Another step towards sustainability

• “Government contracting model”
  
• Turnaround in operations expected
  
• CDG likely to benefit more than SMRT
  

Restructuring Singapore’s public bus industry

LTA announced that it will restructure the public bus industry to a “Government contracting model” beginning from 2H14 (but implementation to take place only in 2H16 after the expiration of the current Bus Service Operating Licenses on 31 Aug 2016). This is aimed at improving service quality and injecting more competition into the industry. The key implication of this is that revenue risk will now fall under the Government instead of the public transport operators (PTOs). Under this model, bus operators will bid for the right to operate bus services via a competitive tendering process. The Government will own all bus infrastructure and operating assets. We believe this means LTA may buy over existing bus assets from the PTOs in the future, although the timeline is unclear. The net book value of SBS Transit’s (75%-owned by ComfortDelGro) buses is S$817.5m (as at 31 Dec 2013), while that of SMRT is ~S$200m (as at 31 Mar 2014), based on our estimate. Three out of 12 bus packages (~20% of existing buses) will be tendered out starting from 2H14, and the contract length will be five years (can be extended by another two years on good performance). The remaining 80% of buses will continue to be operated by the incumbent operators, and these will also come under the new contracting model when their licenses expire on 31 Aug 2016 (five year tenure).

CDG to benefit more than SMRT

Overall, we believe this will enable the PTOs’ bus operations to return to profitability. During their most recent full-year results, ComfortDelgro (CDG) and SMRT reported operating losses of S$14.4m and S$28.4m, respectively, for their core Singapore bus operations (excluding advertising and rental income). We expect CDG to be a bigger beneficiary than SMRT as the former operates the largest bus fleet in Singapore (~75% market share via SBS) and also has experience operating a gross cost contracting model for its UK and Australia bus businesses. It generated an operating profit margin of 8.4% and 19.2% for these two areas in FY13, respectively. We believe a 6-9% operating margin can be achieved by the PTOs.

Upgrade sector to OVERWEIGHT

The Singapore Government’s initiative to move towards a gross cost contracting model is a positive paradigm shift which we believe will help to ensure the longer-term sustainability of Singapore’s public bus operations. Although the financial impact will only take place in 2H16, we believe efforts to improve productivity (PTOs’ bus losses have narrowed) and changes to the fare adjustment system will aid the sector’s recovery in CY14 and CY15. Hence we upgrade the land transport sector from Neutral to OVERWEIGHT. We maintain our BUY rating on CDG (FV lifted from S$2.30 to S$2.56) and HOLD rating on SMRT (FV lifted from S$1.25 to S$1.40).

Positive Paradigm Shift

The Land Transport Authority (LTA) introduced the new bus operating model last night. The details have yet to be finalized and financial impact remains uncertain at this point. We opine positively towards the move as it creates a sustainable operating environment. For the two local incumbent operators, we expect them to enjoy profit boost going forward, from year 2016 to 2020. We continue to favour ComfortDelGro.

A gradual transition. The cost-plus model will kick start when the operating licenses for the two existing operators expires on 31 Aug 2016. Initially, only about 20% of the buses would be tendered out publicly (tender open to foreign operators e.g. Veolia, Keolis) for a five year operating contract with two year extension possibility. The remaining 80% of buses will continue to be operated by the two incumbents under the new model (ie contractual price to be negotiated).

Going asset light. Under the new model, LTA will assume ownership of all the us operation assets. This implies that at certain point of time, LTA will buy over the existing assets from the two local operators. As of the end of 2013, ComfortDelGro’s bus operating assets were recorded at around SGD827m book value whereas SMRT’s was estimated at about SGD250m. However the lack of details makes it difficult to ascertain the actual financial impact. We think the positive impact on ComfortDelGro will be much larger than on SMRT.

Earnings boost for both operators. We expect both ComfortDelGro and SMRT to be better off from year 2016 to 2020 even if they were to lose the first open tender since they have been barely profitable under the existing model. In our opinion, the contractual price (to be negotiated) for this five-year grace period under the new operating model is likely to lift both incumbents’ EBIT margins closer to 8% which is the industry norm, in turn lifting their profits.

Upgrade sector rating to Neutral; Prefer ComfortDelGro. In view of this positive news we upgrade the sector rating from Underweight to Neutral and raise our fair value estimates for both ComfortDelGro and SMRT respectively to SGD2.60 and SGD1.17. However, we prefer the former for its strong track record of operating under the cost-plus model which potentially leads to higher chance of tender wins as well as better operating margins.

Positive Paradigm Shift

The Land Transport Authority (LTA) introduced the new bus operating model last night. The details have yet to be finalized and financial impact remains uncertain at this point. We opine positively towards the move as it creates a sustainable operating environment. For the two local incumbent operators, we expect them to enjoy profit boost going forward, from year 2016 to 2020. We continue to favour ComfortDelGro.

A gradual transition. The cost-plus model will kick start when the operating licenses for the two existing operators expires on 31 Aug 2016. Initially, only about 20% of the buses would be tendered out publicly (tender open to foreign operators e.g. Veolia, Keolis) for a five year operating contract with two year extension possibility. The remaining 80% of buses will continue to be operated by the two incumbents under the new model (ie contractual price to be negotiated).

