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INFORMED SOURCES December 2006

Replacement franchises – there may be trouble ahead.

Brian decides to face the music and join the dance.

You know the world is turned upside down when Chris Grayling , the Conservative's Transport Spokesman comes out somewhere to the left of Gwyneth Dunwoody, on the subject of franchising. Adam Smith has definitely been airbrushed out of David Cameron's new revised edition of the Great Tory Encyclopaedia.

Here is one of the recommendations in the report on the inquiry into passenger rail franchising by Gwyneth's Transport Committee. ‘ The Government must hold firm on its commitment not to re-negotiate franchising contracts with operators who have over-bid to win their contracts. Were the Government to give in to such pressures, the flood gates could be open to many future claims, and tax-payers would be left to foot the bill'.

Contrast that robustly roundhead view with Chris Grayling 's letter recent to Transport Secretary Douglas Alexander. He starts, ‘I am writing to express my concern about the viability of a number of the franchise agreements which your Department has reached with Train Operating Companies, and to ask you to review the process of awarding new franchises as a matter of urgency'.

‘You will have seen that Bob Mackenzie, the Chief Executive of Sea Containers, is reported as saying that GNER may have to give up its franchise to the Government and that it will be "very difficult" to achieve the £1.3 billion premium provided for in the agreement. We have studied other recent contract awards, and believe that GNER will not be the only company to find itself in such difficulties'.

He instances the new South Western franchise. According to Mr Grayling, ‘it is clear that the financial provisions of the agreement can only be met if the company crams more and more passengers onto what are already heavily overcrowded trains, and at the same time increases unregulated fares sharply'.

This, he adds, is a bad deal for the travelling public and is inconsistent with the Government's strategy of moving towards road pricing and encouraging more people to use public transport. The Conservatives want DfT to mount an ‘urgent review' of franchising strategy, and propose ways of improving the current situation.

Cold numbers

I doubt that Mr Grayling will get much change out of DfT Rail. They are extremely proud of their new franchise procurement process and the professionals who implement it.

While they don't say so, the new regime's body language shows that it doesn't think much of the previous franchising process run by the Strategic Rail Authority. Where SRA was gradually introducing some qualitative analysis, the DfT Rail professionals under Jack Paine are cold numbers men. Technical deliverability and financial viability are what counts.

Even pre-qualification has been sanitised. Under SRA the Pre Qualification Questionnaire at least sought to identify a would be bidder's knowledge and experience of running a railway. Under the current process, the emphasis is on satisfying DfT Rail that you can meet the European Quality guidelines.

And when bids are in they are evaluated on the ‘base case' developed by DfT Rail. ‘Frills' are secondary issues. The decision is ‘always on the base case', according to Mr Paine.

This allows DfT Rail to look at risk to deliverability of what it has specified. You cannot win by adding frills in your initial bid.

Despite this DfT Rail still wants to believe that bids are driven by innovation and commercial judgement. A franchise is not a facilities management contract, he tells me. Hmm, you could have fooled me.

But while for the bidder triumph or disaster depend on pricing the base specification, there are add-ons. Bidders have to put in specific prices for nominated changes, local decision makers are asked for proposals and bidders can identify further options that they would consider if they won the franchise.

But, the base case is what counts. And the base case is all about how much money you want, or how much money you are prepared to pay, to run the railway.

And it is naïve of Mr Grayling not to see the legal minefield which his brand of bleeding heart procurement would introduce. You can't stop companies over-bidding, and Jack Paine and his team are neither innocents who have never heart of caveat emptor not rip off merchants who rub their hands when they see an over-eager bus bandit coming.

Since the cap and collar system shares risk and reward, the system includes cost mitigation. If the TOC's revenue turns out to be less than that assumed in the bid, DfT Rail shares the loss with the operator.

It is a relatively easy matter to model a series of ‘what if?' scenarios and knock the revenue support off the premium. If the Net Present Value is still better than the runner-up, then the most optimistic bid is still the best buy.

Just because GNER was the acceptable face of franchising doesn't mean that it should be let off a hook of its own making. Which is not to say that my personal view supports ignoring track record and experience in favour of the cold numbers. But that is the way the industry works.

South Western

And the latest franchise winner to be determined by the cold numbers is Stagecoach. As reported last month, the company has held onto South West Trains and Island Line, now merged as South Western.

