Asbahi: "Student Transportation Is Robbing Peter to Pay Paul"

(This is a highly-abbreviated version of a full SumZero report republished with the author's consent)

Contributor: Eiad Asbahi.
Firm: Prescience Investment Group. Hedge Fund.
Location: New York, NY.

Recommendation: Short Student Transportation Group (Nasdaq: STB)
Timeframe: 6 Months to 1 Year.
Recent Price: $7.10
Target Price: $2.00
Strategy: Other

Disclosure: The author of this report had an active position in this security at the time of its posting.

Quick Thesis:
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.

STB has never been able to cover its dividend from its operating free cash flow and is projected to fall short yet again in FY 2013.

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 tapped 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.

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.

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 is 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 (Appendix 5).

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 62x 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. The absurdity of 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.

STB’s share price has outperformed all its relevant peers and the Dow Jones Transportation Index 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.

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.

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.

Investment Conclusion

Student Transportation is using the guise of helping bus children to school to operate a financing scheme by raising money from Peter to pay Paul. This scheme is highly dependent on paying an illusory fixed monthly dividend to existing investors by issuing stock and bonds to new investors. Management's incentive structure is to maximize revenue and has little alignment with common shareholders given they own a preferential put option in their Series B stock.

Their acquisition strategy has been levered and not evident to be providing tangible bottom line improvements to shareholders. The student bus market is a extremely competitive and capital intensive - STB appears to be managing cash flow by under-spending on Capex, but this will reverse in future periods. The useful life of a school bus necessitates replacing 10% of their fleet ever year. Overall, the company is highly dependent on selling its shares to retail investors, and their recent Nasdaq listing was necessitated by our belief that they have largely tapped out their financing capacity in Canada. STB’s dividend is at future risk of being cut, and its stock price would fall to its fair value of no more than $2.00 per share.

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