Britain’s banks have done it. So have its carmakers. Are rail companies the next in line to receive Government assistance? That is set to be the big question facing Go-Ahead Group next week when the operator of the Southern, Southeastern and London Midland franchises kicks off the reporting season for the big five bus and train groups.

It is not an idle debate. Last month, representatives of all five companies sought a meeting with Geoff Hoon, the Transport Secretary. Although the subject of their talks remains undisclosed, measures to mitigate the impact of economic downturn are expected to have been top of their agenda.

That public transport operators – once considered one of the more defensive corners of the stock market – are susceptible to recession is already proved: falling passenger numbers, job cuts by the likes of First Group, National Express and Stagecoach, and, not least, their share price performance say as much.

But lower ticket revenues from commuter and intercity lines because of rising unemployment are only part of the problem. First, train companies face a hit from falling inflation. The majority of fares are struck on the annual formula of RPI plus 1 per cent, with January’s season ticket prices set on the basis of the official rate of inflation the previous July. That meant rises of about 6 per cent for 2009, but with RPI last reported at only 0.9 per cent, and predicted to turn negative by July, rail operators face the prospect of falling ticket prices next year for the first time since privatisation.

Although train companies also benefit from lower costs – not only from fuel, but track access charges, which are index-linked – the overall effect is modest.

Second, the timetable of franchise awards means that most were bid in the past few years – at what now is clear was the top of the market, and when forecasts assumed annual revenue growth of between 7 per cent and 10 per cent. Falling revenues are to be feared in light of the high operational gearing of rail franchises: about 80 per cent of costs are fixed. Even more so given that the newer the franchise, the more vulnerable they are to racking up losses.

The Department for Transport (DfT) operates a “cap and collar” mechanism, whereby the Government makes up part of the shortfall if a rail operator’s revenues undershoot their original projections. However, such risk-sharing agreements do not kick-in until the end of the fourth year of a franchise, meaning newly awarded deals that rely heavily on commuters have considerable scope to dent profitability. That spells pain for Stagecoach from South West Trains and for National Express from its East Coast line. Conversely, First Group is relatively protected. Its two big franchises – First Capital Connect and First Great Western – are both eligible for DfT revenue protection from April this year.

But according to Joe Thomas, transport analyst at Investec Securities, investors should be braced for the train to take the strain for some time to come – the rail industry faces a “potentially protracted period of large-scale losses”, he warns. Mr Thomas also cautions that, if history is any guide, rail passenger volumes are unlikely to regain their previous strength even after the recession ends. As his chart below shows, growth has returned after past disruptions – either economic downturn or, more recently, the aftermath of the Hatfield rail crash – but volumes have not resumed previous trends.

So what track might hard-pressed train operators take? The straightforward solution would be for rail companies to relinquish their most troublesome franchises. But that is not as easy as it sounds: under the DfT’s terms, if a franchisee defaults on one franchise, it must default on them all – which means junking profitable and unprofitable lines alike, and effectively forfeiting the right to participate in future franchise rounds. The answer might be for the five train operators to band together and default en masse, but securing unanimity is likely to be difficult given the differing importance of rail to each.

Further, it assumes that overseas operators, such as Deutsche Bahn, of Germany, or Nedrail, of the Netherlands, are unwilling to step in – which is far from a foregone conclusion given their previously expressed interest in the UK.

But Investec’s Mr Thomas also pinpoints a previously overlooked financial consequence of reversing out of rail. When a train operator wins a franchise, it lodges cash with the Government: a performance bond to cover the risk of withdrawal, and a season-ticket bond to safeguard the prepaid cash of its passengers. These can be substantial: about £158 million in the case of National Express, which already has borrowings of over £1 billion. On the basis of the sector’s existing indebtedness, Mr Thomas calculates that only Stagecoach and Go-Ahead could afford to quit. The other three would breach, or come close to breaching, their banking covenants.

A bailout of train operators is likely to be politically unacceptable; renationalisation too complex. A relaxation of RPI formulas would provide some relief. Even so, the risk is that, like a faulty signal, the big five’s rail returns get stuck on red.

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