Tough Ask As Aurizon Speeds Up Bulk Haulage

This story features AURIZON HOLDINGS LIMITED. For more info SHARE ANALYSIS: AZJ

To obtain a cleaner image, Aurizon Holdings is swinging the business towards bulk haulage and reducing coal exposure yet this is expected to take time and be capital intensive

-Aurizon has leverage to more normal coal volumes from FY23
-Upside dependent on incremental growth in bulk haulage
-Re-mixing the business will take time and be capital intensive
 

By Eva Brocklehurst

An ever pressing focus on the environment has increased scrutiny of the coal haulage division of Aurizon Holdings ((AZJ)), as the company endeavours to swing the business balance more towards bulks such as grain and iron ore.

FY22 operating earnings (EBITDA) guidance of $1.43-1.5bn is derived from flat coal earnings, revenue growth for bulks and a decline in network revenue. FY22 sustaining capital expenditure guidance is $475-525m.

The company has opted to retain the capacity to pursue growth in bulks rather than instigate another buyback, Morgans notes and, given recent share price strength, downgrades to Hold.

Valuation will be dependent on the sustainability of coal volumes and the speed of growth in bulks, which have lower quality earnings compared with coal. Rail earnings fell -11% in FY21 amid weaker volumes in coal.

Coal earnings (EBIT) dropped -21% as re-pricing continued and scale succumbed. The contribution from coal is expected to be flat in FY22 and the loss of higher-priced legacy contracts will hurt, Macquarie asserts.

The impact will be countered somewhat by a surge in iron ore. Meanwhile, Aurizon is offering a stable 7% yield and has positive leverage to normalising coal volumes from FY23.

Citi considers the FY21 results somewhat soft, as volume in coal was less than expected despite elevated prices in the second half. More was also expected from the bulk division, given the renewed emphasis.

The main positive was the quality of Aurizon's network business. An improvement occurred in net profit because of the better performance of the network. FY21 volumes triggered take-or-pay clauses, lifting income albeit at the expense of FY23. Cost performance was also better.

This implies a tougher FY22, as there will be no one-off WIRP (Wiggins Island Rail Project) fees and the benefit from the independent capacity review will only be evident in FY23.

Citi considers a re-rating could be difficult to come by, as bulk earnings are lower quality. Yet the dividend yield is attractive and underpinned by a quality Central Queensland Coal Network asset.

Australian coal export volumes should also be supported by increasing power generation and steelmaking in Asia. In the medium term in FY23, additional growth should come as the Anglo mines return to plan. Macquarie also notes additional upside if China starts taking Australian coal again.

Bulks

Yet most upside centres on incremental growth in bulk haulage and Macquarie finds it interesting the company has shifted away from volumes and earnings to emphasise cash flow. Aurizon considers volumes a weak indicator of growth.

Moreover, the broker senses a move in focus towards EBITDA and expenditure guidance and away from net profit, a signal that earnings growth will not be a strong part of the outlook.

In bulks, Macquarie estimates an $80-90m revenue boost from the CBH grain contract. Capital expenditure requirements are light as most trains are owned by CBH. While the broker considers this a modest contract it nevertheless builds momentum and scale in the Western Australian narrow gauge network.

A material opportunity exists in a OneRail investment, although Macquarie would consider it negative if Aurizon attempts to acquire 100%, given a policy to shift away from thermal coal, and the balance sheet has capacity to acquire the non-coal business.

ESG

Morgan Stanley finds the reliance on fossil fuel product has limits for investor appeal and downgrades to Underweight. The broker notes management did not achieve FY21 long-term performance outcomes and adjusted FY22 long-term incentive targets by reducing total shareholder return (TSR) weighting to 25% from 50% and replacing that 25% with non-coal revenue growth.

Aurizon also reduced the return on investment hurdle by -100 basis points to 9.5-10.5%. Morgan Stanley is wary of the new formula, despite the ESG (environment, social, governance) aspect, as it is at the expense of TSR.

The broker estimates that at the top end of the FY25, non-coal revenue target along with a "generous" 49% margin, Aurizon will still derive 70-75% of earnings from coal haulage and is likely to remain excluded from many investor mandates.

In pure financial terms, the broker estimates the current share price is implying free cash flow of around 2.9% per annum to FY50, which appears unrealistic under most net zero by 2050 scenarios. Morgan Stanley acknowledges its Underweight rating is counter consensus and it may be the only broker applying an ESG overlay in this way.

Jarden observes the best efforts are being made to re-mix the business but this will take time and increase the near-term capital intensity. This could result in static earnings out to FY23, despite robust free cash flow and dividend generation.

To become more positive on the outlook, the broker would need to witness greater clarity around the incremental returns on capital expenditure for the bulk division and a stabilisation of coal prices as well as a producer volume response. There is also a need to sustain cost reductions in the coal business.

Although Jarden, not one of the seven monitored daily on the FNArena database, considers the current valuation undemanding, uncertainty around the growth outlook is likely to weigh on the share price and, hence, the broker's rating is downgraded to Neutral with a target of $4.30.

There are three Buy ratings, two Hold and one Sell (Morgan Stanley) on the database. The consensus target is $4.51, suggesting 12.4% upside to the last share price. The dividend yield on FY22 and FY23 forecasts is 7.1% and 7.2%, respectively.

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