TRANZ RAIL HOLDINGS LIMITED ANNUAL REPORT 2003 CONTENTS CHAIRMAN’S LETTER 1 MANAGING DIRECTOR’S LETTER 4 REVIEW OF OPERATIONS: RAIL SERVICES GROUP 6 HILLSIDE ENGINEERING GROUP 10 DISTRIBUTION SERVICES GROUP 12 THE INTERISLAND LINE 14 RAIL PASSENGER GROUP 16 HEALTH, SAFETY AND ENVIRONMENT 18 TRANZ RAIL NETWORK MAP 21 FACTS AND FIGURES 22 FINANCIAL SUMMARY 24 BOARD PROFILE 26 FINANCIAL STATEMENTS 27 TRANZ RAIL HOLDINGS LIMITED ANNUAL REPORT 1 CHAIRMAN’S LETTER WAYNE WALDEN CHAIRMAN Tranz Rail concluded the 2003 financial year with an improved financial performance, heads of agreement in place with the Crown on a joint plan for restructuring and developing the New Zealand railway system that included the immediate placement of a secured deposit of $44 million with the Company, and with shareholders considering an offer from Toll Group (NZ) Limited (“Toll”) to take over the Company. It has been an eventful year. The improved performance in the 2003 financial year fell short of the forecast provided to shareholders at the beginning of the year. Operating profit from trading increased from $25.2 million to $40.0 million – against the Company’s rights issue prospectus forecast of $53.1 million. Net loss after tax improved from $122.7 million to $2.6 million. The financial result for the 2003 financial year was largely influenced by adverse changes in the external business environment. Compared with the prospectus forecast, revenue was affected by drought, a strike at a customer’s plant, changes in shipping port calls and increased competition on the Cook Strait. Negative cost factors compared with the prospectus forecast were: lower than expected savings in terminal operations; increased insurance costs mainly from premium increases – a problem confronting most businesses; costs associated with the disposal of certain assets and businesses which did not occur; and increased interest costs arising from unavoidable increases in debt and interest rates as a consequence of the tight liquidity position experienced during the year, and costs of debt refinancing; increased taxation expense due to the recognition of an impairment of tax losses. TRANZ RAIL HOLDINGS LIMITED ANNUAL REPORT 2 These negatives were partially offset by the positive impact of foreign exchange rates on leases and fuel, lower operating costs reflecting lower freight volumes compared with forecast, releases of provisions not required, and higher than anticipated depreciation savings from asset write downs. Surplus asset sales initiated during the year did not eventuate. Negotiations were commenced to sell the Tranz Link Distribution Services Group business, the Tranz Metro Wellington business, Wellington railway station and specialist rolling stock equipment. On 20 June 2003, your Directors decided to suspend the asset sales programme until resolution is achieved in respect of the Crown track network transaction and the offer made to shareholders by Toll. In the 2003 financial year, the Company’s operating cash flow improved by $30.8 million on the previous year’s level. This improvement resulted from better working capital management, increased revenue and reduced operating costs. Total debt was reduced by $24.3 million, mainly as a result of a favourable movement in the NZD/USD exchange rate. Included in the total debt is the secured deposit from the Crown that was received in June 2003. The gearing of the Company also improved with equity at June 2003 being 44.6% of total assets compared to 39.1% at the end of the previous financial year. The Company achieved three major financial restructuring objectives in the course of the year: the negotiation of new bank facilities through to June 2004, the renegotiations of the terms of lease on the ferry Aratere, and a capital raising of $65 million by a 5 for 7 rights issue of new shares at 75 cents a share. The other significant achievement of the year under review was the negotiation of a heads of agreement between the Company and the Crown on a proposal for new arrangements regarding the ownership, operation, maintenance and development of the rail track network. The track and network ownership arrangements proposed in the heads of agreement between the Crown and the Company required shareholders’ consideration and approval before they could be finalised. Details of the proposal were provided to shareholders in the Target Company Statement of 4 August 2003. On signing the heads of agreement, the Crown paid to Tranz Rail a deposit of $44 million in respect of assets to be acquired if the proposal proceeded, and if the proposal does not proceed, that deposit plus interest is to be repaid by the Company on 30 June 2004. Negotiations between the Company and the Crown on the details of new track ownership and operation arrangements were suspended pending the outcome of a takeover bid for the Company from Toll. In developing its bid, Toll has negotiated even more beneficial terms on an exclusive basis for track network ownership arrangements. TRANZ RAIL HOLDINGS LIMITED ANNUAL REPORT 3 The Toll