MTRC and the new Kowloon-Canton railway
12 January 2016
Let's get a few things straight about what's happening at MTR Corporation Ltd (MTRC, 0066), Hong Kong's only listed "state-owned enterprise", of which the HK Government (HKSARG) owns over 76.2%. Yes, there are plenty of unlisted ones, and there is one other listed HKSARG-controlled enterprise, Hong Kong Exchanges and Clearing Ltd (HKEx, 0388), but it is controlled via statutory powers to appoint directors and approve the Chairman and CEO, not through ownership. In small-circle HK, the Chairman of HKEx is the former CEO of MTRC. The serving Chairman of HKEx (since its incorporation in 1999) has always been a member of the HKSAR Executive Council.
Roll the clock back to late 2009, and you may remember an almighty political row, culminating in mass protests outside the Legislative Council, when the HKSARG sought LegCo Finance Committee approval to build the Express Rail Link (XRL) to Shenzhen, connecting with the national high speed network run by China Railway, which is 100%-owned by the PRC Government. The main concern was about the cost and whether cheaper options were available, such as a connection to West Rail at a station further north. On 16-Jan-2010 the Finance Committee eventually approved spending of HK$66.82bn (voting records here) and on 26-Jan-2010, the Government signed an "Entrustment Agreement", commissioning the MTRC to manage the project in return for a fee of $4.59bn. The approved project cost was already some 52% higher than a $44bn estimate in Apr-2008 when approval was given for the design costs of HK$2.78bn (voting records here).
Incidentally, it was also in Apr-2008 that the Government decided that the train terminus would extend underneath the West Kowloon Cultural District, which is why it too is delayed and remains the West Kowloon Cultural Desert apart from the occasional open-air concerts. Stand by for another battle over the cost of completing the project with its "integrated basement" - perhaps we should bring back Henry Tang Ying Yen with his subterranean expertise to oversee it.
Delays and costs
Infrastructure budgets are usually measured in "money-of-the-day" (MOD) prices, so assuming positive inflation, the later an item of expenditure occurs, the more it will cost in MOD terms as wages and prices rise, but not necessarily in real terms. A delayed project usually results in later payments, but at the same time, the Government gets to earn additional returns while the money remains in its investment reserves.
The XRL is a government project to build a government-owned asset, part of the HKSARG's wish to integrate with the mainland's centrally-planned government-owned network. Even back in 2008, with an estimated cost (in 2009 dollars) of $39.5bn, XRL was not financially viable. As the HKSARG put it:
"Based on MTRCL’s assessment, the XRL project in itself is not financially viable and a funding gap of $29.5 billion (in 2009 prices) would result if the project is carried out under the ownership approach."
In other words, MTRC estimated that taking into account its target rate of return and expected revenues, the project could only generate a net present value of HK$10bn in 2009 dollars. As a result, either the Government would have to pay the difference to MTRC (and forego any upside except as a shareholder), or bear the costs and risks of construction and then rent it to MTRC for a very low rate of return on the cost, known as the "concession approach", which it adopted. At the same time, HKSARG made the usual arguments about "economic benefits" to HK. Such arguments always avoid assessment of the economic benefits that might have accrued if the capital had been returned to the private sector instead through reduced taxation. Other examples of this sophistry include the Kai Tak Cruise Terminal and the HK-Zhuhai-Macau road bridge, neither of which is financially viable on its own. Each of those also introduces external costs, such as air pollution, which are never subtracted from the "economic benefits" that the Government likes to promote.
The XRL was originally set to be opened in Aug-2015, but delays accumulated along with cost overruns. Causes included issues with cross-boundary tunneling (the route goes under the Mai Po wetlands), "unexpected geological problems" and a black rainstorm on 30-Mar-2014 which flooded a tunnel, badly damaging a tunnel boring machine (or if civil engineering doesn't excite you, a boring tunnel machine). The net result of all that is the current MOD estimate for XRL of HK$84.42bn, including both inflation and real increases.
How will the revenue be shared?
MTRC agreed to carry out the project management, on the "understanding that it would be invited", when the link is completed, to operate the XRL to Shenzhen in return for a share of the revenues, with the rest being paid to HKSARG as rent. However, so far, despite hundreds of pages of submissions to LegCo, the Government has never revealed the proposed terms of this "invitation" or concession agreement. What rent or revenue share will HKSARG charge MTRC, and how will revenues be divided between China Railway and MTRC? As an operating agreement, minority shareholders will have no say in this - the Stock Exchange exempted MTRC from the connected transaction rules on specious grounds long ago.
All we know is that according to a briefing to LegCo in 2009, the financial model assumed the following fares, from Kowloon: HK$45 to Futian Station, $49 to Shenzhen North Station in Longhua, $131 to Humen Station (Dongguan) and $180 to Guangzhou South station (Shibi), outer Guangzhou. We don't know how much of that fare revenue will go to China Railway, how much to the operator on the HK side of the boundary and how much to the HKSARG. We don't even know whether HKSARG/MTRC and China Railway have reached an agreement on this.
