Description

Hokuriku Electric Power is a Japanese electric power company that can be bought for 5x free cash flow.  A 20% yield seems attractive when comparable US power companies yield less than half that, in an environment where Japanese treasuries yield 2% versus 4.8% in the US.  20% is also a respectable yield on an absolute basis for a stable, regulated return business. 

The knocks on Hokuriku, as I see them, at the outset:

1) Although there is ample English literature available, the collective English language skills of those at the company are spotty at best.  To the extent you have access, many of the sell side analysts are competent in English, and quite knowledgeable.  I’ve provided some leads below.

2) Management has the capital allocation skills of your average American undergraduate intern.  This is what makes investing in Asia so amusing.

3) As catalyst-less investments go, Hokuriku is a poster child.  There has been no management change, there are no activist shareholders, foreigners only own 2%, etc., etc.  There are, however, no controlling shareholders. 

4) As depreciation declines, it is likely that realized rates per kWh will come down over time.

5) The shuttering of Hokuriku’s new nuclear plant, Shika #2, delays the story somewhat. 

6) Hokuriku is pretty levered by some measures.  5.5x debt/EBITDA sounds scary, but given that Hokuriku’s weighted average interest rate is only 2% (fixed for many, many years) 2.1x interest coverage maybe sounds a little less scary.

I think the most relevant question in this situation is why we’re being offered a 20% yield on a Japanese utility.  I believe the answer is a combination of investor sophistication and, more importantly, the as yet little-noticed permanent end to excess capex.

Investor Sophistication

I simply don’t believe investors are looking at free cash flow.  In large part due to management’s 10% payout policy, dividend yield is a very bad proxy for the value of this business.  As witness to this thesis, the Japanese EPCO industry as a whole yields 10% on FCF.  In defense of management, government policies are somewhat of a barrier to dividend increases.  Before the government began deregulating the electric power industry in 1999, annual dividends per share were capped at Y50.  To avoid attracting attention from regulators, dividend increases have been moderate so far.  Dividends have been slowly creeping up however, with 60% of the EPCOs slated to pay a dividend greater than Y50 in 2006 (the highest being Y60 – hooray).  Some of the more brazen ones are expected to pay a Y70 dividend in 2007.  Short of buying back 20% of the shares a year, suddenly lifting your dividend yield to 20% overnight would be the best catalyst I could imagine.  Instead we languish as management pays down debt that costs 2% (not to mention the early retirement penalties).

End of Excess Capex           

Prior to deregulation institutional ignorance compelled management to overspend on fixed assets and operating expenses.  The newly competition-minded management has gotten religion.  The improvements however were masked by Y90 bill of capex over the last two years to build their newly-commissioned nuke, Shika #2.  I have asked the company and sell side analysts repeatedly how much capex will be in 2007 and beyond, and the answer is invariably, “about Y40 bill.”  That’s about Y85 bill less than depreciation for quick reference.  The only other question I’ve asked as often is for how long capex will remain at Y40 bill.  Invariably the answer is, “for at least 10 years.”  So, assuming EBITDA can be maintained near these levels, we have a bona fide free cash flow yield of about 20%. 

Valuation

2007 Projections (billions of Yen):

EBITDA          190

Deprec.            110

EBIT                80

Interest             19

Taxes               22

Net Income      39

Add: Deprec.   110

Less: Capex     40

FCF                 ~100

The valuation depends very heavily on your choice of appropriate yield.  I suggest 10%, which would be a double.  Assuming a 100% premium over 10 year yields (as compared to ~60-80% in the US), you’d have about a five-bagger.  Note that the sharecount on Bloomberg is before subtracting treasury shares.  The real sharecount is 214 million.

Shika #2

A word about Hokuriku’s newly-commissioned Shika #2 nuclear reactor.  On 6/30/06 Chubu Electric Power Co, another EPCO, announced that inspectors found cracks in the turbines of their Hamaoka reactor.  Shika used the same Hitachi turbines.  Regulators ordered the shut down of Shika for inspection of its turbines.  Cracks were found in Shika’s turbines and now work will begin replacing them before Shika can become operational again.  At this point this seems to have little bearing on long-run intrinsic value, but it obviously doesn’t help the timing.  And, in all likelihood, this is the type of setback that will take twice as long to resolve as management expects.  Management’s best guess at this point is that Shika will be shut down through at least March 2007.  One analyst estimates it could be as long as March 2008.  There is no lost revenue as the idled capacity is being supplemented with old coal and oil capacity.  There is however about Y50 million of excess fuel costs per day as coal and oil plants are much more expensive to operate incrementally than nukes.  Hence the reason management updated 2H and annual guidance subsequent to the shutdown.  This siphons off about Y10 billion per year of after-tax free cash flow, meaning we have to live with a 17% yield until Shika is fixed.

It is worth noting that Hokuriku had a newly-authorized buyback authorization for 2.5 million shares good for three months – on a run-rate to buy back 4.5% of its shares per year – prior to the shutdown of Shika.  It has been put on hiatus however until Shika is back up again, or until management grows a collective spine.

It should also be noted that the guidance revision was related 100% to Shika.  Prior to the shutdown the business was humming along very nicely ahead of expectations.  Coinciding with the Shika announcement management lowered pre-tax guidance for fiscal 2007 (ending 3/31/07) from Y39 billion to Y29 billion.  This assumes the full 9 months of shutdown (July – March), which verifies the Y10 billion cost to FCF (10/.75 x .7).  While lowering pre-tax guidance 25% sounds bad, from another perspective they’ve lowered EBITDA guidance only 5%.  The difference is that EBIT is a more ‘levered’ number given how high depreciation is – more accurately how much higher it is than capex.

Rates & Costs

Hokuriku’s revenue is a mix of regulated and unregulated, but both sides of the business allow for a six month lag for fuel cost recovery.  So fuel cost spikes can be an issue in the short-run.

The next most relevant cost is depreciation.  Since much of the depreciation for Shika was front-loaded, and because capex spend will come down dramatically in FY2008 depreciation will come down going forward.  Because depreciation is a component of calculating the regulated return, rates will also decrease.  Management currently estimates rates will decrease by approximately 2% per year – in line with management of other EPCOs, and slightly less than recent years’ declines.  This will of course be somewhat offset by slow volume growth.  In recent years management has kept up with rate decreases by cutting personnel costs.

Information

Annual reports can be found on the company’s Web site: http://www.rikuden.co.jp/. 

CSFB publishes the best research on the EPCOs.  For a good panorama of the industry, as well as detail about individual companies I suggest CSFB’s 3/6/06 report.  Mizuho and Nikko Citigroup also publish respectable research. 

IR Contacts:

Mr. Shin Kita, Director of IR

[email protected]

Mr. Naruhisa Tsunozaki

[email protected]

Mr. Toshiyuki Takahashi

[email protected]

Mr. Masato Fukumara

[email protected]

Catalyst