Brokers brushed aside a robust first half result for Aurizon, instead looking at the issues which cloud the outlook beyond FY17.
-No significant impact on volumes despite improvements in coal and iron ore markets
-Reduced capital expenditure and re-pricing bulk contracts expected to improve confidence
-As additional capital management options are canvassed over time
By Eva Brocklehurst
Bulks and freight haulage business Aurizon ((AZJ)) may have beat many forecasts in its first half result but numerous favourable and non-sustainable items took the gloss off the beat. While there have been improvements across the key commodity markets of coal and iron ore, the company has not yet witnessed a significant impact on volume.
The main benefit of the improved commodity outlook, in Deutsche Bank's view, is that commodity customers are all operating at positive cash margins and this should alleviate some of the pressure. The coal business currently has an average contract life of 10.1 years and new-form contracts account for 96% of volumes.
The network division benefited from higher-than-expected recoveries and around $33m in benefits will not be repeated into the next half. Deutsche Bank forecasts the Aurizon network to deliver operational earnings (EBIT) for FY17 of around $550m but, given the $132m in benefits flowing in that year, FY18 will likely be lower and the broker's current forecast is $505.9m.
At this stage there appears to be some earnings headwinds into FY18 and Deutsche Bank downgrades its recommendation to Hold from Buy, given the shares are now trading at a premium to the broker's $5.10 share price target.
The company remains committed to its transformation program, targeting $380m in savings by FY18. The company has also indicated all investment proposals will be assessed against share buy-backs as a use of capital. Aurizon's network division submitted its draft access undertaking for the regulatory period commencing July 1, 2017, in November (UT5). Further dialogue with the Queensland Competition Authority is expected and a draft response from the regulator is due in the next six months.
Bulk Freight/Intermodal Division Challenged
While the coal division is on track to haul between 200-212m tonnes, the bulk freight/intermodal division remains challenged, brokers believe. The intermodal segment is currently being assessed and a decision on its future structure is expected mid-year.
Macquarie expects the intermodal business, which is losing money, will be sold and this provides an immediate area of leverage in pre-tax profit of around 2%. Bulk freight divisions are more significant, with $400-450m in assets employed. Successful re-pricing and transformation of these should add around $60-70m to pre-tax profit.
Any clarity around a change to fundamental strategy is not expected before mid-year, although the company will act ahead of this and execute on reducing capital expenditure and re-pricing bulk contracts. The broker believes such activity will improve investor confidence around the structural changes. Nevertheless, the fundamental issue remains that the coal boom is over and system volume growth is likely to be only modest going forward.
Macquarie downgrades to Neutral from Outperform, noting the new management team is making changes which are welcome but the fundamentals are challenging given limited revenue growth. Moreover, the current share price more than captures a new management premium and expectations of improvement.
The second phase of the company's freight review, following the first stage of write-downs announced in January, will be unveiled mid-year with decisions expected around intermodal and refining of the bulk business asset values. Macquarie expects further asset write-downs and potentially onerous contract provisions.
Little Room For Upside
UBS downgrades FY18 estimates by -3-4% as revenue one-offs booked in FY17 make for a challenge in following year. The broker acknowledges there is possible upside with the execution of an early exit, or turnaround, in the loss-making freight divisions. Nonetheless, the UT5 regulatory review is unlikely to be completed in time and the broker takes a cautious view on the company's application.
Cash flow is the company's strong point, brokers contend, and long-run capital expenditure guidance continues to decline. UBS forecasts gearing to remain at around 2.0-2.5 times EBITDA and in the absence of asset sales this makes capital management over the near term challenging. Based on the dividend pay-our ratio and free cash flow yield, UBS believes the stock is fully valued at present.
Morgan Stanley also envisages little room for positive revisions to consensus earnings expectations, particularly as UT5 is yet to be fully incorporated into estimates. Nevertheless, with robust cash being generated and further declines in capital expenditure likely, additional capital management options are likely to be considered in time.
In line with the existing conservative gearing policy, the broker suspects at least $400m could be returned to shareholders by FY20. Until the final UT5 outcome is known, Morgan Stanley expects positive news around capital management will support both valuation and sentiment. While constructive on the FY17 outlook, beyond that the broker is cautious as it remains unclear whether the recovery in coal prices will translate into higher above-rail volumes.
Ord Minnett was surprised by the positive reaction in the share price as it considers there were enough one-off items to cast a cloud over the performance. The broker highlights several risks including a possible outcome for UT5 that is 14% below the company's proposal.
Also, pricing pressure evident in iron ore continues to make Ord Minnett wonder about the long-term profitability of the company's two relatively high-cost customers. Finally, the broker worries that the above-rail coal volumes and margins may suffer from increasing competition in the years to come.
FNArena's database shows six Hold ratings and two Sell. The consensus target is $4.75, suggesting 7.9% downside to the last share price. Targets range from $4.20 (Ord Minnett) to $5.10 (Deutsche Bank). The dividend yield on FY17 and FY18 estimates is 5.1% and 5.2% respectively.
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