However, some guidance is provided by the existing Kowloon-Canton rail link. According to the 6-May-1996 prospectus of Guangshen Railway Co Ltd (GR, 0525), revenues on Hong Kong through trains were split 81.2% to GR and 18.8% to Kowloon-Canton Railway Corporation (KCRC), which is 100%-owned by HKSARG. That revenue split is almost exactly in proportion to the length of the two segments. We assume there has been no change in that split. Since 2-Dec-2007, MTRC maintains and operates the KCRC assets under a 50-year concession, so the revenue now goes to MTRC, out of which it pays a share to the KCRC. After the 1949 communist takeover, KCR through-trains were suspended until 1979, but we can go back further. According to the 1934 report of the KCR (British Section), there was a new "working agreement" for through-traffic under which the British Section's share of revenue was reduced from 35% to 28% in the last quarter of the year, replacing the 1911 agreement that had never been ratified.
If that 18.8% revenue share is applied to a HK$180 XRL fare to Guangzhou, then HKSARG and MTRC may be sharing just $34 between them. Legislators appear to be working in the dark on all of this, and it is about time the Government told them what the deal with China Railway and HKSARG/MTRC will be. There has also been no disclosure on how much of the rolling stock will be owned by the HK side and how much by China Railway, but the MTRC press release of 6-Nov-2013 tells us that they have ordered (presumably on HKSARG's behalf) 9 trains for HK$1.74bn from CSR Qingdao Sifang Co., Ltd, "based on" the CRH380A. One country, two paint jobs. It is unclear whether these trains will operate beyond Futian Station or only as a shuttle on the HK Section, leaving all other services to China Railway.
This rather begs the question, what is the point of the MTRC accepting an invitation to "operate" the XRL? For sure, someone needs to maintain the dedicated tunnel, track, terminus and sidings, but why doesn't HKSARG just lease the completed XRL to China Railway for as much as they can negotiate, and leave MTRC to operate the domestic HK network? Legislators should pay attention to this.
Travel time
The much-vaunted travel time of 48 minutes for 140km from West Kowloon to Guangzhou South will only apply to non-stop trains. Allowing for braking, boarding and acceleration times, you can probably add 15 minutes to that if the train stops at all 3 stations in between. Then when you get to Guangzhou South, if you are heading to the central business district (let's say Guangzhou IFC at Pearl River New Town station), according to Google Maps, you are just 14 stops, 3 subway lines and 59 minutes away.
The current through-train from Hunghom to Guangzhou East takes a scheduled 114 minutes non-stop, or 119 minutes with 1 stop. But then to get from Guangzhou East to Pearl River New Town is just 14 minutes involving 3 stops on a single subway line. So depending on where in HK you are travelling from, the XRL may make save very little time.
Yes, there are also going to be express trains from West Kowloon to cities further away, but that is only useful up to a point. Even allowing for check-in times on flights, the expected 8 hours to Shanghai and 10 hours to Beijing will be slower than flying and quite possibly more expensive than budget airlines.
History repeating
History is repeating itself. About once a century, HK tries to build a railway to Guangzhou. Take a look at the LegCo Hansard for 10-Mar-1910. The Governor, Frederick Lugard, delivered the Annual Report on the construction of the "British section" of the Kowloon-Canton (now Guangzhou) railway for 1909. There had been huge delays and cost overruns in the previous years but the project was now coming to an end. One of the major aspects of that project was the 7,212 ft (2,198 metres) tunnel through Beacon Hill, Kowloon, still in use today. He said:
"As we have all learned, these tunnels have been found exceedingly difficult to estimate for, and in consequence of the exceedingly hard nature of the rock and other causes there has been a total increase on the original estimate of $1,607,730, which is something like 73 per cent. on the original estimate..."
Weather was also an issue then as now. In the 1908 report, the Chief Resident Engineer wrote:
"in the end of July and beginning of August the typhoon damaged the coolie sheds so much that the coolies all ran away and in consequence work stopped for nearly a week."
You can hardly blame them - the roof came off their quarters, according to the Report on the Typhoon of 27-28-July 1908.
The British Section of the KCR opened on 1-Oct-1910 and through-trains on the KCR eventually began on 5-Oct-1911, just 5 days before the Xinhai Revolution, with a temporary terminal in a godown on Salisbury Road, pending completion of the reclamation for the permanent terminal, which opened on 28-Mar-1916 where the Cultural Centre now stands. All that remains of that terminal is the clock tower. After the communist takeover in 1949, through-trains ended and the railway was divided into two sections, Guangzhou to Shenzhen, and Lo Wu to HK. Through-trains from Kowloon to Guangzhou resumed in 1979 as Deng Xiaoping's re-opening of China began.
