Warburg slated on Eurotunnel

Investors angry with project's broker after latest setbacks

SEVERAL City institutions are so disappointed at Eurotunnel's latest £387m loss that they will not consider putting up more money for the £10bn project unless SG Warburg is ditched as its adviser.

The anger at Warburg centres on its role in Eurotunnel's £858m rights issue last year and is another blow to the investment bank's already tarnished image.

The institutional attack on Warburg is also the latest twist in the tunnel project, which seems to swallow cash faster than it spits out trains. Despite assurances that its bankers are sticking with it, operational problems this summer - such as the delays on Wednesday after a Eurostar train pulled down its power cables, stranding passengers for four hours - could yet see them demand a restructuring.

The venom against Warburg is based on the prospectus issued by Eurotunnel last year, which has proved to be wildly optimistic. "It does really alter my view on Warburg," said a source at one investment fund. "We felt the numbers, the balance sheet and the research were not of very high quality. If there was a new issue, we'd want someone coming with a new and more objective line."

Another critic close to the issue added: "They've issued a prospectus that was wrong by an incredible margin within six months. It makes last year's dbcle on new issues look like a tea party."

Unlike Sir Alastair Morton, Eurotunnel's co-chairman, Warburg is refusing to apologise to investors. Its role in the rights issue was that of lead broker, not financial adviser, so it played no part in calculating the risk or projections for the issue documents. "It's well known as a risk project and that was fully flagged in the exhaustive prospectus," said a spokesman. "It's the investor who takes a view on whether it's a risk, not us."

Indeed, the bank claims the issue was one of the most successful of 1994, because - despite its size - all the stock was sold. "It was one of the largest rights issues ever done in the City and none of the stock was left with the underwriters."

While that covers Warburg legally, it is doing little to protect the firm's already battered image with investors. One critic involved in the exercise said fingers are being pointed at Warburg because, as lead broker, it was the institution handing out the prospectus to potential investors, even though Morgan Grenfell and Banque Indosuez advised on the actual preparation of the document.

That may seem unfair, but many institutions were already feeling less than charitable towards Warburg when the Eurotunnel results were released. The firm took a hammering on new issues last year, advising on more flops than any other financial institution, according to a survey by the Independent on Sunday last October.

Warburg's troubles did not stop there. In December, a proposed merger with its Wall Street rival Morgan Stanley fell through, and it pulled out of the Eurobond market pioneered by its founder, Sir Siegmund Warburg in January. Senior staff - most notably Lord Cairns, its chief executive - have left. There have been client losses, too: just nine days ago it lost Glaxo, which will become the world's biggest drugs company after its £9bn takeover of Wellcome.

The full damage of the Eurotunnel rights issue may not have been felt yet. Sir Alastair and his co-chairman, Patrick Ponsolle, issued dire warnings last week that worse news might follow in the autumn. "Eurotunnel is at risk," they said in a letter to shareholders. "In 1995, we may succeed or we may fail. Our debt service costs may overwhelm us." Although Sir Alastair later back-pedalled away from the warnings, alarm bells in the City sent the stock crashing 56p in two days. And by the weekend it had

edged back up only 17p to close at 203p

At the moment, shareholders, most of them in France, still have nominal control of the company, although the banks are increasingly calling the shots. That could change in the autumn. Although both Eurotunnel and a source close to the syndicate of 220 banks backing the project insist there are no plans to swap debt for equity, analysts predict that is the most likely scenario. That would hugely dilute the stake of existing shareholders. Unless they are bailed out by the French and UK governments, shareholders could end up owning just 10 per cent of Eurotunnel less than two years after their massive cash infusion.

Eurotunnel faces several large problems. The biggest is interest rates. The banks are confident that they will get their principal back in the long run, but are less sure about the company's ability to cover its £550m a year interest bill in the short term. Every 1 per cent rise in interest rates costs the company £50m a year. At current rates, it looks set to run out of cash late in 1996, more than a year before it is set to break even. When they meet in September, the banks will have four options to deal with the next looming crisis.

