Central Japan Railway: Challenges From Business Travel Recovery And Maglev Project Costs

By Karreta Advisors

Summary

  • Central Japan Railway operates the Tokaido Shinkansen, the ‘bullet train’ line that runs from Tokyo to Osaka – the main transport artery in Japan.
  • The company faces two challenges; recovering passenger volumes post-pandemic from business travelers, and managing the costly Maglev project.
  • With expectations of the company burning cash for the short to medium term, we are sellers of the shares.
Photo by DoctorEgg/iStock Editorial via Getty Images

Investment thesis

Central Japan Railway Company (OTCPK:CJPRY) (referred to as JR Central) is facing two challenges – recovering passenger volumes post-pandemic from business who have adapted to remote working, and managing costs and funding for its Maglev project. With cash-burn expected for the short to medium term, we are sellers of the shares.

Quick primer

JR Central was established in 1987 following the privatization and break-up of the national railway service. The core rail transportation business is the Tokaido Shinkansen, the ‘bullet train’ line that runs from Tokyo to Osaka – the main transport artery in Japan. The Tokaido line sets the global standard for rail service quality. Since inception the Tokaido Shinkansen has achieved zero train accidents resulting in the death or injury of passengers, an average delay of 0.2 minutes, a maximum speed of 285km per hour and runs 378 trains per day.

If you have visited Japan by flying into Tokyo and visited Nagoya, Kyoto or Osaka by train, the chances are that you were on a Tokaido Shinkansen. There are three grades of train – Nozomi (limited stops), Hikari (semi-fast) and Kodama (all station stops).

The core business is the Tokaido Shinkansen (92% of transport revenues, equal to 70% of total sales in FY3/2020), and JR Central operates conventional commuter rail services, retail operations, real estate and hotels.

Our objectives

In this piece we would like to assess the following:

  • The outlook for passenger volumes recovery post pandemic.
  • Consider the impact of the Chuo Shinkansen Maglev Project on future free cash flow.

We will take each one in turn.

Passenger volume recovery

JR Central’s railway business saw a major collapse in passenger volumes in FY3/2021. A gradual recovery was seen in Q3 FY3/2021 as the government introduced tourism subsidies to encourage domestic travel (the ‘Go To’ campaign’) but this was curtailed as infection rates re-surged in December 2020.

Tokaido Shinkansen – quarterly passenger volume trend in FY3/2021 for Tokyo Station Gate

Source: Company, created by author

Passenger volume growth in April 2021 showed a distinct improvement YoY with Tokyo ticket gate passenger volumes up 122% YoY. However, compared to more normalized conditions in April 2019 volumes remain subdued. The Shinkansen has higher economic sensitivity relative to conventional railway services. The cheap, local non-express conventional commuter network in Nagoya is experiencing much less volatility.

April 2021 passenger volume growth – for Shinkansen Tokyo gate, conventional express rail and conventional rail services

Source: Company, created by author

The Shinkansen’s economic sensitivity can be explained by demand from leisure and business travel. Since the pandemic struck amusement parks closed or restricted entry resulting in a drop in customers traveling – the key venues are Tokyo Disneyland and Universal Studios Japan in Osaka. Inbound tourist volumes have dramatically fallen – for January 2021 overseas resident visitors were down 98.3% YoY. Domestic leisure and business travel are currently being discouraged as both Tokyo and particularly Osaka are fearing a ‘third wave’ of infections. The Japanese COVID-19 vaccination program is relatively slow which will delay recovery, despite the Olympics planned to go ahead in July.

Business travel is a key driver for the Shinkansen business, as it is a cost effective replacement to air travel. Costing ¥29,000 for a return ticket from Tokyo to Osaka on the Nozomi, it is still quite expensive and not used for casual travel. Although there is no disclosure over the proportion of business travel use, we get an idea of its importance when we see daily departures on based on the premium Nozomi (the most expensive and fastest train) versus the Hikari and Kodama. The Nozomi departures make up 60% of total – we believe around 50% of this is related to business, with the concern being that remote working and videoconferencing will substitute future demand.

