Sunday, 13 March 2016

Student Transportation Inc.: Globe and Mail cheerleads, I scratch my head in amazement

As a participant in the capital markets trying to make consistently intelligent decisions, sometimes a situation exists which is completely perplexing, and that situation tends to persist for longer than anyone could reasonably imagine. One such situation is Student Transportation Inc.

First, the charts.  STB has thee outstanding classes of securities currently trading, common shares, and two unsecured US $ convertible debentures.  I've charted all three comparatively to give some context as to what's happened recently.

The chart shows relative % price performance between the three securities over the last 5 years, but doesn't properly communicate the context of the move off of the February 11, 2016 lows for the common.  On Feb 11, 2016, the common got down to around $4.30 per share, and has rallied close to 60% currently.

And of course, the Globe and Mail published the following analysis (link here) shortly after the most recent earnings release, virtually endorsing the move and the overall stability of the company, copyright globe and mail:

I wrote the following email to Ms. Dowty in response to this article (which she never responded to):

"Hi Jennifer.  Read your article.  I don’t think you’ve looked far enough into the shenanigans under the surface.  All is not as it seems.

My comments:

  • How did they deliver higher adjusted EBITDA, and why is adjusted EBITDA even relevant in assessing the ongoing viability of the company?  They run a capital intensive business.  They likely have to replace their fleet after 12 years (average age of buses before operating costs start to increase significantly).  The average age of the fleet is just under 6 years.  How are they going to replace the fleet when they don’t generate meaningful cash flow from operations?  They should use free cash flow rather than adjusted EBITDA.
  • Here’s an extract from their annual information form illustrating the reconciliation between their EBITDA and cash for dividends.  Notice that there’s no line for depreciation expense in the reconciliation.  They’ve omitted it because it’s non-cash, but this is a sneaky tactic, considering the capital intensive nature of the fleet replacement requirements.  Depreciation will likely approximate capital spend, yet they’ve only deducted “replacement capital spending, net,” in the figure.
  • Another comment, why are operating leases not relevant?  They are below the adjusted EBITDA line, except that operating leases are the rents they pay for a portion of the fleet.  The lease expense payments are not 100% interest, but in the absence of them making the operating lease payments, you tell me if the lessor wouldn’t repossess the buses they haven’t made payments on?  This is just dumb and it’s misleading.  If we reclassify operating leases into adjusted EBITDA, Dan’s adjusted EBITDA is $73M vs $70M.  Not the quite the result management postulated.  But equity gobbled this up.
  • The other item that sticks out like a sore thumb in the reconciliation is the class B share repurchases.  More on this below…

Here's the extract from the 2015 annual information form:

Here's some relevant information on the Class B shares from the 2015 AIF:

Further comments to Ms. Dowty:

"To “put” the above into context, here’s the dual class capital structure

As you can see below, management owns 100% of the class B shares, distinct and separate from the common shareholders (public).  And in 2015, management put back $2M of stock, around 332K class B shares, at $2,013 /332 = $6 per share and paid dividends to management before the common shareholders got a dime? 

This company is anything but safe."

Obviously I got no response, but that's neither here, nor there.  The Globe needs to publish stories with sex appeal, and that's what they've done.

On the subject of all of the above, I began crunching some my own numbers just to see what it is I'm missing. It's entirely possible that I'm wrong here, and the market, even with STB's current 10% yield after a 60% rally off the lows, is not pricing in the future safety and the stability of the business.

For my purposes, I split my analysis into two parts:

1) Analysis of interest coverage  / ability to cover fixed charges, and analysis of free cash flow
2) Analysis of balance sheet liquidity, efficiency and overall safety

Here's Part 1 over the last 8 years (all data derived from the company's annual financial statements):

Analysis of interest coverage  / ability to cover fixed charges, and analysis of free cash flow

My observations are bolded at right, here they again:

  • Ms. Dowty and the CEO hint at pricing power in upcoming bid renewals.  I note the steady diminution of EBIT margins since 2008.  What pricing power?
  • How in the universe of lunacy is an industrial with 1 x interest coverage safe?
  • Notice the trend in growth in free cash flow? Me neither!
  • There hasn't been one year since 2008 where there was sufficient excess free cash flow to pay the common dividends.  You can see that the company has only been able to pay the generous level of common dividends by virtue of unimpeded and continuous access to equity and debt markets.

Here's Part 2 over the last 8 years:

Analysis of balance sheet liquidity, efficiency and overall safety

A bit of background to explain what I've done.  I took the as reported Sales and as reported net fixed assets over the last 8 years in order to determine fixed asset turnover.  Management chimes on about being an efficient operator, taking advantage of pricing power in its fixed bid contracts and leveraging operational efficiencies out of the fleet.

Here's the caveat, the fleet is not what they say it is.   Since 2008, the % of off balance sheet fleet has grown from 10% to 34% currently, so the as stated fixed asset turnover metric is incomplete.  Yes, the leased assets are not on their balance sheet, but they're still running the leased portion of the fleet in order to fulfill their service contracts.  On an as stated basis, F/A turnover looks strong, up from 1.77x in 2008 to 2.35x now, but I believe this is a function of accounting sleight of hand.  If one were to recast the "estimated" cost of additions to existing fleet by interpolating the % of leased fleet as additions to the owned fleet, the F/A turnover picture changes drastically.  The recast F/A turnover is around 1.78x, up marginally since 2008, but nowhere near the efficiency picture generated from not including leased fleet on the balance sheet.

Even more disturbing is management's propensity to exclude operating leases from their own adjusted EBITDA calculation.  This is a joke.

I'd hazard a layperson's guess that the reason for the lease % growth is to ensure that access to accomodative debt and equity markets continues unfettered, and having to buy additional fleet assets would require diversion of cash flow up front into property and equipment and away from common shareholders.

You can get an idea as to how significant a portion of the capital structure fleet leases are by observing the growth in off-balance sheet commitments since 2008, per below:

Lease commitments (premises + fleet) at the end of 2015 were close to 1/2 of total obligations in the capital structure, up from 30% in 2008.  On a leveraged basis, you can see that the company is running at close to 2x  debt:equity and 100% of debt:assets (excluding goodwill and intangibles).

Concluding Thoughts

I thoroughly disagree with Ms. Dowty's analysis, conclusions and recommendation.  I'd argue that this company is the polar opposite of "safe" and that investors should not even consider "accumulating shares at current levels".

On the contrary, if I were to make any sort of recommendation (and I am not qualified to do so, so take this with a grain of salt), it's for investors to steer clear of the shares, lest they wake up one morning to news of the "unexpected" impact of unaccomodative debt and equity markets forcing the company to cut or eliminate the dividend (or worse).

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