Bus and rail group is on the right lines for long-term growth

Dec 17 2007 by Peter McCusker, The Journal

FIRST Group: Bus and rail travel is impacted by economic cycles, but we feel it is at the lower end of cyclicality within the sector. FirstGroup’s rail franchises are not up for review for at least four years which provides stability.

The Laidlaw acquisition increases the proportion of profits and cash flows from the relatively stable school bus segment which should make the company more defensive within the sub segment.

Finally the transaction means First Group has better growth prospects than its peers. In the near term there are risks associated with absorbing the acquisition and obtaining the promised synergy benefits, plus uncertainties about whether it will retain the Greyhound business (a disposal would, we feel, be perceived as reducing risk). High oil prices remain a depressant on bus margins but these will have to be passed on and increasing efficiencies have helped absorb the impact. With the benefit from Laidlaw we arrive at a 810p a fair value estimate based on a sum of the parts.

Carphone Warehouse: We have upgraded our recommendation on Carphone Warehouse to outperform.

In a sector currently beset by considerable uncertainty, there is now sufficient clarity on the medium term outlook at Carphone to make the valuation look attractive. Broadband subscriptions are on track, broadband margins are running ahead of guidance and the pace of unbundling has picked up significantly. As we approach the all important Christmas trading season, Carphone looks well set to take advantage of the likely increase in footfall created by the launch of the iPhone.

Our DCF based fair value of 433p is based on cautious assumptions both from the broadband and UK retail perspective. The stock trades on a 25% discount to its pan European peer group on a 2009 EV/EBITDA basis, widening further into 2010, meaning the market appears to be underestimating the medium term margin potential of the business. The business is set to register compound annual growth of over 40% in the next 3 years.

Standard Chartered: Having upgraded Standard Chartered to Outperform on October 23, 2007, we are now raising its fair value further due to continued strength in the market of Asian banking franchises. Its unique geographic footprint, largely focused in Asia and the Middle East, offers highly attractive organic growth opportunities.

Investment spending remains higher at Standard Chartered than at most peers due to its focus on future revenue opportunities rather than shorter-term earnings growth. It aims to make the most of its strong local presence to gain access to markets/businesses with superior growth opportunities, to maintain its competitive advantage.

As well as providing above peer group growth opportunities, Standard Chartered’s unique footprint also attracts periodic bid speculation.

With good income growth and limited exposure to the current operating difficulties in UK retail banking, this represents a strong fundamental story. Applying a sum-of-the-parts valuation to the business, and using local market competitor ratings, we feel that good upside remains. Our new 1965p estimate of fair value, based on 2008E profit forecasts, leads us to keep the stock on an outperform recommendation relative to the FTSE350 Banks Index.

Given its significantly different business model relative to its UK-quoted peers, its shares rank poorly on the DDM when compared to UK banks. However, we take encouragement from the high ranking on a global basis.

Reckitt Benckiser: Following the second quarter results, we have raised our fair value estimate on Reckitt Benckiser to 2950p from 2650p previously and we are upgrading the recommendation to outperform, making the shares a buy against the market.

The increase to the fair value estimate reflects the earnings upgrades following the positive second quarter results, the attractive growth outlook for the next two years and places the company on a justifiable premium to its global peers in the Household and Personal Goods (HPC) sector.

Within the FTSE Household Goods sector, Reckitt Benckiser looks expensive, as indicated by our Dividend Discount Model (DDM).

However, Reckitt Benckiser represents around 50% of this sector by market capitalisation and the remainder is largely represented by UK Housebuilders, which are cyclical businesses and tend to be lower rated.

We believe that a fairer valuation comparison is with Reckitt Benckiser’s global HPC peers and, on this basis, the shares are attractively valued in the top quintile on our DDM.

Andrew Miller is regional centre head for Barclays Wealth.