Financial Director's report

Year at a glance

2001 was a challenging year, with a series of significant external events impacting on our results. In particular, our trains division continued to be affected throughout 2001 by network disruption. In addition, the tragic events of 11 September adversely affected passenger revenue in our trains and coaches divisions and at Stewart International Airport in the USA. The Group’s cost base has also been impacted, with worldwide insurance premia doubling from November 2001. Notwithstanding, turnover from continuing operations increased by 24.8% to £2.5bn (2000: £2bn) and normalised operating profit from continuing operations increased by 10.4% to £156.7m (2000: £142m), benefiting from the full year effect of acquisitions made in 2000.

Net interest payable was £26.7m (2000: £34m). Excluding exceptional items, interest cover improved to 5.8 times (2000: 4.5 times) and EBITDA interest cover from continuing operations improved to 8 times (2000: 5.3 times).

After interest and the Group’s share of losses from associated undertakings, normalised profit before tax increased by 8.3% to £129.2m (2000: £119.3m).Normalised diluted earnings per share, restated to exclude discontinued activities, increased by 14.3% to 72.8p (2000: 63.7p restated). Total dividends per share for 2001 are 6.3% higher than in 2000 at 22p (2000: 20.7p).

Group operating cash flow remained strong at £185.5m (2000: £167.5m), before interest, tax and dividends, which has enabled the Group to fund net capital investment in existing businesses of £92.8m (2000: £100.4m). During the year, we sold our airports division for £241m and Bronckaers, our small bus operation in Belgium, for £3.7m. These sales generated net proceeds of £237.6m, which resulted in debt falling from £556.6m at the start of the year to £315m at 31 December 2001.

Net assets increased by 9.7% to £413.9m (2000: £377.3m) and gearing at the year end was 76.1% (2000: 147.5%).

Divisional review

Buses

Notwithstanding the continuing disruption caused by the major redevelopment of Birmingham city centre, turnover in 2001 increased by 4.1% to £208.3m (2000: £200.1m) and operating profit before goodwill andexceptional items increased by 4.3% to £52.8m (2000: £50.6m). The operating margin was maintained at 25.3% (2000: 25.3%). The return on net assets increased to 82.8% (2000: 46.9%) due to investment in buses being funded by a combination of finance and operating leases.

Trains

As shown in the table on page 31, turnover in 2001 increased by £399.6m or 37.7% to £1,458.2m (2000: £1,058.6m) and operating profit before goodwill and exceptional items increased by 19.1% to £40.6m (2000: £34.1m), reflecting a full year’s contribution from the Prism companies acquired in September 2000. Included in turnover are franchise subsidies from the SRA, which increased to £554.8m (2000: £482.6m). This reflects a full year’s contribution from Prism companies, partly offset by a £26.7m underlying reduction in subsidies.

Turnover and operating profit for our London and the South East train operating companies increased by £252.2m and £14m respectively. This reflects a full year’s contribution from c2c and WAGN, which were acquired as part of the Prism acquisition. Thisis a good performance given that network disruption continued throughout 2001. This situation was compounded by the outbreak of foot and mouth disease at Easter, which deterred leisure and discretionary travel, followed by the events of 11 September. Our Gatwick Express business in particular was significantly affected, due to the reduction in in-bound USA travel.

Although turnover for MML, our long distance/intercity train operating company, increased by £8.5m, operating profit fell by £0.2m due to the overall effect of the network disruption.

Turnover for our regional train operating companies increased by £132.6m, reflecting a full year’s contribution from our Welshfranchises, acquired with Prism. However, the network disruption has had the most severe impact on our regional operators, who have lost a high proportion of the leisure and discretionary travel business on which their profitability is heavily based. This, coupled with the effects of foot and mouth disease, has resulted in the operating loss for these companies increasing from £13.4m to £19m.

Given the above, two of our regional rail franchises, Central and ScotRail, have been renegotiated. The SRA has agreed to provide £115m additional franchise subsidy, in return for a payment of £59m and various other concessions. The full cost of £67m has been recognised in 2001 as an exceptional item and provisions as at 31 December 2001 include £62.5m in respect of the total payments to be made in March 2002. Following this agreement, Central and ScotRail are currently forecast to achieve a breakeven position between January 2002 and the end of their franchise periods in early 2004.

Coaches

For the full year, turnover fell by 2.9% to £181.3m (2000: £186.8m) and operating profit before goodwill and exceptional items fell by 6.2% to £10.6m (2000: £11.3m), due to the effects of 11 September on our airport coach business. Consequently, the operating margin fell to 5.8% (2000: 6.0%). Initiatives were put in place to limit the impact of 11 September on the business, and these will take full effect in 2002.

