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Morningstar | Central Japan Railway's 2Q Margins Positive, but FVE Lowered on Chuo Shinkansen Project Risks. See Updated Analyst Note from 30 Oct 2018

Narrow-moat Central Japan Railway (JRC) reported better-than-expected fiscal year 2018 second-quarter (fiscal year ending March 2019) earnings with margins ahead of our full-year assumptions, though growth is trending in line. Operating income growth of 4.8% year over year is commendable and is driven by effective cost management, leading operating margin to expand by 130 basis points (versus the same period a year ago) to 41.7%. The merchandise segment, which accounts for approximately 13% of JRC’s overall revenue, saw the fastest growth at 3.2% year over year, though this came at the expense of slight operating margin compression. Despite its relatively strong showing this quarter, we lower our fair value estimate to JPY 20,500 from JPY 23,800 to reflect a reduction in our longer-term assumptions and the capital-intensive Chuo Shinkansen project. We think the firm is fully valued.

Over the next three years ending fiscal year 2021, we expect overall revenue CAGR of 2.4%, which is driven primarily by decent rail segment growth. This is due to higher passenger volume associated with the Tokyo Olympics in 2020 as well as consumption demand that might be pulled forward from the impending sales tax hike (from 8% to 10%) in October 2019. Thereafter, we anticipate rail segment growth to slow but remain positive at 1% during our explicit 10-year forecast period ending fiscal year 2028. However, we note that heavy capital requirements associated with Chuo Shinkansen will weigh on free cash flow during our forecast period. The multi-decade Maglev project is meant to ease JRC’s reliance on the core Tokaido Shinkansen line and is expected to cost JPY 9 trillion. The Tokyo-Nagoya route is set to launch in 2027, followed by the Tokyo-Osaka route in 2037. Beyond our explicit 10-year forecast period, there’s a considerable degree of uncertainty around JRC’s pricing strategy for this project and the cannibalization impact on the existing Nozomi shinkansen line.

To better reflect this risk, we have decided to value JRC using the sum-of-parts valuation of its existing rail business and the potential value of the Chuo Shinkansen project. Our base-case assumptions include our belief that the ticket pricing will be at a premium to the existing Nozomi Shinkansen’s so as to allow the Chuo project to see marginally positive returns but still remain at a level that we think would attract riders. The Chuo route, which uses Maglev technology, is touted as being faster and safer than existing alternatives. We think the safety argument may find favor with riders as the Maglev system allows trains to hover over tracks, which implies reduced earthquake-related derailment risk. The time savings is also significant. Using the Chuo Shinkansen from Tokyo to Osaka would cut travel time to around 67 minutes from the current 150 minutes. We have assumed that the Chuo pricing would be 60% higher than the Nozomi’s, taking into account JRC’s ability to set pricing freely for the Chuo shinkansen project.

Currently, there are three main programs in place for Shinkansen project pricing and construction:
1. Shinkansen lines that are constructed by the government and then purchased operated by JR companies, such as the Tohuku and Joetsu Shinkansen lines operated by JR east.
2. Shinkansen lines that are developed by the government and then leased to JR companies, such as the Hokkaido shinkansen line operated jointly by JR Hokkaido and JR East
3. Shinkansen lines that are built and operated by the JR company itself, such as the Chuo Shikansen project.

With regards to points (1) and (2) above, maximum prices on both basic fares and limited express surcharges are being set by the authority (Ministry of Land, Infrastructure, Transport and Tourism). Although Japan Rail companies have the autonomy to lower prices at any time, they are required to obtain approval from MLIT each time they wish to raise prices. For the latter program, Japan Rail companies have the freedom to set pricing freely without intervention from the authority.

This prices the cost of a one way ticket on the Chuo line from Tokyo to Osaka at around JPY 16,576 (or USD 150.69). As this is fairly expensive, we think the cannibalization from the Nozomi line for the full route could be limited initially although we don’t rule out the potential for business travelers to prefer the Chuo line. Where the Chuo line may get better ridership response would be on its route between Osaka and Nagano as there is no dedicated Shinkansen serving this route presently so the Chuo line would reduce the journey to less than 60 minutes from around four hours currently. This opens up the possibility for tourists to fly into Osaka instead of Tokyo and take the train to Nagano. This potentially dovetails with Japan’s Integrated Resorts (Casino) plans with Osaka being a likely location for one of the casinos.

However, the Chuo link to Osaka won’t be complete until 2037. As we don’t have enough clarity at this stage on the existing make-up of the Tokyo-Nagoya riders, we have nonetheless assumed that there will be immediate cannibalization by the Chuo Shinkansen of the Nozomi passengers. Arguably, this would be net positive for JRC given the Chuo’s higher tariffs and gives the Chuo Shinkansen a JPY 2.7 trillion net present value. As a result, we think JRC’s current share price already largely reflects a generally positive outcome for the Chuo Shinkansen.