Tranz Rail takes the market on a rollercoaster ride

Friday 5th April 2002

When Fay Richwhite bought the company in 1993 the tracks were worth $24,459 a kilometre. Now they're valued at $104,232 a kilometre

Can every transport analyst in the country be wrong? Yes, says Shoeshine

It should be cheery times down at Tranz Rail's head office in Auckland's Takapuna. After a long and bloody struggle managing director Michael Beard seems finally to have won the confidence of the markets.

In tandem with the departure of his major shareholders - Fay Richwhite, Canadian National Railways (the former Wisconsin Central) and Berkshire Partners, local institutions have piled in.

The six biggest holders - Commonwealth Bank, Axa Asia Pacific, Infratil, ING, UK-based Marathon Asset Management and US-based Principal Financial Group - now hold 43% of the company between them.

Beard must be positively glowing in the sunshine of sharebrokers' approval. Analysts at ABN Amro, CSFB, JB Were, Macquarie, Salomons and UBS all rate the shares a "buy" or equivalent.

The most bullish, JB Were, reckons they're worth $5.50 to $7 if the company meets earnings before interest and tax (ebit) expectations of $80-100 million once the current restructuring is complete.

So why does the company continue to make Shoeshine as nervous as a choirboy at a bishops' conference?

Mainly it's because he gets the jitters when credit rating agencies downgrade companies everyone else seems to love.

Following a feeble half-year profit announcement Moody's Investor Services three weeks ago cut its outlook on Tranz Rail's debt from stable to negative. Its move presages a second rating downgrade following its cut of November 14, to Baa3, on the medium-term debt.

Moody's cited a weaker operating environment and the interim result, saying the next 12 to 18 months would be a critical period for the company to demonstrate improved profitability from the restructuring. Tranz Rail protested loudly.

The outlook cut, it pointed out, flew in the face of the markets' view. It was making good progress with the restructuring, had sold $100 million worth of assets, completed the outsourcing programme and largely completed the simplification of the rail freight business.

It had talked to its banks about refinancing its debt and didn't expect any problems there, a spokeswoman said.

Moody's seemingly inexplicable pessimism sent Shoeshine poring through Tranz Rail's annual reports in search of answers. He found plenty of reasons the agency doesn't buy the Tranz Rail story and why investors should think carefully before shovelling their hard-earned bucks into the company's shares.

Tranz Rail's fundamental problem is that its network is heavily overcapitalised and isn't generating the growth in revenue and profits the company needs to cover its cost of capital.

As a result its debt burden continues to rise. Its senior debt at June 30 last year was $276.6 million.

Interest cover has fallen each year for the last four years, from 5.5 times in 1997 to just 1.4 times in the 2001 year.

Profitability has been declining steadily. Even though the company reported a lift in bottom-line profit last year, ebit fell 30% to $62 million.

For the half-year to December, ebit was negative $10 million, meaning the company had to service its debt with the proceeds of asset sales.

A $250 million "multi-option credit facility" with BNZ, Citibank, National Bank and WestpacTrust expires, as Moody's noted, on October 15.

With trends like Tranz Rail's Shoeshine finds it hard to believe discussions with the banks are as carefree as the company makes out.

The heart of the problem, as already noted, is overinvestment.

Ironically, Beard last month had to write to Wellington's Dominion to correct a column that claimed Tranz Rail had spent little since privatisation.

In fact, Beard said, since 1993 $816 million had been spent on the network and a further $100 million invested in restructuring and acquisitions.

It's precisely that heavy network spending that's responsible for the company's poor profitability.

An analysis of the right of way and fixed assets section of the annual report shows the right of way and track infrastructure and equipment had a book value (after depreciation) of $406.3 million. For each of the company's 3898 kilometres of track that's $104,232. When Fay Richwhite and Wisconsin Central bought the company from the government in July 1993, the network's value was $24,459 a kilometre. It has risen 326%.

If Tranz Rail were to have earned anywhere near its cost of capital with the level of earnings it had last year it would have to have written down the value of its network by hundreds of millions, gouging a massive hole in shareholders' funds.

To put it another way, last year's earnings are going to have to rise exponentially over the next year or two if the company is to pay its way and report positive economic value added.

But, caught as it is between fierce competition from short-haul road transport and long-haul shipping, that's a very, very big ask.

Not helping are the growing bills from all that outsourcing and leasing.

It now has four sale-and-leaseback contracts, one on balance sheet for the ferry Aratere for $US55 million ($125 million) over 12 years, two off balance sheet equipment deals signed in 1996 and 1998, and a short-term off balance sheet S&L on the Lynx ferry.

Lease payments are made in US dollars and are hedged. Over the next two years the company will have to stump up $123 million. The total forward lease payment commitment is $502.1 million.

Those who've cried long and loud about what a great deal Fay Richwhite got from the government ought to ask themselves this question: if Michael and David are selling, should I be buying?

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