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INFORMED SOURCES May 2005

 

ICEC retained with massive premium

Rivals could not understand the numbers; Christopher Garnett couldn't understand why they hadn't done the same; but vision has returned.

Forget the differentiation between talking the talk and walking the walk. GNER's Chief Executive Christopher Garnett transcends such banalities. Christopher lives the vision and, at GNER, it usually shows.

Someone remarked that enthusiasm is a form of faith. GNER's enthusiasm is reflected in a faith in the future of the passenger railway which, when translated into hard cash, obliterated the other bidders for the replacement InterCity East Coast franchise.

 

Profile.

That it was a total wipeout is undisputed. But someone in Government was clearly embarrassed by Sea Containers' grand design.

Ever since franchising started, the year-by-year subsidy or premium payments, known as the ‘profile', have been published when a franchise was signed. Under both the Office of Passenger Rail Franchising and then the Strategic Rail Authority, actual and projected payments were also tabulated in successive annual reports.

When SRA started to let replacement franchises it was a bit lax about publishing subsidy profiles. Having been chased-up a few times, the former service resumed.

But the press release announcing the award of the InterCity East coast franchise to GNER omitted the profile. So I sent off an e-mail pointing out the lacuna.

And got the reply, ‘ I'm afraid that the decision has been taken at the highest level here not to release this information'. Although no official reason was given for this secrecy, the spokesman speculated that ‘it has something to do with commercial confidentiality and the fact that this is premium and not government subsidy we are talking about here'.

But several existing franchises pay premia, notably Gatwick Express, Thameslink and, theoretically, InterCity West Coast. Profiles for all of these were published at the time of signing and subsequently updated in the annual reports, even when West Coast went pear-shaped.

So I promptly whacked off a formal request for the ICEC premium profile under the Freedom of Information Act. I'll let you know what happened next month

 

Puzzled.

But why should a substantial premium payment be seen as a bad news story by government at a time when financial support for the railways is at unprecedented levels. My only theory is that analysis of what the premium payments mean for fares might not be welcome in the run up to the 5 May general election.

All we were told is that the total premium will be £1.3billion over the 10 year term, assuming Sea Containers gets the three year extension for good behaviour. The media assumed this meant £130m a year.

But franchise bids have always been valued on Net Present Value (NPV) which discounts future payments. And SRA was prepared to confirm that the £1.3 billion total was the NPV figure.

So, using the 3.5% discount rate in the Treasury's Green Book, I backwards engineered a 10 year premium profile to get an NPV over 10 years of £1.3billion.

According to Sea Containers' latest financial report, the premium for the 12 months to the start of the new franchise on 1 May was £58 million. So I assumed a premium of £120m in the first year of the replacement franchise which then increased progressively.

To achieve an NPV of £1.3 billion you need a premium in year 10 of around £210 million. This sounds a lot but is less than the final year premium of the original Virgin bid for the 15 year Intercity West Coast franchise. In modern money this was around £270 million.

 

Growth.

Now, here we come to the interesting bit. No one in the industry can make the premium profile add up.

All Sea Container has done is project past revenue growth rates forward. In round terms, before Hatfield, GNER claims a compound revenue growth of 10% per annum. In the last three years it has been 9% and over the last two years 8.2% pa.

According to Christopher Garnet, ‘Our contract for the next ten years is based on compound revenue growth of 8.7% per annum. Some commentators have said they are worried that we will make GNER too expensive for the ordinary passenger. Nothing could be further from the truth – we want passengers to travel more'.

Sea Containers puts GNER's revenue in 2004 at £492m and GNER Chief Executive Christopher Garnett has quoted £500m for 2004/05. Projecting forward at 8.7% pa, at the end of the 10 years annual revenue will have doubled to around £1.1 billion. With GNER committed to acquiring only three more HST sets, operating costs will not increase significantly. Plenty in hand, then, to support a chunky premium profile.

 

Load factors.

So why is everyone baffled at a strategy so simple that, Christopher tells me he can't think why no one else thought of it? The answer seems to lie in load factors.

