MTR Corp takes investors along for the ride

The IPO of the Mass Transit Railway Corporation [66] will be a success. That much is assured. The Government and the issue’s sponsors, in this case Goldman Sachs, HSBC Investment Bank and UBS Warburg, have launched an outright offensive to ensure a positive reception to Hong Kong’s first privatization of a public corporation.

All the stops have been pulled out including a populist television advertising campaign, the establishment of the www.mtripo.com.hk website and an official launch ceremony, complete with champers and caviar, at Government House.

Never mind that a number of questions remain unanswered regarding the longer-term prospects of the company, its valuation, what exactly is on offer or the reasons for the privatization. Hong Kong punters love a bargain and are likely to pour into this IPO. StockHouse readers could do worse than to go along for the ride.

The average duration of an MTR journey is only 15 minutes (that’s why there are no public toilets in any of the stations). Investors should treat the offering with similar regard. Buy a ticket. Step aboard. And disembark. Fast, clean and efficient, like the service it provides.

“But is it a bargain?” cry the cynics from the gallery. This question is difficult to answer given the Government’s refusal to release the listing prospectus until the application process commences. We attempt to get at the nuts and bolts of the issue below based on a copy of a draft prospectus circulated to select brokers that StockHouse has obtained.

But for now, the perception of a bargain is enough and this has been successfully fashioned through a price discount for retail investors and a two-step loyalty bonus similar to that offered for the Tracker [2800] fund. Add in the everyday role the MTR plays in the lives of most Hong Kong citizens and you have a tangible story whose simplicity can appeal to even the least sophisticated of investor. The touchy-feeliness of it is hard to resist.

MTRC will be a core holding for any Hong Kong passive or index fund. Most likely it will become a Hang Seng Index constituent before too long as well as take its place in other benchmarks. Institutional demand will be strong.

The nuts and bolts

The Government is selling 1.0 billion shares equal to 20% of the Company at a price between HK$8.00 ($1.03) and HK$9.38 per share. This would give the MTRC a market capitalization of between HK$40.0 billion and HK$46.9 billion and make it the Stock Exchange’s 20th largest company.

It is intended that 200 million shares will be offered to Hong Kong retail investors, but if demand is heavy and the issue significantly oversubscribed, a claw back clause squeezes the portion allocated to institutional investors and awards it to local punters. Institutions would be relegated to the secondary market and further facilitate our get on get off strategy.

Hong Kong retail investors will be offered a 5.25% discount to the institutional price and receive a one-for-20 loyalty bonus at the end of one year and a further one-for-15 bonus at the end of the second. This alone equates to a two-year return of 18.2%.

Factor in an “expected” annual dividend yield of “approximately 4.5%” (as stated in the draft prospectus) and you can see the punters thinking, “That’s not too bad.” But there is no mention of future payout policy except that the Government (as the major shareholder) will elect to receive some or all of its entitlement in the form of scrip. The forecast dividend yield is for the current year only.

Beyond that is not hard to guess. Net debt of HK$26.0 billion as at 31 July 2000 and planned capital expenditure of HK$24.3 billion to 2002 would appear to limit and perhaps even depress the payout ratio. A yield of 3.0% would be less than half what other utilities are paying out.

On a PER basis, the MTRC is coming to market at 11.1 times to 13.0 times current year earnings. Net profit of “not less than HK$3.6 billion”, equal to HK$0.72 per share, is forecast in the draft prospectus. How this figure was arrived at was left out. Even the section relating to the subject in the appendix was “intentionally left blank”.

Nevertheless, net profit of HK$3.6 billion for the year to 31 December 2000 would represent YoY growth of 70.1% and follow FY1999’s 24.9% decline. The volatility you see is a result of property development contributions. In 1999, this segment accounted for 58.3% of earnings after depreciation of the MTRC. In 1998, it was 43.1%. In the 1H of 2000, it was 54.2%.

There is no breakdown for the level of property development contributions in the 2000 earnings forecast. Nor does the draft prospectus include profit forecasts for any future years. But an HSBC Securities (one of the underwriters) August report does include profit forecasts going forward.

HSBC estimates that net profit for 2001 will rise 132.4% to HK$8.4 billion, largely on the fortuitous timing of property development projects. But in the year after, earnings will drop by half in the face of a shortfall in development contributions.

