Australia | May 08 2019
There is a modest financial benefit in the agreement struck between Aurizon and its coal haulage customers. Of greater significance to brokers is the mending of a sometimes fractious relationship.
-Represents a significant step towards minimising uncertainty
-Greater certainty over the deal going ahead could add upside to valuation
-Aurizon continues to consider restructuring the business into two units
By Eva Brocklehurst
Aurizon Holdings ((AZJ)) and its coal haulage customers have forged a deal, considered no mean feat by brokers, which should ultimately deliver a slight earnings uplift. Several areas of upside exist for the company around costs, leverage and returns.
The agreement represents over 90% of the coal that is railed on the company's central Queensland network. Moreover, what is critical, Macquarie points out, is that it does not discriminate against non-signatories or potential new entrants to the network.
Credit Suisse and Deutsche Bank consider the deal substantially lowers the regulatory risk profile and contains a better allocation of risk, which has potential to create value for the business. The Queensland Competition Authority (QCA) is required to approve the revised undertaking before it becomes operational.
Morgan Stanley assesses the deal adds longer-term certainty to the investment thesis and envisages a strong incentive for Aurizon to plan and invest in a network expenditure reduction program between now and FY27.
Significantly, an independent expert will also be appointed to undertake a capacity assessment of the network. The company believes a capacity deficit versus contracted tonnage could be addressed via maintenance scheduling, capacity relinquishment and expansion. This has potential to add upside to earnings.
There is an immediate lift in the rate of return allowance (weighted average cost of capital) of 0.2% for FY19 and through FY20, until the independent expert issues an initial capacity assessment and the company advises on options to address capacity and contract mismatch. Once completed the WACC steps up 0.6%.
Modest Financial Benefit
The agreement represents a significant step towards minimising uncertainty, UBS agrees, and also helps repair a fractious relationship with the miners. Financially, it is less significant in that, if all goes to plan, the deal adds around $40m per annum to earnings (EBIT), or around 5% to profit from FY21.
This financial benefit is before any rebate is potentially payable by Aurizon for underperformance. Cash flow and dividend stability are a highlight of the stock for UBS, amid a 100% pay-out ratio and a 6% dividend yield. The deal also partially removes the recurring four-year regulatory risk that could increase the appeal of the stock to longer-term investors, the broker adds, although it is considered fair value for generalists.
Credit Suisse believes the deal significantly changes the risk profile of the network and reiterates an Outperform rating. The broker notes the past two regulatory decisions were not finalised until 2-3 years into the regulatory period. Once there is greater certainty regarding a commercial network deal going ahead the broker believes it could be further upside to valuation.
However, Morgans advises trimming overweight positions because of the minimal potential return at current prices. Macquarie assesses the upside is about the potential to improve above-rail relationships and there is now a strong incentive for Aurizon to capture outperformance on operating costs. Still, the broker agrees the immediate movement in the share price has captured much of this value.
The agreement now contains both higher returns and higher risks for Aurizon. The increase in the WACC allowance is the main positive, although this is short lived. The final decision on the latest undertaking from the QCA applied a 5.7% WACC across FY18-21. The agreement will mean this lifts, ultimately, to 6.3% but then will be adjusted for interest-rate changes from FY24, and be fully exposed to review when the undertaking expires at the end of FY27.
The company has agreed to a flat allowance for operating costs between FY21-27 except if the CPI exceeds 2.37%, and Aurizon has the opportunity to pursue costs against the WACC and not share it with customers. This benefit is also not permanent, Morgans points out, as the QCA will use actual costs to derive cost allowances from FY28.
Aurizon will be required to re-pay track access charges to customers when the network is at fault for non-performance. The rebate is only due from Aurizon's actions, such as ineffective maintenance practices, and not for volumes that are lost. However, further detail on this point was lacking and Morgans fears, at the extreme, it could potentially negate the benefit of the increase in the WACC allowance.
Ballast cleaning shifts from capital expenditure to maintenance and this adds to income although has no impact on cash flow. This reduces the risk for Aurizon but also eliminates the issue around the choice of maintenance.
Aurizon continues to consider restructuring the business into two separate units. The case for separation has been made easier, Macquarie suggests, as earnings certainty has increased with the longer-term rail user agreement, the better WACC outcome and the fact the network can capture incentives associated with operating costs. More flexibility can be gained from reorganising the assets and introducing moderate leverage into the above-rail business, especially after the re-contracting cycle has been passed.
FNArena's database shows one Buy (Credit Suisse), six Hold and one Sell (Ord Minnett, yet to comment on the network update). The consensus target is $4.73, signalling -2.8% downside to the last share price. The dividend yield on FY19 and FY20 forecasts is 4.7% and 5.3% respectively.
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