It is indicative of the downbeat mood in which the government and its advisers are approaching this May’s privatization of UK railway operator Railtrack that no high-profile public relations campaign is planned to market the issue to private investors. “Four years ago we might have promoted it as a symbol of the renaissance of the railway, but there is not much appetite for that now,” admits David Freud, managing director of the sale coordinator, SBC Warburg. “It will be a pragmatic, practical campaign emphasizing the company’s role in the railway network, the reliability of its earnings and the share value.”
To a generation of popular capitalists reared on the hysteria surrounding Sid and Frankenstein’s monster (the advertising creations which promoted the share sales of British Gas and the electricity companies when they were privatized respectively), this seems like pretty dry stuff, hardly designed to provoke a flood of applications from Joe Public. Railtrack’s public relations consultants Dewe Rogerson may insist that Sid and his like have been ditched because of the growing sophistication of private investors in the 1990s, but it’s hard to escape the conclusion that this new sober approach represents a response to the British public’s increasing disenchantment with the concept of privatization as a whole.
Professor Colin Robinson, a director of the economic think-tank which provided much of the early intellectual ammunition for privatization, the Institute of Economic Affairs (IEA) believes that after this year’s two major privatization offerings – Railtrack’s in May and nuclear power generator British Energy’s later in the year – the UK’s privatization programme will grind to a halt unmourned, the victim of growing public hostility. “For the time being, it looks as if privatization in Britain may well have run its course,” he says gloomily.
Robinson attributes the unpopularity of privatization to the government’s failure to introduce competition when privatizing previously monopolistic state-owned sectors. “The government has talked a great deal about its enthusiasm for introducing competition, the benefits to consumers and the economy, and so on,” he says, “but it hasn’t proved to be very keen on actually doing so. Raising money has always come first.”
A privatization too far?
Regulation – the government’s preferred alternative to liberalizing markets – is now seen as a failure and in need of urgent reform. Critics point out that its faults have been illuminated by the recent wave of bids for electricity and water companies, which revealed unsuspected profitability and well-padded balance sheets.
If regulatory failure has made privatization a dirty word with the general public, how has this affected the attitude of institutional investors to the government’s disposal programme and, in particular, to Railtrack’s and British Energy’s offerings? After all, institutional money is the engine driving privatization. Institutions price the deals and without their support privatizations can’t happen.
Although institutional investors agree that the national mood has swung heavily against further sales, with the forthcoming flotation of Railtrack attracting particular criticism, most are surprisingly sanguine about public opinion. “I think if you look back over the history of the UK privatization programme, you’ll find that with every major privatization, public opinion was against. Everyone said: ‘It’s a privatization too far’,” says Alastair Ross Goobey, chief executive of fund management company Hermes. “And in most cases, once the companies had been sold off and turned out to work rather better in the private sector, all these objections were forgotten. After all, who now says that British Telecom should be run by the state? Would anyone really want to return to the system we had when it was run by the GPO[general post office]?”
Railway privatization demonstrates many of the problems the government faces in drumming up enthusiasm. Railtrack’s proposed flotation is merely the final stage in the complex two-year restructuring exercise required to prepare the vast old inefficient state railway corporation British Rail for sale. The purpose of this process, according to one banker, was to carve up a loss-making monolith into “bite-sized chunks”.
Many fund managers profess to be baffled by the industry structure which has emerged from the restructuring, whose byzantine complexity has already attracted much derisive comment.
At its centre is Railtrack, the only successor company to British Rail which will be floated. Railtrack owns the rail network, including 16,000 kilometres (10,000 miles) of track, 2,500 stations, 90,000 bridges and 980 tunnels. Its income, £2.3 billion last year, comes mainly from the access charges it levies on the 25 train operating companies (TOCs) and three freight companies the government has established with the intention that they will be run by private-sector operators on seven-year franchises.
These franchisees will be subsidized by the state to the tune of at least £700 million a year (most analysts believe the ultimate figure will be nearer £1 billion). Thus far, only three TOCs have been franchised, and the programme has become enmeshed in a legal battle with a railway passenger pressure group protesting against possible service cuts.
Railtrack’s principal operating expenditure will be on maintaining the network. This it will not do directly, but through 13 specialist infrastructure maintenance companies, which are currently being sold off to private-sector bidders, principally construction and engineering groups. And then there is the rolling stock, which will be owned by three rolling stock companies (Roscos). These were sold at the end of last year, largely to management groups, for £1.8 billion.
