The Most Profitable Shinkansen Route Also Means the Largest Capital Spending in the Future

Leading Independent Investment Research, Morningstar, Inc.

Morningstar

Leading Independent Investment Research

Morningstar, Inc.

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Equity Bottom-Up

We are raising our fair value estimate for Central Japan Railway to JPY 21,300 from JPY 20,000 after the company reported record-high half-year net profits for the period ended Sept. 30, 2017. JRC’s half-year result, with net profit increasing 8.5% year over year to JPY 233.2 billion, did not contain any surprise items, however. The small upswing from our forecast was attributed to a better-than-expected 3.8% increase (against our forecast of 3.3%) in Shinkansen revenue, reflecting more frequent railway services to capture an incremental demand during business peak hours. As expected, the mainstay railway operations remain on track, maintaining stable consolidated revenue growth of 1.2% (against our forecast of 1.1%). Its improving return of capital continues to track above its 8% cost of capital with the latest return on invested capital above 10.3%. With some delay in the construction-related expenditure, we expect the company’s earnings momentum will continue for several more quarters to see if rising charges from the Chuo Shinkansen project starts to weigh down the result.While we had expected the near-term earnings strength, we fine-tune our earnings forecasts to factor in slightly higher demand for Shinkansen. We modestly lifted the operating margin forecast for the segment to 41.5% from 40.5% assumed previously to account for high operating leverage in the Tokaido Shinkansen operation until the end of 2019. Our cost assumption is also revised down slightly as we welcome the news that loss-making subsidiaries in international rolling stock manufacturing, or Nippon Sharyo, are minimizing an expected loss from overseas operations without requiring the JPY 22 billion financial assistance from its parent.JRC’s relative underperformance to its peers, underperforming the Nikkei index by 10% over the past year, reflects concerns over the Chuo Shinkansen Project. JRC has 10 more years to build the 286 kilometer superconductive maglev track, which will include the 25 km South Alps tunnel reaching a depth of 1,400 meters below ground. Our base-case assumption also incorporates about 1.5% uptick in input cost over the company’s forecast of JPY 5.5 trillion and has not yet fully incorporated the longer-term upside from margin expansion linked to the Chuo Shinkansen given its very high execution risk over the next decade. However, we reiterate our view that JRC’s project execution risk is largely mitigated with an extremely strong government support as evidenced with JPY 3 trillion funding through “Zaito” or the Ministry of Finance’s Fiscal Investment and Loan Program. On July 12, the company secured the last round of the government’s Zaito funding of JPY 750 billion at 1% for the next 40 years. Given the comparable market funding would require around 1.4% at the point of funding, we estimate the benefits of interest cost saving would exceed JPY 16 billion each year.Analyst: Mari Kumagai

We are raising our fair value estimate for Central Japan Railway to JPY 21,300 from JPY 20,000 after the company reported record-high half-year net profits for the period ended Sept. 30, 2017. JRC’s half-year result, with net profit increasing 8.5% year over year to JPY 233.2 billion, did not contain any surprise items, however. The small upswing from our forecast was attributed to a better-than-expected 3.8% increase (against our forecast of 3.3%) in Shinkansen revenue, reflecting more frequent railway services to capture an incremental demand during business peak hours. As expected, the mainstay railway operations remain on track, maintaining stable consolidated revenue growth of 1.2% (against our forecast of 1.1%). Its improving return of capital continues to track above its 8% cost of capital with the latest return on invested capital above 10.3%. With some delay in the construction-related expenditure, we expect the company’s earnings momentum will continue for several more quarters to see if rising charges from the Chuo Shinkansen project starts to weigh down the result.While we had expected the near-term earnings strength, we fine-tune our earnings forecasts to factor in slightly higher demand for Shinkansen. We modestly lifted the operating margin forecast for the segment to 41.5% from 40.5% assumed previously to account for high operating leverage in the Tokaido Shinkansen operation until the end of 2019. Our cost assumption is also revised down slightly as we welcome the news that loss-making subsidiaries in international rolling stock manufacturing, or Nippon Sharyo, are minimizing an expected loss from overseas operations without requiring the JPY 22 billion financial assistance from its parent.JRC’s relative underperformance to its peers, underperforming the Nikkei index by 10% over the past year, reflects concerns over the Chuo Shinkansen Project. JRC has 10 more years to build the 286 kilometer superconductive maglev track, which will include the 25 km South Alps tunnel reaching a depth of 1,400 meters below ground. Our base-case assumption also incorporates about 1.5% uptick in input cost over the company’s forecast of JPY 5.5 trillion and has not yet fully incorporated the longer-term upside from margin expansion linked to the Chuo Shinkansen given its very high execution risk over the next decade. However, we reiterate our view that JRC’s project execution risk is largely mitigated with an extremely strong government support as evidenced with JPY 3 trillion funding through “Zaito” or the Ministry of Finance’s Fiscal Investment and Loan Program. On July 12, the company secured the last round of the government’s Zaito funding of JPY 750 billion at 1% for the next 40 years. Given the comparable market funding would require around 1.4% at the point of funding, we estimate the benefits of interest cost saving would exceed JPY 16 billion each year.Analyst: Mari Kumagai

JRC's Efficient Shinkansen Operations Support Stable Outlook, Lifting the FVE to JPY 21,300