Groupe Eurotunn. Equity Research. Outperform. Moving along a high speed track. Transport / France 19 June Initial coverage - Midcaps

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1 Equity Research Initial coverage - Midcaps Groupe Eurotunnel Transport / France 19 June 2008 Outperform Target price EUR14.1 (+36%) Sector rating Outperform Price (17 June 2008) EUR10.3 Market cap./free float (EURbn) 1.9/- EV (EURbn) 5.8 3m avg. volume (EURm) 4.9 Reuters/Bloomberg GETP.PA/GET FP Financial data 12/07 12/08e 12/09e 12/10e Adjusted EPS (EUR) EPS - IBES (EUR) Net dividend (EUR) Sales (EURm) Adjusted EBIT (EURm) Adj. net profit (EURm) Adj. net debt / EBITDA (x) Stockmarket ratios* 12/07 12/08e 12/09e 12/10e P/E (x) P/BV (x) Net yield (%) FCF yield (%) (29.6) EV/Sales (x) EV/EBITDA (x) EV/EBIT (x) * Yearly average price for FY ended 12/07 Performance (%) 1w 1m 3m 12m Absolute (3) 3 26 Rel. Transport (7) 6 12 Rel. DJ STOXX50 (3) Price relative to DJ STOXX Moving along a high speed track We initiate coverage with an Outperform recommendation Groupe Eurotunnel (GET) has been transformed following the 2007 capital restructuring and subsequent securities redemption exercises. Based on a DCF valuation of the concession we set a target price of EUR14.1. We initiate coverage as Outperform. Groupe Eurotunnel has become a key European infrastructure play Following its first ever net profit in 2007 (EUR1m) and the positive outlook for earnings reflecting the growth in Eurostar passenger traffic, a recovery of rail freight volumes and the prospect of incremental earnings through new investment, GET has become a core infrastructure investment. Light ongoing capital expenditure and the long length of the concession support a high FCF yield. The main issue has been the extremely high level of debt and interest payments which is now resolved. Adjusted net financial debt/ebitda is expected to fall from 18.6x in 2006 to 8.1x in 2008e and 6.4x by 2010e while EBITDA/financial charges cover is projected to improve from 0.9x to 1.6x and 2.1x. The Group has been given a Baa2 debt rating by Moody s. High operational gearing supports earnings growth GET has defensive, inflation-hedged investment characteristics. The sunk cost in the core tunnel asset, combined with the long length of the concession and light ongoing capex, mean that it should trade at a premium to other infrastructure plays. Diversification opportunities promise significant upside Diversification into rail freight operations through Europorte 2 and access to FCF for investment in new infrastructure assets, following the capital restructuring, mean that GET also offers considerable growth upside. We have included a growth element in our DCF model and arrive at a valuation of EUR8.38bn (EUR14.1 per share) based on our assumption of a total number of 594m shares in issue Jun Sep Dec Mar Jun 08 Nick van den Brul Geoff van Klaveren transport@exanebnpparibas.com nick.van_den_brul@exanebnpparibas.com Groupe Eurotunn Groupe Eurotunn relative to DJ STOXX50 (rebased) Source: Datastream Please refer to important disclosures at the end of this report.

2 Contents Undervalued long-term infrastructure asset 3 Valuation determined by long asset duration 7 Developing the Eurotunnel concession 15 Company profile and Financial highlights 31 2 Groupe Eurotunnel

3 Undervalued long-term infrastructure asset Exploitation of a unique rail track asset Groupe Eurotunnel S.A. (GET) holds the concession to operate the Channel Tunnel between France and the UK until 2086 after which ownership of the Tunnel and the associated infrastructure will be transferred to the British and French governments. This is a unique infrastructure asset, comprising two 50km main rail tunnels and a service and safety tunnel, which forms part of the rapidly developing European high speed rail network. It is a major conduit for truck and rail freight and for business and leisure transport between the UK and the European Continent. De-regulation of European rail freight infrastructure from 2007 and passenger rail track access from 2010 provide Groupe Eurotunnel with significant growth opportunities which it can now exploit following the capital restructuring. We believe that Groupe Eurotunnel is undervalued given the strong FCF growth profile and long duration of the concession. Economic regulation of Groupe Eurotunnel is light as most of the main regulatory issues were established in the planning and construction phase of the Tunnel and subsequently amended. These included concession length (to 2086) and the Railways Usage contract which runs until The concession length was extended from 2052 to 2086 in GET operates vehicle shuttle services through the Tunnel itself and sells track capacity to other rail operators such as Eurostar and the rail freight companies which include SNCF (the French national railway) and EWS, a subsidiary of the German rail operator, Deutsche Bahn. The key drivers of Eurotunnel s traffic volumes are economic growth (for both passenger and freight traffic) and growth in trade between the UK and Continental Europe (freight traffic). We consider the long-term trends in both of these key drivers to be positive for Eurotunnel, although they clearly make Eurotunnel s business subject to cyclical economic trends. The Tunnel is currently under-utilised in terms of both load factor and train frequency and there is the potential to increase the capacity of the Tunnel through operational improvements, such as synchronising the speeds of rail freight trains and shuttles, and upgrades to the infrastructure, such as increasing the power to the overhead cables or upgrading the signalling to a moving block system which allows Eurotunnel to reduce the distance between trains travelling through the Tunnel. Capacity can also be expanded through the use of larger and longer trains. Initiation with an Outperform rating The drivers of a re-rating of GET, and its acceptance as a high quality equity investment, are based on its return to consistent profitability following the financial restructuring under the Safeguard Plan, which has significantly reduced debt service costs and improved the capital structure, in addition to improvements in operational earnings (following cessation of the Minimum Usage charge paid by the railways at the end of 2006) through management s revenue and cost-cutting initiatives. Resolution of the debt situation, by means of the Exchange Offer in 2007 and the securities operations this year, has positioned Groupe Eurotunnel for growth through development of new business activities. Investment in GET therefore represents an inflation indexed core investment in the Tunnel activities plus an option on growth. 3 Groupe Eurotunnel

