Exam focus – BPP analysis of the pre-seen case study for the May 2013 and September 2013 strategic level exams
BPP subject specialists David Culley, Doug Haste and Steve Whittenbury analyse the pre-seen case study for the May 2013 & September 2013 Strategic level exams from the viewpoint of each of the three papers (E3, F3, P3).
This article outlines the purpose of the pre-seen case study before going on to examine some aspects of the rail transport sector in Europe and how these could be applied to the forthcoming Strategic level exams.
Purpose of the pre-seen
CIMA does not expect students to spend significant amounts of time researching the industry described in the pre-seen; this can wait until you get to T4 and even there it is of limited value. CIMA’s intention is that by giving you a pre-seen case study, no candidate is put at an advantage or disadvantage by their level of familiarity with the industry involved. All candidates now have time to ensure that they have a basic understanding of the main issues involved in the case study before walking into the exam.
The latest pre-seen
In the latest pre-seen we are provided with details of T Railways– a government owned company based in country T, a fictional European country outside the Eurozone. T Railways offers 3 types of service – passenger rail services (TCL), freight services (TFR) and other infrastructure related services (TPTS). The possible privatisation of T Railways continues to be discussed within Government.
The European rail industry is in the process of significant transition at present. To help familiarise you with some of the main issues in this sector we will examine how three significant operators have managed, or in some cases mis-managed, a range of financial (F3), risk (P3) and strategic (E3) issues.
Example 1 - Deutsche Bahn (DB)
Deutsche Bahn (DB), like T Railways, is 100% government owned. DB is a much larger company than T Railways (5,700 stations, revenue over EUR 30 billion).
DB has been investing heavily to create a strong international business, to take advantage of increasing liberalisation in the European transport market. This increasing liberalisation is partly being driven by increased pressures on public sector finances across Europe, which have resulted in widespread moves to sell-off public sector transport services. In 2010 DB acquired Arriva (a UK based company running bus and rail services in 12 European countries) for £1.5 billion. This acquisition is intended to position DB as one of Europe’s leading passenger transport groups, and has created Europe’s largest rail and bus company.
Arriva accepted a cash bid from DB in preference to a paper bid that was being negotiated with the French company SNCF. The price paid valued Arriva at a multiple of 16 times its 2010 earnings (i.e. a P/E ratio of 16)i, and represented a 34% premium on Arriva’s share price before the bid was announced.ii
The European Commission’s anti-trust agency has insisted that DB sell Arriva’s German train and bus activities in Germany, which amount to approximately 5% market share, to avoid building DB’s monopoly power in its domestic market.
Since this acquisition, DB’s international operations are being organised within the Arriva brand, with its headquarters remaining in Sunderland, UK. DB has further ambitions to grow by bidding for train franchises in the UK and through a series of small acquisitions in Europe. Arriva’s chief executive David Martin, predicts a wave of consolidation in the European rail sector as companies seek economies of scale. “There will be three to four big transport groups in Europe in the next 10 years and Deutsche Bahn will be one of them.”iii
DB is also the largest rail freight company in Europe. Here, again, it has a number of overseas operations including EWS (purchased for £280m in 2007) in the UK and a joint venture with Russian railways (RZD) to operate freight trains between Germany and China via Russia.
In 2008 privatisation of DB was considered, which would have resulted in the state still maintaining control of DB with a 51% stake. This was postponed due to the state of the financial markets at the time, but DB’s structure (http://www.deutschebahn.com/en/group/business_units/ ) has been re-organised into 10 separate business units. This will make it easier to sell off parts of the business if partial privatisation proceeds in the future. One notable aspect of this structure is the distinction between long-distance passenger trains (DB Bahn long distance) and short- distance regional transport (DB Bahn regional). This is a structure that might be considered by T Railways if it is considered that these business activities would benefit from dedicated management teams.
Example 2 – Swiss Federal Railways (SBB)
SBB, another company that is 100% government owned, is closer in size to T Railways but is still much larger, with over 4 times the number of stations and over 6 times the turnover.