The conditional XRL Agreement
Now, back to the present, and MTRC minority shareholders are being asked (circular here) at an EGM on 1-Feb-2016 to approve a deal (XRL Agreement) with HKSARG in which MTRC will be responsible for any further cost overruns. In exchange, it will get a higher management fee of HK$6.34bn, up from $4.59bn. Under the previous Entrustment Agreement, there was a liability cap basically equal to the Project Management and other fees received by MTRC, currently up to $4.94bn, which will increase to $6.69bn. However, there are some circumstances (the details of which have not been disclosed) in which the Liability Cap would be invalid, presumably including gross negligence or willful default of MTRC's obligations.
The XRL Agreement has a small sting in the tail. The Government reserves the right to refer part or all of the current cost overrun of $19.42bn to an arbitrator. If the arbitrator rules that MTRC would, but for the Liability Cap, be liable for an amount greater than the cap, then the XRL Agreement requires MTRC to seek approval of its independent shareholders to waive the cap and bear the excess liability. We can't imagine why independent shareholders would vote in favour of that though, so the risk of such a payment being made is fairly small and the clause is there mainly for political effect.
Given that the Government (including the Exchange Fund) owns over 76% of MTRC, there is also little point in racking up lawyers' fees in arbitration or suing its own subsidiary, so we suspect that part of the arrangement will not be pursued. We can also be fairly confident at this stage, with tunneling completed, that there is enough cushion in the budget (which includes a HK$1.95bn "general contingency reserve") not to exceed the new cost.
The special dividend should be unconditional and higher
MTRC proposes a special dividend of HK$4.40 per share in two equal tranches in the second halves of 2016 and 2017. The Government will receive HK$19.51bn of this, which almost exactly equates to the current cost overrun, so it creates the impression that the Government will not have to "put in any cash" to finish the project. This is a political optical illusion, of course, but a welcome one as it results in the return of some of the surplus capital to MTRC's minority shareholders.
What is not welcome, though, is that this dividend is conditional on the XRL Agreement being approved and the LegCo Finance Committee giving approval for the XRL cost overrun, by 30-Sep-2016. The two issues of whether the MTRC has too much capital for its business (it does) and whether the Government should complete the XRL (it now should) are completely unrelated. On the second issue, it would now be stupid not to complete the XRL, firstly because we would have the world's most expensive hole in the ground, and secondly because HKSARG would have to compensate contractors for terminated contracts which would cost a substantial part of the cost overrun anyway.
MTRC has very little net debt, and for years it has operated with far more capital than it needs, dragging down the rate of return on equity for investors. MTRC is basically a utility business; although it also has income from property developments, this often comes with very little capital commitment because typically the various HK developer partners put up most of the land premium and construction costs and just pay MTRC a share of the profits and/or retail investment properties at the end of the project. As a utility company with a steady cash flow, MTRC can and should be more substantially financed by borrowings to improve returns on shareholders' equity.
In the transaction circular, MTRC claims that the net debt at 30-Jun-2015 was 9.1% of total equity of HK$167.4bn. However, even that modest gearing includes $10.59bn (6.3%) of "obligations under service concession". This is the net present value of HK$750m per year being the fixed component of the rent on KCRC assets which have 42 years remaining. With the dividend of HK$25.76bn, the gearing would increase to about 29.0%, or 21.5% excluding the service concession obligations. This is well within MTRC's financial capabilities and the real question should be, if they now admit that they don't need to hang on to $4.40 per share, then why not more? Is this really just the right amount to pay out?
So let's answer that. According to the circular, since privatisation in 2000, MTRC's gearing has a historical peak of 59.3%. Since then, it has been hoarding profits and reducing gearing. By comparison, HK's two territorial electricity monopolies, CLP Holdings Ltd (0002) and HK Electric Investments Ltd (2638), have gearing of 66.8% and 88.0% respectively, and nobody is suggesting that they are financially unsound. In Singapore, the metro operator, SMRT Corporation, has gearing of 79.9%. To get to the average gearing of these three peers, at 78.2%, MTRC would need to distribute an extra HK$39.1bn, or about $6.67 per share. That would increase net debt to $80.10bn (including the obligation under service concession) and reduce equity to $102.49bn.
So in our view, now that the MTRC has recognised its balance sheet obesity problem caused by hoarding historical profits, MTRC should go the whole way and slim down by paying out $11 per share, not $4.40, making a total of HK$64.4bn. The distributable reserves are HK$68.3bn at 30-Jun-2015, so they can do that. The Financial Secretary Inc, on its holding of 75.7%, would receive a total of HK$48.78bn, adding a substantial $29.36bn to the public purse even after the cost overrun on XRL. No shareholders' approval is required for an interim dividend, so the board of MTRC could declare an $11 dividend today, if it so chooses. Suitable debt financing would then be lined up to pay out the dividend. The proposal of $4.40 merely reduces MTRC's balance sheet from grossly obese to seriously overweight. $11 would make it healthy.
Meanwhile, despite the concerns stated above, independent shareholders should vote in favour of the XRL Agreement at the EGM on 1-Feb-2016.
© Webb-site.com, 2016
Organisations in this story
- China Railway Corporation
- GUANGSHEN RAILWAY COMPANY LIMITED
- KOWLOON-CANTON RAILWAY CORPORATION
- MTR CORPORATION LIMITED
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