£600m South Central contract puts bus and rail in spotlight
Financial Times: August 21 2008
By Amanda Vermeulen
The hotly contested battle to win the lucrative South Central rail franchise has put the spotlight on Britain’s leading bus and railway groups.
The size of the £600m-a-year contract, including key London commuter routes, the Gatwick Express and a leading role in the £5.5bn Thameslink project, lends weight to the argument that the sector is undervalued by investors.
Challenging revenue targets are attached to all the big rail franchise deals operated by the big five of Arriva, Stagecoach, First Group, Go-Ahead and National Express. But many analysts argue that the rail sector is steaming ahead strongly through the consumer slowdown, delivering decent growth and confounding experts who expected rail to suffer a gradual decline after privatisation in the 1990s.
Andrew Fitchie, transport analyst at Collins Stewart, believes that bus and rail operators have “one of the best business profiles within the transport sector for the current economic environment”.
In spite of these strong tailwinds, the sector trades on a double-digit discount to sum of the parts valuations – Mr Fitchie reckons about 16 per cent – dragged down by investor worries about fuel costs.
Train operating companies
Until now, rising fuel costs have been offset largely through prudent hedging out to 2009, and through fare increases. Longer term hedging is, though, less secure.
Ironically, the rising cost of fuel has been a prime factor behind the growth in rail travel, alongside heavy traffic on British roads, congestion charges and an improving rail infrastructure.
The sector’s defensive qualities are lent weight by the fact that much of people’s spending on rail travel, particularly on commuter routes, is non-discretionary.
Transport analysts at Credit Suisse believe the trend of motorists switching to both rail and bus represents a step-change in growth prospects for the sector.
Keith Ludeman, chief executive at Go-Ahead, agrees, saying growth in railway usage remains “robust”. The views are underpinned by recent surveys done for First Group and Stagecoach, indicating that British commuters are using public transport more frequently.
There are, however, potential obstructions on the track. Given the economic situation, there may come a point when passengers will no longer accept fare price increases. And demand may weaken. Many rail franchises run into London, and a slowing economy will mean job cuts and fewer tickets sold, although many operators say London commuter numbers have continued to grow well.
Another risk comes from the cost of running franchises. These are awarded by the Department for Transport using a complex formula, which means train operating companies that won in the last franchise round must achieve yearly revenue growth of between 4.5 per cent and 11.5 per cent to break even.
According to Mr Fitchie, Stagecoach, one of the bidders for South Central, is under the most pressure, and will have to deliver close to 12 per cent growth in revenue to break even on its East Midlands franchise.
Go-Ahead, operator of Southern (the current name for the South Central franchise), will face a period of uncertainty until the winning bid is announced in 2009. Damian Brewer, an analyst at JPMorgan, says Go-Ahead “must win” South Central otherwise it could struggle to replace the lost earnings. In 2007, Southern generated £518m in revenue for Go-Ahead.
Such returns and the prospects of greater rewards, explain why National Express, Stagecoach and NedRailways are eager for Southern to change hands.