Rail freight operator Aurizon ((AZJ)) used its FY19 results to announce a new capital structure and a $300m on-market buyback. Brokers note the outlook has considerably improved over the past year, although a lot of the improved fundamentals are deemed reflected in the share price.
Investors are expected to focus on the prospect of sustained capital management going forward as the company seeks to gear up its above-rail (operations) following a legal restructure.
A new deal with miners and additional coal volumes, as well as a turnaround in bulk freight has meant earnings (EBIT) are expected to be more sustainable in FY20, with guidance for $880-930m. At the mid point this implies underlying earnings growth of 9%.
Guidance also implies a turnaround in the bulk business and coal returning to growth as higher maintenance and operating costs are normalised and revenue from new volumes is delivered from the first half onwards.
UBS finds potential upside from three areas beyond the aforesaid factors, including a successful defence of the Wiggins Island rail project appeal, further cost reductions in the network and new contract announcements.
Aurizon has announced a number of contract extensions and additional volumes with Glencore, particularly in the Newlands corridor, which pushes out the contract expiry to FY24. The contract with Jelinbah has also been extended to FY28.
Some contracts were renewed without price reductions, management points out, as customers valued flexibility ahead of price. The price levels on coal contracts which expire over the next three years are at elevated levels but management also stated this is equivalent to only 13% of coal contracts by annual volume.
A year ago, Credit Suisse notes, this was 23% of higher margin contracts and, as a result, margin risk is reduced. FY20 earnings are expected to be largely driven by sustained iron ore prices with the Kararra contract being renegotiated. The company will also benefit from the re-opening of the Mount Isa line.
Despite the fact that FY19 results were solid and there is leverage from additional volumes from new contracts and precision railing, some price pressure and network re-pricing is still more than likely, given low bond rates, Macquarie asserts.
The broker downgrades to Underperform from Neutral, assessing Aurizon as the least attractive of infrastructure assets amid a stretched valuation. Unlike other infrastructure stocks, the company’s operations face re-sets in FY22/23, reflecting falling bond rates on a regulated asset base that is flat.
Network
The company reported network underlying earnings of $400m in FY19, which included a -$60m impact from the implementation of the UT5 final decision. Citi suggests the outlook for FY20 could be very different, should the Queensland Competition Authority approve the company’s UT5 Draft Amending Access Undertaking (DAAU) with miner customers, expected to occur in the first half of FY20.
Overall, underpinning forecasts for total volumes of 248mt is QCA accepting the company’s undertaking, but this could be subject to changes pending a review.
Above-rail
Morgan Stanley forecasts a three-year compound growth rate for above-rail earnings of 8%, noting the potential upside should “precision railing” deliver meaningful cost benefits.
Above-rail recorded underlying earnings of $425m in FY19, characterised by a weaker contribution from coal and amid higher maintenance costs. Bulk (iron ore) performance was more insulated by strong market conditions and cost management.
Restructure
The network and above-rail operations will be combined in a legal restructure as sibling entities under a holding company. This will allow for $1.2bn in additional debt capacity in the above-rail business, taking gearing to 1.5x from near zero, while maintaining independent credit ratings for each segment
Morgan Stanley notes the company’s credit rating agencies have effectively dropped thresholds for the BBB-plus/Baa1 ratings, anticipating headroom for additional growth and/or capital management initiatives as a result.
The vertical integration review concluded that avoiding separation was the best way forward and Credit Suisse believes this is the right decision. This enables easier implementation and better execution of operating improvements and avoiding overhead duplication, which the company estimates accounts for around 10-15% of earnings.
A more efficient capital structure could be implemented as well, regardless of vertical integration. The only potential enduring benefit of separation would be an improved regulatory environment for the network business and this has already been achieved, in the broker’s view, in the commercial deal with coal miner customers.
The company had considered separate ownership of the network and above-rail businesses but the majority of stakeholders were either ambivalent or preferred the current structure.
Capital Management
Adding in sale proceeds from the rail grinding business and Acacia Ridge, Aurizon now has $1.5bn or more to deploy into buybacks and reduce its share count by around -15% over the next four years. Credit Suisse includes $1.5bn of buybacks in forecasts for the next 2.5 years.
The broker assesses the company’s funding capacity could potentially stretch to $2bn. Citi envisages scope for Aurizon to repurchase up to 10% of its outstanding share base, should the gearing of the operations business reach the $1.2bn flagged by management.
Macquarie was interested to note that, because franking levels are low, Aurizon would prefer a share buyback to a dividend when ascertaining capital management options.
The broker notes new enterprise bargaining agreements are nearly complete. The largest from Queensland coal is awaiting approval and represents 55% of the workforce while the Queensland bulk contract continues to be in the negotiation phase. The broker notes, on completion of the two agreements, this will end a sustained period of industrial action across the company’s businesses.
FNArena’s database shows one Buy (Credit Suisse), four Hold and two Sell ratings. The consensus target is $5.44, signalling -9.5% downside to the last share price. The dividend yield on FY20 and FY21 forecasts is 4.4% and 4.9%, respectively.
