Regulatory Concerns Weigh On Aurizon

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Aurizon has re-confirmed FY18 guidance but signalled a deteriorating outlook for FY19. Broker attitudes vary widely, given the regulatory uncertainties hanging over the stock.

-Despite tough earnings outlook, cash generation is robust
-Earnings upside dependent on reversing QCA draft decision on UT5
-Undertaking strategic review of vertical integration
 

By Eva Brocklehurst

Regulatory uncertainties are hampering Aurizon ((AZJ)) and the company is aware that coal customers are dissatisfied because of the regulatory dispute with the Queensland Competition Authority (QCA).

In its investor briefing the company acknowledged competition pressures exist on above-rail pricing, while re-confirming FY18 guidance. FY18 guidance for operating earnings (EBIT) of $900-960m but the outlook for FY19 has softened, although no specific guidance was provided.

Morgans suggests flat coal earnings are likely in FY19, with the volume growth and transformation benefits offset by increases in maintenance costs and the company's share of the 20mtpa UT5 capacity impact.

The broker believes the direction of earnings is to the downside unless the company can substantially reverse the QCA stance on the draft UT5 network undertaking.

Morgans acknowledges a wide range to market earnings forecasts given the uncertainty regarding earnings from the network and expects EBIT to decline to $770-780m across FY20-21.Aurizon has quantified the impact of contract losses in the iron ore division as a -$50m headwind into FY19, although Morgans assumes bulks will break even, given the turnaround agenda.

In FY20 the broker expects above-rail earnings will improve and coal will benefit from volume growth and the cycling of one-off costs in FY19. However, the network earnings are expected reduce even further because of the cycling of transitional tariffs.

If the ACCC blocks the Queensland Intermodal sale, for which a decision is due next week, then closure costs will be incurred, Morgans points out. Aurizon would not elaborate on its plans for the Acacia Ridge terminal.

The target of $70m of combined cost reductions by 2021 appears conservative to UBS, against an ex-network cost base of $1.2bn and given the history of productivity improvements generated by peers.

After the recent investment in the asset base, UBS forecasts $600-650m per annum in free cash flow and this in, in turn, implies a 7% free cash flow yield at the current share price.

Macquarie agrees that despite the tough earnings outlook, cash generation remains robust and there is flexibility for the company to pursue accelerated organic growth, limited acquisitions, de-gearing or new buybacks.

The broker expects Aurizon to seek to maintain an investment grade credit rating and once this is affirmed there should be clarity on buybacks and/or acquisitions.

UT5

Management provided some detail on the earnings impact of an unfavourable outcome on the UT5 negotiations. This is the draft undertaking regarding access to the company's Queensland coal rail network that is currently before the Queensland Supreme Court.

Macquarie notes upside swings around this regulatory re-set. The broker considers the maintenance cost factored into FY19 and FY20 guidance, with potential for up to a $5-10m positive impact on volumes which would add $20m to earnings.

Productivity improvements are also worth $15-20m per annum and would offset wage inflation, providing another source of earnings growth.

UBS assumes a -$60m per annum negative step-down rather than the -$100m implied by the December draft decision, which in turn would suggest a better outcome for maintenance costs. The broker suspects the regulator may concede to some of Aurizon's claims.

However, Credit Suisse noted little detail in the briefing on how Aurizon would get its coal miner customers and the regulator to follow its preferred pathway to better regulation.

In the short term, the broker expects FY19 operating earnings to be 5% above consensus because of higher transitional tariffs in the network. In the medium term, the regulatory structure for the network should improve and ensure a re-rating of the asset.

Vertical Integration

Aurizon has begun a strategic review of its vertically integrated structure. Splitting the vertically integrated below-rail infrastructure from the above-rail train operations is a catalyst Credit Suisse suggests many investors want and a vertical de-merger could be part of a deal to get a better regulatory structure.

Ord Minnett asserts that separating above-rail and below-rail operations would not be in the best interests of investors. The broker highlights that most of the successful rail operators globally are vertically integrated, as this provides incentives for efficiency, productivity and investment.

The broker contends that, to maximise the transaction value of below-rail, Aurizon should wait for a better regulatory outcome, as otherwise a near-term sale would be at the cycle low. Given the uncertainties, Ord Minnett maintains a Sell rating.

Deutsche Bank upgrades its rating to Hold from Sell, adjusting longer-term expectations based on the latest Wood McKenzie production forecasts. The broker considers the dispute with the QCA and miners, while still to play out, is well-known and largely factored into the share price.

FNArena's database shows three Buy ratings, two Hold and two Sell. The consensus target is $4.38, suggesting 2.1% upside to the last share price. The dividend yield on FY18 and FY19 forecasts is 6.0% and 5.4% respectively.

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