Description

Investment Thesis    

Kyushu Railway Company (“Kyushu” or the “Company”) is an undervalued and misunderstood     regional commuter rail and real estate operator on the Japanese island of Kyushu that was privatized by the government and began trading publicly last October. The majority of the Company’s earnings and value are derived from real estate that it has built up around its stations. These are very desirable locations and scarce assets that trade at premium valuations. This, however, has been overlooked as investors improperly anchor the Company’s multiple to that of lower quality peers (the JR rails that have a much smaller RE mix). Technical factors, overly conservative management guidance, accounting confusion and cursory sell-side coverage, among other factors, has created this mispricing. On a sum-of-parts basis the stock is easily worth +50% above its current trading price. On a relative basis, Kyushu trades at 6x EV/ EBITDA while private rail peers with comparable profiles trade at 12x. If Kyushu’s multiple converged to 10x, the stock would trade 45% higher. There are a number of factors and events that we have identified that should lead to value realization. This is a pretty straightforward situation so we have kept this write-up brief.    

Background

In 1987 the government-owned Japanese National Railway was split into six separate regional for-profit rail operators that collectively became known as the Japan Railways Group of JR Group. Following this division the government of Japan continued to retain ownership of these companies. Starting in the early 1990s through 2006, three of the JRs (a sub-group known as the Honshu JRs) were fully privatized and became publicly-traded entities (JR East, JR Central and JR West). In the ensuing years, JR Kyushu management, unlike that of the other remaining government-owned JRs, undertook a strategy of developing and acquiring real estate contiguous to its rail stations. Concurrently the Company also significantly improved the efficiency of its rail operations. Kyushu’s profitability positioned it to operate independently without government subsidy. In October 2016, Kyushu was privatized with shares sold to the public. It is worth noting that 75% of the Company’s stock was allocated to domestic retail investors as part of the Abenomics initiative to increase individual equity ownership. The government sold shares at a discount to encourage future such participation and avoid political blowback should those individuals lose money. Over the last month Kyushu’s share price has drifted back to only a 10% premium to that IPO level.

Company Overview

The Company’s rail operations and the majority of its real estate business are located on the southern Japanese island of Kyushu with a concentration in the Island’s largest city Fukuoka. JR Kyushu derives 51% of its EBITDA from real estate and construction, 41% from rails, 7% from retail and 4% from other activities.

Real Estate: The Company’s real estate portfolio includes shopping malls, office, hotel and residential. Almost of its assets are located contiguous to or within a close proximity to its rail depots. These “station buildings” are the epicenter of commuter travel in the country with rents and real estate values often primarily determined by the distance from these hubs. As such, Kyushu’s portfolio is comprised of some of the most desirable property holdings with very attractive fundamental profiles that trade at premium valuations. The office vacancy rate in Fukuoka (the city where the Company’s real estate is concentrated) is currently 3.5% and is expected to shrink further to 1-2% by 2020. This combined with solid regional GDP growth should be supportive of rent increases for the next several years. Kyushu Island has an attractive demographic profile with the population growing 1-2% versus shrinking across the rest of Japan. Kyushu is also a rising tourist destination for domestic and foreign visitors (major cities in South Korea, Taiwan, Singapore, Hong Kong and eastern China are within a four hour flight) with projections of 15% annual growth through 2020. This helps drive commerce and rail volume independent of native population growth (see Appendix for further demographic data). Below is an overview of the Company’s major property asset as well as its development pipeline through 2020.      

Development pipeline

Railways: The Company’s railway segment operates 22 lines and 567 stations across seven prefectures of Kyushu. It also owns some smaller ancillary transportation businesses including bus lines, ferries and a car rental agency. Its core rail line is the Kyushu shinkansen (high speed train) which accounts for 30% of segment revenue. Traffic on the Kyushu rails benefit from the same population growth and tourism dynamics as it real estate. Although the transport segment in aggregate is less attractive than the real estate, it is growing and there is quite a bit of self-improvement potential. Management has undertaken cost cutting and service reductions to unprofitable lines. Now as a public company they have even greater incentives to improve performance. Several of Kyushu’s lines lack sufficient traffic volume to breakeven and have been perennial money losers. It will require agreement from the local municipalities served but replacing trains with lower cost alternatives such as bus is possible and could materially drive margin improvement for the Company. Under its labor cost reduction plan, as employees age-out of its workforce, those jobs get automated. This margin tailwind will continue as a matter of course. Below is an outline of the Company’s revenue enhancement and cost reduction plans.    