Back in June, at a Stagecoach reception I asked chief Executive Brian Souter whether he would follow Sea Containers and First and put in a win at all costs red-mist bid (subtle as ever – Ed). The gist of the answer was ‘no', with the proviso but it would certainly be a competitive bid.

And we knew for certain that it would be much less profitable than the original 1996 franchise and its three year extension. It was, perhaps, less than tactful for a Stagecoach source to have admitted publicly that the company had taken the SRA to the cleaners in 2003.

Then, you will remember, this column revealed that SWT alone would need more subsidy each year than the whole of Network SouthEast received at the peak of the last economic cycle. When DfT Rail finally released the subsidy/premium profile for South Western at the end of October, we saw that what goes around does indeed come around.

Chart 1

Table 1

Notes:

1) 4 February – 1 April

2) Full financial year

Source: DfT Rail

Table 2

Notes:

* part year

Source: Informed Sources analysis of DfT Rail figures

Chart 1 shows the subsidy/premium profile. To put the new franchise in context I have shown the previous four years' subsidies in grey. The Informed Sources convention shows subsidies as negative numbers – since the taxpayer is forking out. Premia are positive since the money follows into the exchequer.

Table 1 shows the actual subsidy/premia as released by DfT Rail. Once again you get some extra detail with this column. The concept of ‘net subsidy/premium' is analysed later.

First, the graph. You will note that there are two bars labelled 2006-07. And in the chart the subsidy for 2006-07 is shown as £16.3 million. This is because the franchise starts on 4 February 2007 , so the first full year starts on 1 April 2007 .

In the chart I have chosen to multiply the part year subsidy by six to give the 12 month equivalent which can be compared with the final year subsidy of the previous franchise. As you can see it generates a fashionable straight line decline in subsidy before the even more fashionable straight line increase in subsidy – let's call it the Garnett Line – starts.

In the last year of the franchise the premium falls. As with the first year, 2015-16 is a part year, this time because the franchise ends before the end of the financial year on March 31. Apologies for the fact that the chart shows the franchise as having 11 years, but blame DfT Rail. I have not tried to pro-rata 2015-16 to get the full year figure, since who knows what state the railway will be in by then.

Finally, for the present, Table 2 shows the extra money Stagecoach has to raise year on year to meet the change in subsidy/premium. To put this in context, SWT revenue in the last financial year was £530 million.

This means that in the first full year (2006-07) SWT will have to find the equivalent of 6.5% in revenue to meet the fall in subsidy. This will come from continuing ridership growth, increases in regulated and unregulated fares and cost cutting initiatives.

Apropos of which, it looks as if Informed Sources's prediction in the October column on the future of the Class 458 electric multiple units was correct. There were come cautiously happy bunnies at owners Porterbrook when the franchise award was announced.

But there were several phone calls and e-mails from readers pleading with me to tell them that the parallel withdrawal of the Class 442s wasn't true. Sadly, the cold numbers point inexorably in that direction, although next month's fleet reliability analysis may re-ignite the debate.

Unhappy time

But, financially, for Stagecoach, what the U-Boat crews called the gluckliche Zeit (umlaut over ‘u') – the happy time – is over. In the last financial year, the profit on SWT was £59.8 million. According to analyst briefings the annual operating profit for the new South Western franchise will be £14-20 million on revenue currently around £530million. Finance income will add another £3-4million a year.

On top of that, DfT Rail has taken revenge for the shafting of the SRA . In replacement franchises to date, the revenue sharing and support arrangements, known as ‘cap and collar', have kicked in after year four.

Due to various post franchise realisations and embarrassments, DfT Rail has had to bring this forward for both First Greater Western and First Capital Connect as a quid pro quo. But with South Western DfT Rail is decidedly on the front foot.

Thus, revenue sharing arrangements start from Year 1. If South Western outperforms its revenue targets, Stagecoach keeps the first 2% above the revenue line in the bid. Between 2% and 6% above the bid line the extra revenue is split 50-50 with DfT Rail. Above 6%, DfT Rail takes 80%.

But revenue support arrangements come into effect after Year 4 as normal. At the same time, the 6% upper threshold on revenues sharing reduces slightly over the remainder of the franchise.

If revenue falls below the bid line, Stagecoach takes the pain of the first 2%. Between 2% to 6% below target, the shortfall is shared 50-50 with DfT Rail. If the undershoot exceeds 6% DfT Rail takes 80% of the downside).

