MTR Corporation (66 HK)

MTR Corporation (66 HK)

Hong Kong Industrials MTR Corporation 13 April 2016 (66 HK) Target price: HKD42.70 (from HKD42.70) Share price (13 Apr): HKD38.35 | Up/downside: ...

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Industrials

MTR Corporation

13 April 2016

(66 HK)

Target price: HKD42.70 (from HKD42.70) Share price (13 Apr): HKD38.35 | Up/downside: +11.3%

Rating lowered on reduced upside potential  Stock has done very well since January 2015

Jonas Kan, CFA (852) 2848 4439 [email protected]

 Facing near-term uncertainties on FAM Review  Downgrading to Outperform (2); TP unchanged at HKD42.70

What's new: MTRC’s shares have notably outperformed the HSI and property stocks since January 2015. As a result, our upside potential over the next 12 months is now reduced to below 15%. Meanwhile, we have also delved more deeply into the issue of a potential early joint review of the Fare Adjustment Mechanism (FAM) by MTRC and the government. What's the impact: Not yet certain whether there might be a joint review of the FAM in the coming months. This is because MTRC has merely stated that it is aware of the government’s intention to have an early review of the FAM and that it would ‘aim to respond to the government in the next few months’. Given that, legally, the FAM would not expire until 2017, MTRC may not necessarily hold a joint review in the coming months, in our view.

Forecast revisions (%) Year to 31 Dec Revenue change Net profit change Core EPS (FD) change

A positive solution for all stakeholders is difficult, but not inconceivable. In our opinion, the FAM issue strikes at the heart of the issue regarding MTRC’s identity for investors. On the one hand, it has the duty to maximise returns to investors, but at the same time, its business has a large dimension. We believe that, in theory, it is not impossible that these two conflicting roles of MTRC can be separated and the conflict could be resolved or at least mitigated by the government by a creative use of the multi-billion dividends it is likely to receive from MTRC every year (see p.2). That said, actual implementation of this arrangement will give rise to numerous political and social issues, which are rather difficult to deal with under Hong Kong’s current socio-political climate. What we recommend: We maintain our 12-month TP of HKD42.70 for MTRC, based on a 20% discount applied to our end-2016E SOTP value of HKD53.40. However, the share’s strong performance has now reduced our upside potential to 11.3%. Given also the near-term uncertainties related to the FAM review, we lower our rating on the stock from Buy (1) to Outperform (2). The key risk would be unfavourable regulatory changes. How we differ: We think MTRC can potentially stand out as one of the few genuine global stocks in Hong Kong. However, a pre-requisite for a potential change in investor perception would be a constructive and sustainable way to deal with the potential conflict in its role for investors and the society.

See important disclosures, including any required research certifications, beginning on page 5

17E -

18E n.a. n.a. n.a.

Source: Daiwa forecasts

Share price performance (%)

(HKD) 39

140

38

129

36

118

35

106

33

Apr-15

Uncertainties over the FAM review may last longer. We note that a review of the FAM must take place no later than 2H17. As such, not reviewing earlier may drag out the uncertainties over the issue of the FAM review for more than a few months.

16E -

95

Jul-15

Oct-15

MTR (LHS)

Jan-16

Apr-16

Relative to HSI (RHS)

12-month range 33.35-38.80 Market cap (USDbn) 28.66 3m avg daily turnover (USDm) 18.68 Shares outstanding (m) 5,797 HKSAR Government (75.7%) Major shareholder

Financial summary (HKD) Year to 31 Dec Revenue (m) Operating profit (m) Net profit (m) Core EPS (fully-diluted) EPS change (%) Daiwa vs Cons. EPS (%) PER (x) Dividend yield (%) DPS PBR (x) EV/EBITDA (x) ROE (%)