Financial Performance

This quarter Kyushu will be lapping the interruptions from the Kumamoto earthquake which will result in a year-over-year uptick in rail traffic and to a lesser extent a bump to its retail segment. Overall, management has been excessively conservative with its guidance and so far has sandbagged to the point where each quarter they have meaningfully exceeded on every single segment estimate. Based upon the current trajectory and background fundamentals, the Company should fairly easily generate EBITDA over ¥80B in FY2018 versus management guidance of only ¥74.8B.

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Valuation

The restructuring of Kyushu’s balance sheet going into the privatization has created some broad misunderstandings: 1) to cover rail capex for the next three years, ¥60B of capex was set aside in a trust and categorized as “money held in trust” as a long-term asset yet does not get captured in EV calculations by financial databases nor the sell-side and 2) the prior government stabilizations funds were exchanged for a 30-year prepayment of the shinkansen lease, this is effectively a ¥200B asset that does not appear on the balance sheet at all. The result is non-cash amortization burdening income and an understatement of its net cash position (¥78.8B detailed below). The capital structure misunderstanding is particularly relevant as it affords Kyushu more capital allocation options (increase dividend, more investment in development, recapitalization, etc.), particularly relative to its levered peers. The fact that Kyushu recently decided to get a credit rating may be suggestive of potential recap plans.

At the current stock price of ¥3,440 per share, TSE: 9142 has a market cap of ¥550.4B and EV of ¥471.6.5B equating to 6x LTM EBITDA. This is even a discount to the other JRs despite the fact that 50% of Kyushu’s business is high quality real estate versus only 7% for other the rail-focused JRs. Some sell-side analysts totally write-off the value of Kyushu’s rail segment while others focus on it and value the real estate at +8% cap rates, none provide a reasonable appraisal of each and all anchor multiples to the other JRs. Kyushu’s business profile is much closer to that of the private rails which have a larger mix of real estate. Given that groups’ more attractive mix, the private rails trade at 12-14x EV/ EBITDA. In fact, Kyushu derives a larger percentage of its earnings from real estate than any of those names, so one could argue it should trade at a multiple closer to that of a real estate company. Fukuoka REIT (TSE: 8968) holds a portfolio of properties in Kyushu’s core market that are older and further from the stations that those of the Company (see map below). Fukuoka trades at 18x EV/ EBITDA and less than a 6% cap rate. Not to say Kyushu will trade at that multiple but this does illustrate valuation disparity.  

On a sum-of-the-parts basis under different scenarios the stock is worth 50-75% above where it trades today. That may be a useful reference point but many stocks in Japan seem to perpetually trade a discount to NAV. While activism or corporate actions from management could certainly close this gap we believe the most likely scenario is Kyushu starts trading closer to the Private Rail peers given its business mix (rather than the JRs). Even if it traded in-line with the weakest of the private rail peers or 10x, this would equate to over ¥5,000 per share or 45% above the current stock price.   

Catalysts

• Lapping of outages related to Kumamoto earthquake (although this has been laid out by management).

• Re-rating as people better appreciation the quality of the assets and profile of the business. For one, management has indicated they will be doing investor meeting in the US in September.

• Dividend increase: management changed the payout ratio framework from one based on earnings to EBITDA which gives them more flexibility to increase the dividend and a focus on the enterprise which may signal a potential recap.

• Earnings benefit from recently completed real estate development projects.

• Self-improvement in the rails (labor savings, automation efficiency, potential closure of low volume/ unprofitable lines).

• Capital structure confusion should dissipate as the trust assets are drawn to fund rail capital expenditures.

Risks   

• Rails have high fixed costs which could obviously be detrimental should traffic volumes decline. Outages related to natural disaster are not uncommon in the region. It goes without saying that an earthquake of significant magnitude would certainly hit the company across all segments.       

• Missile attack from North Korea and/ or tourism reduction due to fear of escalation.    

     

Appendix

Company filings (English): http://www.jrkyushu.co.jp/company/ir_eng/library/earnings/

JR Kyushu’s Form F-6 IPO prospectus and roadshow deck are actually fairly hard to track down so I can post if anyone would like    

Company Rail Map & Kyushu Island Demographics

Catalyst

• Lapping of outages related to Kumamoto earthquake (although this has been laid out by management).

• Re-rating as people better appreciation the quality of the assets and profile of the business. For one, management has indicated they will be doing investor meeting in the US in September.

• Dividend increase: management changed the payout ratio framework from one based on earnings to EBITDA which gives them more flexibility to increase the dividend and a focus on the enterprise which may signal a potential recap.

• Earnings benefit from recently completed real estate development projects.

• Self-improvement in the rails (labor savings, automation efficiency, potential closure of low volume/ unprofitable lines).

• Capital structure confusion should dissipate as the trust assets are drawn to fund rail capital expenditures

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