National Express, once Britain's biggest rail operator, could quit the train business altogether if its £1.4bn east coast franchise places too great a strain on group profits, according to a city commentator.

Public transport groups are under pressure after the Department for Transport revealed last week that five franchises - out of 19 across the UK - have been classed as "red" under a "traffic light" system monitoring the financial health of rail contracts. National Express has the toughest payment schedule after agreeing to pay the DfT £1.4bn for the right to operate trains between London and Edinburgh until 2015. That contract was struck in August 2007, at the peak of an economic boom that pointed to rising passenger numbers, with customer willingness to absorb inflation-busting fare rises.

However, a note published this month by the investment bank JP Morgan said the east coast contract could miss revenue targets this year and make an underlying loss of £26.1m. National Express needs revenue growth of about 10% to meet targets this year but it could be heading for flat growth instead, said JP Morgan. If the UK economy shrinks by 2.3% in 2009, said JP Morgan analyst Damian Brewer, the group's rail division could slip into an earnings trajectory that will see it remain loss making, or narrowly profitable at best, until the middle of the next decade. National Express also owns the National Express East Anglia and c2c franchises, which expire in 2013 and 2011 respectively.

"If our projections were to materialise, then by 2010 the rail operations would carry a negative NPV [net present value], and it might prove economically positive to exit UK rail," he said. JP Morgan added that, due to the underperforming rail business, it is cutting its earnings per share forecast for National Express by 30% for 2009. By exiting rail, said JP Morgan, National Express will lift earnings per share by 6.4% in 2011.

JP Morgan described the east coast franchise as the "key swing factor" in its parent group's fortunes. National Express has a stockmarket value of about £530m and its debt burden of £1.1bn is a cause of concern to analysts, standing at more than three times projected earnings for 2009. Alongside its rail operations, National Express owns coach and bus businesses in the UK, Spain and the US.

Brewer said a further decline in the UK economy could see short-term losses on the contract increase but could also lead to radical action by train operators such as handing back the franchise or seeking a change in payment terms.

The contract requires a premium payment to the DfT of £133.6m this year, rising steadily to £521.7m in 2014. Under DfT guidelines, any rail company that defaults on a contract can be ordered to hand back its other franchises and an attempt to renegotiate financial terms could trigger a default.

Other analysts have also warned that National Express might need to hand back the east coast franchise or renegotiate it.

"There could be a point where the company sees substantial losses for several years and decides that perhaps the sensible thing is to hand back the keys. But we are not at that stage yet," said Gert Zonnefeld , analyst at Panmure Gordon. A National Express spokeswoman said the company did not comment on market speculation.

She added: "We will update the market on 26 February as normal and we don't have any reason to update the market before that time."

See also:

Express can't deliver

The Guardian: 28 January 2009
Business Viewpoint column
Nils Pratley

"We will not bid at levels we think are unsustainable or undeliverable - there's no point in being a hero for a day and a villain forever more afterwards." So said Richard Bowker, chief executive of National Express, in August 2007 when explaining how his company could afford to pay £1.4bn for an eight-year franchise to run the east coast main line between London and Edinburgh.

Fast forward to today and one City analyst, JP Morgan's Damian Brewer, is already suggesting that it may be financially worthwhile for National Express to hand back its rail franchises (if you bin one, you have to bin them all) next year. "We think that if our projections were to materialise, then by 2010 the rail operations would carry a negative net present value, and it might prove to be economically positive (despite reputation damage) to exit UK rail," he says.

Well, OK, you can see the financial sense if the east coast does indeed turn out to lose £33.9m next year as recession bites. But it is rather harder in practice to see how National Express could hand back the keys. It could never again hope to run a railway in Britain. It may also have trouble persuading more local authorities in the US that it is a company that can be relied upon to run school bus services - and that's the stable part of its business.

For now, this is a potential problem in 2010, not a pressing problem in 2009. Indeed, the pips may be squeaking more loudly at other rail operators. But if National Express thinks there's a chance that it could eventually have to plead for softer franchise terms, it ought to start preparing the ground. That means making a deep cut in a dividend that currently costs £60m a year. That payment, as Bowker might phrase it, looks unsustainable and undeliverable.