Description

Summary

Central Japan Railway (ticker: 9022 JP, “JR Central”) is the second largest railroad operator in Japan and trades at a 24-38% discount to my estimate of its intrinsic value. The business is a monopoly business which generates very stable results and has a FCF yield of 14%. The company will use cash generated from operations to pay down debt for the foreseeable future (not an optimal use of cash but good for a Japanese company). On both a fundamental and comparative basis, this stock seems undervalued. Increasing foreign ownership and the company’s buy back of the government’s remaining 13% stake in the company could be potential catalysts for the stock.





Description

JR Central offers passenger railway service between Tokyo and Osaka, Japan’s largest and third largest cities, respectively. JR Central operates and owns the bullet train (shinkansen) between those two cities, which generates 70% of the company’s revenue and around 90% of its operating income. The remaining businesses are the conventional rail operations in around Nagoya, Japan’s fourth largest city and situated between Tokyo and Osaka, and retail and rental operations from the various train stations it owns. Given that almost all of the operating income is generated from the bullet train, this analysis will focus on that business.



JR Central’s bullet train service has a top speed of approximately 270 km/h and is able to traverse the 500 km (300 miles) distance between Tokyo and Osaka in 2.5 hours. Compared to other forms of transportation over that distance (airline and passenger car), JR Central’s bullet train dominates with approximately 70% market share. While passenger cars do make up approximately 15% of the market as a result of the cheaper cost, the significantly longer travel time of over 5 hours limits the number of passengers who are willing to use this route. Since the Tokyo-Osaka route is the most traveled business corridor in Japan, the company estimates that 60-70% of its bullet train passengers are business travelers, which is a market not likely served by cars. Airlines, with the remaining 15% of the market, represent the only direct competition with JR Central but are at a distinct disadvantage when it comes to price, travel time, convenience, and comfort. The price for the bullet train between Tokyo and Osaka is approximately 14,000 yen, which is 25% cheaper then an airline ticket. Travel times from Tokyo to Osaka are typically equivalent to or less than what would be required by air travel. While flight times including the check-in and check-out process are only 1.5 hours, transportation to and from the airports can take an hour or more. For instance, to get from the business district of Tokyo to the airport takes approximately an hour by train. So, rather than taking a train for an hour, then transferring to a flight, and then taking a taxi or another train at the Osaka airport, most passengers take the bullet train directly from the centrally located station in Tokyo to the station in Osaka. The bullet trains also make significantly more trips per day versus the airlines, which allow travelers to better match their schedules. The market share that the airlines do capture can largely be attributed to passengers who have quick access to the airports or who have strong ties to the airline affinity programs. Recent high fuel prices have put upward pressuring on airline pricing which should only widen the gap.



Combining the high market share and high level of business users generates very stable and high margin business for JR Central. If you look at bullet train revenue for the last 10 years, it has a CAGR of 0.7% and a standard deviation of only 2.2% during that time. Passenger levels have been basically flat throughout that period. Pricing, with the exception of two price increases which coincided with consumption taxes levied, has also been flat. Unfortunately, the company has no real ability to raise prices as it needs Ministry of Transportation approval, who would only agree to price increases if the company started losing money. EBITDA margins for the company as a whole are consistently in the low 40s.



These are the relevant stats:



Stock Price: 833,000 yen

Shares: 2.24 million

Market Cap: 1,866 billion yen (or $17 billion)

Total Debt and Minority Interests: 3,791

Cash: 61

TEV: 5,596 ($51 billion)



2004 EPS 42,807 (19.5x P/E)

2005 EPS 43,036 (19.4x P/E)





Valuation

Let’s look at the FCF generating ability of the company.