16E 42,939 11,211 8,740 1.508 (19.8) (3.4) 25.4 8.6 3.300 1.4 16.5 5.3

Source: FactSet, Daiwa forecasts

17E 44,442 11,930 10,280 1.773 17.6 3.1 21.6 8.9 3.400 1.5 16.5 6.6

18E 46,394 13,108 12,258 2.115 19.2 35.2 18.1 3.3 1.250 1.4 15.2 8.0

MTR Corporation (66 HK): 13 April 2016

MTRC: share price performance vs. HSI (since 2015)

MTRC: share price performance vs. major property companies

(Rebased) 140

(Rebased) 140

120

120 100

100

80

80

HSI

MTRC

HSI

SHKP

Sino Land

Wharf

Swire Prop

Source: Bloomberg, Daiwa

MTRC: price/SOTP valuation

MTRC: government’s share of annual dividend

P/SOTP (x)

1.1

Year 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Total

Current: 0.72x

1.0 0.9 0.8 0.7 0.6

Average since IPO: 0.72x

0.5 0.4

Oct 15

Oct 14

Oct 13

Oct 12

Oct 11

Oct 10

Oct 09

Oct 08

Oct 07

Oct 06

Oct 05

Oct 04

Oct 03

Oct 02

Oct 01

Oct 00

0.3

Source: Datastream, Daiwa estimates

Dividend declared by MTRC* (HKDm) 2,118 2,161 2,215 2,259 2,299 2,328 2,522 2,715 2,977 3,405 4,396 4,575 5,335 6,116 6,210 51,630

Apr-16

Mar-16

Jan-16

Henderson

Source: Bloomberg, Daiwa

(x)

Feb-16

Dec-15

Nov-15

Oct-15

Sep-15

Jul-15

Aug-15

Jun-15

May-15

Apr-15

Mar-15

Jan-15

Apr-16

Mar-16

Jan-16

Feb-16

Dec-15

Nov-15

Oct-15

Sep-15

Jul-15

Aug-15

Jun-15

May-15

Apr-15

Mar-15

Jan-15

Feb-15

MTRC

Feb-15

60

60

Dividend received HKSAR Government* (HKDm) 1,621 1,645 1,690 1,727 1,760 1,783 1,934 2,084 2,287 2,616 3,370 3,502 4,080 4,655 4,701 39,454

Source: Company, Daiwa Note: * Note: the government and some other shareholders have opted to receive shares in lieu of cash dividends in the past

Different scenarios on the relationship between MTRC, the government, investors, and the Hong Kong public* Investor perception of MTRC MTRC as a public listed company MTRC as the provider of a key transport service for the community

Worst case - Obliged to yield to social and political pressure and cannot safeguard the interests of minority shareholders and investors

Base case - Owns some valuable franchises and property assets. However, there are uncertainties as to whether it can utilise them in the best interests of all its shareholders and investors - Cannot work in the best commercial interests of - There is always uncertainty as to whether it can safeguard the commercial interests of the minority shareholders and its minority shareholders and investors investors - This has adversely affected MTRC's ability to - The risk exists that MTRC may lean more toward yielding to work for the best interests of minority social and political pressure rather than maximising the shareholders and investors interests of its minority shareholders and investors

MTRC as an entity majority owned by the SAR Govt.

- The political dimension associated with this will always mean that MTRC may have to bear some responsibility for what it may not have to bear were it not majority owned by the government

MTRC's strong cash flow

- Obliged to use its cash flow to help address the political problems faced by its major shareholder rather than deploy it to maximise the interests of all its shareholders and investors

The cost over-run issue of the Express Rail Link

- MTRC and the government go to court to settle the issue through legal means

Best case - MTRC is able to strike a fair and proper balance between its various stakeholders and the company and the government will strive to safeguard the interests of all minority shareholders and investors - MTRC develops a fair and equitable way to deal with potential conflicts associated with its roles

