R&I Rating Methodology by Sector



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R&I Rating Methodology by Sector Logistics Companies June 9, 2014 R&I applies this rating methodology to logistics companies whose main businesses are in segments such as charter trucking operations, warehouse storage and harbor transport for leading firms. R&I's view of industry risk differs for long-distance trunk line transportation, which combines the cargoes of numerous unspecified customers (less-than-truckload), and parcel delivery service for small packages. Therefore R&I evaluates firms by classifying them into one of three segments: "transport and warehousing," "less-than-truckload" and "parcel delivery." I. Evaluation of Business Risk 1. View of industry risk While logistics demand enjoys a comparatively high degree of stability, maturation of Japan's domestic economy makes it difficult to anticipate medium to long-term growth. Given these circumstances, each company providing logistics services mainly to large-scale firms ensures the volume it handles by offering 3PL (third party logistics) designed to comprehensively undertake all of a customer's logistics activities. Parcel delivery, which has skillfully assimilated the growth in demand for small package delivery resulting from the spread of mail orders completed by Internet (Internet mail order sales), is an oligopoly serviced mainly by the top two companies. In less-than-truckload logistics, on the other hand, new entry is easy and there are numerous competing firms, and companies are also affected by the shift of some logistics demand to parcel delivery because of the diversification of consumer preferences. R&I evaluates "transport and warehousing" and "parcel delivery" to have a medium level of industry risk, while viewing the "less-than-truckload" segment to have a relatively high degree of industry risk. (1) Market size, market growth potential and market volatility According to a study by the Japan Trucking Association and the Japan Federation of Freight Industries, the size of the logistics market is about 20 trillion yen. Of this, this website or any other information included in this website belong to Rating and Investment Information, Inc. ("R&I"). None of the information, etc. may be used, in whole or in part, (including without limitation reproducing, amending, sending, distributing, transferring, lending, translating, or adapting the information), or stored for subsequent use without R&I's prior written permission. 1/8

less-than-truckload and charter truck transport account for roughly 11 trillion to 12 trillion yen. Judging from data such as information released by the Ministry of Land, Infrastructure, Transport and Tourism and the volume of net sales at the two largest companies, the size of the parcel delivery market is estimated to exceed two trillion yen. As the leading companies proceed to shift their production bases overseas, domestic logistics demand is projected to be faced with a gradual contraction. The less-than-truckload segment handling long-distance transport in particular is faced with a severe operating environment, as some demand is being diverted to parcel delivery with the evolution of just-in-time, small lot logistics, and there is scant room for market growth. In parcel delivery as well, where the number of packages handled is growing, there is a downward trend in unit prices and continuous growth in the size of the market is difficult to envisage. The volume of freight handled in each segment tends to be affected by the fluctuations of the domestic economy, and market volatility is somewhat high. (2) Industry structure (competitive environment) The competitive environment is comparatively severe. In total, there are over 60,000 logistics companies throughout Japan, and several firms often compete when receiving new orders. Nevertheless, logistics companies possessing the wherewithal to provide a full range of transport-related activities including packing, warehouse storage and inventory control are concentrated mainly among the major logistics companies. In the less-than-truckload segment, only a limited number of firms have established their own nationwide network for regularly scheduled deliveries and are capable of handling long-distance or heavy, massive freight. Because there are parameters that enable them to differentiate themselves, they have not descended into straightforward price competition. The competitive environment for parcel delivery, on the other hand, is relatively moderate. Parcel delivery is an oligopoly market dominated by Yamato Holdings Co., Ltd. (Yamato Transport Co., Ltd.) and SG Holdings Co., Ltd. (Sagawa Express Co., Ltd.), which together account for about 80% of the market. Along with the construction of distribution centers, investment in systems for operations such as freight tracking is essential. Substantial capital investment is thus required for construction of a network capable of handling deliveries to individuals' homes. The fixed cost burden for maintaining this network is also heavy. Accordingly, barriers to entry are extremely high. 2/8