takeover bid is the second such bid to be made for the Company during the year under review. An earlier bid from Rail America was withdrawn before your Directors were able to make a recommendation on it. Toll lodged its bid soon after the Rail America withdrawal, initially offering 75 cents per share, which was subsequently raised to 95 cents per share. Your Directors did not recommend acceptance of this bid for reasons explained in the Target Company Statement of 4 August 2003. Your Directors sought to encourage competing offers for shareholders to consider. On 5 September 2003, Toll increased its offer price to $1.10 per share. In the interim, no superior competing offer had emerged. Also on 5 September 2003, your Directors unanimously recommended that shareholders accept the new Toll offer. Those Directors who currently hold shares in the Company have also indicated that they will accept the Toll offer for their entire shareholdings. The $1.10 offered represents a value for Tranz Rail that is greater than the underlying valuation of the Company set out in the Grant Samuel Report of 25 July 2003 and is at the upper end of the range of between $1.00 and $1.11 per share that Grant Samuel considers would be fair value for the Company as it would be under the terms of the Company’s agreement with the Crown. Your Directors consider that the Toll offer provides greater certainty of value for shareholders. At the date of this Annual Report, Toll had still to achieve acceptance of its offer by 90% of the Company’s shareholders – the threshold it has set for finalisation of its offer. The current closing date for the offer is Friday, 10 October 2003. While shareholders are considering the proposal from Toll, a Tranz Rail business plan is in place to deliver further performance improvement. It should be noted that although profit forecasts provided at the start of the 2003 financial year were not achieved, the result demonstrates an underlying improvement in the Company’s efficiency. In the absence of any material change, an operating profit from trading of $48 million has been forecast for the 2004 financial year on the basis of the current business plan. Finally, I would like to express my thanks to Tranz Rail’s customers, shareholders, management and staff. WAYNE WALDEN CHAIRMAN TRANZ RAIL HOLDINGS LIMITED ANNUAL REPORT 4 MANAGING DIRECTOR’S LETTER MICHAEL BEARD MANAGING DIRECTOR Tranz Rail demonstrated new operating strengths in the 2003 financial year, even though the improved financial result was below the profit forecast provided to shareholders at the beginning of the year. Drought, industrial disruption in a major customer’s operations, changes in shipping company service patterns, growth in interisland ferry competition, equipment supply delays, protracted asset sales negotiations, tightening liquidity, and a credit rating downgrade all adversely affected our ability to achieve the original 2003 forecast. Our forecast proved to be too optimistic in the face of such a combination of adverse pressures. Nevertheless, Rail Services Group (“RSG”) continued to develop into a significantly more efficient intermodal operation, securing new freight contracts offering better returns. The newly formed Hillside Engineering Group, which is part of RSG, steadily built its external contracting business. The Tranz Link Distribution Services Group (“DSG”) returned a profit for the first time in its history and is continuing to improve its profitability. The Interisland Line fleet has been reconfigured to give it more operating capacity and flexibility at a lower operating cost. The Rail Passenger Group met the challenge of sustaining service under difficult circumstances. Sprint train freight services were introduced during the year between Auckland, Palmerston North, and Wellington. New 25 foot Hi-Cube containers have been designed and deployed, allowing RSG and DSG to offer customers an intermodal service that is more efficient than Tranz Rail’s major non-bulk, road-bound business competitors. Overall, we ended the year with a much healthier, integrated, multi-modal transport operation, capable of delivering the services sought by freight customers. RSG on time arrivals continued to improve and cargo handling errors have declined. Customer satisfaction has improved dramatically. Three years ago, only 32% of RSG customers surveyed said they would recommend the Company to other potential customers. A survey in 2003 shows that figure has jumped to 78%. New business and major contract renewals are tangible measures of improved performance. During the year, Ravensdown signed a five-year contract with Tranz Rail to move fertiliser from Napier to a variety of destinations. The Company and Genesis Power agreed in principle to move a million tonne and possibly more of imported coal annually from Tauranga to Huntly. New partnerships were formed with the ports of TRANZ RAIL HOLDINGS LIMITED ANNUAL REPORT 5 Taranaki, Napier, and Otago, and the Port of Tauranga contract for the Metroport operation was extended until 2013.