Rail goes round in circles

By PAM GRAHAM

The Government rescued Tranz Rail a week before the company's likely collapse because it wants rail to play a central role in its grand plan for land transport.

But 10 years ago, a secret report to the National Government concluded that New Zealand did not need a railway to move freight - and probably needed passenger trains only in Wellington.

A decade on, Tranz Rail is still facing many of the same problems that bedevilled the old state-owned NZ Rail.

The September 1992 Treasury scoping study of the business, released to the Herald under the Official Information Act, showed that NZ Rail was constantly missing profit forecasts and the strategies it had copied from overseas had failed those who invented them.

Rail could not compete with trucks because the hauling distances in New Zealand were too short and there were not enough bulky goods to be transported, it said.

The business should be sold and it would fetch more in a trade sale without too many strings attached or any separation of assets. Buyers lining up included an Illinois Central and Freightways consortium, P&O New Zealand and Ports of Auckland, Owens Group and Port of Tauranga.

In the event, a Fay Richwhite & Co consortium bought the business for $328.3 million in 1993 and it was later listed on the New Zealand Stock Exchange. Its shares traded as high at $9 and as low as 30c.

Before the privatisation, the very future of rail in New Zealand was being questioned in Wellington.

The network was developed when regulations required that freight travelling more than 40 miles (65km) went by train.

Rail had become overcapitalised and work practices were famously bad. The dismantling of the regulations from 1977 to 1985 had led to a halving of land freight costs between 1980 and the early 1990s.

The Government set up New Zealand Rail in October 1990 but the business ran straight into the 1990-91 recession.

Profit forecasts were missed in every month of operation except one in the period up to May 1992. The $34.2 million profit in the eight months to June 30, 1991, was about half the $63 million forecast the year before, and the $36.3 million profit in the 1992 financial year was well down on the $57.8 million forecast at the start of that year.

Rail freight revenue was 15 per cent below budget in 1991 and 7 per cent below budget in 1992.

By 1992, rail had lost about 30 per cent of its market to flexible and quicker trucks that offered door-to-door service without extra handling. NZ Rail estimated that road transport's efficiency was improving about 3 per cent a year.

Trucks had to pay taxes to compensate for tearing up roads, and rail would do better if those taxes were higher. But the advice in 1992 was that road users were already meeting the full cost of their impact. Moreover, the state highway system, plus coastal shipping, could handle everything that was moving by road.

The report's compilers even went as far as estimating how many more people would die on the roads each year if rail closed. The answer: five, taking into account the 14 people who would no longer be killed at rail crossings. But people living next to State Highway 1 would be affected by noise.

However, the most compelling reason the Treasury put forward for selling NZ Rail was that it would resolve an impasse between the company's managers, led by managing director Francis Small, and the Treasury's advisers, CS First Boston and AT Kearney.

NZ Rail wanted to expand by improving its image, creating and building brands and offering new products such as distribution and warehousing. Essentially the strategy was to compete head-to-head with trucking companies.

The Treasury's advisers disagreed. The business should be run down, they said, because it could not compete with trucks for high-value and time-sensitive traffic.

"The intense competition New Zealand Rail faces, its high fixed costs and ongoing capital expenditure requirements makes the business a reasonably high-risk investment," the Treasury concluded.

"A slight variation in either revenue, labour costs or capital expenditure has a significant impact on the business' free cashflow, and hence value."

In 1992, a 5 per cent loss of revenue was estimated to reduce operating profit by $25 million. NZ Rail was forecasting capital expenditure averaging $67 million a year over the next 10 years, not including the cost of replacing the Aratika and Arahanga ferries by 1999.

The Treasury's advisers considered NZ Rail's business plan too optimistic and said its forecasts assumed revenue growth higher than real GDP growth and export growth.

The report said NZ Rail had copied its organisational plan from a structure used by American rail operator CSX Corp in the late 1980s. But CSX had found the structure increased costs, eroded service levels and reduced its ability to respond to competition.

The advisers said that under a downsizing strategy, the business would be run down and regional lines in Southland, Hawkes Bay, Poverty Bay, Northland, Wairarapa, Taranaki and the West Coast considered for closure.

"Locomotives would be overhauled and rebuilt only when absolutely necessary."

Small argued strongly against this strategy in a letter to the Secretary to the Treasury.

He predicted that customer flight would be rapid, and consultants Booz Allen and Hamilton had advised him that there was "no core network or line of business to reduce to".

"If it developed that there was no such core, the owners would have no option but to wind the business up in 10 years or so," said Small.

The benefits from cutting back on capital spending were illusory and would leave the fleet in such a condition that the cost of reinvestment would be prohibitive.

In the end, the Treasury's advice was that a private owner would be "active" and more able to make the difficult strategy call.

"It should be noted that traditionally ministers and their departmental advisers, because of their mixed objectives, have been unsuited to active management of business risk."

It recommended against separating the business for sale. An analysis by Fay Richwhite and Co carried out for NZ Rail in 1989 estimated a $76 million loss in value if the ferries were separated from the rest of the business. A "Swedish Model" that left the tracks with the Crown would be too risky to the company.

The Treasury report said a sale to the public would take longer than one to a trade buyer and would probably raise $165 million to $215 million, compared with $217 million to $315 million for a trade sale. A sale to the public would also present problems with indemnifying the Crown against "residual redundancy risk".

The advice was that it would cost too much to shut the business down straight away. It was worth more if it was run down first.

The Treasury valued NZ Rail at $200 million if the company pursued its current strategy and $265 million if a downsizing strategy was adopted.

"The Government, as owner, would always be under political pressure to resist a strategy that could result in a substantially lower level of activity and possibly closure of the business."

One of the ironies of the whole situation is that the strategic dilemma traversed in the report is still being debated. Tranz Rail is downsizing to what it argues is a sustainable core business. Small argued in 1992 that there was no such sustainable core.

Australia's Toll Holdings, whose 75c a share bid for Tranz Rail is still on the table, plans to make the business part of an expanding empire that would offer service along the whole supply chain from customer to market.

It believes Tranz Rail should not sell its trucking, warehousing, distribution and freight-forwarding business, operated under the brand TranzLink.

But Tranz Rail is pursuing that plan and bids for those businesses are due today, though a period of negotiation will follow.

Tranz Rail shareholders now have to make the strategic call. They vote on the Government plan on July 11. In the meantime, Toll says it is not walking away.

The $44 million down-payment from the Government means Tranz Rail can avoid collapse by making a $20 million lease payment on June 19.

The Government gets the down-payment back next June if the shareholding and asset purchases do not go ahead.

Key elements of the Tranz Rail rescue plan

The Government plans to buy 35 per cent of the company for $76 million, or 67c a share.

It will also buy back the tracks for $1, and pay another $50 million for track-related assets.

The Government will spend $100 million over five years to improve the network.

A new company will own and manage the tracks. Tranz Rail will get exclusive access, subject to a "use it or lose it" agreement.

Tranz Rail will pay a track-access fee of up to $70 million a year.

Shareholders must approve the deal - the vote is on July 11.

Also on the table is Toll Holdings' full takeover offer, at 75c a share.