EBITDA for the last 5 years: 557, 592, 562, 570, and 598

EBITDA for FYE (3-31-06) (1): 628

Average over six years: 585



Non-cash operating expenses/gain:

Write-down of PP&E: 40-60 per year

Provision for future bullet train upgrade: 33

Gain on retirement benefits: 9



Adjusted EBITDA for last 5 years: 620, 656, 629, 651, and 667

Adjusted EBITDA for FYE (3-31-06): 695

Average over six years: 653



CapEx for the last 5 years: 174, 174, 179, 167, and 143

CapEx for FYE (3-31-06): 175



(1) My actual EBITDA estimates for 2006 are 652, which includes 24 from increased passenger volumes and retail from having the 2005 World Expo in its region. The Expo is a six month event ending in Sep 2005 which contributed an additional 12 billion yen to the company’s operating income in the quarter ended June 2005.



The company has roughly 3,800 of debt at an average interest rate of 4.5% generating interest costs of 170 per year. D&A is about 225, so earnings before taxes (average pre-adjusted EBITDA of 585 minus D&A of 225 minus interest of 170) gets you to 190. A 40% tax rate gets you to cash taxes of 76.



So, in a conservative case, let’s assume a go-forward normalized EBITDA figure equating to the average of the six year period ending March 2006. Adjusted EBITDA would be 653 minus CapEx of 175 minus interest of 170 minus cash taxes of 76 gets you to after tax FCF of 232. Using a 10% discount rate for the business, which I think is conservative given the stable operating results, you get an equity value of 2,320 billion yen or a stock price of 1,036,000, which represents 24% upside from its current price of 834,000.



If instead, we take a slightly more aggressive stance by valuing it off of March 2006 figures, then EBITDA would be 695 and FCF 257. Using a 10% discount rate again would equate to a stock price of 1,147,000 or 38% upside from today’s price. Implicit in this more aggressive case is the assumption that macro Japan will do better during next 5 or 10 years than in the previous 5 or 10. While any hint of macro plays usually sends value investors running for the hills, I think it is a fairly reasonable bet to make.



Of course, the discount rate assumption is the other big driver of this simple valuation and all are free to use what they deem appropriate. I will say that if you agree with my FCF estimates, then the market is valuing JR Central at a rate of 12.4% using my conservative FCF estimates or 13.8% using my more aggressive estimates. Seems like there is cushion on the downside.



The 24-38% discounts to my intrinsic values for the business can be explained by the fact that the stock trades at a premium to its peers using the conventional metrics which Japanese equities are measured. JR Central trades at 19x forward P/E and a TEV / EBITDA (unadjusted) multiple of 9.2x. East Japan Railway (ticker: 9020 JP) trades at 17x forward P/E and an EBITDA multiple of 8.3x while West Japan Railway (ticker: 9021 JP) trades at a 15x P/E and 7.0x EBITDA multiple. However, being only approximations of free cash flows, these traditional metrics miss the story of JR Central and how it is unique among its peers.



On a FCF basis, JR Central has a yield of 14% compared to 4% for East and 3% for West. On an EBITDA-CapEx basis, JR Central trades at 12.9x versus 17.7x for East and 16.2x for West. So what’s the reason for the big discrepancy? EBITDA margins on Central are lows 40s compared to 27% for East and 20% for West. This leads to a much higher FCF at Central since CapEx, while a low double digit % of sales for all three companies, is only 30% of EBITDA compared to 54% for East and 57% for West. From a P/E standpoint, the disparity results from CapEx only representing 75% or so of the depreciation expense recorded by JR Central, compared to around 120% for JR East and JR West.



The huge differential in profitability between JR Central and JR East and JR West come from the revenue mix. Bullet train revenue represents 70% of the company’s overall revenue compared to 19% for East and 26% for West. Margins on the bullet train are much higher than for conventional trains, which gives Central operating margins in its transportation division of 29% vs. 16% at East and 11% at West. Furthermore, transportation makes up 82% of sales and 93% of operating income for Central. East and West have larger retail and real estate operations, generating only 75% and 72% of operating income from transportation.



