FirstGroup plc (FGP.L) Earnings Call Transcript & Summary

Hello, and welcome to the FirstGroup Rail update. [Operator Instructions] And just to remind you, this conference call is being recorded. Today, I'm pleased to present Matthew Gregory, FirstGroup Chief Executive; and Ryan Mangold, FirstGroup CFO. Please begin your meeting.

Good morning, and thank you, everyone, for joining us today. I'm joined on the line by Ryan, our CFO; Rachael Borthwick and Faisal Tabbah. First off, I'm going to run through the headlines of the national rail contracts that we're announcing today before moving on to discuss some of the commercial terms in more detail. I'll also discuss what it means for our rail portfolio going forward. And finally, I'll look at how this fits with our retained business and our strong credentials and prospects after the North America transactions are completed. The presentation is published on our website. So I'll try to preface my comments with the slide number to help everyone follow along. So let's turn to the headline details, starting on Page 2. Yesterday evening, we signed agreements for 2 National Rail Contracts with the DfT for our South Western Railway and our TransPennine Express train operating companies. These new National Rail Contracts, or NRCs, will commence on the 30th of May this year, when the current emergency agreements put in place during the pandemic come to an end. We're very pleased SWR and TPE are in the first wave of these new contracts. As the largest incumbent operator with 4 U.K. rail contracts, we will benefit from the NRC structure with its more appropriate balance of risk and reward. The government will take on revenue and substantially all the cost risk, so operators can focus on delivering the reliable service that the public wants as well as innovating and using our commercial expertise to attract more people onto the railway. The terms are in line with our expectations of more consistent and resilient cash generation each year. You'll also have seen that the government has today set out its views on the future of the wider rail industry. These rail reforms will optimize the balance between public and private sectors on the rail, blending the government's policy objectives with our experience, expertise and understanding of what customers want. And we look forward to working with the government and other industry partners to put passenger needs at the core of the railway system as society begins the process of building back better. Moving now on to Page 3. The basis of these 2 contracts are broadly the same and are adjusted to reflect the specific targets or initiatives of each train operating company. Looking at the contract terms in a bit more detail, these are 2-year contracts to May 2023, with options for the DfT to extend by up to 2 further years to May 2025. We will earn annual fees, which will consist of a fixed management fee plus a performance fee that is paid dependent on the delivery of customer-focused metrics. And I'll come back to the fees in a couple of slides time. Key aspect of the NRCs for us is that the DfT will retain all revenue risk. They will also retain substantially all cost risk under an annual budget that we've agreed with them. A large number of the cost categories within the budget are fully on the DfT's risks. For example, variable track charges paid to network rail or the price of fuel. But for the remainder, the operator bears the risk of costs in excess of this annual budget unless we agree in advance with the DfT. There are also contractual change mechanisms in place to allow the budget to be increased for items outside of the operators' control or for changes requested by the DfT. Looking at contingent capital. There's also no significant risk here. Our contingent capital obligations for both the SWR and the TPE NRCs total GBP 15 million, significantly below the levels of the old franchises, with only 50% of that are now bonded. There's more detail about the contingent obligations in the appendix, but I can say that there are only a limited number of scenarios in which these lower bond obligations can be called upon, primarily in the event of early termination through default of the contracts. In summary, these are similar commercial terms to those that we expected, offering a significantly better balance of risk and reward. So what does this mean for passengers? Well turning to Slide 4, you can see some of the examples of initiatives that will be delivered under the NRCs. The new contracts provide continuity for customers, employees and other stakeholders. Initially, both of the TOCs will work with the industry partners and stakeholders to build back patronage. Obviously, that's what's key at the moment. But it's not just about getting patronage to increase. We'll be taking forward a number of initiatives, including upgrading service offerings. Our plans include the introduction of flexible commuter tickets and continuing to move customers towards electronic and mobile ticketing or smart cards. SWR will be introducing 19 new suburban trains and next-generation onboard superfast Wi-Fi will be introduced via our evo-rail business. TPE will finish the deployment of their Nova train fleets, and station improvements are planned at Dewsbury, Molton, Manchester airport in year 1 with works at Hull and Middlesboro for year 2. There'll also be a station improvement fund to allow the pipeline development of further opportunities with third parties. And TPE has been contracted by Network Rail to undertake a package of design study work for stations affected by the TransPennine route upgrade, including Northern stations. We hope that this will be a precursor to project managing actual works delivery. Both companies will take further steps to improve their sustainability. Sustainability is at the heart of the NRCs. Both TOCs will work in the first year on a decarbonization road map, underpinned by science-based targets to achieve net 0 emissions by 2050 or earlier, consistent with FirstGroup's commitment. Commitments also include working with our suppliers to embed sustainability and influence the carbon emissions of our supply chain. We'll also work with industry colleagues to inform an industry-wide sustainable rail strategy and work with local authorities with