Shares of Student Transportation (Nasdaq/TSX: STB) are trading near an all-time high, propped up by retail investors attracted by the feel-good story of investing in a company that provides school bus services to children. As a return on their investments, the company pays a monthly dividend with an optically attractive dividend yield of 8%. In reality, STB’s business and financial strategy benefits its bankers and management, and is not accretive to shareholders. STB’s financing scheme relies on raising increasing sums of capital from new shareholders and creditors to maintain its irrationally high dividend, which is akin to “taking money from Peter to pay Paul.” As a result, in the absence of new capital, we believe STB’s dividend would ultimately be cut, and its stock price would fall closer to our fair value target of $2.00 per share, or 70% below the current stock price.
This article summarizes key points that we have put together in a detailed report accessible here.
As shown below, STB has never been able to cover its dividend from its operating free cash flow and is projected to continue its shortfall again in FY 2013 (See Appendix).
Instead, STB has repeatedly raised money through dilutive security issuances from new investors to pay a dividend to an ever expanding group of existing and new investors. For example, STB recently listed their shares on the Nasdaq in September 2011, and wasted no time tapping new investors for C$75m in February 2012 with a dilutive stock offering. We believe the company’s listing on the Nasdaq signals that they have largely maxed out financing from the Canadian market. The dividend is really the only thing attracting retail investors to their stock, meaning that any strain in financial markets going forward could have severe consequences for the stability of the dividend.
Growth Story Fantasy
The school transportation industry is fragmented, but dominated by two large foreign competitors that have already consolidated a majority of the industry. STB has been selling investors on their acquisition growth strategy given the anemic organic growth in the industry. STB has acquired 47 independent school bus companies over the years in smaller markets where they believe there are lower levels of competition and operating costs. While on the surface this makes intuitive sense, the company’s own financial results do not support the conclusion that the strategy is yielding benefits. There are no revenue synergies and few cost synergies to justify STB’s levered acquisition spree. Overall, the economics of the student transportation industry are highly competitive, capital intensive, increasingly regulated, and result in low margins and returns to shareholders.
Misaligned Incentives: Management and Bankers Win, Shareholders Lose
STB is a banker’s dream client because of all the debt and equity capital they require, M&A deals they complete, and fuel hedges they execute. In return for the millions of fees that STB pays banks, the company receives glowing “strong buy” recommendations and unjustified price targets backing their levered acquisition spree. Of course, STB’s bankers have no accountability or alignment with the shareholders, but what about STB’s management and their alignment and incentive structure? STB’s management owns less than 1% of the common stock, but instead gets rewarded with a preferential Series B stock that allows them to regularly sell shares back to the company. STB’s management has liberally sold millions of dollars of stock back to the company, while virtually no common shares have been repurchased under the common stock buyback program. Worse yet, the management are rewarding themselves with bonuses tied primarily to revenue growth, instead of measures that are directly measurable to shareholders such as EPS or cash flow growth. This allows the management to reward themselves richly for growing revenues at any price. Investors need look no farther for evidence of overpayment than the massive goodwill and intangible accumulation on the company’s balance sheet, which now totals 44% of total assets. As another measure of STB’s outrageous management compensation plan, the founder and CEO reaped $1.8 million of total compensation in 2011, which is greater than STB’s 2011 EPS. The amount is also larger than almost any CEO of a publicly traded North American transportation company, even those with enterprise values 4x larger (See Appendix).
Retail Driven Ownership Leading to Massive Stock Overvaluation
Looking at STB’s shareholder base, it is entirely clear that institutional investors have refused to own shares of the company. As of March 31, 2012, 66% if shares were in the hands of retail investors, leaving 33% in the hands of institutions. However, even this number is misleading due to the fact that two institutions own approximately 21%. Management owns less than 1% of the common stock of the company.
Based on the points described above, it is clear that institutional investors and management are completely unwilling to hold the stock at any price. Yet, retail investors have driven the valuation up to a level which is nearly double that of comparable companies. STB currently trades at 11.5x EV/ 2012E EBITDAR and 61x Price/FY 2013E EPS vs. peers which trade at only 5-8x and 7-12x, respectively. No transportation company has ever been sold in a private transaction at a multiple that even comes close to STB’s current value. It seems clear that retail investors have simply ignored the valuation of STB, its flawed strategy, and misaligned incentive structure. Otherwise, they are being drawn to the highly promotional nature of the company’s press releases, such as a recent release that proclaimed a “Historic Shift” taking place in the school bus market. The absurdity of these press releases, and the company’s valuation, is also seen from the perspective that investors are ascribing a value of $87,000 per school bus, which on average is 6 years old; brand new buses can be purchased for much less.
