Mind your Business - 16 February 2004
Break-Even, Debts, Revenues and Costs
Construction work on the channel tunnel. The time between construction work and the first paying customers was very long, pushing up Eurotunnel's debts.
After the 2003 results, the company outlined a number of reasons for the losses and also discussed plans to restructure its financial position. The highlights of that statement included the following:
The company's financial statement also highlighted a number of problems facing the business and some suggestions on the way forward. The main problems stem from what were called a 'failed business model' by the Chief Executive, Richard Shirrefs.
Eurotunnel was meant to be financed by private capital. The project had been discussed for some years but in deriving all its finance from private sources meant that it immediately had very high debts. Work on a channel tunnel had begun as far back as 1973 but was shelved due to political and economic crises.
In 1984 the project was re-launched and two years later, Margaret Thatcher, the British Prime Minister and the French President, François Mitterand, signed an agreement that confirmed Eurotunnel as having won the bid to continue the construction. The initial construction work began in 1987.
Such a project had clearly never been tried out before so everyone was working in un-chartered territory. Costs rose and the budget was regularly exceeded. By the opening of the tunnel in 1994, the company's debts had spiralled and were reaching the £10 billion level. The company has had to re-negotiate the terms of its debt with its creditors but still faces problems.
The Chief Executive highlighted these as a lack of use of the infrastructure, an inability to attract business because of high access charges, too much debt (currently standing at £6 billion) meaning its interest payment burden was too high, a much lower volume of both passenger and rail traffic than forecast (passenger use was forecast at 16 million when it is actually 6 million, freight volume at 7 million tonnes when it is actually 1.7 million tones) and that the industry was fragmented and in conflict. Eurotunnel's shuttle business (for trucks, cars and coaches) has been a great success, and is the market leader for cross-Channel travel however the issueof access charges relates to other train operators that use the Tunnel, including Eurostar, EWS and SNCF and this is an area the the Company wish to tackle. It also faced increases in costs to counter the problems associated with illegal immigrants attempting to get to the UK. This problem also frustrated attempts to increase freight use through the tunnel, however this problem is now not considered a factor that is impacting on Eurotunnel's performance but highlights the difficulties faced, some of which have largely been out of the Company's control.
Increasing freight use of the Tunnel may be an important factor in future revenue generation for Eurotunnel.
Its strategy is to expand its operations looking to secure routes to Switzerland, Holland and Italy, opening new leisure complexes and a variety of regional train links. But the serious side of the strategy rests on its ability to be able to restructure its debts and have greater control over its pricing. Eurotunnel believes that if it can reduce its access charges to both freight and passenger carrying companies, it can increase volumes and its revenue. It believes that it is caught in a vicious circle - it needs to levy high access charges to meet its interest payments, this in turn causes conflict because it cuts volumes, meaning its revenues are less than they could be, which means it cannot pay off its debts and so on. It believes that freight volumes would increase from 2.5 - 10 million tonnes if it could cut access charges by 50-60%.
It is looking to present its proposals to its stakeholders over the coming year and hopes to gain agreement for its strategy by the end of the year, allowing it to implement its plans during 2005.
In April 2004, the problems it faced over its future came to a head when the joint Anglo-French board of directors was replaced by an all-French team headed by Chairman Jacques Guonon.
Trains - a viable alternative to using an airline? © iStock.com
Image reproduced with permission from Eurotunnel (http://www3.eurotunnel.com/rcs/etun/pb_english/en_wp_corp/
At the heart of the problems facing Eurotunnel is the issue of break-even. Any new business or existing company starting up a new venture has to incur costs in setting up the business before any customers 'walk through the door' and start paying for its goods or services. The early months and years of many businesses therefore will be one in which they will have debt. The success of the business might rely on how effectively the company is able to meet that debt. Break-even analysis can be seen as a planning tool to aid businesses in assessing when they will generate sufficient revenue from sales to cover the total costs of production and move into profit.
