Value Investors Club / The Okinawa Electric Power Company, Inc. (9511)

Description

I am long the ordinary shares of Okinawa Electric Power. They have the regulated electric utility franchise
for Okinawa and the surrounding islands.

The ticker is TYO:9511 on Google Finance and 9511 JP <Equity> <Go> on Bloomberg. It’s down 15%
since the earthquake and 50% over the last 5 years. At 49% of book value and a trailing P/E of 7.6x
(vs. 117% P/B and 14.7x P/E for the Nikkei 225) I don’t see how you can lose much money on this essential business.

Over the decade of the 2000s the stock averaged 79% of book with a P/E of 9.7x. The 10 Japanese electric utilities
averaged higher multiples at 119% of P/B and a P/E of 17.9x, but Okinawa’s total shareholder return put them in the
shade with a CAGR of 12.2% vs. a median of 4.6% because it was growing from a lower starting valuation, and because
of its faster asset growth. They also managed to produce those superior per share returns while substantially
de-levering the balance sheet. Its average ROE of 7.1% was almost exactly equal to the group’s.

The stock doesn’t get much love from global investors, which may help explain the historical valuation discount.
Peers Tokyo Electric and Kansai Electric are two of the largest utilities in the world. They have Western sell-side coverage,
multiple foreign listings, and they can be found in many institutional portfolios but little Okinawa Electric only has the
Tokyo Stock Exchange listing and a market cap of USD 762 million.

Average historical P/E ratios of 17.9x for the group are much higher than historical 7.9x FCF multiples because capex
runs well below depreciation across the industry due to the aging population. Industry free cash flow averaged just over
200% of accounting net income for the last decade. I don’t expect that to change meaningfully over the long-term although
it will in the short-term due to increased safety spending.

In Japan the industry is highly concentrated compared with the U.S. – 10 investor owned utilities compared with more than
60 – so you could argue its participants are more systemically important.

It’s hard to have a precise estimate of the stock’s upside at this point – the situation in Japan is fluid as they say- but I don’t
think you need to. What matters is that for the moment, even though this is a solid business at incredibly cheap levels, the
bears are mostly in control of the price discovery process. That doesn’t last forever unless a stock is a terminal short and
this one is not.

Full disclosure – I am pushing the outer bound of my strike zone with this stock. I know the utility business but this is my
first time investing in Japan. Also, my cost basis of JPY 3,159 per share was lower than the last trade at JPY 3,495. I should
have posted this right after I finished buying but I got distracted with some other stuff. If you’re patient and give the
government a chance to scare utility investors with another round of half-baked proposals for dealing with Tokyo Electric
you may get a chance to buy it cheaper.

***

Japanese electric utility stocks have gotten crushed since the Fukushima meltdown. Tokyo Electric (Tepco) is understandably
down over 85%, but even the median electric stock is down 35% (having been down almost 45% at one point this month)
while the Nikkei 225 is down only 10%. Why?

1. Tsunami damage to power plants along the coast, in conjunction with nuclear capacity taken offline for unscheduled safety
inspections, and the damage to Fukushima Daiichi, is creating power shortages across the grid and forcing reduced
kilowatt-hour (kWh) consumption by customers.

Japanese electric utility ratemaking allows the companies to experience increased revenues when consumption goes up
and decreased revenues when consumption goes down. The high fixed cost bases of these capital-intensive businesses
mean the lower volumes are causing painful negative operating leverage.

2. The Japanese regulatory compact calls for the utilities to adopt national energy priorities that include heavy emphasis
on the use of nuclear power. In exchange, the government provides them with a ratemaking mechanism that allows them
to earn more money by getting a greater percentage of their generation mix from nuclear power above a pre-determined target.

Nuclear power is substantially cheaper than coal or LNG-fired generation so using more of it than the target levels lowers a
utility’s costs. They are allowed to keep the difference between what they paid for the incremental nuclear power and the extra
amount they would have paid for more expensive power that was already built into rates, rather than being required to pass the
savings through to the ratepayers.

