The proposed "merger" of MTR and KCR railways is in danger of derailment. It removes revenue upside from a potential market-based reform of transport policy and ensures a reducing profit margin, at a speed which depends on the future rate of inflation. This will not be acceptable to minority shareholders. The flaws result from the Government's socialist transport policy which means that there simply isn't enough revenue to go around. If that is the long-term transport plan, then they should just admit it and buy out MTRC minority shareholders.

Going Off the Rails
11 June 2006

The Hong Kong Government's proposed deal to unite the operations (but not ownership) of the two rail networks of Hong Kong, the Mass Transit Railway, owned by MTR Corporation Ltd (MTRC, 0066, majority-owned by Government) and the rail system owned by Kowloon-Canton Railway Corporation (a statutory corporation wholly-owned by Government), is in danger of derailing. The deal is subject to approval of the minority shareholders of MTRC. At this stage, the Government and MTRC have entered into a non-binding and confidential Memorandum of Understanding (MoU), so there is still time for them to amend the deal before they sign definitive agreements and put it to a vote.

There are 2 main reasons why independent shareholders are likely to vote against, and why we will recommend that they do so unless the deal is amended:

In essence, the deal removes revenue upside from a potential market-based reform of transport policy and ensures a reducing profit margin, at a speed which depends on the future rate of inflation. As we will explain, the flaws result from the Government's socialist public transport policy which means that there simply isn't enough revenue to go around. If that is the long-term transport plan, then the Government should just admit it and buy out MTRC minority shareholders, rather than asking it to give up its free-market potential.

Now let's deal with these issues in detail...

The revenue-sharing formula

The MoU provides that in return for the right to use existing KCR rail and rail-related assets, the MTR would pay, for the next 50 years, a share of revenue to KCRC as follows:

  1. A flat payment of HK$750m per year, equivalent to 30% of the first $2.5bn of revenue.
  2. 10% of any revenue from $2.5bn to $5.0bn
  3. 15% of any revenue from $5.0bn to $7.5bn
  4. 35% of any revenue above $7.5bn

The percentage payments would begin in year 4. Now based on revenue of $5,236m in 2005, as quoted in the MTRC presentation, the formula would result in a present payment of $1,035m, or 19.8% of the revenue. The catch, however, is that the thresholds continue unchanged until the end of a 50-year post-merger franchise, and inflation over time will push up the nominal revenue figure so that more and more revenue appears in the upper 35% band.

Taking a medium-case scenario of inflation of 5% per year for the next 50 years, which is in line with the current long-bond yield, the revenues would be $22.6bn 30 years from now, and $60.0bn by year 50. That's before allowing for any real revenue growth from the KCR assets under construction, namely the Kowloon Southern Link (KSL) and the Lok Ma Chau (LMC) Spur Link. They just make the problem worse, because they will push revenue into the 35% band sooner. And inflation, of course, could be a lot worse than 5%.

The table below shows you the range of nominal revenues depending on the rate of inflation:

and as a consequence, the payments to KCRC, owned by Government, would be as follows:

which means that the revenue share payable to KCRC is as follows:

Notice how the percentage share accelerates after year 10? That's when revenue has broken through the $7.5bn boundary. In fact, with 5% inflation they get there after 8 years (around 2014), and everything above it get's charged at 35%. Oh, and we almost forgot, MTRC also has to pay HK$4.25bn up front.

As you can see from the tables, the future revenue sharing percentage, and hence the profit available to MTRC, is heavily dependent on the inflation rate. When we asked the MTRC board at last week's AGM what inflation assumption, if any, they had made in evaluating this deal, the CFO refused to say, other than "a range", and then he went off on an irrelevant tangent about how there would be an "independent board committee" comprised of "independent directors", all of whom, of course, are elected by the Government, which is MTRC's majority shareholder and also owns KCRC.

