MTR Corporation: Are long-term prospects at risk due to the Hong Kong protests?

Listed on the Hong Kong Stock Exchange since October 2000, MTR Corporation Ltd is a transport conglomerate that owns and operates Hong Kong’s rail system comprising 10 railway lines serving Hong Kong Island, Kowloon, and the New Territories. MTR also operates light rail services and the Airport Express.

On the real estate side of the business, MTR also rents out station retail space and sells advertisement space on trains and in stations. The group also develops mainly residential properties in Hong Kong by partnering with property developers, and holds investment properties such as shopping malls, offices, and car parks. In mainland China, MTR has invested in and operated rail networks and property developments.

The Hong Kong protests

MTR’s business has generally remained resilient as the rail operator has a monopoly of the rail system in Hong Kong, while its property portfolio generates stable rental income for the group. However, protests and riots have broken out in Hong Kong since June 2019 over a now-aborted extradition treaty. MTR has witnessed many of its stations being heavily vandalised as the country’s youth take their anger out on the police and businesses viewed as being pro-China.

As a result of the violence and heavy damage sustained to many stations, MTR was forced to close many sections of the railway line on multiple days. A recent news report stated that use of MTR’s Hong Kong network is down by 25% — a new low since April 2012. MTR’s Airport Express also saw commuter numbers plunging by 43% year-on-year to just 916,000.

Before we review and assess the implications of these riots, let’s first take a look at MTR’s financial performance over the last five years.

Financial profile of MTR

Source: MTR Corporation 2014-2018 annual reports and 1H 2019 results

MTR has recorded rising revenue from FY2014 to FY2018, and 1H 2019 looks set for another record year of revenue if we annualise the numbers. However, operating profit seems much lumpier as costs may rise more than revenues during certain years. Net profit is affected by periodic revaluation of the properties within MTR’s portfolio and may not always be a good gauge of core profitability. Nevertheless, the five-year financial history shows that MTR’s business has been stable and consistent.

Source: MTR Corporation 2014-2018 annual reports and 1H 2019 results

One clear trend for margins is that operating profit margin has been falling steadily over the years, hitting a low of 19.5% in 1H 2019. This is essentially due to rising costs for operating the MTR network, which cannot be offset simply by raising fares. Though MTR may have a monopoly of the railway network, it is still constrained from raising fares as it is providing a public good. However, net margins seem to have stabilised somewhat at around 19-20%, buffered by cash inflows from the group’s investment property portfolio.

Source: MTR Corporation 2014-2018 annual reports and 1H 2019 results

One strong aspect of MTR is its ability to generate consistent free cash flows over the years. While FY2015 saw around HK$10 billion or so spent on development properties, this was a one-off item and adjusting it out from the cash flow statement resulted in a decent level of free cash flow generated during that year.

Source: MTR Corporation 2014-2018 annual reports and 1H 2019 results

MTR is also a good dividend payer, with an unbroken record of declaring 25 HK cents of interim dividend over the last six years. The final dividend has been steadily rising since FY2014, with FY2018 ending off at 95 HK cents. However, do note that FY2019 may see a significantly smaller dividend due to the protests.

The impact of the protests

Source: MTR Corporation 1H 2019 interim report

It’s time to take a cold, rational look at the potential impact of the protests. With many stations sustaining heavy damage and confidence severely dented, the segments that will be most affected are Hong Kong Transport Operations and Hong Kong Station Commercial Business. Combined, these two segments account for 50% of total revenue and 65% of total profit. A plunge in ridership would impact the transport operations segment badly, and this takes up the bulk of revenue at 37.8%.

As many stations and facilities have been badly vandalised, shops at these stations have also been shuttered and MTR may have to provide rental rebates to tenants as part of compensation. These pay-outs will negatively impact the income statement and, at this point, it’s unclear as to whether this compensation will eat its way into FY2020.

Source: MTR Corporation’s 2018 annual report (click to enlarge)

The Hong Kong Property and Rental Business consists of a long list of investment properties (above) that may or may not be impacted by the protestors’ violent acts on carparks and shopping malls. However, this division takes up just 9.3% of total revenue.

Intensive maintenance and repair needed

Assuming the unrest does eventually die down and no further damage is inflicted on MTR’s network of stations or railway tracks, there’s still the tedious work involved in repairing and restoring the stations back to working order. The good news is that MTR Corporation has recently met with rail union leaders and delivered the message that normal train services can resume if no further vandalism cases arise.

Replacement and restoration work will still carry on, and this will inevitably suck up resources, money, and manpower, but it seems safe to say that the worst is hopefully over for MTR in terms of service disruptions and wanton acts of vandalism.

Expanding the rail network and boosting the property portfolio

Investors should not lose sight of the big picture, though. MTR’s Rail Development Strategy (RDS) 2014 falls under Rail Generation 2.0, which has the potential to increase Hong Kong’s rail network by a further 35 kilometres. For the longer term, the government is commencing the Strategic Study on Railways Beyond 2030 that could see an even further expansion of the existing rail network.

For MTR’s property portfolio, opportunities have opened up for undertaking new residential and commercial property developments. Over the next few years, MTR will open new malls that will add around 49% to the attributable gross floor area of its existing retail portfolio. A total of 15 new residential property projects under development will provide 21,000 new units, also over the next five years. These two initiatives will enhance MTR’s property portfolio and provides visibility to investors on management’s plans for the future.

The fifth perspective

While the headlines scream of uncontrolled violence breaking out in Hong Kong over the last few months with no sign of abating, investors need to be aware that ‘this too shall pass’. In the short term, it is unavoidable that MTR will suffer a sharp drop in profits as ridership has been adversely affected. Money also needs to be spent on repairs, restoration, and compensation to affected tenants located at MTR stations.

However, recent news reports have shown that the worst is hopefully over and that MTR should be able to see a recovery in its transport operations segment from 2020 onwards, though there may still be some minor spillover from the unrest if it carries on into the new year.

MTR’s share price peaked at around HK$55.70 in July 2019 and is now trading at around HK$43.55 due to battered sentiment, down 21%. The P/E ratio of around 18 is considered cheap as MTR traditionally trades above 20, but this is based on 1H 2019 earnings per share. Note that FY2019 EPS may plunge significantly, but this should be a temporary setback and may already have been priced in. MTR’s future for the long-term looks secure, but investors need to be able to tolerate short-term share price volatility as violence continues to roil Hong Kong.

Royston Yang

Royston Yang is a long-time value investor and spent six years as a investment analyst. He believes in a long-term 'buy and monitor' strategy, and places a strong emphasis on fundamental analysis and identifying catalysts that can unlock the value of a business. He graduated with a Bachelor of Accountancy from Nanyang Technological University and an MBA from National University of Singapore. In his free time, Royston enjoys cycling and playing squash.

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