Screening
I like to begin my screening process by looking for low EV/EBITDA shares that have declined in price in the last few months. I favor EV/EBITDA as enterprise value (EV) considers both the debt and cash on a company’s balance sheet providing a more holistic view of firm value than market capitalization does in isolation. Unfortunately, the screening tool I use doesn’t provide this ratio, so for now I make do with P/FCF instead. One such share that fit these criteria is Frontier Transport Holdings (JSE: FTH). Sitting on a P/FCF of 6,3, EV/EBITDA of 3,03 and down 16% YTD. The share is clearly cheap relative to free cash flow generated and getting cheaper still. So, is the sell-off justified, or is the market misunderstanding this stock?
About Frontier
Frontier is a holding company with a portfolio rooted in the commuter bus and semi-luxury coach segments. Their principal subsidiary is Golden Arrow Bus Services (GABS) which has been in business for over 160 years. GABS operates solely in metropolitan Cape Town and employs 1051 buses to transport 220 000 passengers a day, or 56 million a year in a safe, affordable, and reliable manor. Their other commuter offerings include 59 Sibanye buses (providing routes to Atlantis) and the operation of 78 MyCiTi buses around the Cape Town CBD. They also own 46 semi-luxury coaches through their subsidiary Eljosa which provides school tour transport in the Western Cape and Gauteng.
Earnings
In 2021 FTH generated a net income of R198m and EBITDA of R398m, lower than the prior year’s R262m and R524m. This mediocre set of results was due to the Covid-19 restrictions enforced in March 2020, coinciding with the start of FTH’s 2021 financial year. In the four years prior to Covid, FTH enjoyed considerably better performance, growing revenue, and EBITDA at a CAGR of 5% and 4% respectively.
With earnings lower YoY I believe this share won’t begin to materially rerate upwards again until improved earnings performance is reported. As the modern-day investment sage Peter Lynch stated, “Stock prices cannot deviate for long from the level of earnings.”
While I wait for FTH’s earnings to recover, I can report that those earnings are at least considered good quality. FTH generated a cash flow to net income ratio of 0,9 times, close to an ideal 1:1 ratio. Signaling that their earnings aren’t just theoretical, but rather generate a sizeable cash inflow too. The cash flow from operations (OCF) trend is also promising, growing at a four-year CAGR of 2% to R276m pre-Covid.
Dividend
With an OCF growth rate of 2% FTH certainly isn’t a growth stock, but that’s not what I am looking for. Key to my value investment philosophy is a company’s ability to pay dividends. Which FTH delivers in spades. In the most recent year FTH paid an annual dividend of 46c, for an unheard-of dividend yield of 10,45%. To put that in perspective the JSE average is closer to 2%. This brings the total shareholder return (capital gains + dividends) over the last twelve months to an impressive 72%.
Balance Sheet
Reading the above total return you may feel this share has run hard and doesn’t have much more to offer, but on a P/NAV basis FTH has only just reached a very fair 0,99x. Meaning when you pay 99c for a share, it is backed by R1 in net assets on Frontier’s balance sheet. FTH is currently sitting on a Debt-to-Equity of 0,79 which has been declining since 2017, meaning that the balance sheet doesn’t have much debt on it. That’s important because when a business doesn’t have much debt it’s a lot harder for it to go bankrupt.
Manageable debt levels are even more important in a rising interest rate environment. The SARB has indicated that they intend to perform 4 interest rate hikes this year. Each one expected to be 25bps, in an attempt at cooling the economy and slowing the rate of inflation. Higher interest rates increase FTH’s debt costs, for example their busses are purchased through installment sale agreements. These agreements have an effective annual interest rate of 9,09%, which I expect to climb to at least 10,09%.
Fortunately, FTH can cover the anticipated higher interest costs 9,2 times with operating profit. In addition, FTH has proven to be a master allocator of invested capital, achieving a stable long-term average ROIC of 23%, far exceeding its WACC of 9,6%.