Daily departures by Shinkansen train type

Source: Company, created by author

Our view on passenger volume outlook is negative. Leisure demand will recover and when inbound traffic return there is scope for pent-up demand to materialize. However, for business travel we believe there will be clear substitution risk from remote working. Our thoughts translate to sales volumes for the short to medium term not reaching FY3/2020 levels – this is also being reflected by current consensus forecasts.

Current sales consensus forecasts

Source: Company, Refinitiv, created by author

Next we look at the outlook for free cash flow generation.

The very expensive Maglev

In 2011 the government approved the construction for JR Central’s Chuo Shinkansen Maglev (magnetic levitation) project linking Tokyo and Nagoya. This is a train system that is designed for normal operation at over 500 km/h, designed to cut one-way travel time from the current 86 minutes to 40 minutes. Service is planned to start in 2027, with an extension being built to Osaka planned for completion in 2045.

This project has been under development since the 1970s, and management have always known that it will be a very costly undertaking. JR Central has a track record high sustained free cash flow generation but has been very coy about allocating any to shareholder returns. This is understandable considering the estimated cost of the Tokyo-Nagoya line is ¥5,523 billion, 170% of current market capitalization. The project is to be fully self-funded – the company has issued ¥2,622 billion debt in the last 10 years.

Capital allocation FY3/2011 to FY3/2020

Source: Company, created by author

Securing funding had not been a major challenge for JR Central pre-pandemic. In FY3/2020 the company has tangible assets worth ¥4,925 billion including lucrative land assets held at book value, and long term investments of ¥846 billion. Its long-term issuer rating stands at A+ by S&P, although the outlook was downgraded to negative in November 2020. The greater concern is the project cost, a recent red flag being construction disputes with local communities in Shizuoka prefecture around required tunneling by the Oi river. The company failed to secure approval to begin preparatory construction work over concerns over environmental damage. Project completion by 2027 now looks remote and more costs are expected.

The positive scenario is that with passenger volumes recovering as initially planned, JR Central can revert back to its historical free cash flow generative self. This will mean that the Maglev project can be financed organically. However, our current view is with an unlikely return to previous business travel levels hampering cash generation and increasing project costs, there is risk of excessive debt raises or dilutive financing.

The company’s balance sheet currently has enough capital and liquidity. Net debt to equity is at a manageable 0.4x even when excluding the project cash raised (ring-fenced as restricted cash under current assets). However, as construction progresses the outlook is for negative free cash flow as currently forecast by consensus.

Current free cash flow consensus forecasts

Source: Company, Refinitiv, created by author

With expected cash-burn for the short to medium term, we believe JR Central’s outlook will be challenging.

Valuation

On consensus forecasts the shares are trading on PER FY3/2022 19.5x, and FY3/2023 10.2x. On a two-year timeframe, this multiple does not look very demanding. However, when we look at the expected cash-burn profile and the limited dividend yield on offer (around 0.9%), the risk profile looks high. The prospects of increasing indebtedness make the low PBR multiple 0.9x less attractive.https://f67df4baf13eb87b96a6f392527d15c3.safeframe.googlesyndication.com/safeframe/1-0-38/html/container.html?n=0

Risks

Upside risk comes from delays in construction work for the Maglev project, as it will limit capex in the short term. This will allow the company to burn less cash, or even generate some positive free cash flow temporarily. The challenges of this project are well known, and arguably priced into the shares.

A major influx of inbound tourism could lift passenger volumes into H2 FY3/2022 as pent-up demand materializes from key countries such as China, Korea and Taiwan. Japan’s vaccination program is planned to commence fully from May 2021, catering to the elderly first but this should increase confidence in travel overall.

If the government restarts its domestic tourism subsidy program, it will have a more prolonged impact in tandem with the vaccination roll-out.

Conclusion

JR Central faces two uphill tasks – recovering demand post-pandemic, and managing costs over the Maglev project. We believe leisure demand will recover but have doubts over business demand, considering the successful adoption of remote working. The Maglev project was always going to be a challenge, but now with the core business under pressure as a source of funding, there is little room for delays or cost overruns.

Valuations may point to the company being a value stock with PBR 0.9x, but with expectations of cash-burn in the short to medium term we are sellers of the shares.

Source : Seekingalpha.com

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