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The wrong track - First Group is showing the dangers of kicking the debt ‘can’ down the road

04/06/2013

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

First Group saw its share price drop by almost a third in a single day on 20 May as investors reacted badly to a proposed £615m rights issue and the cancellation of the company’s dividend. As is often the case, First Group’s current travails may be traced back to debt, in particular the borrowings it took on through its acquisition of US bus group Laidlaw in 2007. First Group managed to muddle through the financial crisis with only a small equity issue, but that only served to kick the can down the road – until now.

Furthermore, despite its parlous financial position, First Group has continued to pay - and grow - its dividend in recent years and indeed, since 2008, has distributed some £570m to shareholders – a figure not too far off the £585m, after fees, that it now hopes to raise via its rights issue. Obviously this has meant the business could not deleverage as much as it might have done and, if First Group had chosen not to pay a dividend sooner, it might potentially have avoided both the need for such a large rights issue and saved itself a significant amount of interest and fees in the process.

All of this information was out in the open – at least for those investors willing to look for it – as were the size of First Group’s pension deficit and other liabilities such as those stemming from the leases associated with its bus businesses. Investors examining the company’s accounts would also have been able to see how the state of the balance sheet has constrained capital expenditure over a period of years – to the extent that part of the reason for the rights issue is a long-overdue updating of First Group’s UK bus fleet.

Also evident was the fact that a - perfectly legitimate - quirk of pensions accounting was boosting the group’s profits and margins by over £50m in some years. A change in the accounting rules that will remove this quirk is part of the explanation for why profits will fall this year.

The only piece of the puzzle that was not fully visible to investors was the one that fell into place most recently – an indication from the ratings agencies that a downgrade of First Group’s credit rating could be on the cards. However the company’s rating had been put on ‘negative watch’ in late 2012, so even in relation to this it should have been apparent that the ratings agencies had some concerns. The looming downgrade looks to have been the catalyst for the recent events, including the proposed rights issue and the ending of the company’s aggressive dividend policy.

First Group had traded with a high dividend yield in recent months, suggesting the market was pricing in some reduction in the dividend. Unfortunately it seems few were thinking that a 100% cut and a rights issue equal to the company’s market capitalisation – post the announcement – was needed to sort out its balance sheet.

Some investors may have felt First Group could handle its debt situation because of its exposure to growing rail volumes or because of the good revenue visibility that elements of its business have. However every business, no matter how attractive its attributes, can have too much debt loaded onto it and if management don’t take action to reduce gearing, things can quickly go from bad to worse.

Ultimately, though, the moral of this story – as with a few others that feature on The Value Perspective – is debt tends to find you out. It does not matter if you are a company or a government, you can try and keep kicking the can down the road but you will often get your come-uppance – as will investors who ignore the signs of can-kicking or are just plain unaware any can is being kicked in the first place.

Author

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.

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