Going asset light. Under the new model, LTA will assume ownership of all the us operation assets. This implies that at certain point of time, LTA will buy over the existing assets from the two local operators. As of the end of 2013, ComfortDelGro’s bus operating assets were recorded at around SGD827m book value whereas SMRT’s was estimated at about SGD250m. However the lack of details makes it difficult to ascertain the actual financial impact. We think the positive impact on ComfortDelGro will be much larger than on SMRT.

Earnings boost for both operators. We expect both ComfortDelGro and SMRT to be better off from year 2016 to 2020 even if they were to lose the first open tender since they have been barely profitable under the existing model. In our opinion, the contractual price (to be negotiated) for this five-year grace period under the new operating model is likely to lift both incumbents’ EBIT margins closer to 8% which is the industry norm, in turn lifting their profits.

Upgrade sector rating to Neutral; Prefer ComfortDelGro. In view of this positive news we upgrade the sector rating from Underweight to Neutral and raise our fair value estimates for both ComfortDelGro and SMRT respectively to SGD2.60 and SGD1.17. However, we prefer the former for its strong track record of operating under the cost-plus model which potentially leads to higher chance of tender wins as well as better operating margins.

Convergence of negative events

• Downgrade sector rating to Underweight from Neutral in view of recent negative developments.
  
• Maintain SELL on SMRT (TP SGD0.60).
  
• Reiterate BUY on ComfortDelGro (TP SGD2.40) for its low exposure to fare-based business in Singapore.
  

Recent Developments Lead Us To Turn Negative

• Heightened regulatory pressure. Parliament passed a Bill on 17 Feb 2014 that will increase the maximum fine for every rail disruption to 10% of the train operators’ annual fare revenue. This is up from SGD1m previously. The amended Rapid Transit Systems Bill implies that a network-wide rail incident would subject SMRT and SBS Transit (SBST) to a maximum fine of SGD63.2m and SGD14.8m respectively, based on our estimates. In our view, the implementation of the revised financial penalty would easily tip the operators into the red, considering their depressed profit bases.
  
• Risk of higher repair and maintenance expenses. Transport Minister Lui Tuck Yew highlighted an impending change in the maintenance regime for the rail network from the current “find and fix” approach to a new “predict and prevent” approach. He said this in reply to questions from Members of Parliament on the recent train service disruptions. Given the increased scrutiny on system reliability, we expect regulators and operators to adopt a conservative approach, which could lead to higher spending on maintenance work.
  
• Quantum of fare hike lower than expected. The 3.2% increase in bus and train fares that would be implemented from April 2014 fell short of our expectations for a 5% hike. While the fare revision will provide some relief, it will not be sufficient to offset losses at the operators’ fare-based business.
  

What’s Our View

We downgrade our rating for the Land Transport sector to Underweight from Neutral to reflect the abovementioned negative events. Our SELL call on SMRT (TP SGD0.60) remains unchanged, so is our BUY rating on ComfortDelGro (CDG). We are less worried about CDG than SMRT because: 1) CDG’s Singapore fare-based business accounts for just 7% of its market value, 2) losses at its rail segment is mainly due to start-up costs for the Downtown Line, and 3) there may be upside to rental and advertising beyond 2017.

Convergence of negative events

• Downgrade sector rating to Underweight from Neutral in view of recent negative developments.
  
• Maintain SELL on SMRT (TP SGD0.60).
  
• Reiterate BUY on ComfortDelGro (TP SGD2.40) for its low exposure to fare-based business in Singapore.
  

Recent Developments Lead Us To Turn Negative

• Heightened regulatory pressure. Parliament passed a Bill on 17 Feb 2014 that will increase the maximum fine for every rail disruption to 10% of the train operators’ annual fare revenue. This is up from SGD1m previously. The amended Rapid Transit Systems Bill implies that a network-wide rail incident would subject SMRT and SBS Transit (SBST) to a maximum fine of SGD63.2m and SGD14.8m respectively, based on our estimates. In our view, the implementation of the revised financial penalty would easily tip the operators into the red, considering their depressed profit bases.
  
• Risk of higher repair and maintenance expenses. Transport Minister Lui Tuck Yew highlighted an impending change in the maintenance regime for the rail network from the current “find and fix” approach to a new “predict and prevent” approach. He said this in reply to questions from Members of Parliament on the recent train service disruptions. Given the increased scrutiny on system reliability, we expect regulators and operators to adopt a conservative approach, which could lead to higher spending on maintenance work.
  
• Quantum of fare hike lower than expected. The 3.2% increase in bus and train fares that would be implemented from April 2014 fell short of our expectations for a 5% hike. While the fare revision will provide some relief, it will not be sufficient to offset losses at the operators’ fare-based business.
  

What’s Our View

We downgrade our rating for the Land Transport sector to Underweight from Neutral to reflect the abovementioned negative events. Our SELL call on SMRT (TP SGD0.60) remains unchanged, so is our BUY rating on ComfortDelGro (CDG). We are less worried about CDG than SMRT because: 1) CDG’s Singapore fare-based business accounts for just 7% of its market value, 2) losses at its rail segment is mainly due to start-up costs for the Downtown Line, and 3) there may be upside to rental and advertising beyond 2017.