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INFORMED SOURCES June 2005

ICEC franchise – phew! What a premium!

Wrong again – I should have thought of the last number and doubled it

Last month's analysis of Sea Containers' crushing victory in the InterCity East Coast franchise replacement bidding was handicapped by the Strategic Rail Authority's refusal, for the first tine ever, to release the premium profile. So I whacked in another Freedom of Information request.

Meanwhile, the SRA kept up a counter barrage of sophistry. When taxed on this newly imposed code of omerta, SRA argued that details of subsidy are about public expenditure;  details of premia are about commercial payments by franchisees. Thus, ‘the prima facie case for transparency (on grounds of public accountability) in relation to the former is stronger than in relation to the latter.

This is, of course, industrial strength tosh In public affairs, transparency of accountability is independent of the direction of cash flow: going out or coming it is all the tax payers' money.

Iteration

Originally, SRA would say only that the Net Present Value of Sea Containers' premia over the 10 years of the franchise was £1.3 billion. so I fired up Excel and by a series of iterations I got a premium line (Table 1) giving an NPV of almost exactly £1.3 billion.

Table 1

InterCity East Coast franchise premium profile

Source: Informed Sources estimate

In fact, this was my second iteration, after I worked out the ground rules under SRA's new Template Franchises. Hence the colour coding

For the first four years, (red for risk) Sea Containers will be on their own. If they don't bring in the extra revenue – tough. They still have to pay the premium.

But in the next three years (GNER blue), what is called in the trade ‘cap & collar' comes into effect. From 2009/10, if revenue falls to less than 94% of the target in the franchise plan, cap & collar means that the resulting deficit is shared 20% to GNER and 80% to the taxpayer. Any shortfall between 94% and 98% is shared 50/50. Should revenue exceed the target in the franchise bid GNER keeps 100% of the excess up to 102%, 60% from 102% to 106% and 40% over 106%.

So, thinking I was being clever, the strategy for my notional premium profile assumed that GNER would keep the premia conservative in the first four years when the franchisee took all the risk. They would then increase over the final three years, plus the optional three year extension for good behaviour. In the trade, this is called ‘back-loading'.

At which point readers should note a technical error in my estimates. I looked up the Treasury Green Book and used the 3.5% discount rate quoted for NPV calculations. However, this is intended for capital projects as I found when the freedom of information act worked as advertised. SRA provided not only the cash premia I had asked for, but also the NPV of the annual payments plus the discount rate used which is 6.0875%.

Table 2

InterCity East Coast franchise.

Annual premia (£ millions)

Source: SRA

Notes:

2004/05 included for reference

*Year 1 runs May 2005-March 2006 inclusive

Figures assume 2.5% annual inflation

Chutzpah

Table 2 gives the official premium profile and you will see that when it comes to back-loading I was way out of my depth trying to double guess the big boys. But it is Tables 3 and 4 which reveal the sheer audacity of Sea Containers' bid.

Table 3

Intercity East Coast franchise

NPV of annual premia

Source: SRA

Notes

Discount rate 6.0875% nominal

Total NPV £1.278 billion

Table 4

Source SRA

Have you stopped laughing yet? What chutzpah! What brilliant exploitation of the rules. How humiliating for Virgin and Stagecoach, the tieless iconoclasts of capitalism, and the dour hardliners at First Group, to be outmanoeuvred by an impeccably suited Bermuda based establishment figure.

No wonder Christopher Garnett told the scoffers and doomsayers that Sea Containers was happy with the premium profile, despite having bid an NPV 60% above runner up Virgin/Stagecoach. When he told me that the bid strategy was so simple that he couldn't understand why Sea Containers' rivals hadn't done the same, we now see what he meant.

Template

Back in 1996, franchis bidding was simple: the lowest NPV won. Get the business plan right – like Stagecoach – and you made money. Get it wrong, or if the economy dived, and you lost money.

This was fine in principal, but in practice failing TOCs either came back with the begging bowl or were taken over. Whereupon the rescuer demanded more subsidy.

These traumas meant that when franchise replacement started, the scarred survivors were going to price in a much higher risk. One of the aims of the SRA's new template franchise was to reduce this risk – hence ‘cap & collar.

Some simple sensitivity tests on ICEC show how financial risk is reduced. Sea Containers' bid is based on 8.7% year on year revenue growth, but what happens if the economy slows and the annual revenue growth is only 5% from 2009/10?

In this event, cap & collar means that over the final three years of the basic seven year franchise the Government would provide revenue support of £125million while Sea Containers' would take a hit of £40million. With 3% growth, support from the taxpayer would be £190million with Sea Container's exposure limited to £50million.

