ComfortDelgro will be announcing its 2Q result tomorrow on 11th August.

This column is written by @j_chou from InvestingNote.com.
–@J_chou has an interest in global macro trends, financial markets and equity research and enjoys applying a combination of the three in his investments. His eventual investing goal is to manage a risk parity portfolio and achieve true financial freedom.

A component of the STI, Comfort Delgro was once championed as a stable dividend paying stock with a strong economic moat. Recent disruptions in the taxi industry have since changed that view, causing the stock to tumble to its 52-week low despite a relatively muted 1Q17 earnings report. Investors were likely concerned with the falling revenue and operating profits, mostly attributed to the decline from the taxi segment. The share price has since recovered slightly from its 52-week low to $2.310, but there is still an opportunity to capitalize on the negative sentiments towards the company. In this article I will look to determine whether Comfort Delgro is ripe for a contrarian play by assessing its long-term prospects from a bullish, neutral and bearish perspective for the next 5-10 years.

Comfort Delgro: Much more than just a taxi company

The distinct blue and yellow taxis that peppers the streets of Singapore may cause investors to mistake Comfort Delgro as primarily a taxi company.

But a quick look at the company’s financial report will reveal that the taxi segment only contributes 33% of total group revenue; Public transport segment, which comprises of buses and rail, is the largest contributing segment with over 60% of revenue.

By every measurement Comfort’s management has shown that the company is well-run and deserving of its past glory: Since the merger of Comfort and Delgro in 2002 the company has leveraged on its advantages in the Singapore transport industry and successfully expanded overseas. A scan through their annual report will show that Comfort is a leading player in the transport industry: it has a diversified portfolio of transportation services in 35 cities and 7 countries, including Singapore, China, Australia, UK, Ireland, Vietnam and Malaysia, with the overseas segment contributing 36% of total revenue.

Given that the public transport and taxi segments contribute over 90% of total revenue, I will break them down by employing mostly a top-down approach and determine a bullish, neutral and bearish scenario for each.

But before analysing the company itself I will like to discuss about a certain issue that I observed has been widely neglected in the Taxi vs. Uber & Grab saga which will definitively disrupt the transportation industry and form a revolving theme for determining Comfort’s future position in the industry.

The Rise of Autonomous Driving

For decades autonomous driving has always been a hot topic of research in the transportation industry. If fully implemented, autonomous driving will have a massive disruption on urban mobility (one of the many reasons why Tesla’s share price is so expensive!). In recent years, the entry of automotive and AI market players and the combination of three interlocking trends has accelerated the development of autonomous driving technology.

Computer vision: Advances in big data and machine learning have allowed computer vision to finally be good enough to distinguish objects on the road, build 3-D maps of the surrounding area, and be supported by processor speeds powerful enough to be able to operate them natively in a car.

Ride-sharing: The self-driving technology stack is currently still too expensive for the average consumer, but the advent of ride-sharing companies like Uber and Grab has allowed the possibility of distributing the cost over many passengers.

Electrification: Every fully autonomous car company today is planning on an EV platform. This is only secondarily about the environment. Primarily, it is because the cost of maintenance of an EV car is dramatically lower. If a single company owns the car and it has an incredibly high utilization rate, then that lower maintenance cost is easily worth the higher upfront cost.

And the technology is actually not too far away from being implemented. Self-driving cars have already been introduced by Uber in the United States, and companies from Tesla to Baidu have already proven the effectiveness of autonomous driving.

See: Testing Tesla’s Autopilot System At 70mph here.

With technology aspect overcome sooner rather than later, the concerns with autonomous driving will lie only with governmental regulations and consumer acceptance.
With Singapore being a densely packed urban city with land scarcity issues, it should come as no surprise that the government is very receptive to implementing an autonomous driving system. According to a report from Singapore’s Land Transport Authority (LTA), the potential benefits of driverless vehicles include improved fuel efficiency, enhanced mobility for the elderly and the disabled, and the reduction of land needed for roads and parking lots.
Tan Kong Hwee, director of transport engineering at Singapore’s Economic Development Board (EDB), noted: “We have a growing population and more than one million vehicles on the road. Being a small and densely populated country, Singapore has a real need for more effective transportation solutions, while optimising our limited resources in space and manpower.” Hence, in the long term, it is clear that the government is aiming to adopt autonomous driving on a large scale to complement the public transport system.

An article on the many benefits autonomous driving will bring to Singapore:
See: Self-Driving Vehicles: Future of Mobility in Singapore here. 

Therefore, taking into consideration the inevitable adoption of autonomous driving on Singapore roads within the next decade, how will Comfort’s transportation segments fare?