SBB has been investing heavily to improve the quality of its rail services. For its domestic services, this has involved building new lines to shorten the travel distances between major cities (and to create parts of the rail network where high speed trains are not slowed by slower local trains sharing the track). To increase passenger capacity, double-decker carriages have been introduced.
For its international routes SBB has invested in improving its links to the networks of adjoining countries via its construction of two new major alpine tunnels, including the Gotthard Base tunnel, which will become the world’s longest railway line and will reduce travel time between Zurich & Milan from 4 hours to 2.5 hours when it opens in 2017. These investments are also designed to reduce the amount of road freight travelling through Switzerland. In 2012 SBB invested EUR 200 million in 8 new high-speed Italian Pendolino tilting trains, which will double the size of its high-speed fleet when these are delivered in 2015. The new trains are 95% recyclable, will reduce energy consumption by 8%, and are much quieter and more comfortable (even at maximum tilt!). High speed trains also require a quicker, more reliable, signalling system with wireless transmission of information to a display device in drivers’ cabs.
Recently SBB has been attacked for the implementation of a new system whereby ticket sales on trains have been abolishediv. E-tickets can be purchased or tickets can be purchased from the ticket machine at the rail station. Problems have arisen, however, because ticket inspectors have zealously imposed heavy fines on passengers who have:
• been unable to validate their tickets with a date stamp because the ticket machine is out of order, or • purchased more than one e-ticket (the maximum is one e-ticket per person) • purchased an e-ticket via their mobile phone because the ticket machine is out of order, but the payment from the credit card company has arrived minutes after the train has left the station
SBB makes over £1 million a month from fines.
Example 3 – SNCF (French National Railway Corporation)
SNCF’s experience illustrates one of the risks of creating a high speed rail network. This has led to SNCF building up large debts which, in turn, has led to criticism that local lines have been starved of even basic funds for routine maintenance.
On the positive side, SNCF’s TGV system boasts an impeccable safety record. After 30 years it has never had a fatal accident. SNCF has also dramatically cut CO2 emissions by using more electricity from non-fossil sources.
The full text of the pre-seen can be found at www.cimaglobal.com/strategicpreseen. You will need to read this in full before reading the remainder of this article.
Understanding the main issues from an E3 Enterprise Strategy Exam perspective
Although you may be surprised to see a nationalised company in the pre-seen, it is not without precedent – the pre-seen for the Specimen paper contained a recently privatised utility company. From an E3 perspective, the main consideration is the impact on strategic objectives.
Strategic objectives T Railways has four objectives – two strategic and two financial. As a nationalised organisation, there is no objective to maximise profit – instead, the drive is towards maximising efficiency (you might also want to add economy and effectiveness?). It is vital to keep this at the front of your mind when appraising possible courses of action. The government’s fundamental aim is to achieve economic growth by reducing congestion on its roads. This could conflict with the financial objective it set T Railways to cover its operating costs from its revenue. The examiner often expects students to go beyond the numerical analysis, so be ready to assess a proposal from both quantitative and qualitative perspectives.
Key Performance Indicators (KPIs) The objectives have been broken down into a number of KPIs using a “traditional accounting-led approach to strategic planning”. It may be that the financial / non-financial debate could be extended into the setting of KPIs, with the Balanced Scorecard or Performance Pyramid being obvious tools to use.
It is very difficult to critically appraise the KPIs given in the pre-seen as they are only examples, and not a full list. The examiner has previously examined the relationship between KPIs and CSFs, so make sure you are happy about the difference between them and how they both relate to strategic objectives.
Development opportunities The pre-seen concludes with four development opportunities that could all link in to E3.
Structural changes The three subsidiaries may be expected to be more independently accountable. There are currently T$842 million of TPTS costs apportioned to TCL and TFR – separating out the three companies is likely to result in more scrutiny of this cost. Be ready to do some basic transfer pricing calculations but, just as importantly, make sure you can discuss the various options available.