At its simplest level, therefore, break-even occurs at an output/sales level where total revenue = total costs. More formally, we can use the following formula to calculate break-even:
Break Even Point = Fixed Costs ÷ Contribution
Where the contribution represents the selling price - variable costs.
Costs are therefore one crucial element in break-even. Variable or direct costs are those costs incurred during production, they vary with the amount produced, rising as output rises and falling as output falls. Eurotunnel's variable costs are relatively low since the cost of operating the tunnel now it is built is relatively low.
Fixed costs or overheads or indirect costs are those costs that do not depend on output. This does not mean that they do not change, they do, but they do not vary with the amount produced. These costs can be insurance, admin costs, advertising and marketing costs and, very relevant in the case of Eurotunnel, interest payments. In general, a firm must seek to cover its operating (variable) costs in the short term - after all, if it is not generating enough revenue from sales to cover the costs of producing its product it does not have much of a future! However, in the longer term it must, ultimately, cover both its fixed costs and its variable costs - in other words cover total costs. Once it does this, the business moves into profit. You can see the effect of all these on the accompanying break-even PowerPoint presentation.
The increase in Eurotunnel's debts as the cost of the construction mounted has been the main source of its problems. Interest payments on these debts have been a problem to Eurotunnel because they were simply not generating enough revenue to cover the variable costs. The construction costs are what are termed 'sunk costs' in this instance. Sunk costs are those costs, which cannot be recouped. For some businesses, assets can be sold to realise cash to help with cash flow; this is possible if there are other uses for the assets - in other words there is a market for them. Consider the case of Chelsea Football Club. In 1998 they bought Pierluigi Casiraghi from Italian club Lazio for £5.4 million. He played just 10 games for the club before being seriously injured in a match and never playing again. Had Casiraghi not suffered the injury, Chelsea would have had the option of selling the player at some point and realising some of their investment back. The fact that he was injured and could not play again, meant that the money spent on him became a sunk cost. So with Eurotunnel, there is very little likelihood of anyone wanting to buy the tunnel - it only has one use! The costs that went into building it therefore become sunk costs.
The access charges Eurotunnel pass on to the freight and passenger firms using the tunnel are the main source of revenue. The company are suggesting that if they can discuss their pricing strategies with their stakeholders they will be in a position to be able to increase their revenue. The company clearly believe that the price elasticity of demand for their service is relatively elastic because they suggest that cutting freight prices by 50-60% would increase volumes by 300%. The fact that the Chief Executive feels that the infrastructure is being wasted suggests that they believe there is a lot more capacity in the system than currently being used and this can be met by increases in freight traffic and passenger flows.
None of these strategies however will work unless the company can re-negotiate its debts. For the banks involved, the prospect of having to write off such large amounts is not something they are relishing. However, it may be necessary in the long run if Eurotunnel are to ever be able to operate profitably. Eurotunnel would like to be in a position where a reduction in their interest burden allows them to be able to trade profitably - where the revenues they are earning cover the operating costs.
This may be one example of a company who will never break even. This is highly unusual and it is the unique nature of the product and the associated massive fixed costs that have been incurred that have led to this situation. Most firms who survive the initial development period will break even. The price they charge determines how many sales they have to generate to do so but it is important not to confuse the amount of sales with how long it will take to make those sales.
- Using break-even analysis, explain the reasoning behind the Chief Executive's claim that if Eurotunnel were able to have more control over their pricing they would be in a position to reduce their losses. (8 marks)
- Using the information above, calculate the price elasticity of demand for freight services and comment on the degree to which the company's claims in respect of the price reductions on freight services are likely to be successful. (12 marks)
- Consider the market structure in which Eurotunnel are operating and assess, in the light of this, the likely success of their proposed strategy. (20 marks)
Total 40 Marks
Go to Biz/ed's Financial Ratio Analysis pages (http://www.bized.co.uk/compfact/ratios/index.htm) and Eurotunnel's 2003 Preliminary Results (http://www3.eurotunnel.com/rcs/etun/125414/Microsoft%20Word%20-%202003%20Preliminary%20Results.pdf) and use the information to calculate the following:
- Profitability ratios
- Liquidity ratios
- Gearing ratios
Comment on the position of the company from the ratio analysis you have conducted above.
