North train operator has hit the financial buffers

Its parent company is struggling under a mountain of debt and a triple whammy of lower ticket sales, higher energy prices and increased competition is now putting GNER in trouble.

Its parent company is struggling under a mountain of debt and a triple whammy of lower ticket sales, higher energy prices and increased competition is now putting GNER in trouble. Howard Walker asks whether the North train operator is about to go off the rails.

It all looks so promising. "GNER is looking to the future, having won a new 10-year franchise to operate the UK's East Coast Main Line railway, against stiff international competition," trumpets the `Inside Story' section of the website of Sea Containers, the Bermuda-based parent company of the North train operator.

The article paints a bright future of a go-ahead service delivering extra trains, more modern stations and improved punctuality, all with the support of more than 30,000 passengers who backed the company's successful bid - including celebrity supporters such as ex-Newcastle United manager Sir Bobby Robson.

"Everyone in GNER is delighted to have won a new franchise," GNER chief executive Christopher Garnett is quoted as saying.

It is extremely doubtful that is now the case. Fifteen months after the much-trumpeted franchise began, York-based GNER is finding out that the reality is very different to the vision.

The company anticipated ticket sales would rise by 9.9% a year. In fact, they have only increased by 3.3%, leaving GNER already £33m short of its projections. While the company claims more than half of the shortfall can be attributed to the aftermath of the 7/7 attacks on London, it is still a hefty miscalculation.

Costs are also racing ahead of predictions. Electricity prices for powering its trains along the London-Newcastle-Edinburgh line rose 28% in April and are forecast to rise another 65% next year, adding an estimated £11m a year of extra costs to GNER's projections from 2007. And that is before a further possible rise in April 2008.

If all that was not enough, GNER now faces competition on journeys between the North-East and London after the Office of the Rail Regulator (ORR) allowed rival Grand Central to begin running a Sunderland-London service, a decision subsequently upheld in the High Court.

But the root of GNER's problems lies in the price the company paid to retain the East Coast franchise. The £1.3bn it promised to add to the Treasury's coffers was at least £300m more than any of its rivals were prepared to pay for the contract and caused eyebrows to be raised even before the operator's subsequent problems came to pass.

At the time, Christopher Garnett said he would "rather overbid and win than underbid and lose". Garnett stepped down from the chief executive's job last month and, looking at the situation GNER executive chairman Bob MacKenzie is now in, it appears the company has overbid and lost.

MacKenzie, who is also chairman of GNER's troubled parent company Sea Containers, almost admits as much himself.

In a comment heavy with understatement, he told investors earlier this month that GNER had been "optimistic" with its projections when working out how much it could afford to bid for the East Coast franchise.

Even if ticket sales had hit projections and electricity prices had not shot up, GNER would only have made a profit margin of 3.75% - eye-wateringly tight by many standards and amounting to just £20m a year. With sales stuttering, energy costs soaring and competition incoming, the company believes even that potential profit will be wiped out.

While that is a serious situation for any company, the ramifications are magnified by GNER's role within the Sea Containers group.

The Bermuda-based business admits that it has previously been using GNER as "a cash cow" to prop up the rest of the largely loss-making companies in its portfolio, which include ferry businesses, a sea container leasing unit, property interests and a fruit farming division.

Sea Containers borrowed heavily against its assets to expand its interests further, but found itself in deep water when returns from some of its core businesses began to tail off.

Ferry passengers began defecting to low-cost airlines for their travel as operating costs continued to rise, but Sea Containers always had the reliable stream of cash from GNER to keep it afloat and mollify anxious debtors and bondholders. Now the group can no longer rely on its cash cow, the corporate pigeons are coming home to roost. Sea Containers is currently $610m (£323m) in debt, has delayed filing its 2005 accounts and has defaulted on "many" of its secured credit facilities after breaching various requirements of the loan deals. This is despite an extensive sell-off programme which has seen the group dispose of almost all of its ferry businesses and its 25% stake in the Orient-Express Hotels company.

The group admits it is in a cash crisis and chairman MacKenzie is now working on a life-saving refinancing deal.

Last week, he outlined the extent of Sea Containers' plight to key stakeholders and details of the group's financial restructuring plan are expected to be revealed next month.

Exactly what role GNER plays in the future of Sea Containers - and of rail transport in the North-East - remains up in the air, but the company's options are narrowing.

First, it can accept the status quo and try to boost the returns. While the conditions of GNER's franchise mean its actions are constrained to some extent, the company can hike prices in certain areas. It has already started pushing up the cost of parking at the car parks it operates at various stations along the East Coast Main Line while ticket prices have also increased, although if prices go up too much, sales could fall even further behind targets. Cutting costs are also on the menu. GNER will look to take advantage of the trend for more passengers to book online to trim down staff numbers in its ticketing operation, possibly halving the 300-strong workforce there.

Rail union RMT is expecting similar cuts in station staff, on-train personnel and maintenance workers, although Sea Containers has attempted to play down expectations of a mass cull.

Option number two for GNER is to renegotiate its franchise and get the amount of money it pays to the Treasury reduced.

The company argues that 15 months ago it could not have predicted the effects of 7/7 or the dramatic energy price hikes.

It is also smarting about a last-minute change to its franchise bid which it claims wiped out half of its potential profitability at the stroke of a pen.

The company says it was initially advised by the Strategic Rail Authority - the forerunner to the ORR - to put a clause in its franchise bid to ensure it retained exclusive rights to the East Coast Main Line.

A Sea Containers spokesman says: "About two to three hours before the deadline for signing, (the SRA) said to remove that caveat otherwise we would not be allowed to take part in any re-tendering. £10m of our projected annual profitability was wiped out when the ORR decided there could be open access on the line."

However, GNER may find itself given short shrift if it attempts to talk Ministers into renegotiating its franchise deal.

Firstly, the Government is unlikely to freely sign away several hundred million pounds worth of revenues it is already counting on and secondly, any renegotiation could prompt other operators to either push to get their franchise costs lowered or take the Government to court.

If it fails to get a better deal from the Government, GNER could simply walk away from the franchise, leaving the Department for Transport to pick up the pieces and run the railway while tenders were sought again - with any offers no doubt at a drastically reduced price to the original £1.3bn.

A last solution could be a sale of the company.

"There is no doubt that we have some extremely tough talks in front of us," says a Sea Containers spokesman.

"Nothing has been ruled out or ruled in."

May 2005: GNER wins East Coast Main Line franchise ahead of three rival bidders with promise of £1.3bn subsidy to Government. Observers warn the company may have paid over the odds.

July 7, 2005: Suicide bombers kill 52 people in series of attacks on London Underground, including King's Cross station. GNER blames subsequent disruption and travellers' wariness for more than half of a subsequent £33m sales shortfall.

January 2006: Office of the Rail Regulator approves Grand Central Trains plan for Sunderland-London rail service. GNER appeals against the ruling.

May 2006: GNER parent company Sea Containers announces it is delaying filing its 2005 accounts and warns of defaulting on several of its loans.

July 2006: High Court throws out GNER's appeal against the Grand Central ruling, opening the line up to low-cost competition.

August 2006: Sea Containers reveals GNER's sales are running £33m short, its costs are set to rise by £11m a year from April 2007 and the future value of GNER for its owner is "uncertain".

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