Note that cap and collar applies to revenue. There is no profit-sharing provision or a profits cap

Red mist?

With GNER in meltdown (this column passim and below) the big question is whether Brian Souter and his bid team have produced a business plan capable of generating a positive rate of climb – however slight. The alternative is that the rising premium payments put the franchise on the back of the drag curve where it needs more and more money just to avoid falling out of the sky.

Consider what Brian Souter said back in December 2005, when Stagecoach, which has been consistently unsuccessful with bids for other franchises since 1996, failed yet again with the Thameslink/Great Northern and Greater Western franchises. According to the Stagecoach Chief Executive, while the company had submitted ‘competitive bids' for these franchises, the bidding process had ‘become frenzied and the prices being offered are toppy'.

In a typical aside he added ‘if there are too many hungry pigs in the trough, let them eat first'. But at the same presentation Mr Souter said that losing SWT would ‘not only be a disappointment but a surprise and that Stagecoach would bid ‘aggressively' to retain the franchise.

Nine months later, having won South Western with a similar NPV premium to First Group's successful bid for Greater Western, the tune had changed. Now, he claimed 'We submitted a high-quality, innovative and value-for-money bid and the new franchise is an excellent result for passengers, taxpayers and our shareholders'.

Franchise frenzy

A noted financier has observed that the most dangerous phrase in business affairs is ‘This time it will be different'. Informed Sources takes the same view when it comes to railway technology.

While Net present Values, which include discounts for returns and allowance for inflation, are very sophisticated; and while a generous expert reader has given me a comprehensive tutorial on the mechanics of calculating NPVs in Excel, I still feel more comfortable with cash figures. So Table 3 compares the subsidy/premium profiles of four franchises in cash terms. Chart 2 is the graphical representation of this table'

Table 3

Note

Source: DfT Rail

Chart 2

First of all, we can excuse First Capital Connect, where the rate of increase in premium (the slope of the graph) is relatively modest. But the three big beasts, GNER, FRW and SW, have strikingly similar rates of quasi-straight line growth, all starting from current revenues in the £400-500 million range.

Note, for a start, that both FGW and SW start with three years of reducing subsidy. And can I remind you that for SW 2006-07 represents only the first two months of the new profits-lite regime

In contrast, GNER started in premium. And, despite the drop in 2006-07, the company is wallowing along to the blare of stall warning alarms.

Note, too, that once SW gets into premium its rate of increase, from a marginally higher initial revenue base than GNER, is slightly greater. But, above all, consider the FGW premium profile.

From around £130 million less than GNER in 2006-07, FGW turns on the reheat in year 5 and ends up paying more premium in the final year than the GNER business plan. Note that Year 5 is when Cap & Collar kicks in providing Government support if reality fails to match the revenue line you projected in the bid.

In practice, as noted earlier, First got a ‘get out of jail' card from DfT Rail when the start of cap & collar was renegotiated after the franchise had been let. According to financiers J P Morgan this move means that the ‘downside revenue risk is much reduced' and with it ‘investor concern'.

But, with the aid of my graph I take less comfort from the earlier availability of cap & collar than the financial wonks at JP Morgan. If FGW needs revenue support in the relatively gentle slopes of the first three years of the profile, the reheat just won't be there in Year 5 and we could have an action replay of GNER.

London growth

In contrast SW's profile pretty much starts out as it intends to continue – which is what you would expect for a London commuter business. And there has, indeed, been some spectacular growth in the recent past.

Just under a year ago, season ticket growth was running at 14% year-on-year for several months'. At that time overcrowding would probably have been suppressing demand. In the new franchise additional trains and vehicles, plus the additional standing capacity created by taking out seats and toilets should translate into continuing revenue growth.

Currently, the Government has set the annual increase of regulated fares, such as season tickets, at RPI +1, which will also help. Unregulated fares can be hiked up. If the reliability of the Desiros can be improved to something like the contractual level Schedule 8 payments will also fall.

So has the erstwhile bus-bandit simply joined the facilities providers, running a specified service in return for low margins? Or has he, together with FGW's Moir Lockhead, signed up to a GNER-type suicide pact?

No one knows. But reading all the optimistic statements, a vision comes to mind of Moir and Brian, having stepped off the top of the Canary wharf building, reassuring each other as they accelerate past the 49 th floor that everything is fine so far.

Continues.........