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INFORMED SOURCES February 2006

Franchising: buy now pay later

Winning franchises demamand financial creativity?

When privatisation saw bidding for new train orders dry up, the car park watchers diversified. In a fragmented industry, knowing who is meeting whom, where and when is even more valuable than counting boxes of tender documents.

So on 11 October, Central Watcher Control reported a high level of activity at Location Alpha Tango 3, otherwise knoewn as the Passione restaurant in London 's Charlotte Street . Not only is Passione one of the best Italian restaurants in London , it is one of the venues favoured by the Association of Train Operating Companies for off-site meetings.

A high number of senior train operating company directors had been logged, when the watcher on duty hit the jackpot. Director General Rail, Dr Mike Mitchell had just arrived.

Not surprisingly, franchising was one of the topics raised. And, according to Informed Sources, Dr Mike made it clear that with the move of responsibility for franchising from the defunct Strategic Rail Authority to DfT Rail, a new policy was in force. While a company's track record would still account for 66% of the marks in the prequalifying assessment, once the real bidding began, the lowest cost, or highest premium, would win.

That had, of course, been the original policy of the Office of Passenger Rail Franchising (OPRAF). But after the termination of Connex south Eastern, plus the financial difficulties encountered by other first generation franchises, SRA added an assessment of what was ‘realistically deliverable' to bid evaluation.

According to the National Audit Office (NAO) report on the CSE termination, SRA applied a ‘deliverability' assessment to the four franchises it awarded in 2004 and 2005. SRA characterised its approach as seeking ‘best value' as opposed to lowest cost. NAO noted that since DfT Rail took over franchising from SRA it has perpetuated that policy in evaluating bids for the Integrated Kent, Thameslink/Great Northern and Greater Western franchises.

But the NAO also confirmed that DfT Rail is currently ‘re-considering its franchise policy'. The Department has ‘reservations' about rejecting bids that offer the ‘best deal for the taxpayer and passengers in favour of ‘civil servants' and consultants' assessments of what is realistically deliverable.

DfT Rail expected this review, including whether to include deliverability in bid assessments, to be completed in time for any policy changes to be applied to invitations to tender for franchises from February 2006. Note that deliverability is a separate issue to taking track record into account. What DfT is pondering is simply whether caveat emptor should apply to franchise bids or whether it should trust the bidders' own judgement.

Sexy profiles

Since that meeting at Passione, DfT has awarded IKF to Govia and, Greater Western and Thameslink/Great Northern to First Group. The subsidy premium profiles for the first two have been released.

Let's start with IKF which is the most interesting of the two. Fig 1 shows the profile in traditional format, with subsidy positive. Some salient features are noted.

First, although the franchise runs from 2006-07, I have added the subsidy for the current year, the last under state control via South Eastern Trains.

Table 1

IKF subsidy/premium

All figures at 2006-07 prices

Fig 1: IKF subsidy/premium profile

This addition highlights the first characteristic of a winning franchise bid, get some money in early before the falling subsidy/rising premium starts to bite into the profits. Another reason for a cautious start is that the Cap & collar provision in the franchise agreement does not kick-in until Year 5.

Cap and collar, protects the franchisee against revenue shortfall after the first 2% below budget. If income is between 94% and 98% of budget, the shortfall is shared 50/50 by the taxpayer and the franchisee. Below 94% the taxpayer shoulders 80% of the loss.

So to get that winning Net Present Value you simply got for broke from year five onward. This is known as ‘back-loading.

Complicated

But Integrated Kent is slightly more complicated. Channel Tunnel Rail Link Domestic Services (CTRL-DS) start in 2009 and Govia have prudently sought an increase in subsidy for that year.

This is reasonable because of the uncertain effect on the revenue line of the new services. Remember that SRA couldn't get CTRL-DS to make a business case.

