SMRT Corporation - UOB Kay Hian 2016-07-18: A Steadier Track But With Enforced Speed Limit

SMRT CORPORATION LTD S53.SI

SMRT Corporation (MRT SP) - A Steadier Track But With Enforced Speed Limit

The NRFF introduces a new future for SMRT, one without the burden of financing hefty operating assets, while allowing the incumbent to focus on rail reliability.
While this means savings in capex as well as an improvement in cash flow and gearing, the terms of NRFF are engineered such that rail EBIT margin (which also includes the high EBIT margin non-fare rail business) will be capped largely at 5% through the utilisation of a licence charge mechanism.

In view of a limited earnings growth upside for its rail business, we maintain HOLD with a target price of S$1.60 (previously S$1.48). Entry price: S$1.45.

Last Friday, the LTA and SMRT reached an agreement to transition to the New Rail Financing Framework (NRFF) on 30 Sep 16, a framework which has been undergoing negotiations with the authorities since 2011. As part of the transition to the new model, SMRT will become asset light, through transfer of ownership of its operating assets to LTA, while in turn, paying a licence charge for the operation of assets. Previously burdened with heavy capex requirements related to an ageing rail network, the NRFF is believed to be a more sustainable model for SMRT, which will allow the group to focus on providing quality service to commuters and maintaining trains to ensure smooth operations.
Asset sale includes operating assets of the NSEWL, Circle Lines as well as the Bukit Panjang LRT held by the incumbent. The LTA will purchase these assets at net book value of S$991m on 30 Sep16, for which the cash transfer will be done in phases with S$797m to be paid on the initial completion date, and the balance of the consideration payable over the course of the next three anniversaries of the completion date.
Contract period to be shortened from 30-40 years previously to 15 years. Under the NRFF, SMRT will now operate under a new single licence for a period of 15 years commencing on 1 Oct 16, with the possibility of an extension of 5 years.

Under the existing licence, SMRT’s capital commitments and depreciation charges have increased significantly, with the incumbent having projected an estimated capex of S$2.8b over the next five years and additional depreciation charges of S$90m p.a.
Upon transitioning to NRFF, one of the biggest benefits will come from lower depreciation charges, for which we now estimate an 18% yoy decline to about S$181m for FY17. However, this is offset by licence charges under the NRFF, as well as higher staff costs, given that SMRT will look to increase rail maintenance headcount by about 20% over the next three years. Factoring in these events, we now project FY17-18 net profit to increase by 13-21% from our initial forecast.

With the NRFF, we expect capex going forward to fall into the range of S$100m-200m p.a., from our previous estimate of S$400m p.a.. With stronger cash flow as well as proceeds of S$991m to be received from the sale of assets over the next four years, we expect SMRT to use the proceeds to retire some of its existing debt.
As of latest FY16, SMRT’s net gearing stands at 64%. Assuming SMRT uses 50% of its cash received from asset sales to pay down its debt, we anticipate gearing falling to 1.7% in FY17 and the company turning net cash positive from FY18 onwards.

As mentioned by SMRT, the group does not intend to use proceeds from the sale to pay special dividends to shareholders. Instead, SMRT will use these proceeds to pay down debt and also to service a tax payable of S$159m on the difference between the sales proceeds and the residual capital allowances relating to the operating assets.

Upon review of the agreement terms, we understand that the licence charge has been structured with a two-pronged mechanism (revenue shortfall sharing and profit sharing) to allow SMRT to achieve a composite of both fare and non- fare EBIT margin of 5%, with a collar set at 3.5%.
We believe the profit sharing mechanism does not work well in SMRT’s favour, given the event of SMRT generating an EBIT margin in excess of 5%, LTA will share the upside of up to a maximum of 95% of incremental EBIT margin. While the NRFF may have offered a more stable earnings stream, we reckon the group may have compromised on its higher margin non-fare businesses, which include both rental as well as advertising.
As an indication, operating margin for rental and advertising for FY15-16 stands at about 60-65% and 55-60% respectively, where a large portion stems from the rail business.
Nevertheless, we believe the revenue shortfall sharing mechanism will provide SMRT with downside protection, such that if actual revenue falls short of the target revenue set by the LTA, a shortfall between 2-6% will be shared equally between SMRT and LTA, while LTA will bear 75% of any incremental shortfall beyond 6%.

Our adjustments have factored in the lower depreciation expense incurred from lower capex and transfer of assets to the authorities following NRFF.
However, earnings are partially offset by higher operating expenses, which include an increase in rail maintenance staff cost as well as licence fees to operate trains.

Overall, the NRFF framework has a positive impact on the earnings, cash flow as well as gearing for SMRT, offering it a more sustainable rail business model. However, we believe the terms of the framework capped much of the earnings upside for the incumbent’s rail business, thus diminishing its growth prospects. We continue to favour ComfortDelGro for its overseas growth potential, diversification as well as strong balance sheet. Entry price: S$1.45.

Thai Wei Ying UOB Kay Hian | Andrew Chow CFA UOB Kay Hian | http://research.uobkayhian.com/ 2016-07-18

UOB Kay Hian SGX Stock Analyst Report HOLD Maintain HOLD 1.60 Up 1.48