■ Rail segment operating losses look set to persist over medium term
■ Market expectations of a new rail model appear unfounded to us
■ Initiating coverage with Underperform (4); TP of SGD1.31
We initiate coverage of SMRT Corp (SMRT) with an Underperform (4) rating. While the Singapore Government’s overhaul of the public transport sector across rail and bus segments signals a more favourable outlook for incumbent players, we believe the bus operators are positioned to benefit from an arguably more attractive change in the business model than the rail segment, mainly as revenue and ridership risks will be effectively transferred to the government in the case of the former.
Considering that the rail business is SMRT’s largest segment (53% of FY15 revenue), while the bus segment is ComfortDelGro’s (CDG) (CD SP, SGD2.96, Buy ) largest segment (32% of its Singapore revenue), CDG appears better placed to leverage this shift in the operational landscape. Accordingly, we recommend investors seeking exposure to the defensive Singapore transport services sector to switch from SMRT to CDG. Meanwhile, we forecast the operating losses for SMRT’s rail segment to persist over FY16-18, as it grapples with dealing with network disruptions, while concurrently executing its rail-enhancement projects.
Finally, market expectations of a positive outcome for rail reforms in the near term appear unfounded to us, given the lack of clarity – comments made by both the former and current transport minister suggest instead that the central agenda remains on improving Singapore’s rail reliability before addressing asset acquisitions. We believe negotiations between SMRT and the government will gain traction only after the operator has fulfilled its obligations to return rail network reliability to satisfactory levels under its existing licence requirements – indicating a timeline that could stretch beyond 2018.
In the near term, we see the following derating catalysts:
1) news flow suggesting a delay in the implementation of a new rail model,
2) a sharper-than-expected deterioration in the rail segment’s margin, driven by higher repair/maintenance expenses, and to a lesser extent,
3) further major service disruptions to its network, which may result in significant penalties imposed by the regulator.
We adopt a DCF-based approach to value SMRT’s shares, deriving a 12-month target price of SGD1.31. We value SMRT with the following inputs: a WACC of 7.2%, comprising a 6% equity-risk premium, risk-free rate of 2.6% and a terminal FCF growth rate of 1.0%.
The main risks to our call would be regulatory risks in the form of positive rail reforms as well as a decrease in labour costs. (Read Report)