MTRC shareholders dig HK government out of a hole

Hong KongÆs two rail companies will merge but it is a messy arrangement that is a function of political expediency rather than sound financial practice.
Everyone knows that running railways is notoriously difficult but the Hong Kong government appears to have bent over backwards to make it even more complicated.

For the past four years it has been brooding over how to bring the city's two rail companies together under one company. The long running saga was settled earlier this week when the minority shareholders of Hong KongÆs mass transit railway - MTR Corporation (MTRC) û voted in favour of ômergingö with the Kowloon Canton Railway Corporation (KCRC).

The government is calling it a merger but it is closer to a lease.

The scheme the government and its advisers Goldman Sachs and UBS eventually came up with, and to which MTRCÆs minority shareholders accepted this week, was a complex arrangement whereby MTRC leases the railway assets of the KCRC for 50 years on a renewable basis for which it will pay HK$4.25 billion ($547.7 million) upfront and a further HK$750 million annually. At the same time, there are further variable annual payments it has to make on KCRCÆs revenue. In addition, MTRC will also purchase selected development rights and selected investment properties from KCRC for which MTRC will pay a further HK$7.79 billion.

Normally the financially stronger company - MTRC - would acquire the financially weaker - KCRC. But this is no normal deal. It has been pulled into its curious shape by politics.

The government announced in early 2004 that it wanted the two rail providers to operate as one company. Although the government owns 100% of KCRC and 76% of MTRC, the process of bringing the two companies together has been complicated by MTRC's status as a publicly listed company.

MTRC listed in late-2000. Under stock exchange listing rules, the government is a connected party and cannot vote on its restructuring plan. It therefore had to work at convincing minority shareholders that merging in some way with KCRC would bring them financial benefits. This has been made difficult by KCRCÆs sharply declining profits in recent years û a result of losses on its new lines, particularly its West Rail, and sharply rising depreciation costs.

The problem for the government was that if MTRC û as the company with the stronger balance sheet û was to acquire KCRC at a price that appeared to bring benefits to its shareholders, the deal would have to be done at a huge discount to KCRCÆs net asset value of HK$60 billion û some say as much as 50% û which the government, in the wake of the inevitable public outcry, would be unable to swallow.

In addition to securing support from MTRCÆs minority shareholders, it also needed to secure approval from the Legislative Council and having this massive write-down discussed was another reason for seeking an alternative structure for the deal.

To make the deal more appealing to legislators, the government stressed the social advantages of the deal by ordering the two rail companies to come up with, among other things, a plan that would result in synergies and cost savings, as well as fare reductions. And most controversially it also insisted that MTRC give up its fare autonomy and subject itself to an automatic fare adjustment mechanism.

This has been the most controversial aspect of the deal because it was clearly stated in MTRCÆs IPO prospectus that it had fare autonomy and this is why shareholders had been prepared to buy the stock. However, it has been an open secret that political pressure has ensured that MTRC has never raised fares since becoming a public company, though Hong Kong has experienced deflation for most of this period.

A number of commentators have remarked that removing fare autonomy and replacing it with a fare adjustment mechanism, which they say is both vague and crude, could eventually place serious constraints on MTRCÆs future profitability.

One broker noted: ôThe KCRC is significantly better after the lease as it has passed all the business risk to MTRC but has had a HK$12.5 billion inflow to help reduce the debt, with a minimum actual income of HK$1 billion based on 2004 figures being paid, even if the business gets no better for the next 50 years.ö

In his submission to the legislative council committee reviewing the rail merger last year, David Webb, who is a Hong Kong Exchange board member and a shareholder rights activist, wrote: ôFew rational investors would be in favour of a scheme which caps revenues, links the downside on margins to inflation, and saddles MTRC with all of the future capital expenditure but none of the ownership of KCRC rail assets. It would have been far more sensible to negotiate a full corporate merger of the two entities, preserve the fare autonomy, and sell-down the government shareholding to reduce its interference in the transport sector.ö

However, the government has had some luck with the booming property market and stockmarket. Since the agreed price last year, KCRCÆs development property has increased in value by some 25% adding more than HK$2 billion to the value of the deal for MTRC, while MTRCÆs stock price closed at HK$25.55 on Wednesday well up on most broker valuations of around HK$22.

The vote earlier this week got the government off an uncomfortable hook on which it has become caught following a series of missteps that stemmed from its mishandling of the privatisation of the MTRC back in 2004.

The government had originally planned to list both MTRC and KCRC separately. MTRCÆs IPO document of 2000 explicitly stated that the government had no intention of injecting KCRC into MTRC.

The government first became interested in the idea of privatisation during the Asian financial crisis in the late-90s when it became apparent that the decline in asset prices û a traditional source of government revenue û had left the budget deficit with a gaping hole the government was anxious to fill.

In his 1999 budget speech, the then financial secretary, Donald Tsang (now Hong KongÆs chief executive) announced that the government was looking to realise HK$30 billion from the sale of part of its stake in MTRC, in two tranches.

The government eventually raised HK$10 billion from the sale of a 26% stake in October 2000 and then subsequently shot itself in the foot by announcing the two rail companies would have to compete to build a new rail line û the Shatin Central Link (SCL).

Up to this point, MTRC had operated in the urban areas and KCRC in the New Territories north of Kowloon. But the SCL would link the New Territories with Hong KongÆs central business district, bringing the two companies into direct competition for the first time.

This had the immediate effect of delaying any further sale of MTRC shares as if the SCL was built by KCRC, it would bite into MTRCÆs earnings from its lucrative cross-harbour service.

In 2002, the government controversially awarded the SCL to KCRC. This had the unhappy effect of extending the overhang on MTRCÆs stock to around 2008, since the impact of the SCL on MTRCÆs revenue would be unclear until the line became operational.

At the same time, it was becoming clear that with the losses its West Rail was incurring when it opened in December 2003, KCRC could not be listed any time in the near future either.

As a result, the government was advised in early 2004 that, if it wanted to raise more funds from MTRC, it would have to merge the two railways. The move towards a merger was supported by transport experts who said that the railways had reached the point where they were beginning to compete at the expense of the travelling public.

The Hong Kong think-tank û the Civic Exchange û notes in its report æMerging Hong KongÆs Railways', that ôwhile interchanges within either the MTR or the KCRC system are carefully designed to be as convenient as possible, it has not been the case with interchanges between the two rail systems. Under existing arrangements, there is little incentive for the two rail operators to promote smooth interchangesö.

There can be little doubt that in a place the size of Hong Kong it makes sense to have one rail company rather than two. But the corporate structure it will shortly assume is misshapen by the political hoops it has had to pass through and its latent problems are unlikely to emerge for some years by which time the present participants in this arrangement will have left the stage.
¬ Haymarket Media Limited. All rights reserved.
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