Future capital expenditure

Did you notice that we said "existing" KCRC assets? That's because all the burden of the future maintenance and replacement of those assets, including trains, control and signalling equipment, tunnel repairs, and so on, will fall on MTRC. All that MTRC gets is the existing assets "as is", plus the finished KSL and LMC Spur Line, and at the end of the 50-year franchise, the rights to all of it will revert to KCRC. This is, in essence, a "repair and replace" lease of assets. As the Government explained in a paper to the Legislative Council:

"KCRC [will] retain ownership of the assets, capture the upside of KCR railway's performance under a revenue-sharing mechanism and get back a fully operational railway system at the end or upon early termination of the service concession."

Sounds great for KCRC, but what does that leave for MTRC then? In early years of the 50-year franchise, the burden of capital expenditure on KCR assets may be relatively light, as the trains are not so old, but you can be confident that the trains will either be worn out or obsolete within a couple of decades. So at the same time as revenue sharing will be increasing towards the maximum of 35%, capital expenditure will also be increasing. In effect, long before 2056, when the franchise expires, virtually all of the assets apart from the tunnels themselves will have been replaced using MTRC's dollar, but those replaced assets will then revert to KCRC as a "fully operational railway system" without any payment in return.

Fare autonomy

A huge selling point in MTRC's prospectus from 2000 was:

"[MTRC] has autonomy to determine its own fares without any requirement to obtain the approval of Government or any other body."

To understand why this is so important, you have to realise that the current HK Government pursues a socialist transport policy in which all forms of domestic public transport are indirectly subsidised. Franchised buses, for example, pay only $50 per seat per year (plus $25 for the driver) in vehicle tax, and are exempt from fuel duty, which means they pay no incremental costs for road usage or air pollution. As a consequence, bus fares are far lower than they would be on a "user pays" basis for the roads (including the land they occupy, road construction and maintenance) and air pollution. Hence rail fares have to be low to compete with the subsidised buses. There's also no duty on LPG, which powers most taxis and an increasing proportion of minibuses, even though LPG still creates air pollution and the vehicles still use roads.

The Government even prohibits the registration of private cars which run on LPG, because that would allow private motorists to benefit from the hidden subsidy to taxis. For the same reason, they prohibit (by excessively high emissions standards) the registration of private diesel cars, so that the Government can subsidise goods vehicles and private buses, which pay only $1.11 per litre of ultra-low sulphur diesel compared with $6.06 per litre of unleaded petrol. So if you are jealous of motorists in Europe using fuel-efficient modern diesel-powered cars, or of Australians in their LPG-powered cars, then you are out of luck.

In the face of all this subsidised competition, the only way HK's railways can be made financially viable is to subsidise them too, mainly with property development rights, which are granted to the rail companies, which then enter into joint ventures (on secret terms) with members of the property development oligopoly to develop the sites. The land premiums for these sites are discounted on the basis that the railway station does not exist, and that allows the rail company to capture the uplift in value even though they didn't own the land around the station to start with. Most ironically, the value of housing in remoter parts of HK is supported by the low cost of getting to work in the urban areas on this subsidised transport.

The upside of fare autonomy

A future, wiser government may see the merits of shifting towards a market-based user-pays transport policy. For example, they may introduce electronic road pricing (for all vehicles), and make buses pay for air pollution by charging fuel duty on each litre of fuel they burn. They might also auction "landing slots" at urban bus stops to incentivise more efficient routing, increasing the use of interchange hubs and reducing urban congestion and pollution.

If a future Government pursued a user-pays transport policy, then road transport costs and fares would increase, and railways would be able to raise fares to a more commercial level, thereby raising profits. The taxpayer would also benefit, because the Government would get higher revenues from fuel duty and new revenues from road pricing, and would be able to withdraw some or all of the property subsidy to the rail companies and sell the land directly in the open market at full value. Land which would have been needed for yet more roads could instead be used for other purposes. The additional revenue would allow tax cuts, helping those who use the transport in the first place. Those who live nearer work or school would cease to cross-subsidise those who travel further.