USA

Our businesses in the USA represent a significant part of the Group, generating £401.7m (2000: £301.6m) or 16.3% (2000: 15.1%) of Group turnover and £39.3m (2000: £32.7m) or 24.9% (2000: 21.1%) of Group operating profit before goodwill and exceptional items. These results reflect a full year benefit from the acquisitionin 2000 of Forsythe, Stewart and SS&L. The operating margin has fallen to 9.8% (2000: 10.8%), but the return on net assets has increased to 7.8% (2000: 6.6%).

Australia

In 2001, 8.4% (2000: 11.1%) of Group turnover and 8.5% (2000: 8.6%) of Group operating profit before goodwill and exceptional items was generated by our Australian businesses. These businesses contributed turnover of £207.9m (2000: £221.5m), including £56m (2000: £69.6m) of franchise payments from the State of Victoria, and operating profit of £13.4m (2000: £13.3m). Excluding the decline in franchise subsidies of £13.6m, turnover remained stable and operating profit increased by £13.7m. The operating margin has increased to 6.4% (2000: 6.0%) and the return on net assets at the year end has fallen to 13.2% (2000: 24.2%) due to the investment in infrastructure and rolling stock in Australian trains during the year.

Share of operating losses of associated undertakings

We hold a 33% investment in Altram LRT Limited, which started operating the Midland Metro in June 1999, and a 40% investment in Inter-Capital and Regional Rail Limited, which manages the operations of Eurostar (UK). Our share of the operating loss from these businesses was £1.9m (2000: £1.8m).

Interest

Net interest payable was £26.7m (2000: £34m), reflecting the significant reduction in debt due to proceeds of £237.6m being received from the sale of businesses in the year. Excluding exceptional items, interest cover improved to 5.8 times (2000: 4.5 times). Earnings before interest, tax, depreciation, amortisation and exceptional items (“EBITDA”) from continuing operations were £214.4m (2000: £179.8m) and EBITDA interest cover from continuing operations improved to 8 times (2000: 5.3 times).

Goodwill and exceptional items

The goodwill charge increased to £41.9m (2000: £22.7m), principally reflecting the acquisition of Prism in 2000.In 2001 there were exceptional operating charges of £83.5m (2000: £30.6m). These include:

£67m (2000: nil) in respect of the agreement with the SRA, under which Central and ScotRail franchise subsidies were amended;
£7.9m (2000: £7.2m) on the reorganisation of our UK operations. This includes the creation of the London Lines organisation encompassing the support functions of our c2c, Silverlink and WAGN rail businesses. This reorganisation started in 2000. The £3.1m incurred on the reorganisation of the coach division following 11 September largely represents the write-down of assets, including a £1.7m impairment charge of goodwill previously written off to reserves. (The write-off of this goodwill through the profit and loss account has no effect on net assets or shareholders' funds);
£3.6m (2000: £1.5m) on reorganisation costs in the USA, largely in respect of exiting a substantial five year public transit contract that was in place when we acquired ATC in December 1999;
£0.6m (2000: £2.4m) on the reorganisation of our Australian operations which again we started in 2000;
£3m (2000: £2.4m) on introducing new trains across our UK franchises; and
£1.4m (2000: £0.6m) abortive acquisition costs, including costs incurred on franchise bids.

Other exceptional items were a profit on sale of businesses of £91.7m (2000: £1m loss) which arose on the sale of our airports division and Bronckaers. It includes the net benefit of £34.3m negative goodwill taken to reserves on the acquisition of these businesses (the release of which has no effect on net assets or shareholders’ funds).

The tax credit associated with goodwill and exceptional items was £26.6m (2000: £12.8m).

Tax

The tax charge on normalised profit before tax of £129.2m (2000: £119.3m) was £27.8m (2000: £25.7m), which represents an effective rate of 21.5% (2000: 21.5%). This tax rate reflects the mix of earnings in the UK, USA and Australia, and other benefits including capital allowances arising from the continued high level of investment in new vehicles and infrastructure in 2001. The level of planned investment in future years means that a full provision is not required under our current accounting policy for deferred tax. However, we will adopt Financial Reporting Standard (“FRS”) 19, “Deferred Tax”, in our financial statements for the year ending 31 December 2002. This will require a full provision to be made for deferred tax and will result in an increase in our effective tax rate to approximately 23%.

The total tax charge has been reduced to £1.2m (2000: £12.9m), due to the tax relief available on the goodwill and exceptional items.

Cash flow

We generated £185.5m (2000: £167.5m) of operating cash flow, reflecting a £55.5m improvement (2000: £1.2m deterioration) in working capital (due to the establishment of the £62.5m SRA provision).

Net interest paid was £29.2m (2000: £19.2m), as 2000 benefited from syndicated loan interest for the lastquarter of the year not becoming payable until 2001. Tax paid fell to £6m (2000: £26.6m) as tax relief on exceptional operating charges reduced UK quarterly tax payments in 2001 and we received a £4.1m tax repayment in respect of prior years.