The first, and least likely, would be to push Eurotunnel into receivership. Few companies would be likely to bid for the assets, and the price would probably end up well below the £8bn now owed to the syndicate, so the banks would have to take a massive loss.

The second option is less severe - capitalising the interest. Instead of paying it now, Eurotunnel would have the interest added to the principal to be paid back later. This would involve the banks declaring the loans non-performing, and taking large provisions against them that would reduce their ability to lend to other borrowers.

The third option, being pushed by Eurotunnel, is to release the remainder of the almost £700m in senior debt approved last year. The banks voted 93 per cent (by value of their loans) to release the first £300m last week. Giving Eurotunnel the rest would have a similar effect to capitalising the interest, but would not force them to set aside provisions. A source close to the syndicate admitted that unless Eurotunnel's results in the first half are abysmal, they will have little choice but to do this.

Analysts disagree, however, prefering the fourth option - a capital restructuring. If the share price fell to as low as 40p, the shares' nominal value, it might be worth the banks' while to swap, say, £3bn in debt for 90 per cent of the equity.

This would involve an immediate write-down, which banks loathe. But with the interest bill reduced to the tune of £200m, Eurotunnel would hit break- even far sooner; once it became cash-generative, the shares should rise quickly, allowing the banks to make a tidy profit by selling to institutional investors in London.

The second big issue facing Eurotunnel is its operating performance, which has lagged seriously behind the projections in last year's prospectus. The company's track record is not promising. Sir Alastair described the summer of 1994 as a "valley of darkness". Government approval to start the four separate services - Eurostar passenger, through freight, HGV shuttles and tourist shuttles - were granted late, due to commissioning difficulties. Sensors on legs stabilising the shuttle cars during loading did not work properly. There were problems with the track, delays at the terminals and even a fire in the tunnel. Even when the system was working, the capacity was often not available to meet demand.

Sir Alastair thinks Eurotunnel is about to emerge into the sunlight. "This summer will be crucial," he repeated again and again. At peak times, the tunnel currently runs three HGV and two passenger shuttles an hour, plus six Eurostar and 14 freight trains a day - well below its theoretical capacity of 20 trains an hour. Its record to date is just under 10 an hour. The company forecasts a tripling of the traffic achieved in March and plans to quadruple the capacity it had in February by the end of the summer. One worry, however, is the Brussels-to-London route, which has recently had load factors well below 50 per cent on average, compared to the more normal 70 per cent.

Wednesday's Eurostar accident in Kent shows that the system's teething troubles are far from over. Mr Georges-Christian Chazot, the group chief executive, was quick to point out that it does not own or operate Eurostar and that the accident occurred off its property. "This was a hiccup," he said. But any delay to traffic hurts Eurotunnel's revenues. And if the public loses faith in the service, long-term volumes will fall.

Most observers do not see that happening. On the contrary, they are quietly bullish about the project's long-term prospects. The problems they see are short- term, based largely on the management's relative inexperience with running a large piece of transportation infrastructure. Their initial fares, set just a year ago, have already fallen by 40 per cent. "As railwaymen, they dig good tunnels," commented one analyst.

Among the smaller issues that could affect Eurotunnel's fortunes is the share price at the end of October. The company is hoping to raise £150m on warrants, but only if the price crosses the 312p line. (An earlier warrants issue, due to raise £50m in June, is underwritten.)

The company is also fighting against Eurostar's pricing strategy. Eurotunnel foolishly set its tariff at £12 a head rather than taking a percentage of Eurostar's fares. As a result, the railway operator is maximising its returns with low-volume, high-priced seats that compete with the airlines' business fares instead of packing in lots of backpackers at a fraction of the cost. A ruling on the issue is expected shortly.

The case has political as well as legal dimensions. The attitudes of the British and French governments, which own the state railways that in turn own Eurostar, are quite different. Westminster wants a victory for British Rail to boost its planned privatisation, while the French government could be persuaded to use the railways as a back-door subsidy to the cherished national engineering project.

With so many uncertainties still hanging over the project, Warburg executives have received some assurance from Eurotunnel that they will not be losing it as a client - yet.