Economists on wrong track

By Bryan Gaynor

A few faces must have been red at the Treasury and Victoria University's economics department over the past 10 days.

On August 4 the university made public a report applauding the Tranz Rail privatisation. Less than 24 hours earlier Tranz Rail had released an extremely poor result for the June 1999 year, and on August 6 the company was placed on a negative credit watch by Standard & Poor's.

The 160-page, $150,000 report is a Treasury working paper prepared by Victoria University's Institute for the Study of Competition and Regulation.

The institute adopts an extremely positive attitude towards Tranz Rail's privatisation and boldly states: "The financial performance of NZ Rail/Tranz Rail since privatisation is represented as a success story."

This may be a widely held view in the public sector and academic world but not in the investment community. Most investors would argue the report has been a waste of taxpayer money.

The study had two main objectives:

* To determine the nature and extent of the economic welfare gains and losses resulting from the privatisation of NZ Rail.

* To identify which groups have gained or lost and the quantum of these gains and losses.

The first part is extremely subjective because it is based on an analysis of how Tranz Rail would have performed had it not been privatised. This is like trying to assess the score of last week's test in Pretoria on the assumption that Andrew Mehrtens and Christian Cullen did not play.

A retrospective analysis, assuming different variables, is a far more inexact exercise than a measurement of the winners and losers from privatisation. Yet more than 90 per cent of the study is devoted to the first objective and the winners and losers are covered in a few, rather vague, paragraphs.

The report claims that the economy has derived substantial benefits from the privatisation of Tranz Rail. These benefits vary from a staggering $9.8 billion to just $0.9 billion.

It is difficult to agree with these findings. NZ Rail had already undergone a huge restructuring before it was sold in September 1993.

For example, staff numbers had been slashed from 20,865 in 1982 to 5324, a new market strategy had been implemented and the company's operating profit was higher in the 1991-93 period than in the 12 months ended June 1999.

The institute argues that the anticipation of privatisation, rather than privatisation itself, motivated the pre-1993 changes.

The report says: "The prospect of privatisation provided a [potentially rewarding] goal for management and probably brought necessary developments forward in time."

This highly questionable, vague conclusion allows the institute to claim the substantial restructuring between 1989 and 1993 can be attributed to privatisation even though the company was still in public ownership.

Few would disagree with the principle that the private sector is better at managing commercial assets than the Government. But the private sector is also capable of mismanagement, as illustrated by the Bank of New Zealand and many other listed companies in the 1980s.

New Zealand Post performs extremely well under Government ownership.

It has maintained an AA+ credit rating while Standard & Poor's recent statement said that Tranz Rail's "BBB+ rating is expected to be lowered at least one notch."

When Tranz Rail was privatised in 1993 it was a strong company with minimal debt and a bright future. Six years on, its earnings are lower than the pre-privatisation period; its borrowings have soared; a credit watch has been issued; its share price is falling; and the chairman and chief executive have been dismissed and no replacements found.

The institute report assumes that Tranz Rail's performance would have steadily declined if it had not been privatised. The recent profit and credit rating announcements indicate its performance under private ownership has been little better.

As performance and reward should be related, one would expect the investment returns of the controlling shareholders to reflect their poor stewardship.

The institute agreed with this. "To 1997 the private owners' cash position fared little better than the Government, having spent $400 million of nominal 1993 dollars to purchase the company, plus $342 million of investment capital to 1997 while receiving only $23.2 million in cash dividends. Since the inception of private ownership the compound return has not exceeded what could have been expected on average, from other investments."

This is where the study loses touch with reality and fails to make a detailed or accurate assessment of investor returns.

NZ Rail was sold to a consortium of investors for $328 million - not $400 million as reported by the institute - in September 1993.

These investors included a Wisconsin railroad company; Fay, Richwhite; US investment group Berkshire Partners; Alex van Heeren; and Richwhite family interests. According to the study: "A lot of skilled outside help was used in the 1990-93 period to evaluate strategy - much of it came from Fay, Richwhite."

Thus the merchant banker had a strong inside knowledge of NZ Rail when the bids were lodged.

Four years before privatisation the Government injected $360 million of equity into the rail company and all but $72 million of debt had been written off. The investors were able to use NZ Rail's strong balance sheet to borrow money to finance the acquisition and only $107 million of their own money was required.

Thus on day one they effectively stripped out more than $200 million of NZ Rail's equity. This equity had been contributed by New Zealand taxpayers.

In 1995 they took out a further $100 million through a share buyback.

In May 1996 a prospectus was issued for a public float with an indicative price between 460c and 655c a share. The public share issue was a Government requirement under the 1993 sale agreement.

Thirty-one million shares were issued to the public at 619c and to staff at 609c a share. The share price hit a high of 900c in 1997.

The new shareholders would strongly disagree with the institute claim that Tranz Rail has been a financial success story. Also, few would support its claim the original investors "have not achieved returns in excess of a broad range of other investments."

The more widely held view is that Tranz Rail's present problems are primarily due to the original investors putting their own interests ahead of all others. In other words, the company's cupboards have been stripped bare.

The combined profit of the five original investors is $381 million or 256 per cent. This does not take into account dividends or $15 million paid to Fay, Richwhite for fees and financial advice. The sharemarket has risen just 12 per cent over the same period.

Alex van Heeren, the owner of Huka Lodge, has sold all his shares for a cash profit of $43 million. This was from an investment of just $9 million.

Berkshire Partners has also walked away from New Zealand with a huge profit as it sold most of its holding when the share price was well above its present level.

The biggest irony is that the controlling investors have mismanaged the company but still made a substantial profit while public investors sit on a huge loss.

Public shareholder frustration is exacerbated by the Treasury-commissioned report which argues that everything is hunky-dory.

If major institutions, such as the Treasury and Victoria University's economics department, insist on looking at issues through rose-tinted glasses then we will never learn from our mistakes.
* Disclosure of interest: none.