- MTRC, the government and the public develop a fair, open, objective and equitable mechanism to determine the appropriate fare levels and service standard for rail services in Hong Kong. If the government can use the dividends it receives from MTRC to help manage the social dimension of MTRC’s business, this could result in a positive alignment of the interests of all of MTRC’s stakeholders and a separation of MTRC’s financial duties to deliver returns to investors from its social responsibilities - Lingering risk that MTRC may have to compromise its ability - The government, society and MTRC develop a transparent and equitable way to address the potential to work in the best interests of all its shareholders conflicts associated with MTRC's different roles, and MTRC becomes an exemplary case in Hong Kong from a governance perspective. MTRC’s special position also allows it to access opportunities not normally accessible by purely commercial organisations - Uncertainties exist as to whether MTRC can use its cash - MTRC uses its strong cash flow to provide strong and flow in the best interests of its minority shareholders and growing dividends to all its shareholders, and the government can make creative use of the strong investors dividends it has received from MTRC to address the social and political issues that MTRC may be facing - It develops into a severe social and political crisis, though - MTRC pays higher dividends to all shareholders and the eventually the government does get approval from Legco for dividends the government receives from the MTRC the extra funding given fears of the severe consequences become one way of addressing the issues caused by that may result from a forced suspension of the project the delay and cost over-run of the project

Source: Daiwa

2

MTR Corporation (66 HK): 13 April 2016

Financial summary Key assumptions Year to 31 Dec No of passenger travelled (Mils) Rental EBIT (HKDm) Property sales profit (HKDm)

2011 1,367 2,819 4,934

2012 1,553 3,027 3,238

2013 1,600 3,547 1,396

2014 1,676 3,945 4,216

2015 1,707 4,267 2,891

2016E 1,763 4,360 0

2017E 1,831 4,611 2,083

2018E 1,826 4,824 2,567

2011 26,383 3,873 3,167 33,423 0 (17,621) (3,896) (3,635) 8,271 (921) 5,231 12,581 (2,113) 0 10,468 10,468 1.832 1.832 1.832 0.760 8,271 11,477

2012 28,417 4,028 3,294 35,739 0 (17,929) (4,279) (4,539) 8,992 (879) 3,694 11,807 (1,893) (139) 9,775 9,775 1.711 1.711 1.711 0.790 8,992 12,200

2013 30,341 4,588 3,778 38,707 0 (19,224) (4,618) (5,085) 9,780 (732) 1,554 10,602 (1,819) (183) 8,600 8,600 1.505 1.505 1.505 0.920 9,780 13,152

2014 32,828 4,963 2,365 40,156 0 (19,525) (4,849) (5,316) 10,466 (545) 4,337 14,258 (2,496) (191) 11,571 11,571 1.996 1.996 1.996 1.050 10,466 13,951

2015 31,788 5,380 4,533 41,701 0 (20,125) (5,224) (5,730) 10,622 (599) 3,252 13,275 (2,237) (144) 10,894 10,894 1.879 1.879 1.879 1.060 10,622 14,471

2016E 32,471 5,538 4,930 42,939 0 (20,324) (5,346) (6,059) 11,211 (938) 475 10,748 (1,809) (199) 8,740 8,740 1.508 1.508 1.508 3.300 11,211 15,175

2017E 33,289 5,781 5,372 44,442 0 (20,789) (5,430) (6,293) 11,930 (1,330) 2,684 13,284 (2,779) (225) 10,280 10,280 1.773 1.773 1.773 3.400 11,930 16,053

2018E 35,236 6,034 5,124 46,394 0 (21,248) (5,520) (6,518) 13,108 (1,171) 3,205 15,142 (2,650) (234) 12,258 12,258 2.115 2.115 2.115 1.250 13,108 17,396

2011 12,581 3,250 (1,600) 680 5,216 20,127 (18,462) 353 243 (17,866) 0 19 (2,148) (3,104) (5,233) 0 (2,972) 1,665

2012 11,807 3,208 (1,799) 654 6,737 20,607 (11,125) 367 253 (10,505) 0 20 (4,519) (3,450) (7,949) 0 2,153 9,482

2013 10,602 3,372 (1,343) 895 5,200 18,726 (13,356) 341 258 (12,757) 0 0 (4,772) (3,496) (8,268) 0 (2,299) 5,370