a focus on mobile integration with sustainable and e-transport Solutions. Our sustainability targets will also include reduced water consumption, increased recycling and 0 waste to landfill. And finally, both companies will develop an agile, diverse and inclusive workforce with the right depth skills, engagement and motivation, including the introduction of an enhanced apprenticeship program, with a target of 2.5% of employees being on apprenticeship programs. We'll use this opportunity to encourage further diversity and inclusion, build a succession pipeline and attract new talent to the railway. Turning over the page. You can see that the fees for the National Rail Contracts are made up of 2 parts: a fixed management fee and a performance-based element. Historically, we've talked about margin percentages, linking profit to revenue. However, the fees are now provided on an absolute pound basis. As a result, they are not dependent on the revenue or the cost base. For our 70% share of the joint venture with SWR, the fixed management fee is GBP 3.3 million per annum. And there's also the opportunity to earn up to an additional GBP 9.9 million, which is the maximum attainable performance fee. For TPE, the fixed management fee is GBP 2.3 million per annum, and there's the opportunity to earn up to an additional GBP 5.2 million. The punctuality and other operational targets required to achieve the maximum level of performance fee are designed to achieve the highest level of service for customers. The performance-based fee is scored against 4 categories, namely: operational performance; customer satisfaction; finance; and then business management. There are 3 levels for the qualitative scoring with the middle acceptable rating, resulting in approximately 2/3 of the additional fee being payable. And quantitative scores, such as for operational metrics, are measured on different KPIs on a period-by-period basis. There are also potential opportunities for additional incentive fees for industry change projects. For example, TPE supplying project delivery expertise to help deliver the TransPennine route upgrade, which starts this year in earnest and will continue until 2028, transforming the railway in the North of England. And the group will receive an annual dividend from the TOCs, reflecting the post-tax net management and performance fees, and these dividends are expected to be paid in September, following the completion of the audited accounts of the train operating companies. Looking now at Page 6. Having talked about the contractual terms of the NRCs, I thought it would be worth summarizing where we stand with our rail portfolio. The signature of these NRCs now gives us clarity with respect to these 2 TOCs, but also a clear template and road map away from franchising and the emergency agreements. As you can see from the table, SWR, TPE and Avanti have all agreed their termination sums with the DfT, which deals with the historic position on the old franchises. The SWR and Avanti agreements were in line with expectations, and TPE was very much at the lower end of the range. As a result, we've now agreed NRCs for SWR and TPE, which will last until at least 2023, with a 2-year option to extend by the DfT. Avanti is currently on an ERMA until March 2022, and we expect this to transition to an NRC at that time, and it has the potential to last up until March 2032. GWR is still on the original emergency measures agreement until June 2021, and we're in discussions about the right way to transition GWR to an NRC. Now today's announcement gives us much more certainty around the operation of the rail network in the U.K., and we remain the U.K.'s largest operator with 4 DfT contract in operations and a market share of around 27%. This gives us a strong platform from which to grow our business. To this end, we'll continue to develop our open access footprint, bringing the hugely successful Hull trains back to normality. And with our second operator, East Coast trains, launching later this year, providing sustainable and value-for-money travel between London and Edinburgh. And we'll also further develop our 5G technological capabilities, which are being rolled out onto our SWR and Avanti railways as well as our consulting and call center business. Turning to Slide 7. This is really just a reminder that these lower risks are more consistently cash-generative rail contracts are a core component of the group's story going forward. As we set out in the announcement of the sale of First Student and First Transit, we're leaders in public transportation in the U.K. already. Through these NRCs, we are getting increasing clarity on the future of rail, and we now have resolved all of the termination sums, removing the link with the past franchises. As a result of confidence in the sustainable value creation potential of our operations is only increasing. So to sum up, we welcome the Williams-Shapps white paper issued today, which looks to the future of the U.K. rail industry and has the expertise, innovation and experience of the private sector rail operators at the heart of the model. National Rail Contracts leave us well placed for a lower risk cash-generative rail operation on SWR and TPE and confidence in stability for Avanti and Great Western Railway. We have long called for this transition to a new contract structure with a far better balance of risk and reward and which benefits customers by a clearer focus on performance, including the introduction of a new set of passenger service metrics. The last year has shown how reliable rail networks are critical to the country's economic, social and environmental objectives. As we kept key workers moving to where they needed to be. And what's more, our services are essential to local communities as they begin to reopen and society begins the process of building back better. Getting more people on to rail is an essential part of decarbonizing transport and achieving net 0, and we're ahead of the pack amongst U.K. operators in sustainability. Overall, today's announcement is a big step towards a successful railway system that works better for passengers and taxpayers while generating more resilient and consistent returns for shareholders. Thank you for listening. And with that, I'll turn it over to questions.