GNER carried 16.6m passengers in 2004 with a load factor quoted at 50%, which I think is rounded up slightly. Christopher says that meeting the premium profile requires the number of passengers to be increased by 30% to give a load factor of 65% at the end of the 10 years. This equates to 21.6m passengers a year in 2014/15.

So the average fare per journey will be £50 compared with £30 today. If you assume a 5% pa increase in the average fare, you get to a similar number for 2014/15.

However, while these numbers compute. I can't make them align with the load factors. With an average of 500 seats per train across GNER's mixed fleet a 60% load factor equates to 300 passengers per train. At £50 per journey the earning capacity of 141 trains equates to around £800m a year, some £300m short of the projected revenue.

If you start with the projected revenue and work backwards I reckon that the money each train needs to earn is the equivalent of an all day load factor of 83% - the sort of numbers achieved by Easyjet and Ryanair.

Professional industry analysts have come up with similar figures. Given that GNER trains are already running full and standing at peak periods, and that these calculations are based on a projected 5% annual increase in fares before inflation, you can see why unsuccessful bidders for the franchise are having problems reconciling their offers with the winning bid.

What seems clear is that Sea Containers substantially overbid to win the franchise. One industry estimate puts Virgin/Stagecoach in second place on NPV by some £500 million, with DSB/ESW a close third. First Group, which I expected to win on a combination of aggressive premia and cost cutting could have been as much as £600m adrift.

 

Mitigation.

While the Sea Containers bid is undoubtedly bold, it is not as risky as it might seem. The company says that the new premium profile will initially cut GNER's management fee, as a percentage of revenue, by about 1/3 compared with the current franchise. But with revenue rising rapidly the new fees ‘should quickly surpass the levels in the old franchise'.

In addition, the SRA's new template franchises provide some protection for revenue after the first four years. Should GNER's revenue fall to under 94% of target, the deficit is shared 20% to GNER and 80% to the government. Between 94% and 98% below target the shortfall is shared 50/50.

Similarly, if revenue exceeds target GNER will keep 100% of the excess up to 102%, 60% from 102% to 106% and 40% over 106%.

 

Welcome ‘E' word.

So that's the financial analysis. What does the passenger, as opposed to the taxpayer get? Most of the detail is what you would expect from GNER's past record.

Up to £75m will be spent on the HST fleet including leasing an additional spare set, plus two more to deliver the planned increase in Leeds services, giving a total stud of 13. A £25million refurbishment of the HST vehicles will be funded by owners Angel Trains and the power cars re-engined.

Having been impressed by the technical improvements behind the panelling and carpets of the Mallard Mk4s I expect my old chum Richard McClean, GNER's Development Director, and his engineers, to set new standards for HST refurbs. An emphasis on reliability improvements is certain, given the franchise commitment to a PPM of 90% from 2010.

But the big news is that, having once urged the dieselisation of the ECML, GNER's new franchise includes a commitment to develop what Christopher Garnett calls the ‘electric horseshoe' – electrification between Hambleton Junction and Leeds c osted at £70 million for 15 miles.

Currently electric trains can only enter Leeds from the west via Wakefield and this route is close to capacity. Electrification would allow trains to and from London to come in from the east, with a potential increase in the London-Leeds service – the biggest long distance rail market in the UK according to GNER -to five trains an hour and 80 trains a day by 2010.

This is what Christopher terms ‘commercial' electrification. But operationally, putting up the wires from Micklefield to Colton Junction would have substantial benefits.

However, this is rushing ahead. But who would have thought when the bidding opened that we would be talking electrification?

Which brings us back to living the vision. How ironic, and how uplifting, that Sea Containers, which lost InterCity West Coast to Virgin by a reputed £1billion, should have come back eight years later with a killer growth-driven bid of its own.

Announcing the franchise award, SRA emphasised that the premium would be ‘reinvested' in the railway industry. Given those load factors, how about putting some of the money into lease rental for a fleet of electric HST2s? Plus some more capacity enhancements – starting with a flyover or dive-under at Hitchin for the Cambridge line?

 

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