(3) Customer continuity and stability In many cases, logistics companies that provide client firms with custom-made logistics services, such as 3PL designed to comprehensively undertake all of a customer's logistics activities, have stable, long-term business relationships. For less-than-truckload shipments and parcel deliveries, many customers easily switch to other companies, because they enter agreements with several trucking companies and use different service providers depending on that day's shipment preparation status and cargo pickup time. Furthermore, small and medium-sized firms, which represent a large proportion of their customers, have a strong tendency to place top priority on price. In the parcel delivery market dominated by two firms, however, room for selection is limited compared with the less-than-truckload market. (4) Capital and inventory investment cycles Outlays for vehicles, distribution centers and IT systems account for the major portion of capital investment. To meet the diversified logistics demands of their clients, firms have boosted investment in multifunctional distribution centers. A state-of-the-art distribution center capable of handling logistics processing such as tagging and inspection in addition to the normal sorting and storage functions is a large-scale investment, whose cost can amount to tens of billions of yen. In many cases, firms will improve their prospects for distribution volume when building a facility by, for instance, securing customers beforehand, or terminating their agreements with warehouses they have leased nearby and consolidating freight. Because of this, investment recovery risk is not very significant. (5) Protection, regulations and public aspects Basically there are no protective measures or regulations that affect creditworthiness. Harbor transport is strongly influenced by regulations and industry conventions, and with high barriers to entry, industrial order is extremely stable. R&I incorporates this factor into individual firm risk, however, because the percentage of each company's earnings from such operations can vary substantially, and not all logistics companies are involved in this business. (6) Cost structure Logistics companies have created flexible cost structures by, for example, chartering vehicles, subcontracting and using rented warehouses to respond to changes in distribution volume. The less-than-truckload and parcel delivery segments require large numbers of workers to handle 3/8

collection and delivery, so the fixed cost burden is heavy. They have sought to convert personnel expenses into a variable cost using temp and part-time workers. In this case, securing and training part-timers in order to maintain the quality of operations has become an issue, and whether a firm keeps cost flexibility without lowering operating efficiency is a key point. 2. View of individual firm risk In contrast to industry risk, which highlights the standard risks of the industry of which the subject firms are a part, the business risk of each company will differ depending on the individual firm risk as explained below. Because parcel delivery evolved out of the less-than-truckload business and the two businesses have similarities, the main evaluation factors are the same for these businesses. [Transport and warehousing] (1) Customer base Customers are primarily large enterprises, and business relationships can extend over the long-term because many of the work activities are custom-made. A key point is whether a transport provider has been able to establish solid business relationships with leading firms. Moreover, supposing customers are broadly diversified without a bias toward specific firms and industries, the company's earnings are more stable, and it leads to high evaluation. (2) Ability to provide services Leading companies demand a high level of services from a logistics company, and its ability to meet this demand is indispensable for strengthening business relationships and ensuring profitability. If a logistics company can propose distinctive, high added value services ahead of competitors, it would boost transactions with existing clients and the acquisition of new customers. (3) International transport capabilities Against the backdrop of continuing economic growth in Asia and economic globalization, domestic firms have stepped up efforts to advance into foreign markets. Overseas development in response to such trend is essential for maintaining and improving medium and long-term earning capacity and the ability to generate cash flow. Moreover, should this overseas development progress further, it will lead to both the expansion of operations and regional diversification of earnings sources as well. 4/8

(4) Earnings base of the real estate business When evaluating logistics companies that generate a significant portion of their earnings from real estate operations, R&I evaluates the earnings base of this activity as well. Many such logistics companies are warehousing firms. In many cases, the real estate business handled by warehousing firms is built around the leasing of office buildings on redeveloped warehouse sites, which the companies have owned for many years and have low book values. Therefore such business tends to be highly profitable. In cases where the real estate business is a small percentage of total operations, R&I does not evaluate this rating factor. [Less-than-truckload and parcel delivery] (1) Logistics networks and freight collection capabilities A company's logistics network is linked to the relative superiority or inferiority of its delivery service. Drivers frequently promote their service to freight owners and gain new customers. This is an important component for judging a firm's customer base and competitiveness. (2) Quality of delivery The quality of delivery, particularly aspects such as short delivery periods and detailed time bands that allow customers to specify the delivery window, prompt response to re-delivery and collection requests, and driver courtesy, is a meaningful factor supporting competitiveness. The higher quality of delivery helps lock in customers and enables a company to charge higher fees. (3) Ability to develop logistics (surrounding business) operations It has become difficult to increase the profitability of trucking. To maintain and enhance earning capacity under such circumstances, a company needs to broaden its business base in surrounding activities related to transport, such as warehouse storage and cash on delivery settlement. Strengthening surrounding operations is indispensable not only for diversification of earnings sources, but also for meeting customers' needs and improving the added value of the transport business. (4) International transport capabilities Overseas expansion is in its early stage, and R&I therefore does not give undue weight to overseas development, particularly in the less-than-truckload segment. If a logistics company can 5/8