So the potential for real increases in fares under a less socialist, more market-based, user-pays transport policy offers tremendous potential for MTRC, and that's the value of fare autonomy, but they propose to give this up, with the exception of the Airport Express railway, cross-border links to the mainland, and the cable car to the Lantau Big Buddha - so what, these are already closer to user-pays cost anyway.

In the proposed deal, future fare increases would be capped at the rate of inflation minus a productivity factor. The rate of inflation would be the average of the Composite Consumer Price Index and the Transport Wage Index. The productivity factor, which would be excluded for the first 5 years, would start at 0.1% per year, and would be reviewed every 5 years.

So what you have here is a formula which allows for no real (inflation-adjusted) increase in fares, but gives an ever higher proportion of revenue to KCRC while saddling MTRC with future capital expenditure. MTRC has pitched this to investors as a "Downside protection provided by Variable Annual Payment structure", when in fact this is an "upside-removed, downside on inflation" deal.

Pandering

There is barely a day goes by without elected politicians from the democratic or pro-Beijing camp berating the government for this or that high fare on buses, ferries or trains. It's an easy way to score points with the electorate, many of whom live in subsidised housing and have missed out on the benefits of Hong Kong's economic growth in recent decades, thanks in part to the way the economy is dominated by cartels.

But the fact is, we have some of the lowest fares in the world for any modern rail or bus network, subsidised or not. In London, for example, you can't go anywhere on the tube for less than a pound (HK$14.28), even though London Transport received GBP651m (HK$9.3bn) in grants in 2002/03. In HK, you can go from Chai Wan to Tsuen Wan, a 51 minute journey from the end of one line to the far end of another, for HK$11.80, or you can take a bus all the way from Central to Stanley Prison (handy for visiting the relatives) for $7.90.

The Government has attempted to buy legislative approval of the merger with a package of rail fare cuts, so that if legislators vote it down, the Government will accuse them of voting against fare cuts.  For example, in a blatant PR ploy, for 1 year after the merger there would be a $2 Sunday fare for the elderly. There would also be a 2-year fare freeze. These proposed fare cuts will more than eliminate the near-term savings achieved from synergies, including what they euphemistically call "staff synergy" (job losses) in the management layers.

Confidentiality or collusion?

The MoU is described as "Confidential". What is it that the Government doesn't want us to see, and why won't they publish it? We asked that at the MTRC AGM too, and got the usual puff about "commercial sensitivity". The secrecy with which the rail companies conduct their property projects, including the financial details of winning tenders, leaves an enduring suspicion of potential economic inefficiency or, at worst, collusion. There is no logic in the argument that the terms of a winning tender should be secret. Transparency would ensure a more level playing field for developers, and probably increase proceeds since it would help bidders in future tenders to make more competitive bids.

Transparency would also reduce the risk of multi-parameter bids turning an objective single-parameter tender into a subjective beauty parade. For example, if one bidder offers to let MTRC keep some retail space and a 30% profit share on the residential portion of the project, and another bidder offers a 35% profit-share but no retail space, then which bid is better? It depends on your view of future prices, and the secrecy ensures that the railway companies don't have to justify their choice. In such situations, MTRC and KCRC could just as easily be allocating the projects among the developer oligopoly based on an "it's your turn now" principle. Share it around and keep them all happy. We hope that's not the case, but without transparency, we'll never know.

AGM behind closed doors

Speaking of transparency, you might be wondering why all the questions we asked at the AGM on Thursday, and the evasive answers we received, were not reported earlier. That's because, for the first time, MTRC shut out the media. They also moved the AGM from the Convention Centre to a smaller venue, and on the front cover of the circular, they said in bold "Please note that light refreshments will be provided". They knew that if you invite 310,000 people to refreshments, then the hungry retirees of Hong Kong will turn out en-masse in the hope of a free lunch box (they only got cookies, but that's the way it crumbles). Many of the same people show up at the Towngas or PCCW AGMs. That's why the MTRC AGM circular up to 2004 said in bold "Please note that refreshments will not be served".

