OREANDA-NEWS. Fitch Ratings has affirmed FirstGroup plc's (FirstGroup) Long-Term Issuer Default Rating (IDR) at 'BBB-', Short-Term IDR at 'F3' and senior unsecured rating at 'BBB-'. The Outlook on the Long-Term IDR is Stable.

The rating affirmation reflects FirstGroup's operating performance in FYE16 (financial year end March) being broadly in line with Fitch's expectations and, consequently, stable credit metrics, which remain within Fitch's rating guidelines for a 'BBB-' credit. The ratings also reflect the company's business profile as a leading UK bus and rail operator with geographical diversification in North America.

KEY RATING DRIVERS

Strong Business Profile

FirstGroup's 'BBB-' rating reflects the company's strong business profile compared with peers. FirstGroup is the largest company by revenue of three UK land transport companies rated by Fitch. The company generated revenues of approximately GBP5.2bn in FYE16, compared with GBP3.9bn by Stagecoach in FYE16 and GBP1.9bn by National Express in FYE15.

FirstGroup operates within a well-diversified, albeit competitive and fragmented, selection of transport sectors including school bus, transit, intercity coach and local bus services in the UK and North America. This diversity provides the company with a strong mix of consistent contract-based earnings, such as in First Student and First Transit, which can help counter its more cyclical operations, such as intercity coach services, during difficult economic conditions. Contracted revenue accounted for 46% of total revenue.

Stable FYE16 Performance

FirstGroup's FYE16 operational performance was largely in line with FYE15 results at the group level but performance across divisions was mixed. Better performance at the UK Rail division and group cost management led to the overall outperformance of Fitch's expectations. First Student, Greyhound and UK Bus all slightly underperformed while First Transit was in line with our forecasts.

Metrics within Rating Guidelines

FirstGroup's FYE16 metrics of funds from operations (FFO) adjusted net leverage of 3.4x and FFO fixed charge cover of 3.5x were within the 'BBB-' rating guidelines. We expect net leverage to remain around 3.4x, close to Fitch's negative rating guideline of 3.5x, and interest cover to remain near 3.5x over the FY17-FY20 period. This is based on the assumption of continued gradual improvement in the UK Bus, First Student and First Transit divisions.

Fitch also expects free cash flow (FCF) to be neutral-to-negative with future capital expenditure comparable with current levels. We believe dividends are unlikely to be paid until the company becomes more cash-generative and under Fitch's conservative rating case, we believe this is unlikely to happen before FYE19.

First Student's Stable Performance

The rating affirmation is underpinned by an improvement in the First Student business as it accounts for around one-third of FirstGroup's profits. First Student reported better-than - expected revenue due to the weakening of GBP against USD during FY16. However, excluding currency effects revenue declined 1.5% due to a weakening of the Canadian Dollar versus USD, exit from some lower-margin contracts and fewer operating days in the year.

Reported operating profit (EBITA) declined 2.0% and EBITA excluding currency effects fell 6.9% in FY16, resulting in a 40bp decline in margin to 7.1%. EBITA was also impacted by extra costs due to a shortage of drivers caused by strong employment in the US, which resulted in extra costs of USD22m and was a key reason for EBITA underperformance versus Fitch's expectation.

Smaller Rail Business

First Rail revenue was broadly in line but EBITA was significantly better than Fitch's expectations. Revenue declined 40.7% due to the ending of FirstGroup's ScotRail and Capital Connect franchises. Underlying revenue growth was strong with 6.1% growth on the Great Western Railway franchise, 6.0% growth at the TransPennine franchise and 15.8% growth at Hull Trains. EBITA declined 26.7% (adjusted for change in pension accounting) due to the abovementioned completion of two franchises. The adjusted EBITA margin increased 80bp to 4.2%, driven by changes in the business composition.

FirstGroup is currently bidding for the East Anglia and South Western franchises; however, Fitch assumes no new franchise wins in its forecasts.