4 Capital restructuring lowers interest costs The foundation for the positive stance is in the capital restructuring and changes to the investment status of GET (Moody s has given the restructured debt an investment grade Baa2 rating). We believe the equity will attract greater interest from investors as they recognise the marked reduction in financial risk in the stock. This results from the halving of the debt principal to EUR4,010m following the Exchange Offer in mid 2007, the halving of debt service costs and an improvement in the EBITDA/financial charges ratio from 0.9x in 2006 to an estimated 1.6x in 2008e and 2.1x by 2010e. The potential for significant value creation is in completion of the financial restructuring, further improvements to operations which can improve margins and operating leverage and additional gains in the cross-channel market, both through market growth and oneoff effects such as the improvements in the fast train infrastructure following completion of CTRL II. Further value creation is possible through re-investment of GET s free cash flows from 2010 onwards. We value GET at EUR8.38bn or EUR14.1 a share and initiate our coverage with an Outperform recommendation. A more leveraged investment is to purchase the traded warrants. The achievement of the group s first net profit (2007) of EUR1m (excluding the effect of the Exchange Offer restructuring) from a net loss of EUR204m in 2006, following the reduction in financial liabilities after the Safeguard Plan restructuring, was a major turning point for Groupe Eurotunnel. The question for investors is whether this is sustainable going forward and whether an investment in Groupe Eurotunnel will be attractive? Our initiation-of-coverage note therefore focuses on the issue of growth and the valuation using different assumptions of growth rates and pricing as well as the possibility of identifying ways to diversify earnings. High EBITDA and operating margins Infrastructure assets have attractive investment characteristics. The stability of their cash flows is defensive, while they offer considerable growth upside, as highlighted in our infrastructure research publication of 4 June 2008 entitled Duration, Duration, Duration. The theme of this research is that the relationship between EV/EBITDA as the benchmark valuation measure and asset duration shows that some infrastructure assets are undervalued by the market, especially those companies with medium duration assets at an early stage of their asset life. GET is potentially a core infrastructure investment, generating substantial free cash flow based on high operating cash flow generation and limited annual maintenance capex (estimated around EUR50m a year for the next 5 years) through to the end of the Concession in GET is still at an early stage of its Concession life (only 14% of the 99 year duration has expired) with substantial balance sheet restructuring leading to a completely changed outlook for the investment. Because of the unsustainable debt burden, Eurotunnel has no history of creating value. However, our forecasts show that, following the capital restructuring, GET is capable of generating a sustained FCF yield of approximately 7% and will move towards a positive ROCE/WACC relationship, creating significant value from 2020e, according to our estimates. The financial restructuring has created the possibility of increasing funds for investment in diversified activities such as rail freight operations, rail track infrastructure management and real estate development in the Pas de Calais/Sangatte area. Additional value could be derived from business diversification, for example in rail freight operations in the Calais/Frethun area, which were started in November 2007, or in the acquisition of related infrastructure assets such as London & Continental Railways, the owner of the UK stretch of the high speed rail track linking London and Paris/Brussels, which, in our view, is a potential acquisition candidate. 4 Groupe Eurotunnel

5 A large proportion of Eurotunnel s costs are fixed, resulting in high operational gearing. The group s core operating strategy is, therefore, to create shareholder value by growing traffic volumes and revenues, and controlling variable costs. Restructuring of the business from 2005 has had a positive effect on margins and there is further scope to improve margins using additional economies of scale to drive higher asset utilisation. The majority of Eurotunnel s costs are either fixed (payable even if operations ceased) or semi-fixed (not linked to traffic levels). The operational gearing of the business is, therefore, high, potentially leading to rapid profit growth following achievement of the first profit in As part of the group s drive to achieve a profit, costs have been tightly controlled, with a 24.5% reduction in operating expenses between 2005 and Early light: 2007 sees a EUR1m net profit The result of the management actions and lower debt service costs following the capital restructuring and Exchange Offer, was a small normalised net profit (EUR1m), for the first time, in 2007 and following a 4% increase in normalised revenues to EUR775m, including a 5% rise in Eurotunnel shuttle revenues to EUR500m and a 6% rise in Railways revenue (Eurostar and through Rail Freight) to EUR262m. The improvement continued in Q1 08 with a 15% rise in revenues to EUR187.6m. Passenger shuttles (car and coach) rose 11% in Q1 08, while truck shuttle numbers were 10% higher at 385,145 trucks. Eurostar passenger numbers rose 21% to 2.175m in Q1 08 compared with the same period last year, partly aided by the one extra day from the leap year and the early Easter this year. Rail freight traffic fell 13% (744 trains under the new pricing system, compared to 853 the previous year). However, the rail freight trend is positive with the 744 trains in Q1 08 exceeding the 587 trains in Q4 07 and 651 trains in Q3 07. In our view, earnings will continue to rise, driven by the strong increase in passenger demand for Eurostar services following the completion of the second section of the Channel Tunnel Rail Link and reduced journey times, a recovery of rail freight consistent with the development plans of EWS/Deutsche Bahn and SNCF and management action to improve pricing flexibility and reduce operating costs is a pivotal transition year for Groupe Eurotunnel as the Company demonstrates a solid return to profitability, financial stability and the prospect of further infrastructure related growth. Lowered dilution risk From a valuation perspective, the capital restructuring has an impact on the number of potential shares and thus prospective dilution. Success in the SDES (Subordinated Deferred Equity Securities) issue and the rights issue reduces the dilution exposure from 644m potential shares to our estimate of full dilution from outstanding securities, following redemption of NRS 2 and partial redemption of NRS1 securities, of 594m shares. The main remaining variables in respect of the dilution are whether the SDES are reimbursed with cash or shares at the relevant exchange ratio after delivery of bonus shares and whether the management operating targets are achieved thereby triggering the exercise of the warrants (BSA). If the warrants are not exercised (highly improbable if management s plans are successful), the valuation would theoretically be improved to EUR19.5 per share, but this also implies a lower DCF valuation since management would not be achieving their own near-term performance targets. 5 Groupe Eurotunnel