And that’s not all. To add an almost surreal touch of complexity, the Roscos do not actually own the maintenance yards where their rolling stock is stored and repaired. These are owned by the maintenance yard companies, which were also recently sold.
Curiously, this complicated structure does nothing to promote competition. The TOCs, the key point at which money enters the system from ticket sales and government subsidies, will effectively be mini-monopolies, having exclusive access to their own franchised routes. As a consequence, the new system will be heavily regulated. Roughly speaking, the franchise director regulates the TOCs and the Office of the Rail Regulator regulates Railtrack. Most observers agree that the structure finally adopted (which was always opposed by British Rail’s management) is a bureaucratic nightmare. Every train movement requires a series of bargains to be struck between the train operator and separate entities owning track, stations and rolling stock. The “rent book” for the use of the Paddington terminus in London, for instance, established as a consequence of the 1993 Railway Act, is reputedly the size of a telephone directory.
Potential investors are unimpressed. “Looking at the way they’ve done it,” says one fund manager, “with this split between trains and track and Roscos and whatnot, you have to ask whether any structure this complicated can be the right one. And all the problems it causes with consumers – can they get through-tickets from one operator to another? You have to say it just looks a God-damned mess. My reaction is to say: ‘Why don’t I just buy GEC?’ I don’t have to buy Railtrack just because it’s there.” Another potential investor – the head of UK institutional investment at a major US investment bank – is more succinct. “Personally, I wouldn’t touch it with a bargepole,” he says.
Aside from the arcane industry structure, investors advance several specific reasons for steering clear of Railtrack which point to why the City of London is wearying of privatization as a whole. The main one is the heavy level of regulation. “Investors don’t really like regulated companies,” says one fund manager. “Basically, we think that they’re rather dull investments, like they are in the US.” He adds that, given the particular nature of the railways (regarded by the public more as a social service than a commercial entity), the rail regulators will be subject to strong political pressure from consumers to squeeze investors’ returns. “There probably isn’t going to be any growth, because this privatization won’t change the economic case for railways versus roads as a method of transport. And the companies are unlikely to have any flexibility in raising margins, because there will be such a public hue and cry if prices go up. So the only way profits can be increased is through efficiency gains, and those are really one-off gains which should be achieved pretty quickly.”
Another turn-off is Railtrack’s heavy investment programme. In December, the company announced that it intended to spend £10 billion over the next 10 years upgrading the network, a substantial increase on the £6.2 billion investment plan it had previously been talking about. Investors saw this as a politically motivated gesture – an attempt to persuade the public of the benefits of privatization – rather than one driven by commercial considerations. But the main worry is that, because Railtrack will be a highly leveraged investment with limited growth potential and regulated profits, in effect, shareholders will be getting bond-style returns but equity risk.
“Railtrack, like the electricity and water privatizations, can be viewed almost as an infrastructure project,” says one fund manager. “The government wants to privatize it so it can get all this infrastructure spending off its balance sheet. That’s the driving force behind privatization in the UK these days.”
The combination of regulated returns and infrastructure-project risk makes Railtrack a particularly unattractive investment, this fund manager believes. “The experience of Eurotunnel has made investors very wary of these sorts of companies,” he says. “Long-term projects are very sensitive to the economic and market assumptions you have to make in order to value them in the first place. If the assumptions change, even by small amounts, the value of the company can be radically altered – generally downwards.” He recalls the series of prospectuses put out by Eurotunnel. “Every time Eurotunnel came to the market for more money, there was a great deal of detailed valuation analysis put together by highly reputable investment bankers. But each time – as things ultimately turned out – they were later shown to have got it completely wrong.” Having consumed £2.5 billion of equity holders’ money over eight years, Eurotunnel is now technically bust. The shareholders have effectively lost everything.
Says a transport analyst with a major London-based brokerage: “The more government-controlled an investment is, the more shareholders view it almost like a gilt-edged stock [a government security]. If you look at it, Railtrack is going to be highly controlled by the government, both through regulation and because of the high level of subsidy it will receive as a proportion of its turnover. In the best case, you are getting a stream of returns not that dissimilar to an investor in gilts. But clearly, you don’t have the security. Therefore, the problem is in pricing that risk correctly. And it’s not clear yet that the government has really perceived the risks the private sector sees in these companies.”