But being reasonable doesn't win franchise bids. So from years five to eight we see the expected back-loading, with the franchise going into premium in the last year

But if the revenue line goes really pear-shaped you need an exit strategy. And DfT Rail provides this through a change of policy. Instead of, say, a seven year term with a three year extension for good behaviour, we now have a ten year term with the last years subject to performance targets being met. But the Net Present Values of bids are compared on the full term.

Now, if DfT Rail can sack you, after six years in the case of IKF, and seven years with Greater Western, for failing to perform, you, as franchisee can also walk away at the same time if you don't like the way things are going. So back-loading in the extension is pure bunce.

Olympic duty

But IKF has a sting in the tail. in 2012-13, the CTRL-DS will be providing the Javelin Shuttle between St Pancras and Stratford taking visitors to the London Olympics.

Now, suppose DfT Rail is unhappy with performance, it is going to have to announce the termination of the franchise at least a year before the break point at the end of year six. In other words, a year before the Olympics. The replacement franchisee would then take over in Olympic year.

Can you see that happening? Of course not.

So if the revenue growth won't support the heroic back-loading in years seven and eight, Govia could say ‘We're off'. DfT Rail might then have to bow to force majeure and sign a management contract deal, as the SRA did with the Virgin franchises.

Just to put the subsidy profile into perspective, SET received subsidy payments of £80.7million in 2004-05. Fares revenue was £331.3 million and income from other sources was £31.6 million. Income totalled £443.1 million against operating expenditure of £430.9 million.

To give a reduction in subsidy of roughly £120 million from year 2 to year 8 of the franchise farebox income has to be increased by a third. And Govia's subsidy profile suggests that the CTRL-DS generates revenue growth. No doubt fares increases of 5% above inflation will help.

Greater Western

If the winning IKF bid is ingenious, First Group's successful approach to Greater Western has all the subtlety of a thousand bomber raid.

Figure 1

Greater Western and GNER compared

Table 1

Greater Western and GNER subsidy/premium profiles

Both at cash prices

This is highlighted in fig 2. We all thought that Sea Containers' bid to retain InterCity East Coast was heroic. But as you can see, First Group has been braver still.

Once again, there is money to be made in the first two years. In 2004-05, the last year for which figures arte available, the three franchises which make up Greater Western received a net subsidy of £12 million at 2006-07 prices. Since then track access charges have increased, raising the sum to £58 million compared with £97.4 million for the first year of Greater Western.

But whereas in year three GNER is due to be paying £81 million premium Greater Western is still receiving £14 million subsidy. Yet by year 10 Greater Western will have overtaken the GNER annual premium.

True, Greater Western starts with a higher annual passenger revenue – roughly £630 million versus £500 million – but the growth potential could be less, with all three service categories in the expanded franchise – InterCity, London and Regional, compared with GNER's all Intercity business.

Growth

According to First Group, the Greater Western profile is based on straightline revenue growth at 8-9%, with half coming from growing ridership and half from fares increases. GNER's franchise is based on a similar assumption.

But note that the London bombings came just weeks after the replacement East Coast franchise started. And in the three months ending 30 September Sea Containers reported that GNER made a loss of US$6.7 million against a profit of US$14 million the year before. And while passenger volumes and revenued recovered after the summer holidays, they had ‘yet to return to levels anticipated'.

No apologies for focusing on the money side of Greater Western this month. The techie stuff on the re-engineering of the IC125 fleet will come in due course.

But I can't let the following piece of irony go unremarked. Comnmenting on the award of Greater Western Moir Lockhead Chief Executive First Group said

‘We have the experience, drive and proven track record to transform travel for the Greater Western Region'.

Hmm, First took over Great Western in March 1998. Average Passenger Charter punctuality for the previous year had been 86.7 per cent.

This mini table shows Great Western' 0-10 min punctuality for the first eight periods of the current reporting year. As Winston might have said ‘Some track record, some transformation'. But what a premium profile!

Great Western 0-10 punctuallity

Year starting 1 April 2005

Continues.........