6 Inflation hedged return with growth potential Although GET operates in competitive markets, in practice prices have risen in line with inflation and the Railway Usage Contract (a contract between Groupe Eurotunnel and the railway users which is valid to 2052) provides for specific linkage between charges to the railways and inflation. There is also a correlation between traffic growth and growth in GDP. In this sense, an investment in GET shares provides a stable GDP growth-linked inflation hedge, with some additional growth upside offered by the new opportunities to invest in rail freight, real estate and other activities not linked directly to the Tunnel operations. This has been made possible by the re-financing and lifting of the debt service burden. Following the refinancing exercises, GET s capital structure offers participation in the company via ordinary shares, the NRS I securities, the SDES issued earlier this year and the BSA warrants, exercise of which is dependent on business performance and thus bear the greatest risk. We recommend conservative investors invest in the ordinary shares while less risk-averse investors are likely to be able to see geared upside through investment in the warrants (BSA). 6 Groupe Eurotunnel

7 Valuation determined by long asset duration DCF over the life of the concession Our main approach to the valuation of GET is to model the cash flows over the life of the concession. Cash flows are less stable than for motorways as they are determined by competitive prices and are more like the cash flows of an airport in view of the greater cyclicality and exposure to competitive pricing mechanisms (mainly from the ferries and airlines and between different methods of freight transport). Profitability automatically gives value to the substantial tax losses which have accumulated in both the UK and French operating companies during the period of loss-making operating activity (after debt service costs) Given the finite nature of the Concession (2086), we believe a discounted cash flow model is an appropriate valuation method and allows sensitivity analysis to traffic flows and yields. We have also looked at valuation comparisons with airport and motorway stocks, as well as with utilities, focused mainly on EV/EBITDA multiples. In comparison, with the latter, however, GET is subject to relatively light regulation and, although it has control of a unique fixed asset, it operates in competitive markets. GET generates strong and regular cash flows and has relatively small amounts of ongoing capex to maintain the Tunnel operations, in contrast to an airport or port, for example, where expenditure on incremental capacity expansion results in a sizeable capital expenditure obligation. In this way, GET s cash flow characteristics are closer to those of motorways, although revenues are determined by traffic and competitive pricing rather than by traffic flows and a regulated tariff. Arguably, GET should trade at a premium to other infrastructure assets since (i) it has very light economic regulation and the return on the fixed asset base is not capped (ii) the investment can be focused on activities (rail freight or real estate, for example) which are unregulated and (iii) the Concession period is very long, bringing substantial FCF to investors following the restructuring even though in theory, GET is required to share earnings with the British and French Governments through the tax mechanism after The problem for GET as an investment has been the inherited capital structure loaded with debt, including unpaid interest, which has meant that while cash flow before financing has been strong, after financing it has been negative. The Safeguard Plan has changed this relationship and shifted the burden of the analysis on to dilution implied by the debt restructuring and the Exchange Offer. Long length of the concession is undervalued Our DCF cash flow model gives an Enterprise Value for GET of EUR10.93bn equivalent to EUR18.4 per share based on an assumed maximum dilution of 594m shares. This implies an EV/EBITDA 08e ratio of 23x which is a 33% premium to Cintra, for example, but which we believe is warranted by the long length of the Concession contract, the absence of a requirement for major expenditure on the core asset, the strong FCF and the potential for unregulated earnings growth. The value generation with Groupe Eurotunnel is in the period from 2020e onwards when ROCE begins to exceed the WACC by an increasing margin delivering significant added value for shareholders. According to our estimates, the period from 2015 to 2052 (i.e. prior to the termination of the Railway Usage Agreement and the exercise of Government tax rights) is the period of maximum returns from the Eurotunnel Concession investment. This value is largely ignored in the current share price. The main risks to our valuation are exogenous shocks to traffic growth, pricing pressure from ferries and airlines and rising interest costs. We believe our valuation is conservative in so far as it takes into account the equity dilution risks. 7 Groupe Eurotunnel

