Did U.K. Bungle a Cash-flow Calculation?

Sir Richard Branson’s Virgin Trains wins reprieve as a bidding competition to operate a major passenger rail route is found to have “significant fl...
Andrew SawersOctober 3, 2012

LONDON–The U.K. Department for Transport (DfT) was forced into an embarrassing climb-down today in the run-up to a court case that could have overturned a controversial decision to award a railway contract. At fault: government officials who miscalculated the value of the contract. Did they make basic errors in a discounted cash-flow (DCF) analysis? There are clues that this might be the case, but no official confirmation. Meanwhile, three civil servants have been suspended.

Virgin Trains, a joint venture between Sir Richard Branson’s business empire and transport group Stagecoach, has been operating the West Coast railway line that runs through London, Manchester, Glasgow, and other U.K. cities since 1997. In August of this year, however, it lost out to rival FirstGroup in the government’s retender process for a contract that would run until 2027. Virgin branded the government’s decision “insanity” and mounted a legal challenge, claiming that FirstGroup’s bid was unrealistic and that the bidding process was flawed.

Early in the morning of Wednesday, October 3, Transport Secretary Patrick McLoughlin told the two bidders that the competition for the rail franchise was cancelled “following the discovery of significant technical flaws in the way the franchise process was conducted.” His official statement added: “These flaws stem from the way the level of risk in the bids was evaluated. Mistakes were made in the way in which inflation and passenger numbers were taken into account, and how much money bidders were then asked to guarantee as a result.”

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Virgin claimed in August when it launched its legal action that its rival’s bid skewed payments to the government toward the back end of the 15-year-contract. Taking the government’s statement and Virgin’s claim together, it seems possible that officials failed to carry out correctly a proper discounted cash-flow analysis. Failure to convert FirstGroup’s significant back-end-loaded payments into net present values could have resulted in the value of its bid being inflated relative to that by Virgin Trains.

Moreover, Virgin had claimed that FirstGroup could have been able to walk away from its contract before those larger payments started to become due, allowing it to operate the rail franchise for many years at little cost to itself and reduced benefit to taxpayers.

A press spokesperson for the transport department would not comment on CFO European Briefing’s questions about whether flawed DCF calculations were to blame. She said only that the problem was “the data that was input into the modeling system, rather than to do with the way that the system itself worked.”

The errors came to light during the government’s “detailed evidence gathering” in preparation for the legal challenge, scheduled for mid-October. An independent investigation is now under way and a report is due to be published at the end of this month, though Transport Secretary McLoughlin made clear earlier in the day that none of the rail franchise bidders were at fault. Three civil servants have been suspended while the full facts are determined.

In canceling the competition, the government has also said it will reimburse the bidding costs for all four bidders — Virgin Trains, FirstGroup, Dutch group Abellio, and French state-backed Keolis — which will cost taxpayers around £40 million ($64 million; €50 million).

A spokesman for incumbent Virgin Trains told CFO European Briefing it was surprised to be told by the government that the competition for the franchise had been canceled rather than simply recalculated. “It does raise the question of, if you’ve just done a sum wrong why you can’t just do that sum again and do it right and why instead you have to reimburse companies to the tune of £40 million,” he said

FirstGroup said in its statement: “We had absolutely no indication that there were any issues with the franchise letting process and had received assurances from the DfT that their processes were robust and that they expected to sign the contract with FirstGroup soon.”

Andrew Sawers is editor of CFO European Briefing, a CFO online publication.