Conclusion: Buyer Beware
As with any financing scheme, the game ends when the company can no longer raise money from new investors to continue paying out existing ones. STB’s recent listing on the Nasdaq, rapid stock offering, and weak insider and institutional ownership are clear signals that the company is having difficulty finding greater support for their misguided acquisition strategy. Meanwhile, global tightness and instability in financial markets does not bode well for capital intensive business such as STB’s going forward. Investors are strongly cautioned to consider the misalignment of incentives with this company, and the future security of the dividend.
Student Transportation Inc. is reportedly the third largest provider of school bus transportation services in North America with 9,000 vehicles and revenues of $355 million as of LTM 3/31/12. The company’s operations are located in Ontario, Canada and 15 states across America. Below is a quick overview of the business by revenues.
The company has grown its business primarily by executing on its A-B-C strategy. Acquisitions have formed the basis for the majority of the company’s growth over the years. STB has completed 47 companies since its inception. As we’ll explore in greater detail in this report, many of these acquisitions are privately owned, independent regional operators. Bidding activities are directed toward school districts that have chosen to solicit bids from private operators for their school bus transportation contracts. These contracts are primarily awarded by school districts based on a competitive public bidding process or Request for Proposal, on the basis of the “lowest responsible bid.” Lowest responsible bids enable school districts to consider factors other than price in awarding a bid, such as safety records and initiatives, driver training programs, community involvement and quality of service. Conversions are focused on privatizing school districts in regions contiguous to the company’s existing operations. Approximately 68% of the school bus market is operated by school districts, which allows companies like STB to claim there is a large opportunity to grow by converting school districts to outsourced operation at substantial cost savings. To date, STB has completed only 10 conversions.
History and Path to the Capital Markets
The company was initially founded in 1997 by Dennis Gallagher upon his departure from Laidlaw Inc. Prior to joining Laidlaw, Mr. Gallagher sold his school bus transportation company to Laidlaw in 1987 and held a senior position with the company. The formation of Student Transportation nearly faltered from the start, when Laidlaw filed an injunctive motion claiming its executives breached their non-compete contracts, although the courts ultimately denied Laidlaw’s motion for preliminary and supplemental injunctive relief. The company came public in Canada in 2004 on the Toronto Stock Exchange through an Income Participating Securities (“IPS”) offering of C$116 million which included IPS units and Senior Subordinated Notes paying 14%. Over time, the company has eliminated the IPS structure and Subordinated Notes through exchange offers, convertible bond and multiple stock offerings.
Given that the origins of the company’s management and business operations are primarily in the U.S., the choice of listing in Canada through the IPS structure appears motivated by the ability to access retail investor demand for income yielding securities. To this day, the company has maintained an unrealistic monthly dividend policy of $0.046 cents per share which provides a current dividend yield of 8.0 percent. The company’s initial equity sponsors no longer own shares; today’s shareholders are predominately Canadian and US retail investors who own 66% of the shares. The two largest institutional shareholders are Societe Nationale de Chemins de fer France (“SNCF” 12%) and Caisse de Depot (9%).
In July 2011, STB made its trading debut for its Class A common shares in the U.S. on the Nasdaq. According to the company, the listing “Creates access to a larger shareholder base and allows U.S. institutional and retail investors to trade shares more easily and with greater liquidity.” Since the listing event, we don’t believe STB has garnered serious investment from any major U.S. financial institution except a small firm called WealthTrust Axcicom. However, we believe the company has used the listing to attract additional retail investors who are gravitating towards the dividend. As we will explore later in this report, we believe the dividend is a fundamentally flawed financial policy, which the company is highly dependent on paying to sustain its investment appeal, and attract new equity capital for its levered growth trajectory.
