Nikki Marmery: Network Rail's historical legacy and government guarantee make it an unusual credit. Can you describe the company's background and structure?
Samantha Pitt, head of corporate finance at Network Rail in London: Network Rail runs the infrastructure that allows the trains to run - the tracks, the signals, the bridges, the tunnels etc. We are a private company: we don't have shareholders. We have members instead - representatives from the rail industry, such as train operating companies, rail passenger groups, and members of the public. They perform the same role as shareholders, but have no financial interest in the company.
The company was set up to take over from Railtrack, which went into administration in 2001. We bought the assets of Railtrack in October 2002, effectively taking on a basket case. It had no financial stability, no credit rating, and it needed about £21 billion worth of investment to refinance the legacy debt and invest in the network. With no operational or financial track record, it was decided that government support was necessary to raise finance and take the company out of administration. Our revenues come from two key sources: direct from the UK government and from the train operating companies who pay us for accessing our track network. There's also a smaller revenue stream from property: we're the third-largest landowner in the UK.
We have an independent regulator, the Office of Rail Regulation, who sets our revenues based on what they deem an efficient cost level. The funding package for the current five-year regulatory control period is £25 billion running up until March 2009; roughly half of that will come directly from the UK government.
Over the last couple of years we've carried more than a billion passengers, the highest number since 1946. Those passenger numbers are projected to grow, and over the next couple of years we're going to be spending about £2 billion on enhancements to the network.
Talk me through your debt issuance programme.
In March 2004, we entered the capital markets for the first time to raise medium-term notes, which mature by March 2009 - the end of our current regulatory control period. In late 2004, we launched our debt issuance programme with a government guarantee, which allows us to issue all forms of debt - bonds, bank loans, commercial paper, leases etc. We issue all forms of debt in a variety of currencies and maturities. It's all currently explicitly and directly guaranteed by the UK government, so it carries the same credit rating as the UK itself: triple-A and 0% risk weighting. The guarantee is unconditional, irrevocable and unlimited in amount.
Since we launched the programme in October 2004 we've issued more than £13 billion of bonds in various currencies and maturities out to 40 years. We can issue up to 2052 because that's the date the government guarantee expires - 50 years after the creation of Network Rail. The structure of the government guarantee is designed to survive any rail restructuring in the UK. It's very difficult for us to predict what the rail industry could look like in 30 years, but if Network Rail isn't around, creditors still have a direct claim on the UK government.
We currently have just under £19 billion net debt at the moment and that is projected to rise to £22 billion by March 2009. We've got a lot of short- to medium-term debt to be refinanced: over the next couple of years we've got roughly £7 billion of refinancing to do and £3-3.5 billion of new debt to raise.
You recently launched the largest-ever non-government index-linked deal - a £1 billion bond in May 2007. Do you plan to continue issuing index-linked?
We have decided to increase the proportion of index-linked debt in our portfolio. The Debt Management Office (DMO) raises a lot of index-linked debt and has roughly 30% of index-linked debt in its portfolio. Other regulated utilities are big issuers of index-linked debt, with levels of roughly 30%-40%.
We know the market wants a lot of index-linked issuance. The DMO is issuing less index-linked this year, and, although you do get the odd corporate and utility that issues index-linked, that is very irregular. We have a lot of funding to do and we can issue regularly into the market with more of a programme-style approach, similar to the DMO itself.
We did our first index-linked issue, a 30-year bond, on May 2, and another £1 billion 20-year index-linked bond in June. Much of our funding over the next couple of years - and we hope to raise some £10 billion - is likely to come from index-linked, subject to investor demand still being there at a decent price.
Where is the demand coming from?
Pension funds and life insurance companies are currently doing a lot of asset-liability matching. They want index-linked assets and they see us as attractive because they know that we price at a spread over gilts. If they're buying gilts at 1.1% and they can get us at 26 basis points over that, then that's a good return for them. As this is a programme, it's going to provide more liquidity as well, which is what investors are telling us they want. Roughly 90% of May's index-linked bond went to the UK; the other 10% went to Europe.
What are your other plans for debt issuance in the future?
We're looking at raising some debt without the government guarantee. It was always the intention that Network Rail would stand on its own two feet and be a solid investment-grade rated company, able to raise money off its own back. That point has come more quickly than originally envisaged because of a significant turnaround in the company, both operationally and financially. We're now making profits and our operational performance has improved.
