EUR 850.00 For Business Accounts Only

Morningstar | Who’s Riding the Train? We Cut JR East’s FVE to JPY 9,500. Factoring in Weaker Long-Term Ridership

JR East’s, or JRE's, second-quarter (for fiscal year ending March 2019) revenue growth and operating margins across all its business segments were in line with our full-year assumptions, but we cut our fair value estimate to JPY 9,500 from JPY 11,500 on lowered longer-term assumptions and increased near-term capital expenditure. Our narrow moat rating is intact as its railway segment, a regulated business with high barriers to entry, will continue to drive most of JRE’s revenue and operating income over the next 10 years, but we think there is risk to returns thereafter. We think JRE is fully valued at the current price level following our cut to fair value estimate.

During the quarter, operating margin in the core transportation segment, which accounts for almost 70% of overall revenue, saw a slight contraction from the same quarter in the previous year, due to increases in nonpersonnel expenses. Year-over-year revenue growth in the retail & services (0.9%), real estate & hotels (2.9%), and IT & Suica services (10.8%) segments continue to outpace transportation (0.3%), which is in line with our expectations.

Over the next three years ending fiscal 2021, we assume an acceleration in overall revenue growth to 2.9% CAGR, versus 2.0% CAGR in the five years ending fiscal 2018. We believe that traffic volume boost from; (1) the Tokyo Olympics in 2020; (2) pull forward demand from impending sales tax hike (from 8% to 10%) in October 2019; and (3) Shibuya station redevelopment (East Tower) in 2019 are key near-term catalysts. Between fiscal 2021 and fiscal 2028, we expect consolidated revenue growth to slow to 1.4% CAGR, driven by aging workforce headwinds. As part of JRE’s 2027 strategy plans, it expects transportation’s share of overall revenue to shrink from 70% currently to 60% in 10 years time, while nonrailway businesses such as merchandise, hotels, shopping centers, and Suica services will grow from 30% to 40% over the same period.

Our main concern with JRE is its ability to mitigate the risk of declining ridership on its train routes and which the company thinks is its main long-term challenge as Japan's population ages. The good news for JRE is that the bulk of its conventional routes are in the Kanto area, essentially greater Tokyo, where growth is expected to be more resilient compared with more rural areas and smaller towns. We think growing tourism in Japan should also help mitigate the slowdown, which tends to benefit the shinkansen lines. For comparison, revenue from its Kanto lines grew at an annual average of 1.1% the past five years versus 3.6% growth for the shinkansen lines. However, the impact of slowing Kanto line growth is greater to JRE's top line growth as the conventional lines make up 62% of total revenue. Post-Tokyo Olympics, we factor in Kanto line revenue growth to slow to 0.2% CAGR, which is significantly below the recent growth rate.

Shinkansen lines, which make up 30% of JRE’s transportation revenue, are operated primarily within the Tohoku region, whose population is expected to decrease by nearly 30% by 2040. The area was badly impacted by the Great Tohoku Earthquake and Tsunami in 2011. However, we think there is potential for tourism to grow on other routes. Our base case assumes that this will help sustain some slight growth for JRE's shinkansen lines. We currently see Hokkaido as a potential site for one of Japan's integrated casino resorts, which could improve year-round visits to the area beyond the busy ski season. At the moment, there is competition from air travel on some of its Shinkansen routes that limits, for example, the market share of the Hokkaido Shinkansen line to 35%. We factor in 1% average annual growth between fiscal 2021 and fiscal 2028, down from the past five years' average 3.6%.

Our positive views on JRE's real estate income potential is largely unchanged. Much of this strong growth will come in the run-up to the Tokyo Olympics as it increases its hotel capacity and we leave our near-term projections unchanged. Following this, the redevelopment of Shinagawa station will complete by 2024. On the whole, we think JRE should see its real estate and hotels segment revenue grow at a 3.5% CAGR over the next 10 years.

JRE is guiding for capital expenditure of JPY 3.75 trillion between fiscal 2019 and fiscal 2023, which is above our prior forecast of JPY 3.0 trillion. We have factored in the increased costs into our near-term estimates with the bulk of this to be spent in the run up to the Tokyo Olympics. Around JPY 1.4 trillion will be for its commercial real estate projects.

JRE sees adding services around its Suica card to be a potential growth driver. The number of Suica cards issued has more than doubled from 29.9 million in fiscal 2010 to 69.4 million in fiscal 2018, while transactions per day have grown from 1.7 million to 6.6 million over the corresponding period. Suica penetration rate is just over 50%. That said, we do not necessarily think that the scale that JRE enjoys on its Suica card system will lead to a network effect, since all integrated circuit cards issued by Japan Railway companies, that is, TOICA by JR Central and ICOCA by JR West can be used interchangeably throughout Japan. Lastly, there’s uncertainty around how JRE could monetize the large amounts of valuable data collected on the Suica card system. At this point, IT and Suica services account for only 2.6% of overall revenue, hence it does not move the needle much.