East Coast Rail Line is Nationalised

The profitable East Coast rail line north of Newcastle heading into Northumberland towards Berwick upon Tweed is one of the most glorious on the entire British rail network. There are stunning views looking out to Holy Island, Bamburgh Castle and the delightful village of Alnmouth. And as trains pull out of Durham there is a fantastic panorama featuring Durham Cathedral, a view to take the breath away whatever the weather. Even the most hardened commuter is tempted away from their laptop to soak up the view. It is unlikely that senior executives at National Express will be in the mood to savour these delights since the government is taking the East Coast rail line that runs from London to Edinburgh into public ownership.

National Express has struggled with falling revenues and higher costs that have contributed to rising losses on the line. In effect the nationalisation prevents National Express from re-entering the market when new franchises become available and there is the chance that the government will also strip the operator of its East Anglia and C2C services operating out of Liverpool Street and Fenchurch Street stations.

The rail franchise also has suffered greatly from the huge financial commitments it made to the government when bidding successfully to operate the line and has a £1.2bn debt pile. Under the terms of the franchise agreement, National Express is required to pay the government £1.4bn to run the East Coast line until 2015, with the amount rising steeply from £85m in 2008 to £395m this year. In order to meet its targets, the franchise requires passenger revenue growth of about 10% per year, but turnover has been affected by the recession which has cut the volume of business travel and prompted many to trade-down from first class to standard class travel. In this sense National Express is no different to the problems facing airlines such as British Airways whose premium passengers have long been a key source of revenue. They have been criticised for their high walk-on fares, indeed a business that charges £266 for a Newcastle-London peak return journey and still cannot balance the books perhaps deserves to be dumped by the government?

National Express is bound by the terms of a bankers covenant which limits the amount that they can borrow to no more than 3.5 times its earnings before interest, tax, depreciation and amortisation (EBITDA). As a result the business is expected to raise fresh capital by a rights issue to existing shareholders, little wonder that the share price has fallen sharply in recent months. It has already been the subject of a takeover bid from rival transport operator First Group. Here is another example of the winners’ curse – where an auction leads to the winning bidder paying more than was viable to secure the franchise.

The government has refused to renegotiate the terms of the licence. The Department for Transport (DfT) will take control of the franchise towards the end of 2009, putting it into a public company specially created by the department. It will then put the contract out to tender again to the private sector at the end of next year. The government may have to wait until macroeconomic conditions improve to find a buyer for the East Coast franchise; the expectation is that public ownership will last for about a year. The government wanted to send a message to other businesses in the sector that they are keen to avoid moral hazard - no operator is too big to lose their franchise.

Since rail privatisation in 1994, train lines have been operated using a franchise policy through which the government effectively outsources the operation of 19 British rail routes to privately owned companies. On most franchises, it gives operators a multimillion pound subsidy to help pay charges for using the tracks, which are levied by the state-owned Network Rail, who run Britain’s tracks, signals and stations.Among the remaining train operating companies, First Group, Stagecoach/Virgin, Go-Ahead and Arriva now dominate train operating company landscape. How long will it take before we arrive back at a pre-privatisation situation with just one national train operating company and one business (Network Rail) managing the network?

For National Express the failure of the business to make the East Coast line a success will damage their reputation - it is a timely example of the exit costs linked to entering a market.