2014 14,258 3,485 (1,872) 950 9,600 26,421 (13,513) 390 265 (12,858) 0 0 (5,097) (2,866) (7,963) 0 5,600 12,908

2015 13,275 3,849 (1,678) 2,935 2,558 20,939 (20,084) 400 280 (19,404) 0 0 (5,505) (2,910) (8,415) 0 (6,880) 855

2016E 10,748 3,964 (1,357) 2,958 463 16,776 (14,560) 400 280 (13,880) 0 0 (18,825) (2,930) (21,755) 0 (18,859) 2,216

2017E 13,284 4,123 (2,084) 3,020 2,789 21,132 (14,690) 400 280 (14,010) 0 0 (19,301) (2,935) (22,236) 0 (15,114) 6,442

2018E 15,142 4,288 (1,988) 3,860 2,593 23,896 (13,690) 400 280 (13,010) 0 0 (6,950) (2,935) (9,885) 0 1,001 10,206

Profit and loss (HKDm) Year to 31 Dec Railway Station Commercial Other Revenue Total Revenue Other income COGS SG&A Other op.expenses Operating profit Net-interest inc./(exp.) Assoc/forex/extraord./others Pre-tax profit Tax Min. int./pref. div./others Net profit (reported) Net profit (adjusted) EPS (reported)(HKD) EPS (adjusted)(HKD) EPS (adjusted fully-diluted)(HKD) DPS (HKD) EBIT EBITDA

Cash flow (HKDm) Year to 31 Dec Profit before tax Depreciation and amortisation Tax paid Change in working capital Other operational CF items Cash flow from operations Capex Net (acquisitions)/disposals Other investing CF items Cash flow from investing Change in debt Net share issues/(repurchases) Dividends paid Other financing CF items Cash flow from financing Forex effect/others Change in cash Free cash flow

Source: FactSet, Daiwa forecasts

3

MTR Corporation (66 HK): 13 April 2016

Financial summary continued … Balance sheet (HKDm) As at 31 Dec Cash & short-term investment Inventory Accounts receivable Other current assets Total current assets Fixed assets Goodwill & intangibles Other non-current assets Total assets Short-term debt Accounts payable Other current liabilities Total current liabilities Long-term debt Other non-current liabilities Total liabilities Share capital Reserves/R.E./others Shareholders' equity Minority interests Total equity & liabilities EV Net debt/(cash) BVPS (HKD)

2011 16,100 3,757 3,964 6,613 30,434 152,068 344 15,027 197,873 0 16,402 2,721 19,123 23,168 26,537 68,828 44,062 84,797 128,859 186 197,873 229,569 7,068 22.555

2012 18,664 3,016 4,474 6,723 32,877 155,894 256 17,888 206,915 355 15,119 2,415 17,889 23,222 21,324 62,435 44,281 99,992 144,273 207 206,915 227,435 4,913 25.253

2013 17,297 1,105 3,621 1,935 23,958 163,156 115 28,594 215,823 47 13,793 2,723 16,563 24,464 22,094 63,121 44,442 108,115 152,557 145 215,823 229,674 7,214 26.703

2014 18,893 1,076 3,797 2,438 26,204 171,202 105 30,187 227,698 546 16,421 3,697 20,664 19,961 23,591 64,216 45,280 118,045 163,325 157 227,698 224,086 1,614 28.174

2015 12,318 1,139 5,135 2,053 20,645 175,719 81 44,658 241,103 1,649 22,860 3,820 28,329 19,162 23,441 70,932 46,317 123,738 170,055 116 241,103 230,924 8,493 29.335

2016E 5,459 898 5,320 2,312 13,989 183,691 90 46,123 243,893 0 23,125 3,945 27,070 32,812 24,177 84,059 46,317 113,395 159,712 122 243,893 249,790 27,353 27.551