Net capital expenditure in 2001 of £92.8m (2000: £100.4m) included £29m (2000: £24.1m) on infrastructure and rolling stock in Australia trains and £21.7m (2000: £11.7m) on USA school buses. We received £237.6m from the sale of businesses and paid out £8.6m (2000: £283m) on acquisitions, largely for Glenorie Bus Company, an Australian company.

Dividends paid in 2001 absorbed £28.1m (2000: £22m), the increase reflecting the 9.7m shares issued as part of the consideration for the acquisition of Prism in 2000. New shares issued for cash in the year raised £3.2m (2000: £4.9m).

Overall there was a net cash inflow of £258.8m (2000: £226.2m outflow), which was used to repay loans.

Balance sheet

Net assets have increased by £36.6m to £413.9m (2000: £377.3m) at 31 December 2001. This is due primarily to the Group generating £33.2m of retained earnings, after adjusting for the £32.6m net benefit from the realisation of goodwill. This consists of £34.3m negative goodwill included in the profit on sale of businesses and £1.7m goodwill included in exceptional operating charges, the release of which has no net effect on net assets or shareholders’ funds.

Net debt fell from £556.6m at the start of the year to £315m due to the netcash inflow of £258.8m (2000: £226.2m outflow), offset by £1.4m (2000: nil) of debt in subsidiaries acquired and a £15.8m (2000: £14.5m) adverse effect of non cash movements (largely exchange rate movements).

Based on net assets of £413.9m (2000: £377.3m) and net debt of £315m (2000: £556.6m), gearing at 31 December 2001 was 76.1% (2000: 147.5%).

Treasury

Financial risk management

We use financial instruments, in particular currency denominated borrowings, forward foreign currency contracts, interest rate swaps and fuel swaps, to manage the financial risks associated with our underlying business activities. Our financial risks are managed from our centralised treasury function, whose primary objective is to identify and manage those risks. The Treasury function does not trade speculatively in financial instruments and has been set up as a service centre and not as a profit centre.

Liquidity and funding

Our policy is to ensure that we have access to sufficient medium and longterm committed credit facilities to be able to meet all our current and forecast financial requirements as cost effectively as possible. As at 31 December 2001, the Group had committed credit facilities of £610m of which £250m was undrawn. While we centralise these facilities to minimise cost of funds, we also have access to uncommitted working capital facilities in the UK, USA and Australia to help maximise funding flexibility.Cash deposits and derivative instruments are transacted only with banks which have as a minimum an “A” long-term credit rating.

Interest rates

It is our policy to maintain an appropriate balance between fixed and floating interest rates on borrowings in order to provide certainty as to the level of our interest expense in the short term and to reduce the year on year impact of interest rate fluctuations over the medium term. Interest on the Group’s debt is based on LIBOR and, to achieve the above objectives, we have entered into a series of interest rate swaps and forward rate agreements. The net effect of these transactions is that as at 31 December 2001, the Group was hedged against interest rate movements on £354m of gross debt for an average of 3.7 years. Each 1% increase in interest rates would cost the Group approximately £1.7m.

Currency rate risk

Our investments in overseas operations, which are primarily in the USA and Australia, expose us to translation risk on both net assets and earnings denominated in foreign currency. It is our policy to hedge between 50% and 100% of our investment in foreign currency denominated net assets. This is achieved in the first instance with foreign currency denominated debt, the interest on which reduces our translation exposure on net earnings in that currency, and then with forward foreign currency contracts. As at 31 December 2001, the Group had hedged 98% of its investment in US dollar denominated net assets and 93% of its investment in Australian dollar denominated net assets.

The average exchange rates for the year for the US dollar and the Australian dollar were US$1.44 (2000: US$1.51) and A$2.80 (2000: A$2.63). Each 1% weakening of the US and Australian dollar exchange rates would reduce the Group’s operating profit by approximately £0.4m and £0.1m respectively.

The Group also has transactional currency exposures. With the exception of fuel purchases (see below), we believe that such exposures are immaterial.

Commodity prices

We are exposed to commodity price risk as a result of fuel usage. It is our policy to hedge this exposure in order to provide certainty as to the level of fuel costs in the short term and to reduce the year on year impact of price fluctuations over the medium term. This is achieved by entering into fuel swaps and purchase contracts. As at 31 December 2001, the Group had hedged approximately 95% of its 2002 expected usage, 70% of its 2003 expected usage and 65% of its 2004 expected usage.

Accounting policies

The Group has followed the transitional arrangements of FRS 17, “Retirement Benefits”, and has provided the necessary pension disclosures in note 28 to the accounts. FRS 18, “Accounting Policies”, has been adopted in the year and the effect on the Group is not material. As noted above, FRS 19, “Deferred Tax”, will be adopted in the year ending 31 December 2002, when it becomes mandatory.

William Rollason Finance Director