Popular stocks can see their prices rise on positive sentiment alone. Quite often, the increase in a company’s market value will outpace the progress of the underlying business. The converse is also true. Stocks that are out of favour can fall further than the state of their business warrants.

Morningstar’s Brian Han thinks that Kelsian (ASX: KLS) offers an example of the second situation.

The company, which derives most of its revenue from running bus services in Australia and Singapore, has seen its shares fall by around 30% since the start of 2024. In Han’s view, the pessimism is overdone and the shares look materially undervalued.

How does Kelsian make money?

Kelsian makes just under half of its revenue from its Australian bus operations, which mostly serve state governments and resource companies. Kelsian’s international bus operations provide another third of the company’s overall sales, with much of this coming from contracts in Singapore. Following the acquisition of All Aboard America in June 2023, Kelsian is also the fourth-largest operator of private motor coach services in the United States, servicing the corporate, government, and education sectors.

Government transport contracts are typically long-term, averaging 6-10 years, and include indexation mechanisms to adjust the operator’s revenue in line with increases in fuel costs, wage costs, and the Consumer Price Index, underpinning a secure top-line profile. Kelsian’s non-government contracts are generally short-term, between one and five years long, and do not have the same pricing indexation as public transport contracts.

The remaining 20% or so of Kelsian’s revenue comes from its marine and tourism segment, which operates vehicular and passenger ferry services throughout Australia. It also operates leisure dining cruises, packaged holidays, bus tours, and accommodation facilities. Although the division receives some contract revenue with indexation mechanisms from public transport ferry services, most revenue relates to leisure. This is more cyclical, with consumer discretionary spending highly leveraged to swings in the economic cycle.

Why have Kelsian shares fallen?

Han thinks that some of the market’s pessimism may relate to the All Aboard America acquisition. While AAA offers more growth potential, it reduces the share of revenue Kelsian gets from dependable government customers from 80% to roughly 70%. How this new, more cyclical business will hold up against an uncertain US economic backdrop appears to be playing on investors' minds.

The market may also have concerns around Kelsian’s marine and tourism business. In the first 10 months of fiscal 2024, holiday visitors to Australia improved 70% from a year ago but remained almost 25% below 2019 levels pre-Covid. Tourists from China, a material contributor to Kelsian’s tourism revenue, have been particularly slow to return. In the first 10 months of fiscal 2024, Chinese visitor numbers were around half those seen in 2019.

Room for optimism?

Han thinks that the AAA purchase is performing well so far. Integration is complete no contracts have been lost since the acquisition closed. One fourth of AAA’s contracts have been renewed, 70% of which have featured a price increase. With an established footprint in the south to southwest states, AAA serves as a beachhead for expansion into other states, which could provide scale benefits down the line.

On the marine and tourism front, Han notes that China has emerged from its Covid lockdowns and that diplomatic relations with Australia look to be thawing. This could see visitor numbers bounce back towards previous levels. Meanwhile, tax cuts and a robust labor market in Australia could also support domestic discretionary spending, which has been held back by cost of living pressures.

No moat, but the shares look cheap

In its core bus segments, Han thinks the attractive nature of government transport contracts makes it inevitable that Kelsian will continue to see intense competition. And as the services offered by competing parties are largely homogeneous, he doubts Kelsian has any meaningful long-term differentiation from peers.

Kelsian has historically grown in size and geographical reach via acquisitions, which have in turn increased credibility in tendering for new contracts. However, future acquisitions could be more expensive if global competitors pursue a similar strategy. Kelsian’s marine and tourism business also exhibit high levels of competition and also have higher levels of cyclicality and capital intensity.

Han thinks that the AAA acquisition, recent tender wins and a return to normal visitor numbers can help Kelsian achieve sales growth of 13.5% per year over the next three years. As the AAA business has higher margins, Han also expects Kelsian to keep more of these sales as profit. Beyond the initial three year period, he thinks sales growth will moderate to around 3% per year.

All things considered, Han thinks Kelsian is worth $6.70 per share and attaches an Uncertainty rating of High to his valuation. This encapsulates the competition he feels Kelsian will see for government contract renewals, execution risk regarding its acquisition strategy, and cyclicality in its leisure markets.

At a current price of around $5.00 per share, Kelsian commands a 4-star Morningstar Rating.

Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.

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