Go-Ahead Group (L:GOG) is one of the UK’s leading public transport companies, operating buses and trains across most of the country, although primarily in London and the south east.
In this post I’ll look at Go-Ahead‘s financial track record and balance sheet, and outline why I wouldn’t invest in the company, even if the price was significantly lower than it is today.
Growth is fairly steady, but unspectacular
As a general rule, operating buses and trains is a defensive business as people need to travel around regardless of the wider economic environment.
From my point of view this is good because it means that Go-Ahead has produced the sort of relatively steady revenues, earnings and dividends that I’m always on the lookout for, as shown in the chart below:
Its earnings have danced around somewhat more than I would normally like, but the general picture is one of stability, especially at the revenue and dividend level.
In numeric terms the company has the following track record:
- 10-Year growth rate = 1% (FTSE 100 = 2.1%)
- 10-Year growth quality = 58% (FTSE 100 = 42%)
- 10-Year profitability = 11.5% (FTSE 100 = approx.10%)
Compared to the market average (using the FTSE 100 as a proxy) Go-Ahead’s track record is actually quite mediocre. It doesn’t have a record of high growth, particularly strong consistency (quality) or profitability.
In fact, Go-Ahead’s growth rate is so weak that it breaks one of my rules of thumb, which is:
- Only invest in a company if its growth rate is above 2% (i.e. above the Bank of England’s inflation target)
Having said that, it’s a rule of thumb and not a hard rule, so I am willing to be flexible.
In this case Go-Ahead’s overall growth rate (the average of the revenue, earnings and dividend growth rates) is held back by the earnings growth rate which is negative because of the earnings spike in 2009.
It is reasonable to assume that once the 2009 earnings spike drops out of the picture the company’s growth rate, as I measure it, will move back above 2%.
However, even then its growth rate will be somewhat anaemic, but that isn’t necessarily a bad thing. If the shares are cheap enough and the dividend yield high enough then even a slow growth company can be an attractive investment.
But before I look at a company’s valuation ratios I always like to look at its balance sheet and financial obligations first.
Large debt and pension liabilities are a potential problem
There are two main financial obligations that I look at: Interest-bearing debts and defined benefit pension liabilities.
While neither is intrinsically bad, both can become ticking time-bombs if they are too large relative to a company’s profits.
Looking first at interest-bearing debts (or borrowings), Go-Ahead has a total outstanding of £311m. At the same time, the company has 5-year average normalised post-tax profits of £60m.
I call the ratio between these two (somewhat obviously) the debt ratio, and as with most things I have some associated rules of thumb (explained in more detail here):
- Only invest in a cyclical company if its debt ratio is below 4
- Only invest in a defensive company if its debt ratio is below 5
Go-Ahead operates in the Travel & Leisure sector, which is defined as cyclical in the Capita Dividend Monitor.
However, I would say that Go-Ahead is actually a defensive company and so the second of those rules of thumb will apply, once I’ve calculated the ratio:
Go-Ahead’s debt ratio = £311m / £60m = 5.2
And so according to my rule of thumb, Go-Ahead has too much debt. As before, this is a rule of thumb rather than a concrete rule, so I am willing to be flexible.
If, for example, I thought that for one reason or another Go-Ahead could easily handle that amount of debt then I might turn a blind eye to this rule of thumb, because the company breaks it by such a small margin.
In fact that’s probably what I would do, given the company’s defensive business model; so let’s move onwards and look at Go-Ahead’s defined benefit pension liabilities.
The risk from pensions is that the pension scheme’s assets will not be sufficient to cover its liabilities (i.e. will not generates sufficient income to pay those future pensions). When a pension scheme’s assets are worth less than its liabilities there is a pension deficit, which the company can be forced to pay.
To measure the risk of a dangerously large pension deficit I use the pension ratio, which is the ratio between a company’s pension liabilities and its 5-year average normalised post-tax profits.
Here’s my rule of thumb for pensions:
- Only invest in a company if its pension ratio is below 10
10 isn’t a magic number, but it is the amount where a 10% pension deficit (a fairly typical figure) would give a deficit equal to the company’s average post-tax profits.
I think that’s a reasonable definition of a “large” deficit, which could become a significant drain on the company’s cash if the pension trustees insist that the deficit gap be closed.
On the railway side of Go-Ahead’s business it seems that the government is expected to foot the bill for any pension deficit, so I’ll ignore that for now.
On the bus side of things the pension liabilities come to £719m, and so:
Go-Ahead’s pension ratio = £719m / £60m = 12
Much like Go-Ahead’s debt ratio, its pension liabilities is also slightly over the limit.
That pension risk is reflected to some degree in the related pension deficit, which is running at a not too bad 8%. However, even that fairly small deficit translates into £60m shortfall, equalling an entire year of the company’s profits.
Taken on their own, I don’t think Go-Ahead’s debt or pension liabilities are outrageously large. However, they are both financial obligations and can both be potential drains on cash, which is why I have yet another rule of thumb:
- Only invest in a company if the sum of its debt and pension ratios is below 10
In this case we have:
Go-Ahead’s debt and pension ratio = 5.2 + 12.0 = 17.2
That, of course, is heading towards double my rule of thumb maximum of 10, so although I like Go-Ahead and it does appear to be a good business in general, its financial obligations are simply too large for my liking.
As a result I won’t be investing, even if the share price fell off the proverbial cliff.
P.S. FirstGroup is a good example of what excessive debts can do, even to relatively defensive public transport companies.
P.P.S. I have invested in Go-Ahead before, but at the time my debt rules were more lax and I didn’t look at pensions at all.