[Operator Instructions] Our first question comes from the line of Jarrod Castle from UBS.

Three from me. Firstly, contingent obligations. You mentioned kind of capital being freed up. Any kind of comments in terms of degree or potential further distributions? Secondly, just looking at kind of auxiliary or 5G opportunities. Can you kind of put any numbers behind it in terms of how big 5G or auxiliary opportunities could potentially be for the company? And then just on the performance-based fee scorecard, I mean, how active were you in setting that up? And how -- can you give maybe some kind of confidence level in terms of ability to achieve it potentially?

Yes. Well, let me cover off all those questions. On the first point about contingent capital, I mean what -- this is a process that's been in place for many years with the old franchises. And what it did was relied on us signing up to putting bonds in place, in the event of problems with the franchises. Now in terms of our North American sales, the contingent capital was never really a factor in our consideration. So the fact that these are lower doesn't actually affect anything to do with sort of capital distribution. But what it does is reflect the fact that it's lower risk, and this is all about this risk and reward. The only thing that we've, obviously, talked about recently around sort of better situations from a pure liability perspective is the TransPennine Express termination sum, which we've talked about last week. On the 5G opportunity, I mean, it's an interesting question and one that we're more likely to come back at our full year results to give a bit more clarity around addressable markets levels in a number of these sort of growth opportunity areas. Look, I think the 5G opportunity is an extremely good one. We have developed, at FirstGroup, sort of proprietary knowledge that is going to allow us to use this sort of MM wave technology to provide super fast 5G Wi-Fi on trains. It's going to be a huge leap ahead of what we're currently offering and what you're seeing on the railway. Now we've done a trial on the Isle of Wight. It worked and that's great. On the South Western railway, we're looking to sort of implement this on a stretch between Huddersfield and Basingstoke. So commuters will see that during this year. And we're also working on getting that working in Avanti as well. So I think these are still sort of -- in terms of revenue perspective, this is probably sort of in the tens of millions a year at this stage, but the opportunity to grow with this both in the U.K. and international is pretty broad, and there's a lot of effort going on to develop the sales on that front. But perhaps we'll leave it to the full year results to give you sort of some more clarity on that, and we can talk about all of our growth opportunities together. And then on the performance-based fee, look, what we've laid out is that sort of an acceptable performance, let's say, sort of -- we've got 1, 2 and 3 and hitting the 2, gets you 2/3 of the performance based incentive. It's fair to say that during the pandemic, all of our franchises hit the top mark. So now they're very different situations, and it will be different when the railways get more busy. But we have a very good track record of managing projects, managing the introduction of new trains, managing the passenger growth, managing stakeholders. So I think we've laid out there what you get if you're acceptable, but we'll clearly be working very hard to get to the top end of the scale.

[Operator Instructions] Our next question comes from the line of Joe Thomas from HSBC.

Just wanted to ask you about -- well, your expectation of being able to bid for other contracts that come up, the sort of pipeline that you might see ahead of you? And I suppose importantly, you're sort of giving us the gross profit numbers here potentially -- gross operating profit numbers for these contracts. But what sort of bid cost should we be expecting you to be putting against these profits in the future? So that would be one question. Another question, and apologies, I was a little bit late on the call, but -- so not entirely clear on the scorecard. But how confident are you, the sort of the history of this sector's been a dispute with network rail and compensation claims and not always getting claims that you think you do or the amounts you think you deserve. To what extent do you think they are now ironed out? And then finally, just coming back on this issue of lower kind of capital commitments. I realize that this stuff was all, I suppose, it was all contingent liabilities. But if I remember rightly, it was counted towards your credit rating. I may be wrong on that but that's my recollection. So would you expect this to be credit rating positive?

It's good questions there, Joe. Let's make sure I've got them. So look, in terms of the contracts, I mean, the way this is working is the vast majority of the contracts are effectively -- provided people agree to their termination sums, as we have done on our sort of 3 franchises. Then people are getting directly awarded these new NRCs. So in the short term, we're not expecting there to be a huge amount of bidding. It's about sort of working -- using your existing franchises, working with the various industry bodies to focus on growing the rail patronage again and getting people back on the railway. Now obviously, there are a couple of railways that are being run by the government at the moment. So there may be -- who knows, there may be some opportunity there. But as these things develop over time, I would expect the bid cost to be far lower than what we had before. And I think we had big costs that were in the sort of high single-digit millions before. I expect them to be in the low single digits before because I don't have to forecast revenue growth. I don't have to have a sort of 7-year model, trying to work out the impact of the economic growth in East Anglia or Scotland or wherever it is. So I think the actual process will be a lot more straightforward and will be cheaper. And I think in terms of the claims that you talk about, I mean, resolving the termination sums for these 3 resolves or the claim issues largely. And I think going forward, that is not going to be for our account as it were. We are going to have to manage through that in the short term whilst the industry works through the white paper and as things change, but it's not going to be for our account. So that's going to be far less of an issue. And again, comes back to the point of far less volatility, much more resilient performance fees and fees that you can really understand. And I think it was...

Sorry, Matthew...

Go on.

Just on that one. The performance fees are presumably linked in some way to network performance, aren't they? So if network rail or whatever it's called, Great British Railways now is failing to deliver what it's committed to. Doesn't that impact your ability to generate a profit?

Yes. I mean -- well, look, the -- I think in terms of the network rail piece, and I think it will still be network rail, that may have some impact sort of on the customer experience. But in terms of our operational performance, I don't think we'll be penalized for network rail's performance. Yes. I think -- look, I think the vast majority of it is on our performance, and with just -- there will just be a small amount on the network rail piece.

Okay. All right. And so then the question...

So that -- sorry then the...