MTR Corp hits the road

Investor presentations for Hong Kong''s benchmark privatisation will kick off next Thursday following a crucial meeting this Saturday to determine the final size and structure of the deal.

Scheduled for listing on October 5, MTR will open retail and institutional books on September 25, with pricing occurring three days later on September 28. Having accepted a much lower valuation for the railway and property company that it initially hoped for, the government will settle final deal details with global co-ordinators Goldman Sachs, HSBC and UBS Warburg on Saturday.

Faced with the choice of increasing the size and liquidity of the deal in the face of positive pre-marketing feedback, or opting to chase higher pricing from a second tranche of shares to be issued next year, market participants say that the government is leaning towards the latter option. Consequently, a HK$10 billion ($1.28 billion) offering is now deemed likely, representing a roughly 20% stake.

In addition to making a decision on the exact number of shares to be offered, specialists also say that the government has yet to finally determine what kind of discounts will be offered to retail investors. Having decided against giving MTR users extra discounts, the government has the option of pricing the domestic offering at a discount to the institutional book, or offering loyalty bonuses.

Both incentives were used last November when the government set up the tracker fund (TraHK) to sell down part of the massive share portfolio it had amassed a year earlier after intervening in the stock market. In addition to getting units at a 5.35% discount to the average price of a unit at five minute intervals, retails investors were also given two sets of loyalty bonuses if they held onto scrip for two years. Of the HK$33 billion that was subsequently raised, HK$23 billion was allocated to retail, with the average investor tendering for HK$80,000.

Similar to tracker, MTR will have a much higher retail component than most Hong Kong IPO's, which cap retail at 10% subject to oversubscription triggers that claw back shares from the institutional book.  In the event of books closing 15 to 50 times oversubscribed, for example, the retail component will usually increase from 10% to 30% and for books closing 50 to 100 times oversubscribed, to 40%.

In addition to having a much higher initial retail threshold (likely 20%), bankers say that the deal will also have much easier triggers allowing the government to hit its target 50% placement level among the local population.

Anchoring the transaction with domestic investors and squeezing institutions may have the positive knock-on effect of generating extra price momentum from the latter. As one of only 18 companies in Hong Kong with a valuation of more than $3 billion, MTR will be a core holding for passive index funds.

Bankers comment that funds are indicating a willingness to settle for a roughly 15% to 20% discount to DCF (discounted cash flow). What are considered relatively aggressive levels has surprised some observers who thought that a 30% discount was more likely and particularly in the light of the many doubting press reports that have surrounded the deal to date.

One banker explains. "All the valuation analyses have been done on a DCF basis. Analysts have valued the property component on an NAV (net asset value) basis and the railway component on a DCF basis and then combined the two to get a final DCF for the whole company. Between the three global co-ordinators, the company has been assigned a DCF valuation of HK$47 billion to HK$53 billion."

"Normally," the banker adds, "you would then expect funds to start asking a whole lot of questions about what assumptions lie behind the valuation, such as weighted average cost of capital, inflation rates etc etc. In this instance however, most have just been saying 'yes we think DCF rather than NAV is the right way to value the company and this is the discount we want'. But I suspect that although they do mean this and the deal will be priced as discount to DCF, many investors are actually looking at MTR as a property company."

Hence, some observers believed that in addition to sporting a roughly 15% new issue discount, transaction would also be priced a 25% to 30% discount to NAV in line with the property sector average in Hong Kong, bringing the overall discount up to the 40% level. But as the banker continues, "The reason why MTR will be priced close to DCF is because it is a far less riskier proposition than most property developers."

"Firstly," he says, "MTR has its railway operations as its core earnings base. Secondly it doesn't assume any of the development risks of property projects it undertakes and thirdly, it enjoys a hidden premium. This is because it pays the market average to the government for every plot it purchases, but since its sites are all located around railways stations they are premium land."

For retail investors, one of the key pricing considerations will be what dividend yield the deal will trade at. Analysts were initially sceptical that the company would be able to pay any dividends at all, because of the company's heavy capex burden, which peaks in 2002. Payments would cut interest coverage ratios to shreds and see the company's credit rating downgraded.

However, bankers say that MTR should offer a dividend at the high 4% mark and will be able to do so, because it will pay the dividend as scrip. "Since its major shareholder, the government, will still own more than 50% of the company, it is guaranteed that at least half a scrip dividend will be taken up," says one banker.

At this level, the company will be very competitive with bank deposits that currently yield 4.75%, as well as the property sector where rising stock prices have pushed dividend yields down.  As a comparison, Henderson Land is currently yielding 3% and Cheung Kong 1.44%, while a stable utility like China Light & Power which has solid earnings and low growth is yielding 7%.

"Hong Kong companies have never traditionally paid high dividends, because investors are buying a growth story," says one specialist.  "MTR is very much a play on Hong Kong growth and offers the higher yield of a utility play combined with the growth potential of a property play."

However, this unusual and some might say uncomplimentary mix has been the major complicating factor behind analysis of a company for which there is no listed global benchmark.

Where analysts all agree, is that MTR is one of Hong Kong's best managed companies. "The company's treasury team have done a fantastic job," says one." Over the first six months of 2000, for example, ebitda grew 11.3% year on year largely thanks to cost control efforts." 

Total revenue over the period grew 5.3% to HK$3.65 billion ($472 million), principally because of 20.6% revenue growth on the company's new Airport Express line. Overall profit, on the other hand, fell 8.4% to HK$1.051 billion because of lower income from property development, which fell to HK$746 million from HK$1.026 billion over the same period of the previous year.

Analysts also agree that future earnings forecasts for MTR are almost impossible to determine because there is no clear pattern to its property incomes. Because the company does not have a large rental cushion to its property portfolio, revenues are extremely lumpy and almost exclusively tied to individual project development. Hence in 1997, MTR recorded profit on property development of only HK$276 million, but in 1998, profit of HK$1.41 billion.

Adding to the equation is the fact that the company does not (as yet) disclose its profit-sharing formula and the up-front payments it receives from the property companies invited to develop projects along its railway lines.

Where the railway operations are concerned, bankers and analysts remain divided. Some analysts argue that although the company has a heavy capital expenditure programme, Hong Kong is reaching saturation point where transport development is concerned. In particular, a number of analysts point out that the provision of new lines is being counterbalanced by declining ridership on existing lines.

In the first six months of 2000, for instance, total passenger numbers declined 2.6% year on year to 376 million, as more and more air-conditioned buses provide greater competition. One notable exception was the Airport Express line, which saw passenger levels increase from 28,000 to 29,000.

But bankers counterargue, that there are signs of a turnaround. "As the economy improves and growth picks up, ridership improves and the current decline will be turned around," says one.