2017E 5,980 765 5,545 2,465 14,755 188,221 92 48,120 251,188 0 23,658 4,025 27,683 48,447 24,250 100,380 46,317 104,360 150,677 131 251,188 264,913 42,467 25.992

2018E 6,250 712 5,780 2,540 15,282 192,786 95 49,156 257,319 0 23,986 4,325 28,311 47,716 24,650 100,677 46,317 110,183 156,500 142 257,319 263,923 41,466 26.997

2011 13.2 5.1 6.1 20.9 20.9 47.3 34.3 24.7 31.3 8.5 5.5 5.7 5.3 5.5 16.8 38.3 1.6 9.0 41.5 0.7

2012 6.9 6.3 8.7 (6.6) (6.6) 49.8 34.1 25.2 27.4 7.2 4.8 5.6 5.3 3.4 16.0 43.1 1.8 10.2 46.2 4.3

2013 8.3 7.8 8.8 (12.0) (12.0) 50.3 34.0 25.3 22.2 5.8 4.1 5.7 5.2 4.7 17.2 38.2 1.4 13.4 61.1 2.4

2014 3.7 6.1 7.0 34.5 32.6 51.4 34.7 26.1 28.8 7.3 5.2 5.8 5.3 1.0 17.5 33.7 1.3 19.2 52.6 5.8

2015 3.8 3.7 1.5 (5.9) (5.9) 51.7 34.7 25.5 26.1 6.5 4.6 5.7 5.1 5.0 16.9 39.1 0.7 17.7 56.4 0.4

2016E 3.0 4.9 5.5 (19.8) (19.8) 52.7 35.3 26.1 20.4 5.3 3.6 5.8 5.1 17.1 16.8 44.4 0.5 12.0 218.9 1.0

2017E 3.5 5.8 6.4 17.6 17.6 53.2 36.1 26.8 23.1 6.6 4.2 6.1 5.0 28.2 20.9 44.6 0.5 9.0 191.7 2.9

2018E 4.4 8.4 9.9 19.2 19.2 54.2 37.5 28.3 26.4 8.0 4.8 6.5 5.5 26.5 17.5 44.5 0.5 11.2 59.1 4.6

Key ratios (%) Year to 31 Dec Sales (YoY) EBITDA (YoY) Operating profit (YoY) Net profit (YoY) Core EPS (fully-diluted) (YoY) Gross-profit margin EBITDA margin Operating-profit margin Net profit margin ROAE ROAA ROCE ROIC Net debt to equity Effective tax rate Accounts receivable (days) Current ratio (x) Net interest cover (x) Net dividend payout Free cash flow yield

Source: FactSet, Daiwa forecasts

Company profile MTRC is the only rail company in Hong Kong. In December 2007, it merged with the KCRC and now operates a rail network that encompasses the whole of Hong Kong. The company's traditional business model is characterised as "rail and property", which allows it to award property development rights to developers to raise funds to finance the construction of new subway lines.

4

MTR Corporation (66 HK): 13 April 2016

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Should you enter into investment business with Daiwa Capital Markets Europe’s affiliates outside the United Kingdom, we are obliged to advise that the protection afforded by the United Kingdom regulatory system may not apply; in particular, the benefits of the Financial Services Compensation Scheme may not be available.

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MTR Corporation (66 HK): 13 April 2016