The company’s management owns 100% of the Series B shares and less than 1% of the common shares. Management is currently receiving Series B-3 shares as part of their annual Equity Incentive Plan (“EIP”). The Series B is entitled to dividends and receives certain preferences to common shareholders that are noteworthy, particularly a put option which allows management to force the company to repurchase their shares in annual amounts. This put option is accounted for as a liability on the company’s balance sheet, and we will evaluate the impact of management’s exercising these options on cash flow later in the report.
Constrained Fundamentals in the Student Bus Market
The fundamentals in the student transportation market are characterized by limited barriers to entry and few proprietary points of differentiation to customers, capital and labor intensity, thin and pressured margins, increasing regulatory requirements, and constrained growth opportunities.
Limited Barriers to Entry; Few Proprietary Aspects of the Business
There are limited barriers to entering the student bus transportation market. Anyone that can purchase or lease a bus, obtain the proper licenses and insurance, can operate and compete in this market. Contracts with school districts are announced publicly and bid specifications are provided to any interested party. In advance of bidding, any prospective bidder can obtain information regarding that school district’s prior or existing school bus contracts. Prospective bidders may also obtain information on bids that were submitted to the school board in the past in connection with existing or prior contracts from competitors. The awarding of business contracts typically applies the “lowest responsible bidder” principle to determining which carrier is selected. While price is the predominant factor to evaluating this principle, other factors such as safety, quality of service, community involvement, etc. may be taken into consideration.
The industry is largely fragmented with some 500,000 buses in operation across the U.S. However, among the privatized, outsourced segment, the market has been largely consolidated in the past 10 years by UK publicly owned FirstGroup (LON.FGP) and National Express (LON.NEX)whom control approximately 52% of the privatized market. The top 10 providers account for 67% of the privatized market. The current industry concentration presents challenges to the acquisition strategy of companies such as Student Transportation, and will be more formally analyzed later in this report.
Overall, significant competition, limited barriers to entry, and few proprietary aspects of the business that limit the ability for one bus company to differentiate itself, constrain the upside potential of the student bus transportation market.
Capital and Labor Intensive
The school bus transportation market is characterized as capital intensive. New school buses can cost $75,000, have a useful life of 12 years, and require significant maintenance capital expenditure costs. In practical terms, this means bus operators need to replace 8 %- 10% of their fleet each year. Keeping a younger bus fleet is advantageous as it helps minimize maintenance expense. Buses typically have low fuel mileage economy and require a large labor force to operate. Key components of operating capital costs include fuel, wages and salaries and benefits, insurance, regulatory compliance, and maintenance expenses. Wages and salaries are the largest cost of operations, with labor unions playing a large role in the industry. Approximately 15% of Student Transportation’s workforce is unionized.
Revenue and Cost Mismatch Pressuring Margins
As illustrated earlier, revenue contracts are awarded by school districts, which typically last from three to eight years. These contracts are primarily fixed price contracts and may include inflation escalators tied to the Consumer Price Index (“CPI”). Currently, the non-seasonally adjusted all U.S. CPI is 2.7% as reported by the Bureau of Labor Statistics. However, on the operating cost side of the industry, expenses are primarily variable and rising substantially. Take for example diesel prices: U.S. No. 2 Diesel Prices have risen 11% in the past year and 86% in the past two years according to the U.S. Energy Information Administration (“EIA”). Likewise, significant unionization of labor forces in the industry has resulted in increases in salaries in wages, while healthcare costs have also risen significantly. Furthermore, insurance policies must be renewed annually, and these costs have also been rising in recent years. A recent study by the U.S. Department of Transportation (“DOT”) in June 2009 indicated school bus fatal crashes represented the highest proportion of all bus crashes analyzed between 1999 and 2005. The overall mismatch between headline CPI inflation, and real inflation costs of the underlying business pose serious risks to levered school bus operators. For example, the industry’s fourth largest operator, Atlantic Express Transportation, filed for bankruptcy protection in 2002, and upon emergence from Chapter 11 in 2003, later went through another financial restructuring in 2009.
Increasing Regulatory Environment
Student bus transportation companies are required to comply with laws and regulations relating to safety, driver qualifications, insurance, worker overtime and other matters promulgated by various federal and state regulatory agencies including, among others, state motor vehicle agencies, state departments of education, the Federal Highway and Safety Administration, the National Highway Traffic Safety Administration and the Occupational Safety and Health Administration. Regulatory considerations are increasingly being factored into decisions by operators to remain in the industry. For example, Stagecoach recently cited regulatory considerations as a factor for selling its Dairyland business to Student Transportation in November 2011, even though it had a favorable financial profile. The Dairyland business and its financial impact on Student Transportation is analyzed more formally later in this report.