It remains to be seen how the government and its advisers will deal with these criticisms. Railtrack’s capital structure is still being argued over, particularly the question of how much of its £1.7 billion of debt should be written off by the government before flotation. The government has thus far hinted that the maximum it is prepared to forgive is £1 billion, but investors believe there are practical reasons why it will probably end up going further.
In particular, these centre on the importance of Railtrack having a sufficiently large market capitalization to enter the FT-SE 100 index (the index of the largest stocks listed on the London Stock Exchange). “The main institutional buyers for this paper will be index-tracking funds. If Railtrack is included in the FT-SE 100 Index, they will have to have a weighting in the stock – so there’s a clear incentive for the government to make sure it gets in,” says one analyst.
For Railtrack to qualify, it would need to have a market capitalization of around £1.9 billion at flotation. And although the financial information available on the company remains opaque, analysts believe that if it were left with £700 million of debt, this would give it a market capitalization of only around £1.5 billion, given the need to price it sufficiently attractively for investors. No-one doubts that investors are going to demand a pretty unexacting valuation. “Utilities tend to be yield stocks,” says the investment head of a leading British insurance company, who notes that given the risks involved, “we will be looking for a significant premium to the rest of the market”.
Energy boost
All the signs are that this year’s other major disposal candidate, nuclear power generator British Energy, will prove no easier to sell. In order to prepare it for flotation, the government has been forced to strip out all the UK’s older Magnox technology nuclear power stations which are at the end of their working lives. These will be left in the hands of a new state-owned entity, Magnox Electric, and will be decommissioned at the public expense. British Energy will take charge of the UK’s most modern nuclear plants – seven advanced gas-cooled reactors which are mostly authorized to operate until after 2010, and the Sizewell B pressurized water reactor opened last year, which is due to operate until 2034.
The estimated total £6 billion cost of ultimately decommissioning British Energy’s stations – one of the major institutional bugbears – has been partly neutralized as an issue by the establishment of a separate decommissioning fund into which the company will make payments but which will be underwritten by the state. No final decision has been taken, however, on the estimated £3 billion cost of processing spent fuel (half the overall £6 billion figure) which is at present not covered by the fund. In recent evidence to a select committee of parliament, John Reynolds, electricity analyst at James Capel, warned that the financial risk relating to these waste-disposal costs could seriously deter investors if they were to remain uncapped. And a recent study, commissioned admittedly by confirmed opponents of nuclear power, has warned that unless the state at least partly assumes them, British Energy’s equity could be valued at less than £800 million rather than the £2.5 billion the government expects.
Given that part of the government’s case for selling British Energy in the first place was to earmark the proceeds for the capitalization of the decommissioning fund, clearly the financial logic behind its privatization is breaking down. But because the driving force is to shift future infrastructure spending into the private sector, everyone expects the government to cave in, largely in order to ease British Energy’s transition from state enterprise to listed company. One could argue that as the government reaches the end of its privatization programme, it is getting perilously close to paying private investors to take businesses off its hands.
Assuming the cave-in occurs, investors will be buying “a punt on the electricity pool price and the operating efficiency of the stations”, says Dieter Helm of Oxford-based economic consultancy Oxera. “The nearest equivalent to British Energy’s situation,” he argues, “is the contracts which have been let for managing prisons – it is an operating vehicle with a cash stream.”
Although the efficiency of British Energy’s stations is widely admired in the nuclear industry, the economics of atomic power still militate against its being a money-spinner for investors. Falling world gas prices mean that competitors in the UK energy market can generate power profitably at 2p per unit, while British Energy only goes into the black at 2.7p. Consequently, it is liable to be the swing producer in the UK energy pool, called upon to supply only at peak demand periods. Profitable base-load contracts will be hard for the company to win, even though it is to be one of the UK’s three main power producers.
Little enthusiasm
Thus far, investors have shown little more enthusiasm for British Energy than they have for Railtrack. They are perplexed by the evident artificiality of the structure being privatized. For instance, because of the arbitrary way in which the old nuclear power operators – Nuclear Electric and Scottish Nuclear – were broken up, in certain cases there are older Magnox stations on the same sites as those owned by British Energy, posing safety and decommissioning risks. It is indicative of investors’ lack of interest that since the announcement of privatization the news that has been best received has been the company’s decision to abandon any further plans to build nuclear power stations in the UK. “It’s good news because no-one wanted to buy into a company investing £10 billion-odd in nuclear technology,” says an analyst, “but it does pose the question, who the hell is going to want to buy a company with nil-growth prospects?”