8 Main valuation assumptions Our main valuation assumptions are shown below. We use a WACC of 7.5% based on a RFR of 4.43% and an Equity Risk Premium of 4.86%. The geared Beta is 1.3, based on an asset Beta of Table 1: DCF valuation assumptions % RFR 4.43 Risk premium 4.86 Longterm growth 2.0 Pre-tax cost of debt 6.0 Tax rate 30 Post-tax cost of debt 4.2 Forecast % of debt 50.0 Forecast % of equity 50.0 Beta 1.3 Cost of Equity 10.7 WACC 7.5 Source: Exane BNP Paribas estimates Our model assumes a long-term growth rate of 2%, approximately in line with our internal long-term inflation forecasts which are applied to our Shuttle fare and railway charges escalation estimates. Traffic growth In general, traffic growth between the UK and France is correlated to GDP growth in those countries. GET s exposure also depends on its pricing and product proposition relative to the cross-channel ferries and the airlines. As illustrated in the table below, which shows traffic growth rates over the past three years, truck movements (the mainstay of the Shuttle operations) and Eurostar growth have been positive, with CAGR growth rates of 4% and 5.3% respectively over the past three years, while coaches have declined 8% in conformity with the long-term trend. Rail freight was stable in 2005 and 2006 but fell sharply after the abolition of the Minimum Usage Charge. Table 2: Groupe Eurotunnel: traffic growth Traffic CAGR % 2008e 2009e % change Cars 2,047,166 2,021,543 2,141, ,205,820 2,271, Coaches 77,267 67,201 65,331 (8.0) 65,984 66, Trucks 1,308,786 1,296,269 1,414, ,513,739 1,559, Eurostar passengers 7,454,497 7,858,337 8,260, ,087,078 9,723, Rail freight 1,587,790 1,569,429 1,213,647 (12.6) 1,456,376 1,966, Source: Company, Exane BNP Paribas estimates Our expectation is that growth will recover in rail freight, Eurostar will continue to improve strongly with the boost from completion of CRTL II and extension of the fast train network from Brussels to Amsterdam (and onwards to Aachen and Cologne). From 2010 onwards, Deutsche Bahn is considering the possibility of operating ICE trains from Germany through the Channel Tunnel. Competition with Eurostar should assist GET s ability to maintain charging levels. 8 Groupe Eurotunnel

9 Price inflation Prices in the Shuttle operations have exceeded inflation in the past three years. Rail pricing is more complex with the Eurostar tariff set at EUR18 per journey per passenger and rail freight tariff having been changed by GET s management in 2007 from a volume related tariff to a per train tariff, in order to increase the attractiveness of the Tunnel to rail freight operators. We forecast an average long-term price increase of 2% per annum in line with inflation. Capital expenditure We project maintenance capital expenditure going forward of approximately EUR50m a year. We assume capex for expansion from the Company s own resources of EUR20m (1x estimated sales) in Capital expenditure on a new signalling system is expected to be funded by a subsidy. In practice, capital expenditure is likely to rise as GET begins an expansion and diversification programme (for example on Europorte 2 and possibly even ownership of the Channel Tunnel Rail Link infrastructure). However, there is currently very little information on the potential investment cost and the associated cash flows. Tax rates We have assumed a 30% tax rate for GET. The Group pays no cash taxes on the French operations because of the prior losses and the agreement with the French Government that EUR2bn of tax losses could be utilised in France. There are also significant tax losses in the UK operating company, Eurotunnel Ltd. FCF generation Following the reduction in debt service costs, GET is a strong free cash flow generator. We assume part of the cash flow will be used to invest in new activities while part will be used to pay dividends. We assume gearing will decline but stay just above 50%, in our view. Core valuation of EUR14.1 a share Based on our DCF valuation, we value GET at EUR8.38bn or EUR14.1 per diluted share. This represents a 20% premium to capital employed (which is approximately equivalent to the RAB in a regulated airport, for example) and, in our view, is justified by the long duration and early stage of the Concession. Our DCF model forecasts cash flows through to the end of the Concession in From 2052, the sponsor governments have the right to 50% of pre-tax revenues generated by the Tunnel. Value of tax losses Based on the 2007 accounts GET has EUR7,675m of accumulated tax losses (EUR2,005m in Eurotunnel SA and GBP4,536m in Eurotunnel PLC). We have valued the tax losses at EUR1,305m based on the NPV of the tax losses at the assumed absorption rate (i.e. no sale of tax assets is assumed). 9 Groupe Eurotunnel