If you value JR Central with an EBITDA-CapEx multiple inline with its peers, lets say 16.5x, then fair value for the company would be a share price of 1,538,000 or 84% above its current price. While comps are not my favorite method for valuing a business, I find it instructive when looking at non-US companies just to make sure I’m not missing any country-specific or industry-specific risks that I not might be capturing, which does not seem to be the case here.



What is a critical element of this investment thesis is regarding the company’s use of cash. Management has prioritized debt pay downs in order to get leverage, which is currently at 6.5x inline with East which is currently 5.7x and West at 4.5x. When JR Central was privatized, the company took on a fairly massive loan from the government which amortizes annually. Relative to its peers, however, the assets transferred to JR Central were of much higher value, given the much higher operating margins of the JR Central bullet train, resulting in higher leverage at JR Cental. While I would argue that higher leverage is actually a good thing for this type of business, I still see the pay down as a positive given that Japanese companies have historically been poor allocators of capital. Though non-ideal, paying back 5% debt is better than having it sit as cash or being spent on some extremely long payback investment project (expansion of retail operations, land development, etc.). Additionally, management has stated that they will look into the buy back of up to 300k shares after March 2006, which roughly coincides with the government’s remaining 13% ownership in the company. The dividend for this year is expected to be 6,000 yen or a yield 0.7%.





Risks

- Use of cash. Japanese companies are not typically managed with the interests of shareholders front and center which have often led to poor capital allocation decisions in projects with negative IRRs or extremely long payback scenarios. If JR Central was to diverge from its goal of reducing debt and instead started investing in new retail or land operations (as its peers have done) or on further development of next generation bullet train technology I would be concerned.

- Declines in top line. Given the very high fixed cost nature of the railroad business (close to 100% for the transportation business, which generates 80% of sales), any declines in passenger volumes / revenue will fall to the bottom line almost dollar for dollar.

- Weak Japanese economy. Given that passenger volumes are tied to GDP, if the Japanese economy were to weaken considerably, JR Central would suffer. What makes me comfortable with this is that even during the last 10 years, the company’s performance has been relatively stable.

- Inflationary environment. Given the inability for the company to raise prices, if costs starts escalating in a reflationary Japan without a corresponding increase in passenger volumes, JR Central could get squeezed. Reductions in the workforce of around 2.5% per year, though, should provide cushion to offset cost increases.





Background

Japan is an archipelago of four main islands, including the largest island, Honshu, in which JR Central’s marketing area is located. Since a significant portion of land area is mountainous, Japan has an extremely populated belt of urban centers along the Pacific coastline on Honshu, which includes Tokyo, Nagoya, and Osaka, the three largest metropolitan areas in Japan. JR Central’s marketing area includes the historical and cultural centers of Kyoto and Nara, which are the most popular tourist destinations in Japan after Tokyo.



Railway plays a much larger role in travel across Japan as compared to other industrialized nations. While railway travel’s share of domestic passenger transportation (in passenger kilometers) is approximately 29% in Japan, it is under 10% for the UK, France, Germany, and Italy and under 1% for the US. The bullet trains, which are capable of traveling at 270 km/hr are a key component of Japan’s long-distance passenger transportation infrastructure. Currently, there are six bullet train lines in Japan, each of which operates on a network of specially-built standard gauge tracks without level crossing.



JR Central was formed in 1987 from the privatization of the national railroad system.



Foreign ownership of this company has increased and should continue to increase going forward which could be a catalyst for a revaluation of the stock. The government had previously owned 40% of the company which kept foreign ownership low at 3.7%. In July, the government sold 27% of the company in an offering, which increased foreign ownership to 11%. After March 2006, the company is expected to repurchase the remaining 13% owned by the government. Foreign ownership of its peers, in which the government sold off its stakes earlier, is around 30%. Increasing foreign ownership should lead to an increase in pressure for shareholder friendly actions (higher dividend, increased share buy backs) and could also lead to a re-rating of the stock.

Catalyst

Catalysts

- Increase in foreign ownership

- Buy back of remaining government stake after March 2006

- Continued operating results