Public Transport
The public transport segment is broken down into two sub-segments, mainly bus and rail. The segment is primarily operated under its subsidiary SBS Transit, which owns a significant fleet of public buses and runs the North East Line (NEL), Punggol and Sengkang LRT as well as the new Downtown line (DTL).

Buses
Comfort operates bus services in Singapore(through subsidiary SBS), UK (through subsidiary Metroline), Ireland and Australia. The overseas bus business actually contributes a significant amount to the public transport segment; It is not specified in 2016 Annual Report but from past data it is highly likely the contribution from overseas bus segment amounts to 2/3 of total bus revenue.
In Singapore, 75% of subsidiary SBS’s total revenue of $1098M in FY16 comes from the public bus segment. The catalyst for this segment going forward will be the change in revenue model given the LTA’s decision to transit to the Bus Contracting Model, which states that the government now bears all fare revenue risk and the capital expenditure for the purchasing and ownership of public buses. Operators such as SBS will be instead paid a fixed amount to operate the buses. This has so far been a positive change for the bus segment, evident by the 0.75% growth in 1Q17. Management has also stated in 1Q17 that the BCM will allow Comfort to enjoy greater revenue intake. Looking forward, this provides a clearer outlook for projected bus income from 2017 until 2025(maximum duration of current BCM contracts) and the substantial reduction in capital expenditure(as the company will not have to purchase buses anymore) will free up cash flow for Comfort.
Not much information is divulged with regards to Australia and UK Bus business but management guidance states revenue from the Australia Bus Business is expected to be higher while revenue from the UK bus business is expected to decrease from the foreign currency translation effect of the weaker £.

Bullish:
Switch to BCM has a net positive effect on profit margins and winning upcoming Bukit Merah Bus Package and maintaining existing 8 bus packages until 2025. Conclusion of Brexit will bring certainty and strengthen the pound, resulting in increased revenue from UK bus business. Australia segment to also maintain its revenue growth. Utilising cash holdings to make more acquisitions and increase overseas revenue.

Neutral:
Renewals for existing bus packages will be more difficult as Increase in competition for tenders will squeeze margins and cancel positive effect of BCM. Revenue contribution from Australia and UK to maintain and grow at rate of inflation. Utilising cash holdings to make more acquisitions and increase overseas revenue.

Bearish:
SBS to lose some of its existing bus packages to competitors as LTA seeks the participation of more competitors to improve operational efficiency. Acquisitions overseas to also become less effective due to disruption from autonomous driving.

Overwhelmingly Bearish:
Government has hinted on occasion in the past that the public transport system may have been over privatised. The switch to the new contract model signals LTA’s intent to wrestle more public control. By taking back ownership of public buses, the introduction of autonomous driving may cause the role of operators to be reduced significantly reduced as drivers and other operating services such as bus depots are no longer required; hence future operator contracts will be awarded at a fraction of current cost thus severely impacting operators’ revenue.

See: LTA inks agreement with ST Kinetics to develop and trial autonomous buses here.

Rail
The rail segment has enjoyed positive growth y-o-y. Operating under its subsidiary SBS, rail segment contributed around $250M to total revenue. For FY16, demand for SBS Transit’s rail services grew with over 329 million passenger trips made, which is a 27% increase over the previous year. The spike came from the Downtown Line (DTL), which added on 12 more stations in December 2015. Ridership hit 80.7 million during the year, which almost tripled that of 2015. Average daily ridership on the North East Line (NEL) grew by 5.2% to 564,701, while that of the Sengkang and Punggol Light Rail Transit systems (SPLRT) saw a double-digit growth of 15.3% to 114,094. With the opening of Downtown Line Phase 3 in 2H17, the tender for Thomas-East Coast Line and projected CAGR of 10% for LRT and 5% for MRT ridership, there are multiple catalysts for growth in the rail segment. However, the reduction of 4.2% in fares and the likelihood of further decrease may counteract the positive effects.

Bullish:
SBS wins tender for operating Thomson-East Coast Line, which is a strong possibility as competition is only between them and SMRT. Given the route’s location it is projected to have ridership volume comparable to that of NEL and hence increase daily ridership on SBS rails by 30-40%.

Neutral:
SBS does not win tender for TEL, but increase in ridership volume will still allow rail segment to enjoy stronger revenue growth.

Bearish:
I can’t really think of a bearish scenario in the case of rail.

Taxi
The introduction of ride-sharing companies Uber and Grab has had a swift impact on the taxi segment as the bad reputation, uncompetitive taxi rentals and lower demand for taxis are compelling taxi drivers to abandon the once dominant market leaders, with the unhired rate of taxis hitting 9.1% this quarter, which is double the average unhire rate of 5% in the same period last year. As per LTA, Comfort’s taxi fleet also recorded a decline in numbers of 5.7% YTD to 15,683. Given historical data for the past one year, the decline will look to accelerate given increasing supply of private cars on the road. Furthermore, average daily ridership of taxis was at an eight-year low of 853,000, which is a 12% drop in the same period last year.

