Here's why the new rail scheme could endanger SMRT, LTA

SMRT sacrifices lower EBIT margins for higher free cash flows.

Although the New Rail Financing Framework (NRFF) is supposed to relieve SMRT of its capital expenditures, the new scheme seemed to pose an uneven risk-reward sharing between the transport group and the Land Transportation Authority (LTA).

SMRT is required to share profits through a tiered structure should earnings before income taxes (EBIT) margins exceed 5%.

According to OCBC Investment Research, the licence annual licence charge SMRT will pay LTA will be calibrated to account for deviations derived from the projected revenue figures of SMRT rail businesses as determined by LTA.

"In our view, we reiterate the point that the risk-reward sharing mechanism between SMRT and LTA is uneven. Firstly, the sharing mechanism is based on a tiered EBIT margin cap starting at 5% and EBIT margin collar at 3.5%. Any EBIT deviations beyond the cap and collar would be shared with LTA, but based on the terms of NRFF, there is limited risk sharing by LTA, up to the licence charge payable by SMRT to LTA each financial year," the report said.

And while LTA will share 50% of the shortfall should EBIT margins fall below 3.5%, there is no limit to the upside sharing.

"If SMRT composite rail EBIT margin ranges between 5-6%, LTA will share 85% of the incremental margin exceeding 5%, and if SMRT composite rail EBIT margin exceeds 6%, LTA will share 95% of the incremental margin exceeding 5%," OCBC said.

"All the upside sharing will be adjusted through the licence charge to reduce SMRT’s composite EBIT margin to a level closer to 5%," the report explained," the report added.

To recall, SMRT's composite rail EBIT margins from 2012 to 2016 ranged from 9.5% to 23.5% under the current rail financing network.

More so, since ridership and fares are largely beyond the control of SMRT, the revenue shortfall mechanism would mitigate the downside revenue impact, adjusting the group's license charge to LTA.

With this, OCBC deemed it necessary for investors to accept the planned SMRT buyout by Temasek, as the group's share price is expected to go downhill on weak earnings outlook.