One sure way to push an AGM along is to flood it with people who are more interested in the food than the discussion, and who heckle questioners to hurry up. Nevertheless, the media were excluded before the huddled masses showed up, so claims that the media were excluded due to the high turnout are false - they were never admitted to start with. MTRC had arranged a separate media briefing at a nearby hotel, but that's no excuse for closing the AGM to coverage.

Hong Kong was built on the rule of law and freedom of speech and the media, and we think it sends a very bad signal when a government-controlled company with 310,000 shareholders, over 99% of whom could not attend, excludes the media from reporting on proceedings. Defending the fourth estate, we engaged the Chairman in a 30-minute debate over this, and we threatened to propose a motion of adjournment and demand a poll on it, which would have taken an hour or so, and perhaps would have changed his mind (as we did in Cathay Pacific in 2003). The hungry holders heckled. In the end, we compromised on an undertaking from the Chairman that the whole proceedings would be webcast within 48 hours, and they did so, but next year, we will not be so soft! You can watch the webcast in broadband or narrowband.

Note to media editors

We made a point of forcing open the doors of blue-chip meetings to the media when we launched Project Poll in 2003, but we have noticed recently a number of companies are back-sliding on this, treating themselves as private companies rather than public companies and shutting out reporters. They can't stand the heat. We shall be more vigilant in the next year. We also remind journalists that in respect of blue chip companies, we can appoint you as proxy for 1 share each if you want to attend and observe, up to a maximum of 5 journalists per meeting, but we need a week's notice before the meeting. Your independence is maintained because we do not require you to vote the share. So plan ahead!

Where's the profit?

Now back to the so-called merger, or more accurately, the 50-year lease.

In 2005, KCRC had earnings before interest, tax, depreciation and amortisation (EBITDA) of $2,356m, or 43.8% of corresponding revenue. This was depressed partly by the opening of West Rail, but it has never been higher than 55.1%, which it reached in 2002, and was as low as 42.9% in 1995, according to the MTRC presentation. Even if we generously assume a gradual recovery to the long-term average of 49% EBITDA, when you take off a future revenue share of about 30% for KCRC, you are looking at an EBITDA margin of only 19%, out of which you have to finance and depreciate future capital expenditure on asset replacement (this averaged 14% of KCRC revenues in the last 3 years), leaving perhaps a low single-digit profit margin if we are lucky. Things may look OK in 2006, but it's all downhill from here.

Now you might think that there is some sort of compensation for taking on a near profit-less railway, such as more property development rights. However, that is not true, because although MTRC will get some developments, they have to pay KCRC $4.91bn for the full fair market value of those rights (which KCRC received from Government for free in the past), based on a professional independent valuation. So there's no free lunch there, no compensation for taking on the railway on such poor terms.

Incidentally, KCRC never had the development rights to property on West Rail - that has been retained by the Government, so all that MTRC gets on West Rail is a low-margin agency agreement for managing those projects, the details of which have not been disclosed.

Conclusion

Unless the proposed deal is revised to retain fare autonomy and to reduce KCRC's revenue share, we intend to recommend independent shareholders to vote against the deal when it is put to the vote some time in the next year. Few rational investors would be in favour of a scheme which caps revenues and links the downside on margins to inflation.

The Government should think hard about whether it wishes to pursue its market-distorting socialist transport agenda, with heavily subsidised fares for all, or whether it wants to pursue a more market-based solution, in which case road and rail transport fares will rise, but urban air pollution will be reduced as rail becomes more viable. If socialism is the preferred route, then they should buy out the minorities in MTRC, run both railways at inflation-capped uncommercial fares and have the intellectual honesty to admit that this is not a market-based system. It would be totally contrary to Hong Kong's supposedly free-market principles, but that is Government's choice to make. However, if they pursue the deal on the current terms, then MTRC minority shareholders will make that choice for them.

© Webb-site.com, 2006

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