This type of unpredictability is not what is expected of a utility. On a longer-term view, property contributions will not only be inextricably tied to the broader performance of the notoriously hot-blooded Hong Kong property market but also on the MTRC’s ability to secure development approvals.

The draft listing prospectus does state that the Company has a net asset value of HK$79.3 billion, equal to HK$15.88 per share. As such, the offering is being touted at a discount of 40.9% to 49.6% to NAV. The HK$15.88 figure was dated 31 July and represents a revaluation carried out by Brooke International (China) Ltd.

There is no mention of how Brooke International managed to lift the MTRC’s net asset value by HK$31.7 billion or 67% in only one month except a note stating “the surplus arises after adjusting for the balance of the amounts of up-front payments received or receivable by the Company in respect of the awarded packages and Kowloon Station Development Packages Five, Six and Seven.” More notably, the note goes on to state, “The surplus will not be incorporated in the financial statements of the Company for the year ending 31 December 2000.”

The net asset value of the Company, as deemed by KPMG on June 30, was HK$47.2 billion, although a balance sheet was noticeably left out of the draft prospectus. This would have placed the per share NAV at HK$9.45, slightly above the indicative price range and which brings us back to the perception of a bargain theme.

Between the tracks

The trains lose money. But that shouldn’t surprise anyone given the titanic capital expenditure required to build the stations, tunnels, bridges and rolling stock. Nor would many dispute the idea that the provision of an efficient subway system should be a sort of social subsidy provided by the Government.

But as an ongoing business concern, the MTRC’s railway operations look less than rosy. Patronage has declined since 1996 despite the opening of the Tung Chung Line on 22 June 1998. From January 1996 to the end of 1999, the number of passengers riding the MTRC’s trains fell at a compound average annual rate of 1.5%. The first six months of 2000 show a further drop. Meanwhile, that HSBC Securities research report forecasts passenger growth of 3.0% annually for the next 15 years.

Some new lines are planned and a few others are awaiting approval. The former consist of the Tsueng Kwan O extension and the Quarry Bay Relief works. A Penny’s Bay Rail Link, to support the new Disneyland on Lantau Island, has also been approved. However, final approval is required for the extension of the current Island Line while the much talked about Sha Tin to Central Line has yet to be and may never be awarded to the MTRC.

If the experience of the Airport Express is anything to go by, the Company may want to forgo the new projects. Since its opening on 6 Jul 1998, the Airport Express has been a calamity as a business concern but as a mode of transport, it’s a fast, clean and efficient way to get to the airport.

Above ground

As an important source of income to finance the construction of the railway projects, property development plays a crucial role in the Company’s overall operations.

The amount of actual profit that can be realized by the MTRC depends on the development costs, the ability to sell or lease the completed properties, the market competition prevailing at the time of sale or leasing and the general economic situation.

It should be pointed out that in the event that a development ends up in a loss, where the sales proceeds or rental income is insufficient to cover the development cost and the upfront payment, the MTRC holds no liability whatsoever and the developer alone bears the loss.

To date, a total of 15 development packages above or around the five Tung Chung Line MTR stations have been awarded. The stations are Hong Kong, Kowloon, Olympic, Tsing Yi and Tung Chung. These packages will comprise 26,620 residential units and approximately 14 million sq ft of commercial space, of which approximately 30% and 22%, respectively, have been completed. The balance is expected to be completed before 2007.

The Company’s entitlement to profits or “shares in kind” for the above station developments is as follows:

Tung Chung Line Property Developments

The Company derives most of its rental income from the following major rental properties:

MTRC Major Investment Properties

The MTRC has secured the right to undertake development at four locations on the Tseung Kwan O Line under the TKE Project Agreement with the Government. Collectively, the four development projects will comprise a total floor area of approximately 25 million sq ft, made up of 28,800 residential units and 2.53 million sq ft of commercial space.

The four developments listed below will be divided into 23 packages to be offered for tender. Completion is planned over the next decade.

Tsueng Kwan O Property Development Projects

End of the line

It’s not a pure utility. It’s not a pure property play. The (arguably incompatible) combination of the two makes the MTRC a hybrid animal unlike any other. Do the prime property assets boost the railway’s return? Or do the volatile property earnings purge the railway’s stability?

More than likely the answer is both and, like most things, all a matter of timing. So purchase a ticket, get on board but don’t forget when to get off.

Copyright StockHouse Media Corporation