The gravy train? Investing in railways

15th August 2012

Virgin's failure and First Group's green light in the franchise bidding process will bring fresh debate on how UK railways are run. A return to British Rail style nationalisation is out of the question – European Union rules now require the separation of train operations and track infrastructure, even if this has led to additional costs and complications.

Branson has now vowed never again to enter UK rail franchising after losing out to First Group in an auction process which has widely been characterised as deeply flawed. Virgin had already lost the Cross-Country franchise (effectively south-west England to northern Scotland) in 2007.

The Department for Transport (lovingly known in Private Eye as DaFT) invites bids for franchises which are now generally around 15 years in duration – they were shorter in the earlier years following privatisation; Investors like the certainty of the longer franchises.

Basic standard but price is paramount

The Department sets out a basic service standard for each route – so many trains an hour between Birmingham and Manchester, for example, with intermediate stops. It is prescriptive. And while privatisation was supposed to usher in an era of free enterprise, it is restrictive.

In 2000, Virgin gave up direct trains between Shrewsbury, Wrexham and London. In 2007, a new company Wrexham & Shropshire restarted the service from Marylebone, with older (more comfortable) carriages and an easy to understand fare tariff.

It quickly gained admirers but not revenue. For although it called at Wolverhampton, it was not allowed to carry passengers between this West Midlands station and London and while it passed through Coventry, it was banned from stopping there, thanks, in part, to Virgin lobbying against potential losses to its own fare take. Wrexham & Shropshire ceased operating in January 2011.

The world of UK railway financing is arcane. Franchise holders promise to pay a fixed sum to the Treasury in return for the ability to run trains on the network. The Treasury then pays varying amounts in subsidy to the train operating companies. As a rule the less profitable routes receive the most from central government. This table shows the amount per passenger mile. Figures for 2011-12 are due shortly but these are likely to show a further subsidy fall from the 2010-11 average 8.1p per passenger mile.

Potential franchisees who overbid or find passenger numbers falling seem able to walk away from commitments to government without severe penalties. FirstGroup decided to hand back the First Great Western franchise three years early after falling commuter numbers due to economic factors made its £1.1bn contract uneconomic. The deal had a break clause, which activated, saved FirstGroup nearly £830m in payments to the Treasury. First Great Western has had to contend with old diesel trains on most of its routes.

East Coast disasters

Even better known is the failure of the government to recoup promised franchise fees on the East Coast London to Edinburgh route where Sea Containers and more recently National Express have handed back the train keys when they found they could not keep up with the payments. This East Coast example is central to Branson's arguing that First Group has overpaid.

The franchise risk is asymmetric. If it works out, then the train operator makes money but it if fails, the route is handed back to the government. The East Coast route is now state-run.

There is little competition on most of the network. The only substantial price and speed choice is between London and Birmingham where three lines compete – London Marylebone to Birmingham Snow Hill (Chiltern), London Euston to Birmingham New Street fast lines (Virgin) and the same route more slowly on London Midland.

Most routes are monopolistic and most operators know they face no competition. Train operating companies can present good opportunities to long term investors with some listed concerns offering high dividend yields.

Here's our investor listing of the train operating company runners and riders (in alphabetical order). Not all are stock market quoted.

Abellio runs the Greater Anglia route. It is owned by state-owned Dutch Railways who bought the company from private equity.

The Department for Transport is the operator on East Coast – attempts to find a private enterprise franchise holder have hit the buffers.

German state railway Deutsche Bahn is responsible for Arriva Trains Wales, Cross Country, Chiltern Railways and Grand Central Railway.  It is also the operator for London Overground although that is a "fixed fee" rather than franchise model – it has to run the London suburban network on a set amount from Transport for London.

First Group has First Capital Connect (Bedford to Brighton) First Great Western, First ScotRail, First Transpennine and First Hull Trains.  Barring a legal challenge, it will add the West Coast route to its roster in December, probably renaming it Horizon (which will prevent Last Group or Late Group jokes).  It also operates buses in the UK and elsewhere including yellow school buses and Greyhound in the United States.  It is quoted on the London Stock Exchange. Over the past year, the share price has slipped badly from 350p to under 200p before recovering to 242p. It has substantially underperformed the FTSE 250 over the same period. The market expects very little of it – it offers a 9.1 per cent yield while trading on under six times current earnings.

Govia is the Go-Ahead group. It embraces London Midland, Southern and Southeastern.  It also operates buses in the UK and school buses in the US. Over the past year, the share price has slipped, underperforming the FTSE 100 by
some 20 per cent. Most analysts – there are 20 looking at the stock – expect earnings to fall next year as passenger income slows.  Only six rate it a buy or strong buy with 11 going for holding it, presumably for the 6.2 per cent dividend yield and the undemanding 9.2 price earnings ratio.

National Express Group has just one franchise – the c2c line in south Essex and east London. It also has substantial bus interests.  The share price has lost 6 per cent over the past year – against a 9 per cent gain in the FTSE100.  Analysts expect revenue and earnings to remain static over the next year. But the shares are starting to look more attractive with 11 out of 17 analysts rating the firm a buy or strong buy, an improvement over the past three months, as value improves.  It yields 4.4 per cent and trades on 12 times current earnings.

Serco has a joint venture with Abellio to run Merseyrail and Northern Rail. Rail transport is just a small part of the overall mix so this is not really one for trainspotters. The share price has held up better than the concentrated mass transit stocks.

Stagecoach will soon be without the 49 per cent minority stake in the Virgin West Coast route. It still has the valuable South West Trains out of Waterloo, the tiny Island Line on the Isle of Wight and East Midlands as well as bus and tram networks in the UK and elsewhere. The share price gained 2 per cent on the news Virgin had lost the franchise – minority stakes are rarely popular with investors. It has outperformed the FTSE 100 over the past year, strongly over the most recent two months. Analyst opinion is strengthening even though earnings are estimated to remain static over the next year.  The share is not cheap – a 2.7 per cent dividend yield – but the 10.2 times price earnings ratio offers scope.


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