Outsourcing Market Share Shift Slow to Materialize
The growth of the industry through “conversions,” or outsourcing of bus operations to private contracts, has been slow to evolve. Currently, approximately 68% of the market is still operated by school districts, which in theory leaves a large market opportunity for private contracts to gain market share. Commentary provided by industry participants such as First Student (FirstGroup) and National Express also indicates that the market share shift to conversions has only been ~2% in the past few years. In practical terms, outsourcing has been slow to materialize due to municipal funding pressures, competing priorities for other issues faced by school districts, overall bureaucracy, labor union intervention, and limited changes in the total student population and like-for-like mileage growth. Take for example, the recently released report in May 2012 by the New York School Board Association. The results of the study indicate that 30.9% of NY school districts plan to reduce transportation in their 2012 – 2013 budgets. On a national level, the effects of reducing student transportation needs are becoming more tangible. For the month of April, the U.S. Labor Department reported that school-bus related employment saw the biggest decline in jobs for the month among all industries. These data points cast doubt on the industry growth story.
STB’s Flawed Acquisition Strategy
Now that we’ve provided an overview of the industry’s conditions, we can analyze whether Student Transportation’s aggressive acquisition strategy makes sense. According to the company’s recent February 2012 investor presentation, they have acquired 47 companies and target purchase price multiples of 3.5x – 5.5x EBITDA. Given the fragmentation of the industry beyond the largest providers, the company has focused on smaller operators in rural markets where they believe there are lower levels of competition and operating costs. While on the surface this makes intuitive sense, the company’s own financial results and incentive structure do not support the conclusion that the strategy is yielding benefits.
Let’s first look at the management incentive structure of the company. The company’s Short-Term Incentive Plan (“STIP”) provides that 40% of management’s cash bonus is tied to annual revenue growth, with another 20% listed as discretionary. A comparison of small-cap North American transportation firms reveals that Student Transportation is the only company tying short-term management bonuses to revenue growth. The most common compensation factors in the industry are EPS and return on capital targets. Therefore, we conclude that the company’s managers have a strong incentive to maximize revenue, and not cash flow or capital efficiency.
Acquisitions of bus companies appear to offer few synergies to justify aggressive empire building. There are no identifiable revenue synergies from adding target companies. In an acquisition, Student Transportation adds its acquired contracts with school districts, physical assets, and employees. There may be some very marginal economies of scale in negotiating price concessions in purchasing fuel, new vehicles, and other related services. However, adding companies and entering new territories and regions also has added integration costs and expenses, such as adding new terminals and dispatchers. Overall, it does not appear that there is a net synergy benefit from an acquisition strategy in the student bus transportation industry. Take for example the company’s recently announced acquisition of Dairyland for $47 million. By analyzing the company’s recently filed pro-forma financial statements, we can assess the potential free cash flow impact. A cursory view of the deal indicates that STB’s free cash flow margin would increase from 7.4% to 8.4% or 100 basis points from the deal. However, this ignores any incremental capital expenditures required from adding this new territory in Wisconsin to the company’s geographic profile. A sensitivity analysis suggests that any additional expense above $3 million for this acquisition negates free cash flow margin expansion. A careful review of Student Transportation’s acquisition announcements indicate a steady disclosure of the revenue accretion from transactions, but provide no information on synergies or incremental costs associated with integration.
Other challenges faced by Student Transportation of maintaining its acquisition strategy include the expense of identifying and sourcing a pipeline of actionable investment targets. With over 4,000 private contractors in the market, many local family businesses, the company is dependent on acquiring small operators who want to sell to Student Transportation versus retain control, or sell to a competitor who might have greater financial resources to pay for the business. Many of the company’s competitors have all been active in the M&A market in recent years, and have shown the willingness to pay for the right target, not just any target at all. See the section on Valuation for a complete list of M&A deals in the sector and how these deals compare with Student Transportation’s overall company valuation.