10 Table 3: Groupe Eurotunnel: DCF valuation EURm PV of ,930 Terminal value 0 EV 10,930 Net financial debt 3,839 Pension liability 11 NPV of tax losses 1,305 Other assets 0 Outstanding shares (m) 189 Employee stock options (m) 0 NRS 1 dilution (m) 160 SDES dilution (m) 100 Warrants dilution (m) 145 Total potential shares (m) 406 MV 8,385 Total shares (m) 594 Value per share (EUR) Source: Exane BNP Paribas estimates Sensitivity to dilution As mentioned previously, the valuation is highly sensitive to assumptions about dilution. We have assumed full dilution for the BSA (warrants) and a partial buyback of the NRS 1 securities with cash, in line with guidance from the Company. We have included the projected dilution for the SDES (100m shares) and 145m shares dilution from the warrants. This gives total additional dilution of 406m shares and thus a fully diluted number of shares of 594m shares. Dilution could be higher or lower depending on success on buying back the outstanding securities. Potential dilution The main areas of uncertainty are in the issue of EUR800m SDES (Subordinated Deferred Equity Securities) being used to redeem the NRS 2 in cash and the BSA. Each SDES gives the owner the right to receive new ordinary shares. This could give rise to the issue of 83,040,000 new ordinary shares plus a further 4,320,000 if owners of the SDES hold them until redemption on 6 March The first uncertainty is therefore in respect of the bonus shares associated with holding the SDES. The second uncertainty relates to the amount of cash/debt that will be used to repay the second tranche of NRS 2 and the amount that will be left to be financed through the rights issue. Eurotunnel has the ability to raise debt by GBP225m. The redemption amount for the NRS 2 securities following the SDES issue (and including the 40% redemption premium) is EUR812.7m. The redemption of a part in debt significantly improves the dilution prospects. Value per share impact of dilutive securities The Safeguard Plan, which was completed successfully in June 2007, led to a reduction in net debt from EUR9,392m to EUR4,162m. This was achieved by the renegotiation of the various debt tranches into a senior debt tranche of EUR4,162m and the issue of dilutive securities (NRS 1 and NRS 2) to replace various debt tranches. The Exchange Offer of GET shares for Eurotunnel SA and Eurotunnel PLC units was accompanied by an issue of warrants to buy GET shares. Eurotunnel is entering the last phase of its financial restructuring with the issue of SDES in February 2008 and the rights issue in May Following the success of these issues, we believe Eurotunnel will be in a position to show an increase in net profits to EUR16.9m and to pay a dividend (estimated EUR0.20 per outstanding share or EUR0.03 per fully diluted share for 2008e), following a reduction in net interest costs and substantial improvement in the business (especially in Eurostar traffic growth). 10 Groupe Eurotunnel

11 The valuation and trading level of GET shares is sensitive to assumptions about dilution resulting from the Exchange offer and debt restructuring completed last year. There are four main classes of securities (i) non-callable Notes Redeemable in Shares (NRS 1) in 2008 (15%), 2009 (a further 15%) and 2010 (the remaining 70%); (ii) callable Notes (NRS 2) all of which are being redeemed from the process of SDES and the rights issue; (iii) the SDES (Subordinated Deferred Equity Securities) and (iv) Warrants (BSA) to buy additional GET shares. The potential maximum shares following exercise of the SDES, the NRS 1 securities and the warrants is m shares. In our view, Eurotunnel will undertake a further capital markets operation which is to try to buy back some of the outstanding NRS1 securities on the open market. In our dilution calculation, we have assumed that the Company will be successful in buying back 8.6m shares. However, if they manage to re-purchase 25% of the outstanding NRS1 securities, this would reduce the potential number of dilutive shares to 556m leading to a DCF based target price of EUR14.9, giving 45% upside. Table 4: Estimated potential dilution Share dilution No. of adjusted shares Comment Equity 59,784,111 SDES 101,609,861 includes interest and bonus Rights issue 109,377,743 includes bonus NRS 1 T1 16,790,519 assumes 8.6m share buyback NRS 1 T2 25,440,615 NRS 1 T2 135,521,978 NRS 2 - Warrants 145,475,173 Total estimated shares 594,000,000 Source: Company, Exane BNP Paribas estimates It is assumed that around 95% of the non-callable Notes (NRS 1) will be fully exercised for shares. It is also assumed that given the probable increase in the value of Eurotunnel, all of the warrants will be exercised. Phases of the capital restructuring Phase 1: July 2007 the Exchange Offer and debt cancellation The first major restructuring was a write-off of approximately EUR4bn in debt owed to the banks and the implementation of the Exchange Offer which led to the exchange of tranches of senior and junior debt for a combination of EUR4,010m in long-term debt and three categories of securities : interest bearing NRS 1, interest bearing NRS 2 and performance based warrants (the BSA). Table 5: Eurotunnel debt: pre-restructuring Senior debt category EURm Senior debt 4th tranche 537 Tier 1A 1,102 Tier Tier 2 1,315 Tier 3 2,617 Resets 682 Stabs 826 PLN 1,269 Total 9,145 Source: Company, Exane BNP Paribas estimates 11 Groupe Eurotunnel