When we took over Railtrack, the percentage of trains running on time was around 70%. Now, it's frequently over 90%. Other operational aspects are also improving - reliability, efficiency and safety. Last year rail was safer than air for the first time ever. This means we are becoming viewed as a stable, well-run public interest utility and are confident we can raise debt off our own balance sheet as an independent, regulated utility. The intention is to raise debt off our own balance sheet by the start of our next regulatory control period in April 2009.
What are the key concerns about Network Rail that investors raise at roadshows?
We have just under £19 billion of debt at the moment, so people often say, 'that's a lot of debt'. Most other utilities' debt levels are a lot lower. But we always say it's like buying a house: work out what you can afford and how you can cover your interest rate payments. Our revenues and costs are set every five years by the Office of Rail Regulation, and they're set at a level that ensures that we can cover our costs. So we look at our debt level as a percentage of the value of our asset base and at the moment that's roughly 74%. That's forecast to lower to just over 70% by the end of our regulatory control period; a gearing level of 70% is quite reasonable for a utility.
Other than that, investors are very comfortable because they know they're buying a UK government credit. When we start raising corporate debt, we'll have to go through more of an extensive roadshow and marketing effort because it will be a whole new credit. At that point people are going to have to understand the business in more detail.
Who would you say are Network Rail's traditional investors?
Our investor base is global. The UK investor base is very important to us because sterling is our home currency. Global central banks are also very important for us. We issue in sterling, US dollars, Australian dollars, Canadian dollars and Swiss francs to access the domestic investor bases in those countries, and we have also done private placements in Norwegian kroner and yen.
Half of our investors are traditional UK investors - life insurance and pension funds; the other half are central banks in Asia, the Middle East or Europe and institutional investors in Europe. People like the fact that we are the only frequent issuer in the UK with a UK government guarantee - it's the only opportunity for them to get exposure to the UK sovereign outside of gilts. Given that the UK government very rarely issues in anything other than sterling, it also gives investors an opportunity to get exposure to the UK sovereign in different currencies.
We respond to what investors want and we issue in the markets and at the maturities that they want.
What have been the historical funding problems for rail companies in the UK?
A major problem has been the lack of investment in infrastructure for decades. When the railways were privatised in the 1990s, the premise was that it was a declining market. But since then, the complete opposite has happened: more people are using the railways.
The mindset has therefore changed from managing the investment of a declining asset into one that is growing hugely. That is evidenced by the amount of debt that we've raised over the past couple of years to fund that catch-up investment. Our debt levels over the next five to seven years are to fund enhancements and improve capacity and safety on the network.
Why should anyone invest in the rail industry in the UK?
The government guarantee programme makes it very easy. And it's the only opportunity to get exposure to the UK sovereign outside of gilts and sterling. It's a stable industry: having the regulatory regime reset every five years, we have a stable revenue stream.
Also, we've taken out more than 20% of the cost base over the past three years. That's been achieved by getting the structure right. Railtrack had a regional structure; we have a functional structure so engineers report into the chief engineer, not to a regional boss. Getting that structure right and bringing maintenance in-house cut out a layer of profits that third parties were taking. We've increased the number of people using the railways, cut out the cost, and it's safer and more reliable.
What are the risks of investing in the rail industry? What about rail accidents: do they impact your profits?
There was an awful accident in Cumbria last year - the first passenger fatality caused by a rail accident in five years. But during that period, 15,000 people died on the roads. We didn't see any dip in public confidence. The statistics stack up: rail is now safer than air. The Independent Rail Safety and Standards Board statistics show the railways are safer than they have ever been.
The biggest challenge for the railways in the next five, 10, 15 years is dealing with the extra capacity, dealing with growth that hadn't been planned for. We are carrying more people on the railways than at any time since 1946; but in 1946 the railway network was twice as big. We're running the most punctual railway there has been for seven years and, at the same time, more people using it. Coping with that is difficult but that's why we're putting in the extra investment.
Finally, how will a turn in the credit cycle affect Network Rail?
If the bubble bursts there will be a flight to quality, to triple-A rated companies like ourselves.
The week on Risk.net, March 10-16 2018Receive this by email