The company insists that its growth prospects are rather better than this suggests. It is talking about building gas-powered stations and has also raised the possibility of acquiring a regional electricity distribution company. Neither of these ideas has met with an enthusiastic response from potential investors. According to one electricity analyst: “The first job of [British Energy’s] financial advisers will be to curtail expensive talk of expansion into areas it knows little about. British Energy’s first task will be to sort out what it has got and cut costs to generate cash.”
Clearly, given all the unanswered questions – British Energy’s capital structure has yet to be settled, as has the crucial issue of waste-disposal liabilities – the company remains almost impossible to value. Most of the figures quoted thus far have effectively been plucked out of the air. But even when the financial structure is finally settled, analysts agree that it will be difficult to place a price on what will be the world’s sole pure nuclear energy play.
The main concerns expressed by institutional investors include safety and regulatory risk. What happens if either the regulator or subsequent legislation pushes up safety costs so as to make an already marginally profitable business into a loss-maker? Accident risk, such as a disaster like that at Three Mile Island, is seen as less of a worry, largely because most investors consider the possibility pretty remote, and also because British Energy plants are well insured against such eventualities.
But there are more mundane worries about the underlying financial case for nuclear power. Not only are the stations more expensive to run than conventionally-powered ones, but a nuclear operator’s cost of capital is also likely to be higher. According to Mo Ying Seto, who covers nuclear utilities for Moody’s Investor Services in New York, nuclear utilities have lower credit ratings than non-nuclear utilities – because of the higher risk factors such as safety – so they suffer a financial handicap because this drives up funding costs. Potential investors take such news stoically, but they warn that it will have an impact on pricing when British Energy is sold. “It’s a very unusual industry,” says one. “One of the biggest drawbacks to the nuclear sale is that the business is difficult to understand. I don’t like investing in an industry where I don’t understand how it works.” For this reason, what may be the UK’s last major privatization is, by the most optimistic estimates, likely to go for £2.5 billion, only marginally more than the cost of building its newest asset, the £2.3 billion Sizewell B station.
Whether it will be the last privatization is at least partly a political question. Although the government insists that it has further plans, before April 1997, at the latest, there will have to be a general election. If, as many investors expect, this returns a Labour government, it is likely to spell the end of the disposal programme. While investors probably won’t mourn its passing, feeling that there’s nothing attractive left to sell, many right-wing economists feel that if the Labour party takes power and calls a halt to privatization, the revolution started by the Thatcher government in 1979 will be abandoned unfinished.
Madsden Pirie, president of economic think-tank the Adam Smith Institute and one of the architects of the privatization pro-gramme, argues that further work remains to be done: “Privatization in this country has been an evolutionary process. It’s because of the experience built up over the past 15 years that we’re now able to contemplate selling off the more difficult sectors of the economy which were avoided in the early years.”
The road ahead
One bit of unfinished business he identifies is the privatization of the road network. This, he suggests, would provide the UK with a “unified transport policy”, something 50 years of state planning has failed to deliver, and thus level the economic playing field between the use of roads and railways as transport systems. “The current situation doesn’t work,” he says. “At the moment the economic case is slanted towards roads, because a railway user pays directly both for his journey and the infrastructure, whereas a road user pays only for the cost of his journey. All this means is that everyone uses a car and the roads get congested. The government tried to solve the problem by building more roads, but this didn’t work and just added hugely to the infrastructure bill. The case for roads privatization, with tolls being charged by private-sector operators, is unanswerable.”
But such arguments, despite their apparent logic, leave investors cold. “Who’d want to own the roads?” asks one fund manager. “You would never be allowed to make more than a minimal return by the government, and you would be crucified by the public every time you had to dig one of them up.”
Investors are equally unimpressed by the visionary schemes of Robinson at the IEA. He argues that the key objective for future privatization is for the government to transfer its infrastructure budget to the private sector. “Why does the state need to own the assets it uses?” he asks. “Why does the state need to own roads or hospitals?”
Investors tend to think, however, that privatization has reached its limits. “The best privatizations the government did were in the early years, when they were selling companies like Jaguar and Cable & Wireless,” says one fund manager. “In those days, no-one really knew how to price privatizations, so there was always something to go for. And everyone understood what these companies did and how they would work.”
This, he feels, is no longer the case. “You could say that the government has tried to push privatization too far into new areas without having the right structure. The regulatory system hasn’t really worked. And anyway, there’s only a limited appetite for regulated stocks in this country – and I think that limit has now been reached.”
