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Rail Rivals

By Shoeshine

Friday 23rd May 2003

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For market-watchers already suffering the first pangs of Tranz Rail burnout, the news is all bad; this story still has a long way to run.

Although the airwaves have been assaulted all week by the Aussie twang of Freight Australia's Marinus van Onselen and Toll Holdings' Paul Little, neither man yet has anything like a firm bid on the table.

RailAmerica, through Freight Australia, has merely notified its intent to make an offer for Tranz Rail's shares. Toll hasn't even gone that far, saying simply its 6.1% stake is a chip on the table while it watches how things pan out.

For public consumption, the two might-be bidders have adopted very different approaches.

Little bluntly told National Radio that Toll, if it ended up as Tranz Rail's owner, was not interested in selling the tracks to the Crown so the government could set up an open access regime. Toll needed exclusive access so it could control the hefty investment needed to bring the network up to scratch.

Van Onselen has taken an entirely more circumspect approach, meeting Transport Minister Paul Swain to hear what the government plans for rail. He indicated RailAmerica could live with a track sale and open access.

But beneath the differences in style Tranz Rail probably looks like pretty much the same beast to both companies.

Van Onselen has been over this way before, back in 2001 when Tranz Rail's previous owners, Fay Richwhite, Wisconsin Central and Berkshire Partners, invited him over to kick the tyres and consider buying them out.

He says he saw value in Tranz Rail then, but not as much as the institutions who bought the three out for $3.70 a share and have been kicking themselves ever since.

Toll already has some operations here and has been doing due diligence on Tranz Link, Tranz Rail's trucking subsidiary.

So the two already have good local knowledge. But comparisons between Toll's weighty balance sheet and RailAmerica's skinnier resources aren't flattering to the US player.

Its shares have taken a spanking since the bid was announced, falling to about $US6.44, giving it a market capitalisation of $350 million. But they were under $US5 in March after following the rest of the US market on a long downward track.

Its $US500 million of net debt is 179% of its $US279 million of equity.

But as Van Onselen says, it would not have waved 75c a share over the table if it didn't have financing lined up. While $394 million may not be chickenfeed to it, the company has grown dramatically since it was founded in 1986, all with high leveraging, and it hasn't run off the rails yet.

Toll, with a market capitalisation of $2.3 billion and a net debt to equity ratio of around 47%, certainly has deeper pockets. But it will be able to pay more than RailAmerica and still get an adequate return only if its cost of capital is lower than the US company's ­ which it almost certainly is.

Both players are also well aware of the need to inject big dollops of capital into the network.

And here's where the two ostensibly diverge.

Toll can well afford to own the network and pay the deferred and future maintenance bills, hence its declaration it's all or nothing.

For RailAmerica, sinking in a further $200 million plus would be a stretch, to put it politely. If the government took track ownership off its plate that would be a huge capital cost avoided. It would still of course have to pay whatever access charge it agreed with the government as part of the deal, but at least that could come out of operating earnings.

The reality is that New Zealand doesn't have anything like the density and volumes needed to justify the capital costs of setting up an operator to compete with the incumbent. The capital costs of operating rail are huge; a single locomotive, for instance, costs upward of $4 million. Then you have to have facilities to maintain it.

The good news for rail users, and particularly for Tranz Rail's biggest customers, is that the competing non-bids will put huge pressure on the government and the Tranz Rail board to shake themselves out of paralysis and make some decisions.

The government's land transport strategy, aiming to shift freight off the roads and on to rail, was published last December but six months later there is no decision on the crucial question of how to deal with the effective subsidies road freight enjoys at the expense of rail.

RailAmerica, Toll, and anyone else who might crop up will want to know what the government is going to do so they can assess what effect that will have on Tranz Rail's economics. Toll also needs to know before it commits to buying Tranz Rail's trucking business.

Both will also want assurances they won't be ambushed by future legislation mandating open access to rail ­ as RailAmerica was in Victoria, and as, in the telco arena, Vodafone was here when the government changed the law to give Econet Wireless a leg-up.

For most companies the conditions attached to RailAmerica's bid ­ 90% acceptance, finance and no asset sales ­ would normally be enough to recommend shareholders decline but Tranz Rail's board isn't in much of a position to spurn any advances.

The other directors' faith in managing director Michael Beard's "virtual railway" strategy must surely be badly frayed. And, as one railwatcher recently put it, "when you're worrying day by day whether you're trading while insolvent, it's got to detract from your attention to running the business."

Whatever the board recommends shareholders face a tough task working out what fair value actually is. Estimates of $3 ­ emanating, cynics suggest, from the institutions that bought in at $3.70 last year ­ have been floated around.

But the shares were trading only a few weeks ago at 30c. And some would say that was expensive.

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