12 Phase 2: February 2008 the SDES Offering The second phase was the offering of SDES in February 2008 which enabled the repayment of approximately 50% of the NRS 2 securities, with the remainder purchased after the successful rights issue. The effect of the capital restructuring has been to reduce net debt service payments from around EUR447m in 2007 to an estimated EUR291m in 2008e. Success of the rights issue and repayment of the remaining NRS II securities could lead to a further EUR30 35m reduction in annual debt service payments (with potentially a corresponding improvement in net earnings). Repayment of a part of the NRS I securities using free cash flow is also possible. Table 6: GET capital structure: post SDES Post Exchange & SDES Offer EURm Warrants 127 NRS NRS1 163 SDES 85 Shares 60 Total 562 Source: Company, Exane BNP Paribas estimates Phase 3: May 2008 the Rights Issue The third phase of the capital restructuring was the rights issue involving a free issue of 59.78m warrants, each to buy 4 shares, which was completed last week with 70% take up by shareholders and a successful placing of shares represented by the remaining 30% (104m shares in total). The total number of shares and dilutive securities following the rights issue is equivalent to 561m shares, implying a fully diluted market capitalisation of EUR5.78bn at the current share price of EUR10.3 However, there are adjustment factors to the warrants and the SDES, which, in our view, increase the potential dilution to 594m shares (see table 4 above). Table 7: Capital structure post rights issue New equity structure (m) Warrants (BSI) 127 NRS SDES 85 Shares 186 Total 561 Source: Company Potential dilution timetable The potential dilution timetable is as follows. Please note that all of the NRS II securities are expected to be repurchased this year at a premium to nominal value. Table 8: Dilutive securities conversion dates Conversion dates NRS IT1 NRS IT2 SDES NRS IT3 NRS II Warrants 3 months 15 months 16 months 27 months 27 months 39 months Source: Exane BNP Paribas estimates This leaves the NRS 1, the SDES and the warrants as potentially dilutive securities. GET has an option to repurchase the NRS I securities at a premium but we believe they are unlikely to do so as this brings only minimal benefit in terms of interest cost reduction. 12 Groupe Eurotunnel

13 Sensitivity analysis The following sensitivity analysis shows the range of options related to traffic/revenue growth and interest costs. Sensitivity to traffic/revenue growth In addition to the dilution, GET s valuation is highly sensitive to traffic and revenue growth as illustrated in table 9 below. Our base-case scenario shows strong growth in Shuttle and Railway operations this year and next following the one off effects of management cost reduction and revenue stimulation actions, the growth in Eurostar traffic, boosted by the shorter travel times, and recovery in through-freight traffic from its low point in We have also assumed that, as stated by management, they will also invest FCF in growth areas outside the present activity (this is conservatively assumed to bring business with annual revenues acquired of EUR20m). We have undertaken a sensitivity analysis which assumes the same WACC but a worst-case rate of revenue growth of 3% in the shuttle and rail operations and 1% in other operations (including the Europorte 2 start-up) but no acquisition programme. This assumes underlying economic growth of 1.5%, compared to the current Exane BNPP forecast for the Eurozone of 1.7% for 2008 and still some ability to raise prices (long-term inflation is assumed at 2%, with GET able to match inflation through fare increases). This gives a DCF valuation of EUR10 a share. Table 1: Valuation sensitivity to growth assumptions Sensitivity analysis 2008e 2009e 2010e 2011e 2012e Base-case value per share EUR14.1 Revenue growth assumptions (%) Shuttle Railways Other Worst-case value per share EUR10.0 Revenue growth assumptions (%) Shuttle Railways Other Blue Sky value per share EUR16.4 Revenue growth assumptions (%) Shuttle Railways Other Source: Exane BNP Paribas estimates On a Blue Sky approach, we have assumed a higher rate of growth of traffic and revenues, including some expansion by acquisition. Revenues grow by an average of 7% in the period in the shuttle operations and then by 6% falling to 4% in the long term from Railways have a catch up period on volumes and prices resulting in revenue growth of 8% falling to 5% in 2013 and then 4% from 2016 and other revenues grow by 15%, rising rapidly through acquisition in 2009 and 2010 and growing by 2% from This gives a DCF valuation of EUR16.4 per share. 13 Groupe Eurotunnel

14 Sensitivity to interest rate changes The sensitivity of GET s earnings to interest rates is clearly lower than prior to the Safeguard Plan restructuring, and the interest cost reductions through replacement of the NRS 2 securities are also very significant in this regard. Nevertheless, interest changes can have a major impact on EPS and could defer consistent net profit generation by several years. We have assumed, in the following table, an increase in the net rate of interest from 6.2% in 2008 onwards to 8% per annum This reduces EPS from EUR0.03 a share to a loss of EUR0.06 a share in 2008 and from a profit of EUR0.10 to just above breakeven at the net profit level in 2009 (EPS based on fully diluted shares). Table 2: Sensitivity to interest rate changes Interest cost/eps 2008e 2009e 2010e 2011e 6.2% interest EPS (EUR fully diluted) % interest EPS (EUR) (0.06) Source: Exane BNP Paribas estimates Comparative valuation analysis: premium reflects concession length Comparative valuation analysis gives little in the way of realistic benchmarks at this stage of the restructuring process. The closest comparables on EV/EBITDA and EV/EBIT measures are the toll roads, especially Cintra, the Spanish toll motorway operator. GET is more attractive on a FCF comparative than all other stocks in the infrastructure sub-sector apart from Cintra. This results from a combination of the capital restructuring and the absence of a major capital expenditure commitment. Table 3: Infrastructure companies : comparative multiples Calendarised P/E (x) EV/EBITDA (x) FCF Yield (%) EV/CE (%) EV/Sales (%) ROCE ex gw (%) Airports 08e 09e 08e 09e 08e 09e 08e 09e 08e 09e 08e 09e ADP Fraport (12) (10) SAVE Weighted average (3) (1) Toll roads Abertis Cintra Ferrovial (6) (6) Weighted average Utilities Infrastructure na na na na na na Water na na na na na na Generation na na na na na na Weighted average na na na na na na GET nm Source: Exane BNP Paribas estimates Beyond 2018, the ROCE multiples expand very rapidly as the operating leverage takes effect on an asset which requires little capital expenditure and where a large proportion of the investment has already been written off but which, we believe, has not yet been recognised by the market. Thus Eurotunnel is currently very inexpensive if held as an inflation hedge asset through to 2052 or for the full life of the Concession. 14 Groupe Eurotunnel