Lucrative franchises
The structure of British rail privatization is horrendously complicated. Even bidders for franchises frequently fail to understand its intricacies. But the rewards for successful franchisees look set to be enormous.
British Rail (BR) has always needed government subsidy and always will. After privatization, however, BR as it is known today won’t exist. The subsidy which used to go to BR now goes to the franchising director, Roger Salmon. He then distributes it among the 25 private-sector train operating companies (TOCs) which run different sections of the passenger rail network. The TOCs have two major sources of revenue – the subsidy and ticket sales. Most of this revenue then goes on their two fixed costs: the cost of leasing the trains and Railtrack access charges.
Franchisees take over the TOCs from public ownership for periods of seven, 10 or 15 years. The franchise agreements set out the minimum service levels they must provide, the maximum prices they can charge on certain fares and the amount of money they will need to pay the Roscos and Railtrack. Their room for manoeuvre is thus limited. The only ways they can increase profits are by increasing uncapped fares, decreasing operating expenses (staff and station costs) and increasing the number of passengers. These costs, too, are to a great extent fixed. So passenger rail franchising looks rather more like subcontracting than classical privatization.
Either way, it is set to be very lucrative for franchisees. Profits are very highly geared. The TOCs are sold, with no equity and no debt, for £1 each. The franchising director sets a minimum capital requirement for each franchise of about 15% of revenues. Half of this is in the form of a performance bond, guaranteed by a bank, in favour of the franchise director. The other half has to be available to be paid in by the franchise winner, should the need arise. The amount of this capital which is called at the beginning of the franchise ranges from zero to about one third.
It is not entirely a free lunch for franchisees. The bidding process is highly competitive and there are some risks. Much of the revenue to franchisees depends on circumstances outside their control – local employment levels and national GDP growth. It is even likely that one or two of the franchisees will find that they cannot survive on the level of subsidy for which they have bid. In that situation, they forfeit their guarantees. The franchise director then has to decide whether to give them more subsidy or give the higher subsidy to a rival company. It is very unlikely that the guarantees will cover the extra amount of subsidy needed. So why are the franchise winners not asked to put in more capital?
The answer lies not in the economics but in the vexed politics of rail privatization. In order to get the rail privatization bill through parliament, the government had to promise to instruct the franchise director to give preference to management buy-outs (MBOs). The TOCs have no assets to place against bank guarantees. Capital for the MBOs’ guarantees is mezzanine at best and very expensive. “The bond is the killer,” says one bidder from a company with a rather lower credit rating than Stagecoach, the first franchise winner. MBOs have to find their money from venture-capital companies, and venture-capital companies want venture-capital returns – in the order of 40%. If the bond were set much higher than it is, no MBOs could afford to bid.
Bus company Stagecoach won the franchise for South West Trains. Stagecoach is a rich company and got its bank guarantee from the Royal Bank of Scotland without too much difficulty. The company itself provided the rest of the guarantee. Paid-in capital in the new company, Stagecoach South West Trains, remains very low. It is set to receive steady passenger revenues and subsidy. As soon as it makes any profit, both return on capital and return on investment are going to be enormous. Any efficiency savings it makes are very highly geared. Its forecasts for the first three years of the franchise show a pre-tax profit, after restructuring costs, of £1 million or 0.2% of revenue in year one, rising to £12 million (4.1%) in year two and £23 million (7.4%) in year three. And all achievable without any investment.
Richard Hannah, an analyst at UBS who advised Stagecoach on its bid, points out that “the franchises are massive cash producers”. There is very little incentive to reinvest any of the profits in the franchise: it’s generating more than enough itself. What’s more, Stagecoach’s downside is strictly limited to the £42 million of guarantees it has provided.
A secondary market in awarded rail franchises may well spring up. Potential bidders, attempting to value a franchise, will find that its equity behaves more like a volatile bond than conventional share capital. Eventually, the TOC has to be handed back to the government in much the same state as it was sold – with no debt and no share capital.
Meanwhile, a franchise’s price derives from the net present value of the dividend stream, plus any remaining paid-in capital due to be returned to the franchise winner at the end of the franchise period. Chances are that neither the franchise director nor the rail regulator will block acquisitions, unless they clearly decrease competition on a given route. That would be rare as most are being privatized as monopolies and share very little track with another TOC.
For most franchise operators, the future looks rosy. Expect headlines in the next few years screaming about the huge sums former managers are making out of privatization. Mark Piper
