Brian Gaynor 's Opinion

Investment columnist for the NZ Herald

Brian Gaynor: Shares in a downhill train-ride


Tranz Rail went on the offensive this week after questions were raised about its accounting policies.

The company's comments brought some relief to its battered share price, but left unanswered questions.

Does Tranz Rail have creative accounting policies? Did Wisconsin Central and Fay Richwhite sell investors a pup when they sold out this year? What are the company's long-term sustainable earnings and does it have a future?

Tranz Rail was incorporated on July 7, 1993, and two months later bought New Zealand Rail from the Government for $328.3 million.

The original Tranz Rail shareholders - Fay Richwhite (31.8 per cent), Wisconsin Central (27.3 per cent), Berkshire Fund (27.3 per cent), Alex van Heeren (9.1 per cent) and Richwhite family interests (4.5 per cent) - contributed $107.4 million of equity.

The rest of NZ Rail's purchase price was borrowed against the rail company's assets. This is reflected in the big increase in debt between 1993 and 1994.

In 1995, $91 million of a $100 million capital repayment went to the original shareholders, leaving them with a net equity contribution of $16 million or an average cost of 20c a Tranz Rail share.

Ron Russ was appointed chief financial officer in December 1993, three months after the acquisition of NZ Rail. Russ, who was to play an important role in the group's accounting and financial operations, was previously treasurer of Wisconsin Central Transportation.

One of the first decisions of NZ Rail's new owners was to change the company's accounting policy on track renewals.

Under Government ownership, all track renewals were treated as an expense and deducted against revenue.

The new board treated all track renewals as capital expenditure. Costs incurred in this area were treated as an addition to fixed assets and were not deducted from revenue.

Renewals were then depreciated on a straight-line basis over 40 years. Tracks were not previously depreciated because all costs were charged to revenue as they occurred.

The change had an extremely positive impact on Tranz Rail's reported profit.

Restated profits for the 1992 and 1993 year, shown in the 1996 IPO prospectus, showed net earnings of $80.9 million for the two years under the new accounting policies compared with $53.2 million under the old approach.

Tranz Rail also took a more liberal approach towards depreciation.

The depreciation life of wagons was extended from 25 to 30 years, ships from 18 to 20 years, tunnels and bridges from 45 to 80 years and locomotives from 13 to 23 years.

The longer economic life of these assets led to a dramatic drop in the annual depreciation charge as a percentage of total assets.

In the June 1993 year, the last under Crown ownership, the depreciation charge represented 9.1 per cent of average fixed assets. In the June 2001 year, the charge was down to 6.4 per cent.

Russ also took a fairly aggressive approach towards other forms of capitalisation. His attitude was to capitalise costs unless accounting standards made it absolutely clear that they had to be expensed. This approach is now being widely criticised in the US.

On Wednesday, Tranz Rail revealed it had capitalised $186 million of track renewal since 1993 and charged depreciation of $45 million.

Some of the depreciation relates to track expenditure before 1994 that was retrospectively capitalised after Tranz Rail acquired NZ Rail.

Tranz Rail said: "This treatment is entirely consistent with New Zealand and US accounting standards, and is consistent with treatment applied by comparable international railroad companies."

This statement is highly debatable. Section 4.13 of New Zealand Accounting Standard 28 says repairs must be expensed but expenditure that increases the service potential of a fixed asset can be capitalised.

A few years ago, rotten sleepers were replaced on the Dargaville line because freight trains could not travel at their normal speed.

The cost of the new sleepers was capitalised, but there is a strong argument that this was a repair and should have been expensed against revenue.

Expenditure can be capitalised only when it adds value. The true test of this is whether revenue and profits are increasing as rapidly as the value of fixed assets.

This is not the situation at Tranz Rail. Its fixed asset values have increased 208 per cent since 1992. Revenue has risen by 27 per cent and net profit has fallen over the same period.

Whatever the accounting argument, the commercial reality is that Tranz Rail has capitalised far too much expenditure and its assets are over-valued.

The role of the auditor is important in this area. KPMG has received audit fees of $2.1 million in the eight years since privatisation and $20.5 million for non-audit work.

How can shareholders have full confidence in KPMG when 91 per cent of its Tranz Rail income has come from non-audit work?

Another change made while Russ was chief financial officer was the sale and lease-back of assets. In December 1996, the company sold rolling stock for US$93 million and leased it back for twelve years.

Two years later, the new Aratere ferry was sold for US$55 million and leased back for the same period. The two sales generated a profit of $90 million, amortised over the period of the leases.

But Tranz Rail has also taken on huge lease obligations. On June 30 last year, it had unrecognised profits of $61 million associated with these two deals and lease commitments of $542 million based on the then US$/NZ$ rate.

This amount has fallen because of the rise in the New Zealand dollar, but will still take a huge bite out of earnings.

The sharp drop in Tranz Rail's share price follows the sale of Wisconsin Central's 23.7 per cent stake for $3.70 a share and Fay Richwhite's 14.5 per cent at $3.60 in February, and the resignation two months later of chief financial officer Mark Bloomer, who replaced Russ in February 1999.

But the blowtorch was turned on the company when accounting scandals surfaced on Wall Street and investors started looking at accounting policies round the world, particularly in companies closely associated with the US.

Wisconsin Central and Fay Richwhite have sold shares in a company severely weakened by an over-emphasis on creative financing and accounting and a poor business strategy.

Its financial situation is not strong, but it has received a temporary boost from the $81 million sale of the Auckland Rail Corridor.

Tranz Rail's sustainable earnings are probably far lower than analysts are forecasting. It will have to adopt more realistic accounting and financing procedures and has yet to develop a robust business plan (the good result in 1999 was achieved after a tax credit of $57 million).

Institutional shareholders are fuming over the share price decline but have only themselves to blame. They did not recognise the unreality of Tranz Rail's accounting policies, its huge lease commitments and the absence of independent directors to curtail the self-interest of the controlling shareholders.

The board is still dominated by Wisconsin and Fay Richwhite appointed directors five months after they sold out. Why did the institutions not insist on their resignation and the appointment of strong independent directors, when they bought into Tranz Rail this year?

* Disclosure of interest: none.

* bgaynor@xtra.co.nz

Brian Gaynor

Investment columnist for the NZ Herald

Brian Gaynor has written a weekly investment column for the Weekend Herald since April 1997. He has a particular passion for the NZX and its regulation. He has experienced - and suffered through - the non-regulated period prior to the establishment of the Securities Commission in 1978 and the Commission’s weak stewardship until it was replaced by the FMA in 2011. He is also a Portfolio Manager at Milford Asset Management.

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