Comparison: Jan 2017 vs July 2017

Comfort should be worried about taxi’s future prospects. Uber and Grab are not disrupting the taxi industry simply through introducing a fancy app and artificial pricing. And institutional investors such as SoftBank and BlackRock are definitely not mindlessly dumping money into a loss-making taxi business. The excitement with ride sharing companies is in its potential to radicalize the transportation landscape. Uber and Grab are competing not just on pricing but also technology: It is no secret that the most inefficient component of the taxi business is in its drivers, hence eliminating the need for one will significantly reduce cost, improve trip efficiency and keep pricing competitive. As such, if implemented successfully, which could be as early as within the next decade, it will not bode well for Comfort. The major problem is that Comfort’s current business model is asset heavy; through purchasing a fleet of taxis and relying on rental fees collected from the drivers. In comparison, Uber and Grab’s model is currently asset light as they anticipate to spend massively on driverless cars in the future. Hence, they currently do not own majority of the existing cars and instead generate revenue by taking a 20% cut of ride fares. As you can see, this is a huge problem. On top of Comfort requiring a very large amount of capital expenditure to replace their existing fleet with driverless ones, their lack of R&D in technology will imply that even if they switch business models and implement driverless taxis it is unlikely to be as efficient as the ones introduced by Uber and Grab. Hence one way or the other once driverless is introduced Comfort will soon lack a competitive advantage in the taxi industry. Of course, on a positive note if the technology fails to take off then Uber and Grab’s current model which is unsustainable will lead to their demise and Comfort should again see the light of day. But I would think the former scenario is much more likely and will err on the side of caution.

Investors that are also hoping for some sort of intervention from the authorities to protect local taxi drivers (case in point: Taiwan, Italy, Denmark) may be disappointed to know that in Singapore’s case it is apparent as shown in my previous paragraphs that the government is very open to disruptive technology and highly enthusiastic about the prospects of a driverless system. In fact, the world’s first self-driving taxi was actually implemented right here in Singapore!

See: World’s First Self-Driving Taxis Debut in Singapore here.

Consumer resistance is also in my opinion a non-issue. Uber and Grab can simply offer a cheaper fare for the driverless option and Singaporeans are tech-savvy enough to respond to new technology. Government may even offer incentives to encourage consumers to engage driverless in a bid to implement an autonomous system.

Also to take note, the increasing network of public transport systems may cause cannibalization as increasing accessibility of MRT and buses will imply less commuters willing to travel by taxi. Automotive engineering segment, which contributes around 5% of total revenue will also take a hit as revenue contribution from that segment is highly dependent on servicing of Comfort’s taxis.

Bullish:
Autonomous driving technology takes a lot longer than expected to develop. LTA implements stricter regulations for private car hires. Uber and Grab are unable to further compete on prices and Comfort is able to improve upon their business model and maintain market dominance.

Neutral:
Self-driving cars successfully implemented on the roads. Comfort acquires self-driving car technology such as nuTonomy. gradually transitions to a mixture of drives and driverless business model. Significant decrease in market share but able to engage in healthy competition.

Bearish:
Self-driving cars successfully implemented on the roads. Comfort is unable to adapt and could only maintain minority market share with existing fleet of drivers.

Conclusion
The transportation industry is facing an impending disruption in the next decade, and I fear Comfort is underprepared to face it. Management has hinted from FY16 annual report that they do not think autonomous technology will be disruptive play here; “We will keep a keen eye on the development of electric, hybrid and autonomous technologies and the ensuing changes in legislation, which I suspect will take a while as mindsets and attitudes towards such new innovations slowly change.”
I think that they may have underestimated the technological forces at play here, and that is concerning. Remember the case of Nokia and Blackberry?

Nevertheless, management are not resting on their laurels and have indicated their intent to further expand overseas:

“Our efforts to continue our overseas investments may need to be intensified. A new strategy may need to evolve in light of new changes and challenges.”

Comfort’s main issue currently is that Singapore is small and revenue growth here is limited. Management has already shown they can do a stellar job translating their local expertise into expanding to other geographical regions. With a healthy amount of cash and low gearing levels, It is my guess that moving forward they intend to focus more on inorganic acquisitions and increase revenue contribution of the overseas segment. As such, I believe Comfort will follow in the footsteps of SingPost, hence expect a cut in dividends as the company reverts back to a transitional period and utilize more debt and cash for expansion purposes.