One way to assess the relative aggressiveness of the Company’s acquisition spree is to look at the goodwill accumulation that has been associated with these transactions. Intangibles primarily include contract values, non-compete agreements, and trade names. Goodwill is the excess of the deal price over working capital, PP&E, and intangibles less assumed liabilities. Goodwill and Intangible assets on the company’s balance sheet currently total over $221 million or 44% of the company’s reported assets. On average, 35% of the recent purchase price from acquisitions is attributable to goodwill.
Is STB’s Financial Strategy Sensible in the Long Run?
With our foregoing discussion on the challenging industry dynamics and Student Transportation’s aggressive acquisition strategy, we are now in a position to assess if the company has an attractive and sustainable financial business model. The charts below show a remarkable result about the company’s capital allocation and margin profile. First, using publicly reported information in segment disclosures, we can compare Student Transportation’s adjusted operating margin (EBIT) with its two largest competitors, First Student and National Express. The chart shows very clearly that the company’s margins trail its competitors by 500 – 600 basis points, and their margins have been under pressure in the past few fiscal years. Meanwhile, both competitors have recently undertaken restructuring efforts in their North American student bus operations to improve and stabilize margins.
However, the two most striking observations from the charts are related to the company’s capital allocation strategy in the past five and a half years. From these charts we can see clearly the sources and uses of their cash flow, and can reach some conclusions about the financial model. Looking at the sources of cash, we see the company has generated $166 million from operations, but has raised more money from selling equity in the amount of $180 million in the same period. Approximately $212 million has been used for acquisitions, $146 million for capital expenditures, and $120 million for the dividend have been used. Actual free cash flow, or cash from operations less capital expenditures, has amounted to only $21 million. Typically, it would be prudent to use free cash flow for discretionary measures such as debt reduction, dividends, or share repurchases. However, the company’s free cash is significantly less than the amount used for dividends and Series B stock repurchased from management. Looking more closely at the capital allocation chart, we can see that cash from operations has been largely stagnant in the past three years, while total debt funded for acquisitions has increased by $154 million.
Leverage Levels are High and Will Increase with More Acquisitions
The escalation of the company’s debt outstanding and margin pressure is concerning from the viewpoint that free cash flow has not increased commensurately. At the start of 2012, the company’s liquidity was not adequate with less than $4 million of cash on the balance sheet, and under $30 million of borrowing capacity under its credit facility. The company’s financial strategy has been to borrow short term for acquisitions, and then term out the debt with dilutive securities (straight equity issuance or convertible bonds). The company has the ability to exercise a $100 million accordion in its credit facility as well. According to our analysis, earlier this year the company was close to its covenant levels of 5.0x total leverage and 3.0x senior leverage. The covenants reference the company’s EBITDA metric and allow for pro forma adjustments based on the acquisitions being made. Accordingly, the company recently announced a C$ 75 million new equity raise at $6.85 per share on February 28, 2012. We also consider the company’s use of off-balance sheet operating leases amounting to over $70 million a form of debt.
Transportation companies do not typically support such high levels of leverage due to many risk factors. The company has made use of the fact that it has contracted revenues of 3 – 8 years, and over 184 contracts which provide revenue diversity. However, 26% and 29% of its contracts mature in fiscal years 2012 and 2013 and there is no guarantee that contracts will be renewed; however, the company tends to have success in renewing contracts in the 90% range. With school districts under pressure to cut costs, re-opening contracts are expected to be fiercely competed. The company also has fuel protection measures in 60% of its contracts, with an additional 20% of exposures hedged through annual fixed-price fuel contracts with suppliers. However, pricing under these fuel contracts has annual rollover risk. To illustrate, pricing under new contracts has increased 30% year-over-year as of the current quarter.
How Shareholder Friendly is the Dividend and Series B Share Repurchase?
In the context of a management team that is highly incentivized to grow revenues, levering up to acquire companies, and not growing free cash flow, how wise is the dividend and management owned Series B stock repurchases? As we’ve illustrated earlier and in the chart below, the company’s free cash flow is not sufficient enough to cover either the dividend or Series B repurchases. The company also recently announced a common stock repurchase program up to $5 million, but has only purchased $100,000 of common stock. Where is the money coming from to fund these payments? The answer is that the money is coming from both creditors and new investors through share issuance. Put in this perspective, the dividend is not so friendly after all, but rather akin to taking money from Peter to pay Paul. The company will have to continue attracting new sources of capital to grow and maintain its current financial practices; otherwise, the dividend will be in jeopardy. As more shares get issued, the total annual cash dividend payment increases. Given that leverage is already at elevated levels and will increase with more acquisitions, the most likely outcome for the company is continued stock issuance in the foreseeable future. The common stock repurchase announcement also does not look friendly from the perspective that the company has repurchased $15 million of management’s Series B stock since 2007. The Series B has also been collecting dividend payments too, which further incentivizes management to maintain the dividend.