The mechanism also works in reverse. It forces them to absorb the incremental costs that occur when they get less than their
target percentage of the generation mix from nuclear, and instead get an above target percentage of their mix from the more
expensive sources. That is what’s happening right now because so much nuclear capacity has gone offline. The lost nuclear
capacity that can be replaced is being done with higher cost coal/LNG/fuel oil generation.

3. Nuclear plant operators will likely have to pay for expensive safety retrofits before the capacity can go back online, causing
further cash outflows (with uncertain prospects for cost recovery given the political environment). One of the more extreme
retrofit plans I’ve read about would effectively require the operators to mothball every other reactor in order to expand the
physical distance between live reactors.

4. Another key aspect of the Japanese regulatory compact is that the government agrees to foot the bill for liability damages
if a nuclear operator experiences an accident that is caused by a “grave natural disaster of exceptional character”. The chain
of liability is exclusively between the Japanese government and the operator of the damaged plant, as compared with the
United States where we have a system of shared liability amongst all operators in the industry.

Here, if the liability exceeds $375 million but is less than $12.5 billion, the difference of $12.2 billion gets split pro rata amongst
all the other nuclear operators based on how many of the nation’s 104 reactors they own, regardless of their involvement in
the accident. $12.2 billion dividend by 104 reactors = $117.5 million per reactor.

The Tohoku earthquake was the 5^th largest in recorded history. In conjunction with the tsunami these were clearly extreme
events and should fall within the pre-established liability framework that requires the government to pay the liability compensation
bills. I have read that Marsh and Moody’s both expected that classification to be assigned. The government is avoiding it for

political expediency, and Tepco doesn’t exactly have the moral authority or public support to challenge it.

The government is also formulating plans to require all the nuclear plant operators to contribute unspecified amounts of money
to a new entity that will backstop Tokyo Electric. This is highly disturbing because the government is retroactively changing
the compact from a cost-sharing regime exclusively between the operator and the government to a cost-sharing regime amongst

the government and all nuclear operators.

The rating agencies cite a utility’s regulatory environment as the number one determinant of credit quality. Japan has long been
viewed as having one of the most credit supportive regulatory systems in the world, enabling nearly all of its 10 utilities to be
assigned AA- credit ratings and raise trillions of Yen capital at lower rates than they otherwise would have.
A Japanese utility has never had a significant cost disallowance.

The vague and open-ended appearance of the Tepco backstop obligation, along with the ex-post reinterpretation of the liability
framework, is scaring capital away from the industry. It is particularly surprising in light of the market's previous view of

Japan as a stable and predictable environment for utility investment. Investors thought they knew Japan and now they
are having to rethink that assumption.

Kansai Electric’s lenders didn’t sign up to shoulder Tepco’s obligations. What are Kansai’s executives supposed to tell new investors
about how much the company will be required to contribute to the Tepco backstop? What are they supposed to say about whether
the rules of the road will be changed after the fact again in the future?

Incidentally, Kansai tried to float a bond the other day and they had to pull the offering. That is almost unheard of in the utility
world for such a top tier company.

The good news is these risk factors shouldn’t ultimately affect Okinawa Electric too much.

1. Their service territory is on an island and not connected to the mainland grid, so their excess generating capacity isn’t being
siphoned off to other utilities’ service territories where various plants were damaged, thus reducing the consumption of Okinawa’s
own customers.

2. They don’t own any nuclear generation, so they have not suddenly lost a low cost form of thermal generation. Their
fuel mix is predominantly coal (78%) and fuel oil (21%), so they also aren’t forced to also buy LNG cargoes at elevated spot prices.

3. No nuclear ownership means no expensive nuclear retrofits.

4. The government would be insane to keep behaving like a chicken with its head cut off. If they want to have an economic
recovery they’re going need electricity. If they want to have electricity the industry has to be able to attract capital. If they want
the industry to attract capital they’re going to have to give investors clarity about the regulatory compact. Eventually they’ll come
to their senses.