respond to the growing logistics demand between countries, however, this will work advantageously for boosting transactions with existing clients and acquiring new customers. II. Evaluation of Financial Risk Critical indicators are the same in each business category, with the reference values of each rating category differing to reflect disparities in industry risk. (1) Earning capacity EBITDA (earnings before interest, taxes, depreciation and amortization)/average total assets Price competition is severe and logistics companies are under pressure to lower prices. Strong earning capacity provides a significant cushion enabling companies to absorb a drop in unit prices, and is an important evaluation factor for examining competitiveness. Given that the depreciation and amortization burden differs as a result of capital investment timing, R&I uses an indicator based on EBITDA, which permits easy comparisons over time and across companies. (2) Scale and investment capacity EBITDA, equity capital The investment burden for the vehicles and distribution centers required to continue operations is not significant. Investment capacity, however, is becoming increasingly important. To maintain their earnings base over the medium to long-term, firms will require substantial funds for activities such as new construction of high-performance distribution centers, mergers and acquisitions (M&A) aimed at acquiring markets, and the creation of an overseas logistics network. As indicators, R&I focuses on EBITDA and equity capital. (3) Debt redemption period Net debt to EBITDA ratio For comparisons with the investment recovery period, the net debt to EBITDA ratio is a highly important indicator. R&I looks at measures such as the vehicle depreciation period, the recovery period for investments in logistics centers, and working capital. Given the possibility that future strategic investments including M&A and overseas development will require substantial funds, a substantively debt-free condition is a yardstick for a strong evaluation. 6/8

(4) Financial profile Equity ratio, net D/E ratio (ratio of net debt to equity capital) The role of equity capital as a risk buffer against losses is not that large because cost structures are flexible and revenues and expenditures are comparatively stable. However, this indicator takes on greater importance for judging the strength of the financial base for maintaining strategic investments for the future and judging whether a firm has the capacity to procure external funding. Because the less-than-truckload segment has higher industry risk than the other business segments, a firm in this segment needs to ensure a greater level of equity capital than those in the other segments. III. Rating for Logistics Companies [Transport and warehousing] Issuer Rating Individual Firm Risk Financial Risk Importance Indicator Importance Customer base Earning capacity EBITDA/average total assets Ability to provide services Scale and investment EBITDA International transport capabilities capacity Equity capital Earnings base of the real estate business* Debt redemption *If the real estate business is period Net debt to EBITDA ratio a small percentage of total Equity ratio Financial profile operations, this is not evaluated. Net D/E ratio Industry risk: Medium Note) Importance is indicated by : extremely important, : important, or relatively important. 7/8

[Less-than-truckload and parcel delivery] Issuer Rating Individual Firm Risk Importance Indicator Importance Less-than- Parcel Earning capacity EBITDA/av erage total assets truckload deliv ery Scale and inv estment EBITDA Logistics networks and f reight capacity Equity capital collection capabilities Debt redemption Net debt to EBITDA ratio Quality of delivery period Ability to dev elop logistics Equity ratio Financial profile (surrounding business) operations Net D/E ratio International transport capabilities Financial Risk Industry risk: Less-than-truckload: Relatively high, Parcel delivery: Medium Note) Importance is indicated by : extremely important, : important, or relatively important. * This report replaces all previous versions that have been released to date. The Rating Determination Policy and the Rating Methodologies R&I uses in connection with evaluation of creditworthiness (collectively, the "Rating Determination Policy and Methodologies") are R&I's opinions prepared based on R&I's own analysis and research, and R&I makes no representation or warranty, express or implied, as to the accuracy, timeliness, adequacy, completeness, merchantability, fitness for any particular purpose, or any other matter with respect to the Rating Determination Policy and Methodologies. Further, disclosure of the Rating Determination Policy and Methodologies by R&I does not constitute any form of advice regarding investment decisions or financial matters or comment on the suitability of any investment for any party. R&I is not liable in any way for any damage arising in respect of a user or other third party in relation to the content or the use of the Rating Determination Policy and Methodologies, regardless of the reason for the claim, and irrespective of negligence or fault of R&I. All rights and interests (including patent rights, copyrights, other intellectual property rights, and know-how) regarding the Rating Determination Policy and Methodologies belong to R&I. Use of the Rating Determination Policy and Methodologies, in whole or in part, for purposes beyond personal use (including reproducing, amending, sending, distributing, transferring, lending, translating, or adapting the information), and storing the Rating Determination Policy and Methodologies for subsequent use, is prohibited without R&I's prior written permission. Japanese is the official language of this material and if there are any inconsistencies or discrepancies between the information written in Japanese and the information written in languages other than Japanese the information written in Japanese will take precedence. 8/8