Daiwa Capital Markets Europe Limited has in place organisational arrangements for the prevention and avoidance of conflicts of interest. Our conflict management policy is available at http://www.uk.daiwacm.com/about-us/corporate-governance-regulatory. Germany This document is distributed in Germany by Daiwa Capital Markets Europe Limited, Niederlassung Frankfurt which is regulated by BaFin (Bundesanstalt fuer Finanzdienstleistungsaufsicht) for the conduct of business in Germany. Bahrain This research material is distributed in Bahrain by Daiwa Capital Markets Europe Limited, Bahrain Branch, regulated by The Central Bank of Bahrain and holds Investment Business Firm – Category 2 license and having its official place of business at the Bahrain World Trade Centre, South Tower, 7th floor, P.O. Box 30069, Manama, Kingdom of Bahrain. Tel No. +973 17534452 Fax No. +973 535113 United States This report is distributed in the U.S. by Daiwa Capital Markets America Inc. (DCMA). 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The principal research analysts who prepared this report have no financial interest in securities of the issuers covered in the report, are not (nor are any members of their household) an officer, director or advisory board member of the issuer(s) covered in the report, and are not aware of any material relevant conflict of interest involving the analyst or DCMA, and did not receive any compensation from the issuer during the past 12 months except as noted: no exceptions. Research Analyst Certification For updates on “Research Analyst Certification” and “Rating System” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. The views about any and all of the subject securities and issuers expressed in this Research Report accurately reflect the personal views of the research analyst(s) primarily responsible for this report (or the views of the firm producing the report if no individual analysts[s] is named on the report); and no part of the compensation of such analyst(s) (or no part of the compensation of the firm if no individual analyst[s)] is named on the report) was, is, or will be directly or indirectly related to the specific recommendations or views contained in this Research Report. The following explains the rating system in the report as compared to relevant local indices, unless otherwise stated, based on the beliefs of the author of the report. "1": the security could outperform the local index by more than 15% over the next 12 months. "2": the security is expected to outperform the local index by 5-15% over the next 12 months. "3": the security is expected to perform within 5% of the local index (better or worse) over the next 12 months. "4": the security is expected to underperform the local index by 5-15% over the next 12 months. "5": the security could underperform the local index by more than 15% over the next 12 months. Disclosure of investment ratings Rating Buy* Hold** Sell***

Percentage of total 66.9% 19.7% 13.5%

Source: Daiwa Notes: data is for single-branded Daiwa research in Asia (ex Japan) and correct as of 31 March 2016. * comprised of Daiwa’s Buy and Outperform ratings. ** comprised of Daiwa’s Hold ratings. *** comprised of Daiwa’s Underperform and Sell ratings. Additional information may be available upon request. Japan - additional notification items pursuant to Article 37 of the Financial Instruments and Exchange Law (This Notification is only applicable where report is distributed by Daiwa Securities Co. Ltd.) If you decide to enter into a business arrangement with us based on the information described in materials presented along with this document, we ask you to pay close attention to the following items.  In addition to the purchase price of a financial instrument, we will collect a trading commission* for each transaction as agreed beforehand with you. Since commissions may be included in the purchase price or may not be charged for certain transactions, we recommend that you confirm the commission for each transaction.  In some cases, we may also charge a maximum of ¥ 2 million (including tax) per year as a standing proxy fee for our deposit of your securities, if you are a non-resident of Japan.  For derivative and margin transactions etc., we may require collateral or margin requirements in accordance with an agreement made beforehand with you. Ordinarily in such cases, the amount of the transaction will be in excess of the required collateral or margin requirements.  There is a risk that you will incur losses on your transactions due to changes in the market price of financial instruments based on fluctuations in interest rates, exchange rates, stock prices, real estate prices, commodity prices, and others. In addition, depending on the content of the transaction, the loss could exceed the amount of the collateral or margin requirements.  There may be a difference between bid price etc. and ask price etc. of OTC derivatives handled by us.  Before engaging in any trading, please thoroughly confirm accounting and tax treatments regarding your trading in financial instruments with such experts as certified public accountants. *The amount of the trading commission cannot be stated here in advance because it will be determined between our company and you based on current market conditions and the content of each transaction etc. When making an actual transaction, please be sure to carefully read the materials presented to you prior to the execution of agreement, and to take responsibility for your own decisions regarding the signing of the agreement with us. Corporate Name: Daiwa Securities Co. Ltd. Financial instruments firm: chief of Kanto Local Finance Bureau (Kin-sho) No.108 Memberships: Japan Securities Dealers Association, The Financial Futures Association of Japan Japan Securities Investment Advisers Association Type II Financial Instruments Firms Association

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