Ann: Agreement for acquisition of One Rail Australia, page-32

Aurizon is a significant holding in my portfolio.

I was attracted to this company because of its monopoly assets and massive free cash flows. It’s share price has been under pressure for a while because of its ESG taint (as a rail company, it hauls coal). Nevertheless, the company has used its massive free cash flows to judiciously buy back shares and pay out generous dividends. Management had made it clear that there were looking to increase non-coal revenues. The pressures was there to move away from “dirty coal” and to improve their ESG metrics. As the AFR reported this weekend “its shares have underperformed the broader share market”, apparently because investment managers and pension funds have not been happy to have such an ESG ‘ugly duckling’ in their portfolios. So, at the end of the day that Aurizon (AZJ) announced this move away from coal, through the One Rail purchase, the share price ended at 3.65, a 6.2 percent drop. Why?

Firstly, what is One Rail? One Rail Australia (ORA) has two main business, Bulk (B) and East Coast Rail (ECR). ECR is the big earner (EBITDA CY 2021 of 140 million), with Bulk EBITDA of 80 million. But wait, ECR the big earner, is all about coal haulage. It appears to be a solid business, with long term haulage contracts with Glencore. You see AZJ is buying the whole business, but what it really wants is the Bulk business. It does not want to add more “dirty coal”. Hence the plan is to divest ECR (sell it to someone else or demerger into a separate corporation).

Valuations
AZJ paid 2.35 billion for this EBITDA. That works out to about 10.6 times. Now remember, it really only wants the Bulk EBITDA, and that is the smaller fraction. Aurizon had an EBITDA of 1.48 billion for FY 2021. Aurizon’s EV (effectively the takeover price as it includes total debt) is 12 billion. Aurizon’s EBITDA is valued at 8.1 times. On this simplistic measure, AZJ is paying more for ORA then it itself is being valued.

What happens to ECR?
It will be divested through a sale or demerger, apparently with “whichever creates greater shareholder value”. Getting rid of ECR will not only help concentrate the overall revenue in bulk, but also keep the ACCC happy (AZJ would otherwise have a stranglehold on East Coast coal haulage). My concern is that they will struggle to find a buyer (at a satisfactory price) for this asset. Who is going to want a big negative ESG mark by increasing their coal exposure? It is highly unlikely that AZJ will even get the 8 times their own EBIDTA is valued. A demerger is again unlikely to be priced at a premium valuation.

Macquarie Asset Management
ORA is owned by Macquarie Asset Management. Why are they selling? If you are on the other side of the trade to these guys, you need to think twice as to how good a deal your shareholders are getting.

Overall assessment
Firstly, I must state that next week the share price of AZJ could catapult and make this look like a tremendous deal for shareholders. Nevertheless, I do not think in the longer run this will be a wise use of shareholder funds. AZJ is paying too much for an EBITDA that is predominantly coal related and has bought from a likely very informed and formidable seller (Macquarie Asset Management). A better use of shareholder funds would have been a massive share buyback or dividend. But, in general management are not incentivised to shrink companies to greatness!