15 Developing the Eurotunnel concession Strategic positioning Eurotunnel is now an integral part of the rapidly evolving European high speed rail network (Eurostar/ICE/TGV/Thalys/AVE). It is the only land connection between the UK and the European Continent by means of the world s longest continuous undersea tunnel. Eurotunnel s two terminals at Folkestone (UK) and Les Coquelles (France) are linked by three parallel tunnels, each approximately 50kms in length, located on average 40 metres below the English Channel sea bed. The two traffic tunnels have a single railway track each, although there are cross-overs between the two that allow operations to continue during maintenance work. The service tunnel runs between the traffic tunnels and allows the passage of service and emergency vehicles, as well as housing fibre optic cables owned by telecommunications operators. SWOT analysis Following the capital restructuring, Eurotunnel has certain advantages over other types of infrastructure investments as shown in the SWOT analysis below. Strengths Long length of the concession Sunk cost in the core infrastructure Time and weather advantages over ferries attracts truck market Post restructuring balance sheet is manageable and Moodys investment grade rating Opportunities Ability to re-build rail freight volumes following rail freight deregulation Eurostar volumes on strong growth track Opening of fast train links between Brussels and Amsterdam end 2008 One-off events, e.g. Olympic games in London 2012 Weaknesses Exposed to cyclical downturn in the economy Continued complexity of the financial structure reduces valuation visibility Threats Price discounting by ferries Rise in electricity prices (partly compensated by switch to France) Terrorist actions Source: Exane BNP Paribas The advantages of the asset are the long length of the Concession and the fact that the investment is a sunk cost, with relatively low maintenance capex required and, now, a significantly reduced debt burden. Following the restructuring, the balance sheet is manageable, as evidenced by Moody s investment grade rating of Baa2. The main operating drivers are traffic growth and the ability to raise pricing. In the past, Eurotunnel pursued a volume growth strategy but more recently there has been a focus on maintaining and improving unit revenues wherever possible, through the use of a dynamic pricing approach which can combine the best volume/price mix (similar to airline revenue management, for example). Groupe Eurotunnel now dominates the cross Channel truck shuttle market. Approximately 75% of freight to and from the UK is carried by sea and approximately 25% by trucks loaded onto Eurotunnel trains and the ferries. Both the ferries and the airlines are more exposed than Groupe Eurotunnel to the high price of fuel. Competition from Ferry Operators GET s shuttle services face competition from ferry operators, especially on the short sea routes between Dover and Calais, Boulogne or Dunkerque. Industry-wide capacity on the short sea routes has stabilised, following a major restructuring of the ferry services of P&O after the acquisition of Stena Lines in The main competitors are: 15 Groupe Eurotunnel

16 P&O Ferries P&O Ferries, which was acquired by Dubai Ports World in 2005, remains one of the largest ferry groups on the short sea routes despite a major restructuring in 1998 following the acquisition of Stena Lines which saw it consolidate a large number of cross-channel routes. SeaFrance SeaFrance is a subsidiary of SNCF and the only French owned short-sea operator. It operates on the Calais-Dover link for passengers and truck, with 30 daily crossings operated by six ships. One additional ship has been acquired and is entering service in mid Car volumes rose 13% in 2007 and passenger numbers were 6% higher yoy. Speed Ferries Founded by a Danish entrepreneur, Speed Ferries launched a new fast ferry service on Dover-Boulogne and Dover-Calais routes in May It has a 12 per cent share of the short sea passenger vehicle market. Norfolk Line Norfolk Line, a subsidiary of AP Moller-Maersk, specialises on Dover-Dunkerque routes and is focused on a higher quality, higher price traveller segment. Other operators on longer sea routes which do not compete directly with Eurotunnel in terms of speed, are Brittany Ferries (French northwestern to UK southwestern ports as well as Cork in Ireland and Santander in Spain) and Louis Dreyfus Lines which operates a Le Havre-Portsmouth link. Competition from low-cost airlines Eurotunnel also competes with low-cost airlines such as Ryanair and easyjet on the broader short-break market, especially to France and the Low Countries. Ryanair flies to Beauvais and easyjet to Paris-CDG and Paris Orly airports and both have extension route networks to popular leisure destinations, accessible by car, in southern France and in Spain. Low-cost airlines period of rapid development in saw significant price competition and lower car passenger volumes for the short-sea area as a whole. However, the price war has now ended with Air Passenger Duty and higher fuel costs prompting the airlines to pursue a policy of yield maximisation above volume growth. Tunnel traffic Eurotunnel operates a fleet of truck 16 shuttles, each with a capacity of 30 trucks. Of these, 14 are fully utilised at any one time. Its current service frequencies are up to 110 daily services by passenger vehicle shuttles and up to 130 daily services by freight shuttles. In 2007, the number of trucks transported increased by 9% yoy compared to Short Straits truck market growth of 4%. The Groupe has 9 passenger shuttles, each able to carry up to 180 cars or 120 cars and 12 coaches. The number of cars transported increased by 6% in 2007 while coaches declined 3%. 16 Groupe Eurotunnel

