Bubble, bubble as market grasps at Tranz Rail's trouble

Friday 16th August 2002

Tranz Rail Holdings chief financial officer Wayne Collins must wake up every morning and think; "It can't get any worse." Collins has been in the financial hot seat only since April 29 but he has already seen the share price slide from $3.80 to below $2.

Following a weak third quarter TRH has had to downgrade earnings expectations for the fourth.

A show-and-tell exercise in late July drew praise for its candour from the media and sharebroking analysts but failed to impress rating agencies Standard & Poor's and Moody's, both of which put the company on negative watch.

And last week the Stock Exchange weighed in, referring to the Securities Commission allegations TRH hadn't disclosed to the market information its former major shareholders knew before they sold out last February.

This week the shares again dipped below $2 as investors struggled to digest the implications of any rating agency downgrades.

Not helping are the opacity of the company's accounting practices.

It has endured accusations, unfounded as it happens, of indulging in WorldCom-style fiddling of the treatment of its track assets. These have served to distract attention from the creative treatment of its sale and leaseback arrangements.

There are two of these. The first was the 1996 sale, to GATX of the US, of locomotives and wagons which, the company says, resulted in a gain of $59.2 million. The lease has a net present value (NPV) of around $135 million.

The second, with an NPV of $120 million, was the 1998 S&L of the ferry Aratere for a gain of $30.6 million.

Quite how TRH managed to "realise" such a huge gain on rolling stock remains a mystery. The Aratere gain, it claims, is the difference between the construction cost and the sale price.

Most people would treat these gains as one-off "unusuals" and book them in the year in which they were realised.

Contact Energy, for instance, last year booked a $13.3 million gain on the sale of its surplus Whirinaki turbine.

Had TRH adopted this straightforward treatment there would have been two big profit years followed by years of profits depressed by the lease payments.

Instead it held the gains off balance sheet and is drip-feeding them through the earnings statement in annual lumps to offset the lease payments.

This year, however, the company has changed its practice.

Both the Aratere and GATX leases have until now been treated as "operating leases," meaning the payments are expensed in the year in which they are incurred.

The relevant accounting standard, SSAP 18, allows this where a company is leasing an asset for only a non-major portion of its economic life. Buildings, for instance, usually fall into this category.

From this year TRH will treat the Aratere lease as a finance lease used, for instance, for the likes of photocopiers where the lease will cover all or most of the asset's life.

Under finance leases the payments are capitalised on the balance sheet and depreciated.

According to TRH the switch will have the effect of boosting 2002 June year ebitda (earnings before interest, tax, depreciation and amortisation) by $4.8 million, to $78.4 million.

Curiously, the GATX lease remains off balance sheet. Quite why rolling stock differs from a ferry in terms of accounting treatment is another of those little mysteries.

Bringing it on balance sheet, according to company-supplied figures, would boost ebitda by a further $15.8 million this year, to $94.2 million. Perhaps that's a trick the company's saving for a rainy day.

Little wonder the market complains of TRH's "lack of earnings visibility."

Of more immediate concern are the rating alerts from S&P and Moody's.

S&P noted TRH's key financial measures would be "substantially subpar" for the current BBB rating but added the rating "could go down by one notch" - to BBB minus - meaning the company will at least be spared the ignominy of losing its investment grade status.

S&P met Collins on July 29 and the agencies should deliver their verdicts soon.

Lurking in the background are negotiations with banks whose $250 million "multi-option credit facility" expires on October 15.

Nowhere has TRH mentioned publicly the ratings "triggers" in its bank loan and lease contracts.

Shoeshine learned of them from inquiries at the agencies but when he asked for confirmation and comment he was told the company wasn't talking about its covenants.

Sharebroking analysts mention them in reports to their clients, which is as well for those clients as they're highly material.

Take the one relating to the Aratere S&L.

If TRH's S&P rating is cut it could be required, at its election, either to post a letter of credit - for around $118 million, according to one analyst - or to repurchase the vessel.

Should its banks be unwilling to supply the letter TRH would be forced to raise equity, even at the current bombed-out share price. Already there is talk executives are softening institutions up for a rights issue.

The bank debt documents also have S&P rating "triggers." And the imminent writedowns, signalled at between $148 million and $170 million, could come close to breaching covenant ratios.

Much depends on the speed with which the company can conclude its garage sale. Tranz Metro in Wellington, the remaining 50% of Tranz Scenic, and the main trunk line fibre optic cable are on the block and Australian Transport Network is under review.

Meanwhile some brokers continue to tout the stock. Got a strong stomach?

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