Related Web sites for research
- Eurotunnel Company Information (http://www3.eurotunnel.com/rcs/etun/pb_english/en_wp_corp/index.jsp)
- 'Eurotunnel begs for rescue plan' - Guardian Article (http://www.guardian.co.uk/guardianpolitics/story/0,3605,1144676,00.html)
- Eurotunnel's 2003 Preliminary Results (http://www3.eurotunnel.com/rcs/etun/125414/Microsoft%20Word%20-%202003%20Preliminary%20Results.pdf)
- 'Ryanair faces new payment probe' - BBC Story (http://news.bbc.co.uk/1/hi/business/3458423.stm)
- 'Eurostar boosted by high speed link' - BBC Story (http://news.bbc.co.uk/1/hi/england/3206420.stm)
- 'Eurostar 'upbeat' about year ahead' - BBC Story (http://news.bbc.co.uk/1/hi/business/3388243.stm)
- 'High-speed Channel link opens' - BBC Story (http://news.bbc.co.uk/1/hi/england/3112250.stm)
- EWS Freight Company (http://www.ews-railway.co.uk)
- The basis of the answer to this question is the shape of the total revenue curve. Using the PowerPoint presentation to help you with the diagrams, you need to think about the impact of Eurotunnel being able to lower their prices to attract more business and what would happen to the break-even point as a result. (It will be necessary to assume that the existing debt is being 'written off' to allow you to be able to analyse using a 'normal' break-even chart.) You would expect to get up to 4 marks for the use of the diagrams and the remaining 4 for the quality of the explanation that supports the answer.
- The information referred to is proportionate changes in price and demand. This answer expects you to be able to use the formula for price elasticity of demand and make some deductions from your calculation. Remember that if the demand is price inelastic a rise in price would lead to an increase in total revenue. What you are looking for therefore is the link between elasticity and total revenue. You will earn up to 6 marks for the correct calculation - make sure you show all your working and the formula clearly - and another 6 for the evaluation of the success the company is likely to have in achieving its claims. This latter part is where you are seeking to make judgements. With this type of answer use the 'it depends' rule. What we mean by this is that the outcome will depend on a variety of other factors that will determine whether freight users will now seek to use the tunnel rather than other means of transporting goods across the channel - so think of alternative methods of freight transport. In addition you might want to consider the impact of the cross price elasticity of demand for these alternative methods!
- This third question follows on from the other two. To assess how likely the strategy is to be successful you will need to think about the other players in the market and how they are likely to react to the strategies adopted by Eurotunnel. Those other players might include the low-cost airlines (especially in the light of the recent judgements by the EU Competition Commission against Ryanair), the ferries and the rail networks. Such factors as the quality of the rail network on the UK side of the channel may well be an important factor - does the fact that the new high-speed link is now partly open have any bearing on decision-making? What is the likely trend in the trading links between the UK and Europe over the next 5-10 years? How likely are they to get some form of negotiated settlement on their debt problems? Are their estimates of the price elasticity of demand for passenger and freight services accurate? All these points may be relevant. To get the 20 marks you need to create a logical and coherent answer, ensure each paragraph is carefully thought out and that each paragraph follows from the next in some way. You are asked to 'assess' so again, you will need to make judgements wherever possible try to ensure that they are supported by some recourse to the facts or information that you may have been able to gain.
Extension work: The links take you to the Eurotunnel accounts and to the Biz/ed guide to ratio analysis. Select the appropriate data from the profit and loss account and balance sheet (scroll down in the accounts pages and you will find good, clear information) and see what you can work out. This is good practice in using ratios and doing some limited analysis about the company.