Expansion of the network Given the lack of competition and extensive coverage (including lines to remote locations), expansion opportunities appear somewhat limited. Potential projects could include improving the lines (see plans for high speed rail links in England to identify a range of stakeholders) or taking advantage of overseas opportunities.
Diversifying the portfolio The most obvious diversification would be the nationalisation of the bus network, although synergies with T Railways would need to be considered carefully. The examples above, particularly Deutsche Bahn, highlight some of the themes that could emerge.
Outsourcing parts of the business Any part of the network could be outsourced, with the UK approach demonstrating just how many different companies can be involved in providing a train service. If TPTS services were outsourced (consider Network Rail), there could be an interesting debate about the levels of service, prices and liabilities. For example, how would TCL feel if it failed to meet its customer complaints KPI due to poor track maintenance by the outsource provider?
Privatisation This policy seems to be treated in a lukewarm manner in the pre-seen, but it is an issue that is explicitly highlighted and therefore cannot be overlooked. While it’s unlikely that T Railways will have been privatised by the time of the exam, the government could easily request a report asking you to clarify the strategic implications of privatising some or all of the network.
Conclusion
If your initial reaction was to think that the rug had been pulled from under your feet with this pre- seen, I hope that the analysis above demonstrates that you can still rely on exactly the same skills and technical knowledge you have built up through your studies. Remember that you are not expected to be an expert on the rail industry or nationalisation, as long as you remember to consider the broad implications of these issues as explained in the pre-seen.
Understanding the main issues from an F3 Financial Strategy Exam perspective
From appendix 1 of the Pre-seen, T Railways, although reliant on government debt finance, appears to be successful in terms of achieving its financial objective of covering its operating costs:
2012 Workings
ROCE net operating profit 3.1% T$87m / (T$1,000m + T$1,800m) (equity +long-term borrowings)
Gearing T$1,800m / (T$1,000m + T$1,800m) long-term debt 64.3% (long term debt + equity)
Operating profit margin 6.7% T$ 87m / T$1,291m Operating profit / sales
However, we are also told that T Railways has the objective of providing value for money. We are not given a complete picture of how this could be measured, and therefore we cannot fully evaluate T Railways’ performance. Possible value for money measures include:
Economy - cost per station, cost per unit of energy purchased (or any other input cost), average ticket prices (this could be considered a measure of a economy from the customer’s perspective) Efficiency - train kilometres per T$ of operating expenses, operating profit Effectiveness - success in achieving objectives, e.g. CO2 emissions, timeliness and utilisation (for freight) and customer satisfaction (for rail), no. of accidents per train kilometre
From the above we can see that there are a number of potential issues that could be developed in the Unseen. These include:
• Investment appraisal, this could include analysis of: - a new initiative such as a move into the bus market, or re-development of its station facilities - further investment in new electric freight trains - expansion of the rail operations (new high speed trains, double-decker trains, new routes) • Financing issues, this could potentially cover: - obtaining suitable finance to support its expansion, recognising the desire of T Railways to reduce its reliance on government lending - this could include consideration of whether to lease or buy new assets • Valuation of T Railways: - either as part of a question on a proposed stock market listing, or - an evaluation of a takeover bid for T Railways • Other valuation issues: - T Railways could be considering the acquisition of a rival firm, either within or outside Country T • Impact of any of the above on T’s key financial objectives: - Covering its operating costs - Achieving good value for money - In this context cost reduction proposals may be discussed. The experience of the UK may be relevant here. In the 1960s the Beeching report in the UK led to the closure of about a third of the rail network, by focussing on branch lines that had low usage levels. This closure program is generally regarded as having gone too far because it ignored the impact that these lines had on providing passenger traffic to the overall railway network.
Finally, because T Railways is an unlisted company you may be asked to calculate its cost of equity (or the cost of equity of any of its subsidiaries) by taking the beta factor of a quoted company (which would be given) and adjusting for differences in gearing.
