City & Business: Eurotunnel will not be another grande folie

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The Independent Online
BOTH Nick Knight and Terry Smith, two of the most controversial share pundits in the London market, predicted last week that Eurotunnel will be the worst-performing share of 1994. At the other extreme, most brokers in Paris appear to think the shares will continue motoring - in the past year they've doubled. As the Channel Tunnel's grand state opening on 6 May approaches, there doesn't seem to be much middle ground in the debate over what kind of future Eurotunnel can look forward to. The investment community falls into two distinct camps: those who like Mr Smith and Mr Knight believe in the nightmare scenario, that Eurotunnel is destined to follow Euro Disney into ignominious commercial disaster, and those who think that with the passage of time it will prove a monumental cash cow, a licence to print money.

Both cases are equally plausible. But the truth of the matter is that until the tunnel has a year or two of trading under its belt, answers are going to be hard to find. There are too many imponderables. Can the fares structure announced last week be made to stick? To what extent will travellers prefer the tunnel to ferries and air? How much market share are the ferries prepared to give up? Can Eurotunnel, as exponents insist, really be expected greatly to expand the market? Is the tunnel's first year destined to be its best because of novelty value, as the pessimists predict, or is there going to be a slow but persistent build-up of traffic as the years march on?

First the nightmare scenario. Under this view of the future, the tunnel will never generate sufficient revenue to cover even its pounds 850m a year of operating and interest costs, let alone begin to pay down its debt. According to some estimates, the total size of the short-haul cross-Channel ferry market is only pounds 600m a year. Eurotunnel surely cannot hope to capture any more than half of it; even if there's rapid growth from here on, that's not going to be nearly enough.

On top of that, the tunnel will derive substantial revenue from through train traffic where the competition is mainly from the air, but even so, it's going to be hard to find sufficient volume to cover crippling interest payments on the company's mountain of debt. The other variable is tariff rates. It doesn't matter how much extra cross-Channel traffic Eurotunnel generates if it only does so at the expense of halving the price; in revenue terms, the effect is going to be neutral or worse. And in any case, can anyone really believe Eurotunnel's own revenue forecasts, sceptics ask, when the company so spectacularly underestimated construction costs, which came in at more than double the forecast level?

By its own admission, Eurotunnel is going to be cash-negative for at least the next four years. If revenue doesn't build up in the way anticipated, it's going to be a lot, lot longer; more debt and more equity will be required to keep the show on the road. It's easy to see why parallels are being drawn with Euro Disney. Here too is a project where the crowds have failed to arrive in the numbers anticipated. Here too is a venture where, in a vain attempt to attract custom, tariffs have been cut to the bone. Here too is a project which simply cost too much; it will never be possible to generate sufficient income even to pay off the borrowings, let alone yield an adequate return on equity.

On the face of it, the numbers at Eurotunnel look equally ominous. There is perhaps pounds 1bn of capital presently invested in the short-haul cross-Channel ferry market. When Eurotunnel opens next May, the amount of capital employed will expand by pounds 10bn or a factor of 10. Even if the ferries were to go away entirely, it wouldn't make a blind bit of difference; this is a quantum leap in capital devoted to what may prove a quite limited market. It simply won't be possible, sceptics claim, to generate sufficient revenue to justify such investment.

It all sounds frighteningly convincing, doesn't it? Certainly post- Euro Disney, there are some extremely worried bankers out there. So much so that Eurotunnel debt has begun to trade at well below par. The most recent refinancing negotiations with the banks went right to the wire, and it proved extremely difficult to secure agreement. Without the Government's commitment to extend the life of the concession for 10 years, giving the tunnel more time in which to pay off borrowings, some banks would have broken ranks.

Every penny of debt has to be secure before there's a penny for the equity. It therefore seems inexplicable that the debt should trade at below par while the shares are reaching sky-high levels; one of these markets has got it horribly wrong. Which is it?

Here's the more optimistic scenario - the one Sir Alastair Morton, chief executive, and his financial advisers, SG Warburg, will be preaching as preparations are made for a pounds 500m rights issue later this year. Eurotunnel will be tapping a market that is actually much larger than the pounds 600m often quoted by the pessimists. The total ferry market to the Continent is more like pounds 1.25bn. This figure can be doubled once you take into account the air market to the closer European cities. Moreover, this is a market growing at between 6 and 7 per cent a year. It seems certain the Government will allow the two largest ferry operators, P&O European Ferries and Stena Sealink, to merge after the tunnel is opened. Ferry capacity will be further reduced by new regulations that will cause at least four vessels to be withdrawn from short-haul routes. Tariffs are bound to fall in real terms but probably by not much more than 10 per cent. Add all these factors together and there should easily be sufficient revenue to start paying down debt by the turn of the century. Within 10 years of that, the debt mountain will have been fully paid off, at which point the Channel Tunnel becomes a pure cash cow for its shareholders.

The truth in all this probably lies somewhere between these two extremes. Yes, there's still a crisis or two to go at Eurotunnel, but I don't believe we are staring another Euro Disney in the face. Meanwhile, Sir Alastair must deserve some kind of award for his ability to raise capital for such an uncertain return; bankers, investors and commentators alike, he's caused us all to suspend our disbelief and make this great venture possible. It truly is an incredible achievement.