JR Kyushu: Initiating Coverage; Stock Screens as Slightly Overvalued

We initiate research coverage of Kyushu Railway 9142, or JR Kyushu, with a fair value estimate of JPY 2,900 per share. Shares currently trade at a 9% premium to our valuation, on a P/E ratio of 14 and offering a dividend yield of 3.2%. Significant improvement in returns to shareholders is unlikely in the medium term given a stretched balance sheet and significant capital expenditure requirements. We assign JR Kyushu a Medium Morningstar Uncertainty Rating, with relatively defensive revenue and a positive medium-term outlook balanced by high financial leverage. We assign a Standard Capital Allocation Rating based on its relatively weak balance sheet, fair investment efficacy, and appropriate shareholder distributions.

JR Kyushu lacks an economic moat. The rail network, which contributed 40% of prepandemic earnings, benefits from high barriers to entry and cost advantages to other transportation modes. But soft passenger demand following the pandemic, rising operating costs, a declining population, and a tough regulatory environment mean maintainable excess returns are unlikely for the foreseeable future. Real estate development and ownership (40% of prepandemic earnings) typically lack strong or durable competitive advantages, and the moaty in-station retail operations (20% prepandemic earnings) are insufficient to justify an economic moat in aggregate.

We estimate a return on invested capital slightly below our weighted average cost of capital over our 10-year forecast horizon. While adjusted returns marginally exceeded its cost of capital prior to the pandemic, that period benefited from low inflation and a stable population. Following the pandemic, conditions have deteriorated with softer demand and rising operating costs. The firm will need the regulator to approve significant ticket price increases just to earn a fair return, rendering consistent excess returns unlikely.