Chart Observations: Cash from operations (CFO) per share peaked in 2009 and has been under pressure even as significant acquisitions have occurred. Free cash flow (FCF) per share is significantly lower than CFO per share; the gap has been widening recently. Dividends per share are higher than EPS, CFO or FCF per share. Cash for dividends and Series B buyback is approximately 75% of CFO and 111% of FCF.
Valuation and Price Target
By almost every objective valuation metric, the company’s stock price appears overvalued. We have analyzed the company from the perspective of relative stock price performance, comparable trading companies, historical valuation, broker target prices, and precedent M&A deal values.
STB’s share price has outperformed all its relevant peers and the Dow Jones Transportation Index (IYT) in the past two years. This outperformance is despite the fact that the company’s diluted share count has grown at a compounded average annual growth rate of 33%, and per share metrics have also struggled to match the rise in share price. In light of our previously highlighted concerns, STB’s share price appears terribly overvalued.
Comparable Companies Analysis
By analyzing a set of comparable companies in the student bus transportation and North American mid-cap trucking universe, we see that an appropriate valuation range is 6.0x – 7.0x Adjusted Enterprise Value to EBITDAR. Some of truckers we compare STB against include: Knight Transportation (KNX), Heartland Express (HTLD), Marten Transport (MRTN), Celadaon Group (CGI), and Arkansas Best (ABFS). We have adjusted our financial figures to account for sizeable off-balance sheet operating leases that are commonly used in the industry. We treat these operating leases as a form of contractual debt and capitalize them through an NPV analysis. Student Transportation makes use of these operating leases in their business. On an Adjusted Enterprise Value to Revenue basis, an appropriate valuation range is 0.8x – 1.2x
The following charts better illustrate the extreme overvaluation of the company’s shares. The shares appear overvalued on an EV/EBITDAR and Price/Earnings basis. The company is highly levered, and its dividend yield is matched only by FirstGroup, which is distressed and subject to a likely dividend cut.
The following charts illustrate the company’s historical valuation in the past few fiscal years. The most interesting observation relates to the company’s enterprise value to vehicle fleet. A new school bus can cost up to $75,000, while the company’s enterprise value to vehicle ratio at 3/31/12 implies a valuation over $90,000. The average age of the company’s fleet is approximately 6 years old. Put in this context, the valuation implies a 25% premium to the value of brand new vehicle fleet.
Another sensible approach to evaluating Student Transportation’s intrinsic value is to look at precedent acquisitions in the student bus and transportation market. Fortunately, there are ample transactions to review that point to a consistent firm valuation. A very relevant and recent transaction comparable is National Express’ $200 million acquisition of Petermann in September 2011. Petermann is currently the 6th largest student bus operator in the U.S with 3,300 buses. This deal valued Petermann at 1.3x EV/Revenues, 6.8x EV/EBITDA and $60,000 per bus. On average, the analysis suggests valuations in range of 6.0x – 8.0x EV/EBITDA and 0.70x – 1.3x EV/Sales.
Broker Price Targets
Student Transportation is currently covered by 4 brokers in Canada and 1 in the U.S., all of which have recently assisted the company to raise capital. The average analyst price target is $7.45 per share. Given the current stock price of approximately $7.10, the shares appear fully valued with limited upside potential.
Price Target and Conclusion
We arrive at our share price target of $2.00 by applying realistic multiples to revenues, 2013E EPS and EBITDA based on the comparable companies and precedent transaction analyses. Given STB’s current share price of $7.10, we believe the stock is a strong sell and materially overvalued.
Summary of Flawed Business and Financial Model
STB Will Continue Failing to Cover its Dividend
STB’s Excessive Management Compensation
STB’s Capital Structure
Disclosure: We are short STB.
Additional disclosure: Please read our full disclaimer at the end of our report.