ComfortDelGro Corporation (CD SP) - UOB Kay Hian 2016-09-20: Wheels Of Change Offer Entry Opportunity

COMFORTDELGRO CORPORATION LTD C52.SI

ComfortDelGro Corporation (CD SP) - Wheels Of Change Offer Entry Opportunity

The past months have seen major changes, ranging from SMRT’s transition to NRFF, the bus contracting model and disruption from private car hire operators.
We analyse the potential implications of each of these events and believe that current share price weakness is a buying opportunity.

Also, we have revised our valuation methodology from DCF to PE-based, reflecting the uncertainty and ongoing changes in the sector.
Maintain BUY with PE-based target price of S$3.11 (previously S$3.22).

Share price of ComfortDelGro Corporation (CD) has retraced 7.6% from its recent high, and is now close to the levels post Brexit period.
We reckon the share price pullback is due to several factors, including concerns over the New Rail Financing Framework (NRFF) terms for the North-East Line (NEL), margin outlook for the bus government contracting model (GCM) and the ongoing disruption from private car hire operators in the taxi segment.
This report highlights our key takeaways on CD following our channel checks as well as meeting with management.

As rail lines began their transition to NRFF, all eyes are now on NEL, which remains under the old rail financing framework, despite being asset-light. While the NRFF structure for SMRT serves as a reference point, we believe the terms of SMRT’s NRFF should not be taken lock, stock and barrel with regard to NEL. We think it is important to look at these terms based on the lifecycle of the various rail lines (NSEWL: 30 years vs NEL: 14 years) as well as the earnings history of the two incumbents. If we reference the historical earnings of SMRT, the operator has enjoyed a sizeable rail profit margin of up to 29% since 1998.
On the other hand, NEL, which has been in operations since Jun 03, has yet to see its margins reach full potential. With regard to this, we believe the onerous profit cap and collar policy set by the Land Transport Agency (LTA) on SMRT may have been calibrated to reflect the “supernormal” earnings SMRT has garnered in the past and may not necessarily apply to CD.
With negotiations already underway, we anticipate CD’s NRFF transition to take place likely in end-17 - the period when Downtown Line (DTL) III is due for completion and the entire DTL anticipated to break even.

In the next one year, we believe taxi earnings will remain relatively intact, and we continue to assume hire-out rate of 99% with a 3.0% growth in taxi bookings (1H16: +2.5% yoy) in FY16-17. Interestingly, Transport Minister Ng Chee Meng indicated in a recent Parliament statement that the average monthly net income of drivers rose about 5% in real terms due to lower fuel costs.
Furthermore, the government has acknowledged that more needs to be done to level the playing field between taxis and ride hailing services, where we anticipate a potential review of the taxi availability framework by end-16. Having said that, we are also cognisant of the increasingly challenging operating environment for taxis, as inroads of private car hire operators rattled the status quo of the traditional taxi business.
We reckon that in the medium to longer term, taxi operators may be inclined to introduce initiatives targeted at attracting a more diverse driver profile, such as increasing flexibility in rental policies or putting up cheaper cars for hire.

CD’s wholly-owned subsidiary Metroline is one of the biggest bus operators in London, with about a 19% market share (Go-Ahead is the largest bus operator with 24%). As Metroline operates under the gross cost contract/quality incentive contract model, the London bus operations does not bear any revenue risk.
Metroline was able to maintain a strong operating margin of 8-9% based on efficient cost management, where we estimate Metroline tenders for bus routes on a 3- 4% profit margin, with the additional 4-5% derived from cost efficiency.

According to the negotiated contract starting 1 Sep 16, SBS Transit (SBST) will be paid a contract fee estimated to be worth S$5.32b for seven years. The contract fee will cover the service fee for the provision of bus services (ie the cost to operate the services as well as an agreed operating margin), and leasing fees based on depreciation of the buses over the statutory lifespan.
The fee however does not take into account adjustments for inflation, wages, fuel costs, incentive/disincentive payment during the contract period as well as advertising and rental revenue.
Under the bus contracting model, we estimate SBST to generate FY17- 18 bus EBIT of S$65m-70m p.a., translating into margins of as high as 8.1-8.8%. This is in line with CD’s UK bus operating margin, and higher than historical Singapore bus margins of 1-3% (2013-15)

We reduce our 2016-17 net profit forecasts by up to 5% as we modelled in:
1. transition of Loyang bus package to the third bus operator in September,
2. lower assumption for growth in taxi bookings to 3% (previously 4%) and
3. lower growth assumption for international taxi operations of 1% (previously 2%) to reflect the increasingly competitive taxi business.

We are changing our valuation methodology from DCF to PE, given the structural changes in the land transport sector and increasingly competitive taxi business. Based on our new methodology, our target price is S$3.11, based on 17.9x FY17F PE, which is a 10% premium to the 10-year mean PE.
The premium looks deserved as 2017-18F ROE are higher than the long-term mean ROE of 13.9%, CD is more diversified (in terms of segment and geography), with a stronger cash flow generation capability now.
Also, we believe there is dividend payout upside as its Singapore bus and rail segments transit to an asset-light model.

Andrew Chow CFA UOB Kay Hian | Thai Wei Ying UOB Kay Hian | http://research.uobkayhian.com/ 2016-09-20

UOB Kay Hian SGX Stock Analyst Report BUY Maintain BUY 3.11 Down 3.220