17 The restructuring by management since 2008 has led to fewer shuttles with higher load factors and greater choice of prices depending on time and availability. 54 trains a day are projected for Eurostar in 2008 compared to 50 trains in These have increased by 10% a year over the past 5 years. In our view, the outlook for the truck shuttle market is positive, supported by the growth of trade and congestion at the UK s main sea ports. Under the terms of the Concession agreement, Eurotunnel was required to submit a feasibility study for a second fixed-link tunnel. However, the group has no plans to construct such a link. The tunnel is operating at only approximately 50% of capacity, and there is potential to raise capacity through both additional shuttle trains and upgrades to signalling systems and other parts of the infrastructure. GET s main revenue contribution is from the Shuttle operations (trucks, coaches and private vehicles), which generated 56% of revenues in 2006 prior to the lapse of the Minimum Usage Charge (which mainly affected Railway revenues). The Tunnel remains significantly under-utilised in terms of both load factors and train frequencies. The load factors for the Eurotunnel-operated shuttles services are at 60-65% for the car shuttles and above 70% for the freight shuttles. This is therefore currently the main area of growth in the Tunnel operations. Although not yet required, there is the potential to increase the capacity of the Tunnel through operational improvements, such as synchronising the speeds of rail freight trains and the shuttles, and upgrades to the infrastructure, such as increasing the power to the overhead cables or upgrading the signalling to a moving block system. Eurostar are also considering the introduction of twin decked trains. Eurotunnel traffic growth has shown mixed development over the past seven years with truck traffic growing by 3.2% CAGR and rail passengers by 2.1%, Car and coach shuttle traffic declined as Eurotunnel pursued the higher yield, more predictable truck shuttle market. Rail freight also declined as lower volumes of goods were carried by rail. Table 4: Traffic development Tunnel traffic CAGR (%) Trucks carried (m) Car shuttle traffic Cars carried (m) (3.7) Coach shuttle traffic Coaches carried (000) (2.7) Eurostar passengers Passengers (m) Railways freight tonnage Rail freight tonnes (m) (12.0) Source: Company, Exane BNP Paribas estimates This is expected to turn around following the major boost to Eurostar traffic following completion of CTRL II, the acquisition of EWS, the UK s largest rail freight operator by Deutsche Bahn and the takeover of Geodis by the French State rail operator, SNCF, both of which have stated ambitions to expand their rail freight operations. Shuttle operations Eurotunnel s shuttle services run between the tunnel s two terminals at Folkestone and Coquelles. The shuttles are the principal Eurotunnel-managed business. They compete with ferries in the transport of cars, passengers, trucks, and other vehicles between the UK and the Continent. The shuttle services have the unique combination of speed (35 minute crossing), frequency (up to 3 car shuttles per hour and 6 freight shuttles per hour) and reliability (unaffected by adverse weather; good punctuality record). Eurotunnel is aiming to improve its punctuality with more effective maintenance and improved procedures. 17 Groupe Eurotunnel

18 Revenues GET generates revenues from the Concession through both the Shuttle operations (truck, car, coach) operated by Eurotunnel itself and from the railways (Eurostar, SNCF and EWS where the track is leased to the railways) Table 5: Eurotunnel: revenue trends Revenues (adjusted, EURm) CAGR (%) Eurotunnel shuttles Railways Other (17.5) Total Source: Company, Exane BNP Paribas estimates. Railways excludes Minimum Usage Charge prior to 2007 Other revenues have been earned through operation or leasing of retail and other commercial facilities at the terminals at Folkestone and Calais, Frethun and leasing of telephone cable space to telephone operators. Since the second half of 2007, new direct rail freight operations were started through Europorte 2 and an agreement was signed for participation in the development of real estate in the Pas de Calais. We expect revenues from these areas and other new initiatives, to become more significant as a proportion of revenues going forward. Revenue growth from truck shuttles The main driver of earnings growth at GET is the truck shuttle market. This partly results from a successful re-positioning of the truck shuttle service, emphasising speed and certainty above price but offering large volume discounts to regular trucking customers prepared to sign long-term contracts. Truck contracts with the larger operators are now signed for five-year terms with approximately 30% of volumes for the next two years locked in. Truck performance has been improved by changing the timetable (increased shuttles at night for example), signing up the larger trucking companies on long-term (usually 5 year) contracts with price incentives for volume usage and improvements in efficiency. We estimate growth of truck shuttle volumes of 3% per year over the next five years (compared to 3.2% CAGR in the period ). Eurotunnel has a natural hedge between road and rail freight. Not only is it able to handle both types of traffic, but it also has the capability, over the long term, to switch its capacity between the two markets. Passenger (car and coach) shuttle operations Eurotunnel is positioned for speed and uninterrupted service in the passenger market, as opposed to the leisure aspects of the trip which is where the ferries have increasingly positioned themselves. In the Eurotunnel operations, cars drive into specially designed shuttles where the occupants may move around, but the facilities are limited. Each passenger shuttle consists of two locomotives (one at each end), two single-deck loaders for 12 single-deck carriages, and two double-deck loaders for 12 double-deck carriages. Eurotunnel has nine car shuttles that cost around 80m each, significantly more than freight shuttles due to the far more stringent safety requirements 18 Groupe Eurotunnel