JR East: Reinitiating Coverage; Stock Screens as Marginally Overvalued

We reinitiate research coverage of East Japan Railway Company 9020, or JR East, with a fair value estimate of JPY 7,200. While a high-quality business, we think it is marginally overvalued. Shares currently trade at an 11% premium to our valuation, on a P/E ratio of 22 and offering a dividend yield of 1.4%. Significant improvement in returns to shareholders is unlikely in the medium term given a stretched balance sheet and significant capital expenditure requirements.

We assign a narrow moat rating, because of the firm’s high-quality rail network that spans Japan’s most populous and wealthy area. Basic train fares are regulated, but the firm can boost returns through add-ons like first class tickets and seat reservations. Additionally, its in-station retail and advertising business generates strong returns by leveraging high foot traffic through the stations—JR East currently transports about 14 million passengers per day.

We expect solid earnings growth in the medium term, driven by recovering demand following the pandemic and completion of developments, particularly mixed commercial property developments around Takanawa and Oimachi stations. Over the next five years ending fiscal 2028, we forecast JR East’s consolidated revenue to grow at 7% per year on average.

Operating margins were negative during the pandemic, increased to 6% in fiscal 2023 and are expected to rise to 10% in 2024. Improvement should slow from there: we forecast 12% by fiscal 2028, compared with about 16% prior to the pandemic. Key headwinds to profitability include inflation in operating costs, as well as the aging and shrinking population, which is likely to weigh on demand. We forecast return on invested capital increasing from 2.7% in fiscal 2024 to close to 5% over the next decade, marginally exceeding our estimate of the firm’s weighted average cost of capital.