***

Once the crisis subsides and the market regains its willingness to value Okinawa Electric from a more balanced perspective,
there are some positive factors to focus on.

Okinawa Prefecture’s population, and therefore electricity demand, is growing at a faster rate than the rest of the country.
Pre-earthquake the company was estimating 1.4% annual kWh growth over the next decade vs. a national average of 0.9%.

The company’s business is less sensitive to the business cycle than other Japanese electric utilities because a higher portion of
its demand is from residential and commercial use (75% combined in 2009 vs. a national average of less than 60%) as opposed
to industrial use. Note that 12% of volumes are industrial demand that comes from the U.S. military bases. Polling shows large
segments of the public support the elimination or downsizing of the bases but they aren’t going anywhere any time soon.
Two reasons – China and North Korea.

The government gives the Okinawa economy special support in the form of tax breaks and various economic incentives

because of its political importance and its remoteness.

***

I know we’d all love to own stock in great businesses that don’t have any risks, but those businesses don’t exist and Okinawa
Electric is no different. However, the stock is more than cheap enough to give you a margin of safety against normal business
risk factors. Since the situation is fluid there are some black swan risks to keep an eye on anyway.

Okinawa Electric is somewhat levered, and if the government lets Tepco’s creditors take a haircut that is going to have a couple
of consequences for the utility industry.

First, it would obviously hurt all utilities’ ability to raise financing. Okinawa is currently building their first LNG plant, which is
scheduled to come online next year, and they have normal periodic debt refinancings to fund. Their debt/capital ratio is currently
62.3% and a good chunk of that comes from the local bond market, although it is well termed out and Bloomberg indicates YTMs
under 1.4% for all 9 bonds shown under 9501 JP <Corp> <Go>. In fact, they were able to access the bond market last week.

Second, it would hurt revenues by reducing economic activity across the country and causing a dropoff in electricity consumption.
The banks and insurance companies that would otherwise be financing the nation’s recovery would be severely damaged.
Moody’s and S&P have said they would classify haircuts as a default, thus requiring much larger amounts of capital to be held
against Tepco debt. Forcing haircuts looks to me like a date with disaster.

In case the 62.3% seems high it’s actually much lower than its domestic peers. Japanese utilities tend to use more financial
leverage than their Western counterparts. They typically operate with over 70% debt/capital compared with just over 50%
at American electric utilities. They can do this mainly because, as I mentioned earlier, Japan’s regulatory environment is
considered by the rating agencies to be very credit supportive – more so than the state model in the U.S. As a result the typical
credit rating is AA- compared with BBB/BBB+.

It doesn’t hurt that Japanese interest rates are much lower. Partly because of lower interest rates the average cash flow
interest coverage ratio at 6.5x is actually higher than the U.S. with 4x.

Another catastrophic risk I see is the failure of Tepco to bring the Fukushima plants into a permanent cold shutdown, which
in turn causes a much greater radiation crisis which in turn causes a much more severe recession. I don’t have anything
smart to say about the probability of that risk occurring, but if it were material it should also be priced into the broader
equity averages more so than it currently appears to be.

The final black swan risk I see is the potential for the long-awaited Yen death spiral. You guys know how to hedge that risk
better than I do.

***

Domo arigato, and thank you for reading.

Catalyst

-- Clarity around Tepco's compensation liability framework

-- Fukushima Daiichi being brought into permanent cold shutdown

-- The eventual end to electricity blackouts in eastern Japan

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			2011	2012
Price:	3,495.00	EPS	$460.00	$0.00
Shares Out. (in M):	18	P/E	7.6x	0.0x
Market Cap (in $M):	61,064	P/FCF	0.0x	0.0x
Net Debt (in $M):	198,604	EBIT	0	0
TEV (in $M):	259,668	TEV/EBIT	0.0x	0.0x