Full steam ahead

Hong Kong government announces the merger of its two train operators, subject to the approval of MTR CorpÆs minority shareholders.

In a welcome display of transparency and decisiveness, the government of Hong Kong yesterday announced that its two rail operators would start merger negotiations. As the government owns 76% of MTR Corp and 100% of KCRC, it alone could force the two warring sides to start talking to each other. However, sources close to the deal say that any eventual deal will only go ahead if MTR Corp's minority shareholders approve it.

"We have examined carefully the pros and cons of a proposed merger. We believe that a merger of the two railway corporations could bring synergies and more effective utilisation of resources for the two corporations," a government spokesman said. "We have hence invited the two railway corporations to commence negotiations on a possible merger."

The government has also made public a series of parameters under which the negotiations will take place. On the downside for shareholders the deal will have to mean the combined company can adopt "a more objective and transparent fare adjustment mechanism... [as well as] ...the abolition of the second boarding charge and review of the fare structure with the objective of reducing fares."

Other deal parameters include dealing with interchange issues between the two companies and protecting jobs. Negotiations will have to be concluded in six months time. On the plus side for MTR Corp's minorities, there is scope for the company to pull out of the deal if enough synergies cannot be found from an operational, management and development point of view.

In other words the merger will only go ahead if it makes sense for MTR Corp shareholders. "It's expected that the merger will result in a stronger company with enhanced growth potential and a world class rail company in which all employees can take pride," says Raymond Kuo-fung Ch'ien, chairman of MTRC. "Terms of the merger will be evaluated and structured to gain minority shareholder's approval."

Key to the discussions will be who will actually be buying who. Most market talk is of the MTR buying the KCRC, even though the KCRC is actually slightly larger in terms of assets. MTR has a market cap of almost HK$68 billion ($8.7 billion).

Given that the MTRC is partially privatized and has a hard-won ordinance from the Legislative Council, it would be much easier for it to be the purchaser than the KCRC, which is still a statutory board of the government. If this were the case it would adhere to the government's long-standing policy of putting these assets into public hands.

"This is a different way of privatizing the KCRC," said a banker close to the deal, speaking off the record. From a credit standpoint, any diminution of government ownership of the combined entity will be viewed negatively by the rating agencies, which would create issues for bondholders of both the MTR and KCRC.

But given how essential the merged entity would be to Hong Kong itself, government support on the credit side will undoubtedly be strong. "Standard & Poor's will monitor how the government merges the two companies," says Mary Ellen Olson, a credit analyst at Standard & Poor's in Hong Kong. "Important issues to consider include regulations, such as fare setting, the post merger financial profile of the merged entity, ownership levels, and any explicit expressions of support".

Olson believes that if the actual ownership levels of the government decrease, credit protection could be provided through mechanisms such as the continuation of property grants, the asset buyout provisions already granted to MTR bondholders and perhaps even explicit guarantees.

"This will become a very important assets to Hong Kong... but even then we would like to see some [support] that is explicit.," she says.

Interestingly no financial advisers have been announced as no formal mandate letters have gone out to banks for the merger. However, strong relationships exist on both sides, with Goldman Sachs, UBS and HSBC being close to MTR while Morgan Stanley is known to be close to KCRC. Rothschild has been advising the government on general transport issues.

The deal has strong political ramifications as well. Dr Sarah Liao, secretary for the environment, transport and works has been trying to get both MTR and KCRC to reduce their fares for over a year and this deal very much has her imprimatur. Moreover, the financial secretary Henry Tang made a bold commitment to privatization from his first few weeks in office.

This merger will enable a much clearer picture to emerge in terms of fares and ownership, which in turn would ease future sales of government stakes. Moreover, if the acquirer turns out to be the MTR, then this will diminish the influence of the Legislative Council in running this aspect of the transport policy. And any diminution of Legco influence always makes the Tung administration cheerful.