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Why SMRT Corporation Ltd’s Management Supports the New Rail Financing Network and Privatization

Change is coming to land transport services provider SMRT Corporation Ltd (SGX: S53).

On 15 July 2016, SMRT and the Land Transport Authority (LTA) announced an agreement to transition the company’s North-South Mass Rapid Transit (MRT) Line, the East-West MRT Line, the Circle MRT line and the Bukit Panjang Light Rail Transit (LRT) line to the New Rail Financing Framework (NRFF).

SMRT has been working with the LTA on the NRFF since 2011. You can find more details about the NRFF here.

This development could be significant, since SMRT’s rail business segment accounted for 52% of total revenue for the company’s financial year ended 31 March 2016 (FY2016).

In its latest earnings report and presentation, SMRT’s management shared its reasoning behind this agreement.

Red ocean

2016-08-09 SMRT Train EBIT
Source: SMRT’s earnings report

SMRT has been posting declining profits under the Current Rail Financing Framework (CRFF), which sees the company absorbing all the risks and rewards that come with operating rail networks.

Under the NRFF, SMRT will share in the risks and rewards with the LTA. An EBIT (earnings before interest and taxes) margin range has been set between 3.5% and 5% for SMRT. In the event when SMRT’s EBIT margin crosses either threshold, there will be sharing of both the upside and downside with the LTA.

Manfred Seah, SMRT’s chief financial officer, said:

“Heavy capital expenditures, enhanced operating standards and stagnating fare revenue have all contributed to the steady decline in profitability for the Rail segment from 23.5% in FY2012 to 9.5% in FY2016. As mentioned, the composite EBIT margin for 1Q FY2017 further declined to 6.1%.

The trend of declining profitability is expected to persist under the Current Rail Financing Framework as the additional capital expenditure and increased depreciation would exert additional pressure on the future cash flows and profitability of the SMRT Trains entities.”

Scenario planning

2016-08-09 SMRT CRFF and NRFF
Source: SMRT’s earnings report

Under the CRFF, SMRT could spend as much as $2.8 billion on capital expenditure over the next five years. With reference to the slide above, the company compared the financial effects of the CRFF with those of the NRFF under three simulated scenarios:

  1. Scenario A adds a $90M depreciation to Base CRFF, based on the aforementioned $2.8 billion in capital expenditure
  2. Scenario B adds a 5% increase in net operating expense to Scenario A
  3. Scenario C adds a 10% increase in net operating expense to Scenario A

Seah commented on the scenarios:

“The graphs in the upper half represent the EBIT margin for the Trains Entities business, while the graphs in the lower half represent percentage of fare increase needed to achieve a 5% composite EBIT margin.

Our base case for the Trains Entities business shows that the CRFF, which has been normalized for FY16 property tax savings (relating to prior years’ over assessment), yield better results than the NRFF.

However, after we factor in the estimated annual depreciation charges relating to the $2.8 billion capital expenditure obligations over the next 5 years under the CRFF (as shown in Scenario A) we can see that the NRFF scenario will yield better results compared to the CRFF.

Scenarios B and C are simulated outcomes after factoring in potential increase in Opex [operating expenses] by 5% and 10% respectively, for the purpose of improving rail reliability and achieving standards set forth by the authorities.

With a 5% increase in Net Opex, the Trains Entities Business is expected to make a loss of about 5.3% under the CRFF but could still achieve a 5% EBIT margin under the NRFF. However, if Opex were to increase by 10%, the EBIT margin expected under the NRFF is only 2.3%.”

Although the NRFF could still cause SMRT’s EBIT margin to fall below the 3.5% lower-bound, Seah said that the three scenarios show that the NRFF is a more sustainable model. He continues:

“This illustration demonstrates that while the NRFF is a more sustainable model than the CRFF in view of the Capex relief and rising Rail Opex, the Trains Entities business is by no means guaranteed a 5% EBIT margin and will continue to face significant operating and regulatory risks, as can be seen from the 2.3% EBIT margin in Scenario C.

In the bottom right of this slide [referring to the slide above], we illustrate the impact on fares should we desire to achieve an EBIT margin of 5% under the conditions in Scenario C. In order to achieve an EBIT margin of 5% under Scenario C, fares would have to increase by 5.5% from the present levels so that the cost pressures could be sufficiently covered.”

SMRT could be presenting these scenarios to reinforce its reasoning for Temasek’s bid to privatise the company. Temasek, which is one of the Singapore government’s investing arms, was already SMRT’s majority shareholder prior to the privatisation offer’s announcement that was made in July this year. Seah added this statement:

“The proposed privatisation will better enable Temasek to closely support the Group as it retools and reinforces its core skillsets in operations, engineering and maintenance, and allow minority shareholders to monetise their holdings through this Scheme and avoid the uncertainties of the transition.”

The ball is now in the investor’s court to decide whether SMRT’s arguments hold water.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.