

First Group was the biggest faller in the FTSE250 this morning, its shares losing 5.5% after a cloudy outlook overshadowed a 23% increase in profit last year.

The group, which carries around 2.2bn passengers a year, owns the world-famous Greyhound buses, the only national operator of scheduled intercity coach transportation services in the US and Canada.

The company also operates bus and train routes in the UK, commanding a fifth of the market outside London under the First Bus brand and operating the Great Western Railway, TransPennine Express and Hull Trains railway franchises.

The company has struggled to turn operations around for years now, but even a near-doubling of capital expenditure over the past few years has not done the trick. Profits still languish well below 2010 levels, so the market’s reaction to yet more slow progress is unsurprising.

Cash generated from operations hit a five-year high at £520.4m, with strong free cashflow and the lack of dividend payment allowing the company to strengthen the balance sheet, with net debt reducing from £1,521m to £1,389m.

There’s certainly progress on view, but an investment in First Group could be risky. The company has a marred track record, an unclear outlook, significant debt and pays no dividend. Counterintuitively, the low oil price is bad for bus and rail operators, because while it reduces the utility bill, it also makes motoring a more attractive proposition to commuters, thus denting passenger numbers. 

Furthermore, the attractive features of travel businesses, including those monopolies on certain routes and that predictable, repeat business, are undermined by the regular bidding wars held over certain franchises. Driverless cars could throw another spanner in the works, because I honestly have no idea how this will impact the industry over the coming years.

Given the long-term uncertainty and lack of exciting growth prospects, I feel the business does not warrant an investment at a PE of 16.5.

Stand and deliver?

Like First Group, UK number two travel group Stagecoach (LSE: ) has struggled over the last couple of years as low petrol costs have made the car a more affordable option again. Unlike First Group however, Stagecoach does deliver. It pays investors 5.7%, covered by free cashflow, to keep investors warm while they wait for capital appreciation. What’s more, the company’s valuation is lower than its rival, at a PE of 12.3.

While First Group’s sales are split fairly evenly between here and the US, Stagecoach derives the majority of revenues from the UK. Despite future potential like the lossmaking MegaBus Europe division possibly set to move towards profitability in years to come after the disposal of the division’s retail arm, it has many of the same potential problems that affect its industry peer.

I’m not madly keen on either business right now. It’s true that over time, the UK’s population looks likely to rise steadily and be a beneficial, if gradual, trend for transport companies. But I don’t trust the stability of the franchised model enough to invest now. If I had to choose, Stagecoach’s superior dividend, balance sheet and track record seem to represent the more attractive option, although I’d prefer to fish in very different waters. 

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Zach Coffell has no position in any shares mentioned. The Motley Fool UK has recommended Stagecoach. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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