Understanding the main issues from a P3 Performance Strategy Exam perspective
When looking at any P3 scenario, we often start by considering the risks that are present and what controls could be used to mitigate them – fortunately in the case of T Railways, these are plentiful and accessible.
Operational issues
T Railways operates a series of services using a blend of vehicles, premises and staff, some of which could be classed as hazardous, especially when considering locomotives and rolling stock. SNCF’s record of 30 years with no fatalities in a similar environment surely says more about its safety controls than the lack of risk, so we could expect to see something more about the inherently risky nature of running these services. Specific examples could be:
− Customer and employee safety and security while on board trains and on the platform
− The safety of track-side maintenance crews
− The impact of adverse weather conditions or peak travelling conditions
− The security of freight travelling on the network
− Security track-side in general – trespassing on the line can cause accidents and delays
− Impact of over-crowding
In all these cases, controls need to be designed, implemented and maintained while the service is provided to paying customers. Such controls need to consider issues such as:
− The use of signalling technology. The Pre-seen does not provide details of such signals. In some countries they still operate using electrical wires and pulleys that have not changed in over a century – this is surely an area of improvement that the Unseen could expand.
− Controls over expenses and revenues – ticketing was mentioned earlier on SBB but even an e-ticket needs to be reconciled and audited. The Pre-seen points towards costs allocated across both TCL and TFR from TPTS which look arbitrary at best – so it’s worth considering now how management accounting controls and audit could appear here.
− Other controls are required that P3 could test – scheduling of services, timetable and staff shift systems, value for money studies on less-profitable routes, information provision for staff and customers, contingency planning for bad weather. As we also saw with E3, the use of suitable key performance indicators for any of the subsidiary companies must surely be an area where theory could be tested further.
Regulatory issues
The nationalised nature of T Railways’ ownership and governance is also an area worth exploring in more detail. If the company is to become more financially self-sufficient, it must consider who would invest in it and why. There is undoubtedly money to be made in providing rail services as long as value for money can be secured, but at the moment visibility of all this is very limited and dependent on Country T’s Government. Should the Government decide to raise funds from either full or partial privatisation, governance structures promising greater transparency and accountability (within an environmentally sound agenda let’s not forget) would be required to tempt investors into putting their money on the line (quite literally).
P3 is comfortable here, not only when considering the “non-corporate” governance systems that might replace the bureaucratic regulatory structures which are currently in place, but also when considering potential exposure to new markets for resources including capital, both from within Country T and without, thus satisfying some of the financial risk elements we are bound to see as well. Other possible financial risks arise from the fact that T Railways operates beyond Country T’s borders and thus receives revenues in other currencies. It may also face other risks, for example regulatory interference, from its international operations or economic risk from overseas pressure on its home currency, the T$.
Change issues
The issues raised by both E3 and F3 have focused on where T Railways goes next and P3 is no different – whether that is expansion, fragmentation or even innovation, the company must consider the risks that such changes might pose and how it should deal with them. As already stated, the current governance structure is built on a very traditional bureaucracy that serves the public interest only, so before any change can happen, this culture and its agents both need to evolve. One thing is for sure though – you will need to be familiar with all parts of the P3 syllabus in order to apply them to an organisation like T Railways that is surely poised for fundamental change.
Conclusion To conclude, while consideration of the Pre-seen is an important activity, students must remember that it forms just one dimension of exam preparation and should not be over- emphasised at the cost of question practice and other exam preparation.
Good luck in your exams!
David Culley, Doug Haste and Steve Whittenbury are subject specialists working at BPP.
i Reuters Deutsche Bahn seal Arriva buy April 22 2010 ii Railway Gazette 22 April 2010 “DB confirms Arriva bid” iii Quoted in the Financial Times April 19 2011 “Deutsche Bahn Arriva eyes £2 bn spending spree” iv BBC News 4 Feb 2013 “Swiss love affair with rail turns sour”
Further resources http://www.deutschebahn.com http://www.sbb.ch http://www.railwaygazette.com/news/freight.html http://www.networkrail.co.uk/