Valuation
I will attempt a simple DCF valuation based on my personal opinion of how the three main segments of buses, rail and taxi will play out.
Bus segment: Neutral
As stated on the LTA website, SBS operates 8 bus route packages from 01 Sep 2016 for a total sum of $5,322M. Given the total number of bus operating years is 58, we can assume each bus operating year will generate around 95M of revenue p.a. If SBS is able to renew its contract for upcoming Bukit Merah Bus Package, revenue should project to 760M p.a. till 2025. For overseas segment, in UK and Australia Comfort enjoys significant market share and is likely to seek growth hence I anticipate 2017 revenue from both UK and Australia bus business to maintain at 1200M and a conservative growth rate of 3%p.a. until 2025. This is of course assuming that autonomous buses has not become a thing within the next decade. Cost efficiencies from transition to BCM should allow operating margin to improve slightly from 7.7% to around 8%.

Rail segment: Bullish
As per LTA projections, with the opening of DTL phase 3 daily ridership should increase by another 100,000 on the existing 1 million SBS riders, hence rail segment revenue of around 300M should see further growth of 10%. Subsequently, it should rise by around 5% year on year given increasing daily ridership for MRT and LRT. Using the DTL contract as a benchmark, which was awarded at $1.6billion for 19 years, translating to a value of around $850million for 9 years, adjusted for different contracting model, for the TEL tender. Given that the government will now bear all revenue risk for the TEL, this should translate to additional fixed revenue stream of around 95million per year for SBS however this can only be realized in parts from 2019 onwards as the line will be opening in 5 stages: Stage 1 in 2019, Stage 2 in 2020, Stage 3 in 2021, Stage 4 in 2023 and Stage 5 in 2024.

Taxi segment: Bearish
I will go out on a limb and predict self-driving system to be fully implemented by 2023. Local taxi fleet contributes around 75% of taxi segment revenue. In between, Comfort should see a decline in taxi fleet of around 5% year on year. Based on 2016 data average revenue generated by each taxi should arrive at around $66,000 p.a. given 5% unhired rate. With a constant 10% unhired rate, each taxi should contribute around $62,500p.a. moving forward. The negative effect should actually be counteracted by more drivers returning back to Comfort as Uber and Grab utilise more driverless cars, though I am unable to determine by how much hence I will not factor that in. However, after 2023 with the implementation of driverless system I expect Comfort’s business to rapidly decline by an extreme 20% year on year. This will leave Comfort with a minority share in the taxi market, to cater to niche consumers who do not wish to use driverless. This is also assuming that Comfort sticks with its current business model and does not implement driverless themselves.

For reasons unknown Comfort stopped reporting breakdown of overseas segment since FY15. Hence, due to lack of information on how their overseas segments will play out, I will simply base this DCF on initial assumption that Comfort’s revenue will maintain at 65% Singapore, 35% overseas. I predict that management will attempt to grow the overseas segment, hence overseas segment will increase by 2 percentage points year on year, playing out to 40% Singapore, 60% overseas in 2026 assuming constant currency. Correspondingly Capital Expenditure should increase to around 500M per year for increase in overseas acquisitions. This is counteracted by less capital expenditure in Singapore due to BCM and decrease in purchase of new taxis.

With that in mind, my breakdown of Singapore segments:

My view is that bus segment with a fixed contract model and limited number of new routes will only enjoy stable growth of 1% p.a. Rail segment to have explosive growth if TEL tender can be secured. Taxi segment to rapidly decline in face of disruptive technology. I have cross checked the table figures until 2018E with that provided by other analysts, and the numbers were similar hence I have confidence that my estimates(at least until 2018) are fairly accurate.

I employed a 10-year two stage FCFF model as I view Comfort to soon undergo a transitional phase ala $SingPost hence stable dividend pay-out will unlikely be maintained. I mainly use this to do a sensitivity analysis on how the extent of decline in the taxi business will impact the overall share price. I calculate total revenue based on how the overseas expansion will play out and determined EBIT margin to be around 10%, which when cross checked with other analysts numbers were again quite similar. However, I project capital expenditure should increase to at least 500M per year given management hint of overseas expansion and technology development, which differs from other analysts who have CAPEX mostly projected at around 300M.

Using a 9% WACC and 2.0% terminal growth, assuming taxi business will decline 5% year on year from 2017 and then 20% year on year after implementation of driverless system in 2023, counteracted by the slight growth for bus segment and huge growth in rail segment, I arrive at a price of $1.57 (34% downside).

Even with a more muted decline of 3% y-o-y from 2017 then 10% decline from 2023 onwards price still arrives at around $1.63 (30% downside).

Hence, my long term view is that taking into account the growth story in Singapore has more or less been maximised, Comfort will have to prove over the next few years that it can further expand overseas, to the point where overseas segment will have to comprise more than 70% of overall revenue for the company to counteract the negative impact of a devastated taxi business in order to maintain and grow its current share price level.

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