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Are Stagecoach shares set to go off the rails?

Releasing its latest annual report today, Scotland-based transport group Stagecoach (LSE: SGC) has seen a somewhat mixed reaction in the early hours of trading, and here is why.

Problems with the trains

The company reported that full-year pre-tax profits have grown 30%, up to £101.2m from £77.6m in 2018, a number that should surely have investors flocking to buy? Well unfortunately, this news was somewhat tempered by the equally large decrease in total revenue for the year, which fell by 33% after two of the company’s rail franchises ended.

It is this rail franchise aspect that investors are really focusing on and that is no surprise. In April this year, the UK Department for Transport disqualified SGC from three rail franchise competitions because it was unwilling to take on the pension liability, which totalled more than £1bn.

The company has taken legal action against this, arguing that the government breached its statutory duties when it kicked it from the tendering process. But despite this legal battle, CEO Martin Griffiths said in a statement that “we have no intention to bid for new UK rail franchises on the current risk profile” – that is, I suspect, unless it somehow wins its lawsuit.

On the buses

So where does this leave Stagecoach? Well the problem is, nobody really knows – and that’s never a good thing for investors. The company said in its release that it would now be focusing on its core business of bus and coach transport in the UK. This seems to have potential: revenue-per-vehicle-mile in the bus and coach market, a cost-efficiency metric, was up 3.8% for the year, while revenue-per-journey was up 3.4%. The problem is, its rail division has historically been one of its best performers.

Stagecoach maintained its dividend of 7.7p, and reiterated its outlook for 2019/20 earnings. The company has reduced its net debt and successfully sold its North American division, but the truth is that with its rail franchise problems, it is hard to know what the true outlook will be over the next few years. This is exacerbated by the legal battle, with the true costs of time, effort and cash, not yet known.

Taking on ‘the Man’

While the company obviously hopes it will win its legal case, when taking on the government, I would rarely back the challenger – it is, after all, the entity that sets the rules in the first place. All this also comes in an environment in which the rising costs of train travel and perceived declining quality of service mean the public is rarely sympathetic to train operating companies. And in turn the government is pressured to act and to be seen to be getting the best deal for passengers, especially important when a general election could be on the cards.

I don’t think Stagecoach shares are going to plummet just yet – strong words and good dividends can hold investor interest for a while at least – but as we just don’t know how successful the company will be in focusing entirely on buses, I think its fair to say it has a tricky road ahead.

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Karl has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.