We are increasing the fair value estimate of West Japan Railway, or JRW, to JPY 8,200 per share from JPY 7,200 per share previously, representing an attractive price/forward earnings of 14 times and an enterprise value/forward EBITDA of 7.4 times. We have incorporated a better-than-expected growth of new Property Developments after the 70% ownership purchase of Mitsubishi Heavy Industry’s real Estate Division for JPY 100 billion, lifting the real estate segment revenue, net of amortization and tax effects, as much as 18% or JPY 3.2 billion for fiscal 2017. In our view, the deal which was announced in the previous quarter, appears attractively priced with a price/EBITDA multiple of less than 5 times after accounting for large tax benefits. We like that management plans to limit new capital spending on scheduled business expansion utilizing the former Mitsubishi Heavy Industry’s real estate division. Leveraging JRW’s high brand equity as a former government-owned entity, the new business will benefit from reduced market expense, minimal cost of funding, and higher operating margin relative to its smaller peers.
We maintain our long-term view that JRW will continue to benefit from stable returns from a combination of regulated returns and rising tourist traffic in the region despite JRW’s less sophisticated operations and less affluent client profile relative to its two immediate peers. After incorporating the quarter’s results, we maintain our no-moat and medium uncertainty ratings. We think that the benefits of expected business expansion is priced in after the deal was announced in the previous quarter.
After adjusting for the acquisition impacts, we model that real estate revenue grows at rates similar to those of past real estate upcycles, and model top-line expansion of this segment at 2.2%, 2.8%, and 2.2% for the next three years, respectively, before slowing to the long-term average real estate growth rate of 1.5%, at the end of our forecast horizon. Looking ahead, improving free cash flow yields from substantially reduced capital spending, down 14% year on year unlike the two immediate peers, could provide some upside to its low dividend yields as management has already signaled its intention to enhance total shareholder returns consistently above a reasonably attractive 3%.
Analyst: Mari Kumagai
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