Asset Valuation - Red light for the gravy train

Railtrack plc is every company’s dream. The customers are captive; the revenue is largely guaranteed by the state; the share price is sky high; and it has several billion pounds worth of prime city centre building sites.

In short, however hard the company tries, it just cannot fail. Unfortunately for Railtrack’s investors, the party is rapidly coming to an end.

The future of Railtrack, owner of Britain’s railway track, signals and stations, is now under threat. The recent appointment of Chris Bolt as the acting rail regulator has promised radical changes to Railtrack’s finances. The regulator is intent on reforming the pampered and inefficient financing scheme, and proposals to restructure Railtrack’s return on capital are set to hammer the company’s earnings.

In many privatisations, a state monopoly was simply replaced by a private monopoly. Typically, market forces would not be allowed to freely determine the earnings potential of these newly floated operations. Most of the regulatory control was conducted by a government-appointed regulator who determined the rate of return for these companies. But of all the privatised industries the regulatory problems of the railways have proved the most challenging.

On privatisation, the railways had their own special difficulties. They were privatised in a hurry. The organisation of the privatised rail system was hideously convoluted and financially inefficient. Politicians, civil servants and rail managers were in total disagreement about the reforms to the rail network.

Railtrack’s interim regulatory regime reflected this. The scheme was over-generous and excessively costly for the taxpayer. As a consequence total rail subsidies doubled, compared to the former state aid received by British Rail.

The Conservative government decided that privatisation of the state industries was a cornerstone of its policies and railways were to be no exception.

Since 1948 the state-owned railway system had been a fully integrated organisation owning and controlling both track and trains. The government decided to split the train operations from the supporting infrastructure.

Passenger rail franchises were awarded to 25 train operating companies and the infrastructure was given to Railtrack. Essentially, all of the railway’s assets that were not designed to move belonged to Railtrack.

The train operators are required to pay Railtrack track access charges for use of their infrastructure assets. These are set within a regulatory regime that controls the overall return on assets employed.

Since privatisation Railtrack’s regulatory regime has faced mounting criticism for its rather weak and ineffective controls. During the privatisation planning stage the government proposed using a regulatory mechanism of 8% return on assets.

The valuation of these assets was based on an accounting valuation methodology that used an obtuse replacement cost methodology termed modern equivalent asset values (MEAV). Under this valuation methodology the railway industry assets were rebased on the replacement cost of new assets, adjusted for any increased capacity.

Ascertaining replacement costs in the railways caused horrendous practical problems. Many of the rail assets were over a century old; previously written-off assets were crudely recapitalised; and simplistic estimates were made for missing ancient accounting records.

With some assets the determination of MEAV was totally unfeasible. For example, the MEAV of an antiquated semaphore signalling system could produce absurdly high revalued figures. The value of the modern equivalent might be a computerised electronic signalling system which would bear little relationship to a signalling system dating back to the last century.

Many of the asset figures under this methodology were little more than guesswork. Even the regulator considered this initial regime too slack.

As an interim measure, an annual price control charging mechanism of the retail prices index minus 2% was implemented. But this simplistic method was too inaccurate.

A recent review of Railtrack has allowed the regulator an opportunity to reassess Railtrack’s financial framework. He has used the review to assess the company’s performance and to set operating targets and appropriate track charges for the next five years.

The regulator now proposes substantial changes by introducing far-reaching plans to recalculate Railtrack’s asset base. A lower rate of return on these assets will also form a fundamental feature.

The nature of Railtrack’s business is fundamental in the rebasing of a new regulatory mechanism. Railtrack is a low-risk business. It receives secure government-backed revenue streams from train operators. The regulator’s revised controls also reflect the fact that train operators have no choice but to use Railtrack’s provision of the infrastructure.

The regulator is approaching Railtrack’s earnings potential on two main fronts. First, he wishes to recalculate the asset base on which Railtrack’s rate of return is centred. Determination of the asset basis has always been problematic because of so many ancient assets and incomplete supporting records.

Many assets that Railtrack now capitalises were previously written off immediately to the income statement.

At privatisation, asset values were frequently reinstated in a seemingly crude and arbitrary manner.

On flotation, Railtrack’s net assets were calculated at a historic cost of #1.5bn and at a current cost valuation of #3.7bn. Rather than directly using either of these valuation bases, the regulator selected the value of the company’s equity at the close of business on the first day’s share trading.

This basis valued the company’s equity and debt at #2.54bn, which was a 5% uplift on the share offer price. Railtrack had demanded a 60% uplift on this initial valuation. Justifiably, the regulator was not prepared to allow the asset base to be set at a later date.

Even a date six months later would mean that the company’s market capitalisation would be much higher.

The astronomical increase in equity values over the last two years has arisen largely because the government underpriced the company on flotation.

Accordingly, shareholders were not to benefit by solely having a rate of return based on a higher equity value at a later date.

The regulator’s other major change concerned the calculation of the rate of return. After reviewing Railtrack’s cost of capital, he decided that the permitted rate of return should be between 5% to 6%. This target was at the lower end of market expectations.

The regulator is clear about this level of return. Railtrack will not be able to obtain a high return on those assets which are used to provide the day-to-day rail network. Although the company is a relatively stable and low-risk business, Railtrack will be allowed to lift profits by innovative undertakings in property development, involvement in the Channel Tunnel rail link and imaginative freight transport schemes.

The possibility remains that the regulator might retreat or the government may oppose some of the changes. Already Railtrack is hinting that its investment policy might be threatened if the proposals are not relaxed.

The company’s implied threats to withdraw from funding the politically sensitive Channel Tunnel rail link might still generate some last minute intervention by the government.

If these changes are implemented then Railtrack’s profitability will be hit. Although the effect of the changes is still uncertain, some analysts believe that these new regulations will eliminate over #100m from Railtrack’s bottom line earnings from 2001.

If earnings do suffer as a result of controls on track charges then Railtrack has access to other sources of income generation. The company has an extensive property bank that was grossly underestimated at privatisation. It is one of the UK’s largest land owners with immense potential to develop prime location city-centre station sites. Already Railtrack is building on top of railway stations and has extensive plans for further expansion.

Currently, profits from property development of under #1bn are solely attributed to Railtrack. Over this limit the train companies take a 25% profit share. But the real loser is the taxpayer. Government plans failed to make realistic provision for the state to share in the profits on property disposal.

Arguably the regulator has been too generous. The railway infrastructure was sold off on an ridiculously low earnings multiple of seven times.

Since 1996 the value of Railtrack’s shares has risen fourfold. It has been an extremely attractive investment venture of low risk and high guaranteed returns. The investors have received excess investment returns at the taxpayers’ expense. Railtrack has many billions of pounds worth of investment land.

It has also considerable scope to enhance earnings by property joint ventures and station redevelopment. The nature and value of this land was only superficially identified at the time of flotation. More onerous profit claw-backs should have been introduced by the government.

It is unjustifiable for Railtrack to complain that the regulator has been too tough. He has not. If anything, many of his proposals, at least in the short term, are too generous and undemanding.

Nevertheless, in the longer term, investors in Railtrack should be concerned.

In the next five years Railtrack will not be an easy ticket to income generation and investment success.

The gravy train is still moving but, at last the brakes are being applied.

John Stittle is senior lecturer in accountancy and finance at Anglia Polytechnic University.