Business Cycle & Environment
However even with a solid balance sheet and attractive dividend it’s important to consider the business context in which Frontier operates in before investing even one Rand. With rising inflation and fuel prices climbing to never-before-seen levels Frontier has its work cut in overcoming these medium-term headwinds. Diesel prices have risen 38% from R14,12 per liter in March 2021 to R19,49 now, which means FTH’s high gross profit margin of 23% will come under pressure. Of course, they could hedge the rising fuel prices through futures contracts or pass the rising costs on to their customers. Given Golden Arrow’s announcement on the 14th of March 2022 that fares would be increasing by 8% and potentially more through the year it is clear they selected the latter option.
Rising inflation also poses a risk to the business by lowering the buying power and thus disposable income of the vulnerable lower LSM market segments that FTH services. I expect this could result in a marginal decline in demand in the short term as passengers cut down on unessential trips. However, most users commute to work, in effect ensuring that demand for trips will remain relatively price inelastic, provided taxi’s also increase their fares. Taxi associations have confirmed that prices will increase for 2022 but have not said by how much. I anticipate an increase in excess of 9,3%, which has been the long run average annual increase since 2013.
Economic Moat
Part of the reason GABS can implement fare increases is due to their sizeable and yet still growing economic moat. While there are several long-distance coach options in SA there is only one commuter bus provider in Cape Town, and that’s Golden Arrow. This monopolistic position in the market is further secured by the scale of Golden Arrow’s operations, which create substantial economies of scale.
While GABS has no direct competitors, their nearest competitor comes in the form of mini-bus taxi associations. This fragmented competitor offers greater convenience to the passenger at a higher fare and with much lower safety and reliability standards. Commuters continue to choose Golden Arrow when their route aligns with a bus stop to benefit from the lower price and superior reliability.
GABS has recently implemented a “Gold Card” offering which allows customers to load cash on their card and enjoy cashless commutes. This provides added value for the customer while further embedding the customer relationship and increasing switching costs.
Management
The management of Frontier Transport Holdings consists of a small group of highly experienced industry professionals with very low turnover. The CEO, Francois Meyer has held various rolls within Golden Arrow since 1991 and was appointed CEO of FTH in 2018. Frontier’s CFO, Mark Wilkin has a similarly impressive track record starting in 1983 with City Tramways, a subsidiary of GABS.
FTH has avoided an overly bloated board with just 2 executive and 5 non-executive members. The bulk of remuneration is allocated to the two above mentioned executive directors of which just over 50% of their remuneration is in the form of bonuses tied to the performance of FTH. Further detail is not provided on how performance is measured, but this remuneration structure should help align the interests of shareholders and management given that neither director is a major shareholder in FTH.
I also like to assess management’s adaptability, in other words their ability to overcome obstacles. In 2019 the current FTH management had to bounce back from a five-week long national strike. Not to mention their swift response to Covid-19 restrictions. Both situations provide me with confidence in their ability to overcome unexpected threats to the future of their business.
Intrinsic Value
FTH and its subsidiaries are well run transport businesses with solid financial footing that allows them to service and grow with the people of the Western Cape. However, the question remains whether this company represents good value at current market prices. To answer this, I have performed a DCF, which I admit can be inaccurate. A DCF is only as good as the assumptions it is based on. Thus, to minimize the risk of overestimating the intrinsic value I have combined conservative assumptions with a significant margin of safety.
My first assumption is an earnings growth rate of just 2% for the next 5 years despite actual earnings growth of 4% from 2017 to 2020. I have done this in anticipation of the negative impact of rising inflation and increased fuel prices on earnings. Secondly, the SARB is expected to hike repo rates which will increase FTH’s cost of sourcing capital through either equity or debt. Thus, I have assumed a conservative discount rate (WACC) of 13%, rather than their actual WACC of 10,7%. Further conservative assumptions have been made regarding Net Working Capital and Capital Expenditures.
Even after all the above-mentioned conservative assumptions the intrinsic value of Frontier Transport Holdings is expected to be R7,62. Meaning that there is a 42% margin of safety for the investor who buys the share now at R4,4. This is important given that I have no idea what the future may hold, and a sufficient margin of safety ensures that the risk of losing capital is limited, or as Ben Graham put it, “The function of margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future”. accompanying
Appendix
DCF
Share Price
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