UK Bus Supported by Cost Cutting

First Bus reported revenue and EBITA slightly below Fitch's expectations. Reported revenue declined 2.8% due to lower-than-expected passenger volumes from lower high-street retail footfall, exceptionally wet weather and a reduction in tendered contracts due to funding constraints at local authorities. EBITA increased 0.4%, leading to a 20bp increase in the EBITA margin to 6%, as the impact from cost inflation was more than offset by management's cost-saving initiatives - such as reduced fuel consumption, better procurement and optimisation of operating bases.

The potential impact of devolving transport powers to local authorities in the UK, which may affect operating margins for bus operators including FirstGroup, is not expected in the near term.

Greyhound Remains under Pressure

Greyhound reported revenue broadly in line with Fitch's expectations, while EBITA was below expectation. Reported revenue declined 0.7% and excluding currency effects it declined 7.3% due to lower passenger volumes on the back of lower fuel prices, which promoted the use of personal vehicles. Reported EBITA declined 14.9% and excluding currency effects it declined 20.6%, resulting in a decline in the EBITA margin of 90bp to 6.9%. The decline in EBITA was due to lower passenger volumes partially offset by actions to improve yield and cost management.

First Transit in Line with Expectation

First Transit reported revenue and EBITA were broadly in line with Fitch's expectations in GBP terms. Reported revenue increased 2.4%, driven by the benefit of a weaker GBP versus USD while revenue excluding currency effects declined 4.3%. This decline was caused by the contraction in business linked to Canadian Oil Sands activity and the weakening of the Canadian Dollar against USD. Reported EBITA increased 0.7% while excluding currency effects it declined 5.7%, resulting in a 10bp decline in the EBITA margin to 7.0%.

Brexit Impact Likely Neutral

FirstGroup is exposed to the impact of Brexit as it is UK-domiciled with operations both in and outside of the UK, most notably in North America. The main impact of Brexit could be the effect of GBP depreciation against the USD. A weakening of GBP will deliver higher earnings from North America when converted back into the home currency, which would be positive given the majority of FirstGroup's debt is GBP-denominated. However, this could be offset by a negative commercial impact that arises from any economic weakness in the UK, leading to a reduction in bus or rail travel.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for FirstGroup include:

-Resumption of dividend payments in FYE19

-Future capex comparable with current levels

-No major acquisitions or disposals

-No new rail franchise wins

RATING SENSITIVITIES

Positive: Future developments that may, individually or collectively, lead to positive rating action include:

-FFO-adjusted net leverage sustainably below 3.0x (FYE16: 3.4x)

-FFO fixed charge cover at or approaching 4.0x (FYE16: 3.5x)

-Positive FCF (before disposals)

Negative: Future developments that may, individually or collectively, lead to negative rating action include:

-FFO-adjusted net leverage consistently above 3.5x

-FFO fixed charge cover significantly below 3.5x for a sustained period

-Sustained negative FCF

-Weakening of the business profile, including unfavourable developments in the UK rail franchising process

LIQUIDITY

Good Liquidity

At FYE16 FirstGroup had unrestricted cash of GBP140m in addition to GBP800m of undrawn committed facilities. This is more than sufficient to cover its short-term financial liabilities of GBP109m. There are no material debt maturities falling due until 2018 when its GBP300m bond matures. Fitch expects FCF to be neutral-to-negative during FY17-FY20 as improved operational performance is offset by capex being maintained at current levels and Fitch's assumption of dividend reinstatement in FY19.

FX Exposure

The depreciation of GBP versus USD benefitted FirstGroup in FY16 as it generates over 60% of its profits in USD while only about 16% of debt is USD-denominated. While we expect the company to continue benefiting from further GBP depreciation in FY17, any adverse currency fluctuations in the medium term are likely to have a negative impact on credit metrics unless the company's fundamental operational performance improves.