SMRT Corporation - UOB Kay Hian 2016-08-24: Accept The Offer And Move On

SMRT CORPORATION LTD S53.SI

SMRT Corporation (MRT SP) - Accept The Offer And Move On

We hosted SMRT in an investor presentation where management shared details of the NRFF, as well as the privatisation of SMRT by way of Scheme of Arrangement (SOA).
Management also addressed key questions raised, which mostly revolved around the mechanism of the SOA, as well as the reasons for transitioning to the NRFF.

We re-iterate our recommendation to accept the offer price of S$1.68, which we believe provides a more palatable exit as fundamentals could deteriorate further.

We recently hosted SMRT in an investor presentation. Management shared details of the New Rail Financing Framework (NRFF) as well as the privatisation of SMRT by way of Scheme of Arrangement (SOA). This report highlights the key updates as well as questions raised during the investor meeting.

Key questions raised inluded mechanisms of the SOA, details of key upcoming events for the NRFF EGM and Scheme Meeting, as well as reasons for transitioning to the NRFF.

The rationale of a SOA is to allow minority shareholders the right to vote and determine the outcome as Temasek will not be able to vote. Additionally, it is important to note that the SOA is designed such that it is an “all or nothing” transaction, where the key aim is not for Temasek to increase its shareholdings, but to take the company private. If shareholders do not approve, the delisting will not take place.
We believe that there will be no further changes to the offer price. Additionally, there is a time bar of a year for Temasek to consider another attempt to move SMRT to private ownership should the SOA not succeed this time.
Given our projection that FY17-18F earnings could deteriorate further upon transition to the NRFF, we retain our recommendation for investors to accept the offer.

The EGM for the NRFF will take place on 29 Sep 16 where the threshold for approval is at 50%. We believe the resolution for the NRFF is likely to be passed since it is a positive (from a cash flow and earnings downside perspective) compared with the current rail financing framework (CRFF).

The scheme meeting for shareholders will likely take place in September or October. Under the scheme meeting, there are two conditions which must be satisfied for the scheme meeting to gain shareholder approval:
1. a majority in the number of shareholders present and voting at the Scheme Meeting (50% excluding Temasek), and
2. 75% in value of scheme shares present and voting at the scheme meeting.
The SOA has a risk of not gaining shareholders’ approval due to issues such as poor shareholder turnout, so it is vital for shareholders to exercise their rights and attend the scheme meeting in person or through a proxy vote.

... given the challenges of the CRFF, such as rising operational and maintenance related costs to meet enhanced operating standards as well as fares not keeping pace in accordance with prescribed fare adjustment formula.
Additionally, rail capex spend for the next five years is estimated to reach S$2.8b on the back of an expanded and ageing network. The aggregate 5-year capex of S$2.8b deviates from our CRFF rail capex estimate of S$250m p.a. as it includes the purchase of the CCL Line from the Land Transport Authority (LTA) at book value on 4 May 19 under CRFF (which we believe to be in excess of S$1b). With additional capex and depreciation, this would exert further pressure on SMRT’s free cash flow and future earnings.

Under the NRFF, licence charges will be structured under 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%. The profit sharing mechanism limits the earnings upside of SMRT, where in the event of SMRT generating an EBIT margin in excess of 5%, LTA will share the upside of up to maximum of 95% of incremental EBIT margin. However, the LTA’s downside risk is limited to the quantum of the licence charge payable.
Furthermore, management emphasised that there will be no certainty the trains will earn an EBIT margin of 5%, considering the risks relating to fare adjustments, operating expenditure increases, timing of asset renewal and regulatory changes. As an indication, a scenario with a 10% increase in net operating expense will require a 5.5% increase in fare revenue to achieve composite EBIT margin of 5%, which in our view, is no walk in the park.

While the NRFF may be a more sustainable model run than the CRFF in the long run, we believe the asymmetrical profit sharing model caps the earnings upside for the incumbent’s rail business.
We highly recommend investors accept the offer price of S$1.68, which is above the consensus target price range of S$1.10-1.45. We believe the offer price provides a more palatable exit as we think fundamentals in FY17-18 could deteriorate further.
We continue to favour ComfortDelGro for its overseas growth potential, balance sheet and diversification.

Thai Wei Ying UOB Kay Hian | Andrew Chow CFA UOB Kay Hian | http://research.uobkayhian.com/ 2016-08-24

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