So, now we understand why it's called cap & collar. The taxpayer caps the loss and the franchisee collars the profits.

Of course, if the franchise plan was threatening to crash and burn, it is unlikely that the three year extension would be taken up. So Sea Containers could either seek to renegotiate the deal, as other franchisees have done in the past, or walk away. Yet, as Table 4 shows, 47% of the £1.28billion NPV is back-loaded into that three year extension.

Before we move on to the implications of the winning bid I though it might be instructive put it into some context. Chart 1 shows the premia Virgin should have been paying over the same period to run a modernised InterCity West Coast franchise if various kinds of stuff hadn't happened.

Chart 1

Note in particular that from 2009/09 Sea Containers' annual premia increase in a straight line (shown in green) at a steady £40-50 million a year. Compare and contrast with Virgin's 1997 vision of the 21 st Century where revenue growth tails off after four years.

New paradigm?

This chart highlights the dilemma facing Virgin/Stagecoach when the renegotiation of the InterCity West Coast franchise reconvenes under the DfT's auspices in September. Do Virgin/Stagecoach take the revenue growth rate since the 125 mile/h tilting timetable started last September, project it forward forever and back-load like mad?

According to Informed Sources, before negotiations were put on hold, a proposal including back-loading was rejected by SRA. But that was before Sea Containers triumph rewrote the book.

Of even greater import is how the bidders for Greater Western react. Do they take the hint and catch up with what appears to be a new paradigm for InterCity based on straight line growth, with heavy back-loading to exploit cap & collar?

Certainly, at wash-up meetings for unsuccessful ICEC bidders, SRA officials are reported as claiming that the winning premium profile was as expected, while adding that the Authority remained nervous about accepting heavily back-loaded bids. Senior SRA figures are also reported as considering the ICEC bid as unexceptional.

So straight line revenue growth on inter city services and a premium profile which rises sharply only after cap & collar comes, could be the winning approach for Greater Western.

Model figures

While a lot of hot air is spouted about the quality of service in winning bids, the real aim of each bidder not to offer the best railway service at the lowest cost/highest premium. The aim is to bid what the SRA's, soon to be the DfT's, comparator model, used to evaluate bids, says is the best set of numbers. In other words, the aim is to structure a bid which when fed into the comparator produce ticks in more boxes than your rivals.

Thus , in the case of ICEC, other bidders may have thought of something similar to the winning bid, but then decided that the SRA's comparator model would penalise the straight line revenue growth for irrational exuberance. Alternatively, when the numbers were fed in, the comparator model would reveal a gap between its own predicted revenue lines and the irrationally exuberant bid and knock off the future premium support this difference implied.

But it didn't. So even now the modelling geeks and nerds at Stagecoach, First and National Express are backwards engineering the Sea Containers bid – and I hope these official figures are useful chaps – to recalibrate their model of the SRA comparator ready for Greater Western0.

Conspiracy

All of which leaves two unanswered questions. Why, for the first time in nearly a decade of franchising did SRA seek to suppress the premium profile and tell us that we would get the same reply from DfT? And why did DfT then leak the information? Cock-up is invariably preferred to conspiracy in this column, but, for once I make an exception.

Given that Sea Containers' successful bid was going to pay £1.9billion in premia over the 10 year extended term, surely this was good news in the run up to the election? So why did the press release quote the smaller NPV figure? Did someone fear embarrassment if the sort of analysis you are now reading got out?

Remember that 59 MPs had signed an Early Day Motion calling on Sea Containers to keep the franchise. And that handing GNER over to Virgin/Stagecoach would have caused an outcry when all parties were trying not to mention railways ahead of the election.

So it was in the interests of the Government for Sea Containers' to put in an unstoppable bid. And when you read below about what went on inside the corridors of power over Railtrack's demise, it is not too fanciful to have a special adviser urging SRA to accept a bid which, while fully compliant, has a pretty exuberant revenue line.

Certainly, there would have been no skin off the SRA's nose in complying, since the organisation is fast winding down. Tony Blair and Alistair Darling are unlikely to be around when we find out whether the bid line was sustainable.

But the civil service plays it long. Decisions today may come back to haunt you when you are much further up the departmental tree. So, and I hope this has helped the DfT too, it was important to have the details out the open, to back the memo expressing concern, carefully put on file against a stormy day. Yes I know, cock up is more likely, but this is more fun.

All of which is not to diminish the achievement of Sea Containers and their bid advisers. It is only a shame that they, in conjunction with Laing, failed to pre-qualify for Greater Western.

Continues.........