Description

Kintetsu operates Japan's largest private railway covering 508km from its main rail station in southern Osaka extending to Kyoto, Nara, Mie, and Aichi prefectures. Note that Kintetsu's railways are conventional lines, not the high-speed bullet-trains operated by the "JR" railways. The transportation division accounts for approximately 80% of EBITA and includes the core railway business as well as bus and other transport operations. The company also operates 13 regional department stores, 40 supermarkets, hotels, a theme park, travel services, and a real estate leasing and condo development business

Structural Issues

Japan's declining population is well documented - the population peaked around 2006 and the working age population has been declining for the past decade. The population is declining even faster outside of Tokyo because of net-migration to the city. The sparsely populated regions outside of Osaka that Kintetsu serves are declining particularly rapidly and the decline is forecasted to accelerate. Passenger volumes on Kintetsu's lines have declined by -1.4% p.a. in the past five years and -2.8% p.a. in the past two years. Passenger volumes increased in the June 2010 quarter by +0.3% but this was due to a tourist traffic for the 1,300th anniversary of Nara. In the September quarter traffic declines resumed at -1.3% y/y. I expect volume declines to continue for the remainder of the year and into 2011. Additionally, in the past year Japan's government reduced tolls on highways which has made driving incrementally more attractive compared to taking the train.

The railway business has a very high fixed cost base and the company is restricted from raising fares by government regulation. The last increase in rail fares occurred in 1995 and an increase in the future seems very unlikely with the deflationary environment in Japan. As a result, there is little that the company can do to maintain profitability in its core business. Transport division profits have shrunk by 38% in the past 7 years including 11% in the past year alone. I expect this trend to continue for the foreseeable future. The related retail, real estate, and tourism businesses are also exposed to these negative demographics and revenue and profitability are similarly being eroded.

Balance Sheet

Kintetsu has a lethal combination of a structurally declining business and a highly leveraged balance sheet. The balance sheet is a legacy of the bubble years in Japan and the leverage metrics are quite astounding. On TTM numbers, Net Debt / EBITDA is 16.4x, Net Debt / Book Equity is 811%, and Net Debt / Market Cap is 300%. Interest / EBITA Cover is 1.86x but would be much worse if Kintetsu wasn't paying an average interest rate of only 1.7%. If the average interest rate on debt rose to a mere 3.0%, interest cover would fall below 1.0x on current earnings.

How a company with such a poor outlook hasn't already been forced into a balance sheet restructuring can only be understood in the context of Japan. A little over two thirds of the debt is bank debt with the rest straight bonds and one convert. Mitsubishi is the company's lead bank although the Development Bank of Japan is the largest lender. The company has not had any problems rolling its bank loans each year despite the deteriorating operations probably because Mitsubishi doesn't want to realize the losses on the bad loans. There are no covenants in the bonds that I am aware of and the bank debt has pretty loose covenants. Recurring profits cannot be negative three years in a row and the company's credit rating must remain BBB or higher with at least one of the two domestic credit rating agencies, R&I and JCR. Currently R&I rates Kintetsu BBB and JCR has a BBB+ rating. So a single notch downgrade from R&I and double notch downgrade from JCR would trip the covenant.

Mitsubishi, R&I, and JCR have been willing to ignore Kintetsu's problems so far but I believe that operations will deteriorate enough in the next 1-2 years that the lenders and rating agencies will be forced to act. Concerns about the company's Abenobashi project, which I will now discuss, may accelerate this process.

Abenobashi Project

Kintetsu's main railway terminal is in southern Osaka neighborhood of Abeno-ku. This serves as a commuter hub for the regions to the south and east served by Kintetsu lines. The company is in the process of building a skyscraper on top of the terminal that will be Japan's largest building measured by occupied floor, measuring 300 meters high, 59 floors, and 210,000 sqm of floor space. The construction cost and department store fit-out cost is estimated at approximately Y115 billion or just under US$1.5 billion. This is almost certain to be a poor investment and it could be a disastrous one. The company believes that it will generate a 5.0% net return but this looks optimistic. Osaka office vacancy rates are above 10%, the worst since 1996. Supply is also set to surge in Osaka after very little new supply between 1994-2008 with the new Umeda North Yard project coming online in 2012. Furthermore, Abeno-ku is not one of Osaka's two primary business districts and the building may struggle to attract tenants. This project seems to be pure empire-building and will ensure that Kintetsu's cash flows are negative at least through the scheduled completion of the building in 2014.

Valuation

TTM valuation multiples are 22x EV/EBITDA, 56x P/E, 1.9x EV/Sales, and 2.7x P/B. Unleveraged FCF / EV is negative and the dividend yield is 2.0%. I forecast revenues and profitability to continue to decline every year so forward multiples are even higher. Remember that the company has 16.4x Net Debt / EBITDA so if you believe the company is worth less than 16x EBITDA as I do, then the equity is worthless. The stock has little if any valuation support and it will continue to sell off as earnings disappoint and negative balance sheet catalysts begin to emerge.

I should mention why I think the stock is trading on such inexplicably high multiples. A large portion of the shareholders are retail investors living in Kintetsu's service areas. The company gives retail shareholders perks like coupons on rail fares, hotels, and tourist attractions. This may add an extra percent or two of yield for large retail shareholders. These shareholders are also probably more immune to quarterly earnings disappointments and falsely believe that the railway is a safe, stable investment. Nevertheless, the stock has been going down and I expect it will continue to do so as fundamentals deteriorate.

Catalyst