This analysis from Fairmont Equities provides some insight into the challenges facing Aurizon Bulk:
Is it worth buyingAurizon for the dividend?
June 12, 2024 by Michael **le
We recently researched AurizonHoldings (ASX:AZJ) in The Dynamic Investor. Following the interim resultsrelease for 1H24 in mid-February, the shares enjoyed momentary gains. However,this has largely reversed despite no obvious catalyst for such a move.Accordingly, we consider whether the recent weakness presents a more attractiveentry opportunity for the given yield.
About AurizonHoldings
Aurizon Holdings is an Australian railfreight operator that operated three divisions: i) Network, which manages the2,670km Central Queensland Coal Network (CQCN) which is governed by a regulatedreturn agreed with customers; 2) Coal, which has contracts to haul coal inCentral Queensland and the Hunter Valley from mines to export terminals; and 3)Bulk, which encompasses the group’s non coal rail haulage activities, includingbulk mineral commodities (including iron ore), agricultural products, and miningand industrial inputs.
AZJ’s asset base is classified aseither ‘Above Rail’ or ‘Below Rail’. ‘Above Rail’ comprises the Coal and Bulkbusinesses, while ‘Below Rail’ refers to the regulated Network business.
Key FundamentalDrivers
Can Aurizon Coal Earnings Surprise onthe Upside?
EBITDA for the Aurizon Coal segment in1H24 was well ahead of expectations. Revenue yield more than offset softervolumes with better-than-expected customer/corridor mix. Coal contractutilisation remained flat at 82%. The Company has reiterated the target of 90%,which is likely to be achieved in FY25/FY26. We consider that there are upsiderisks to earnings growth expectations for Aurizon Coal in the short- andmedium-term from several factors:
i. The expectation for falling revenueyields has caused some market concern that underlying EBITDA growth for AurizonCoal will slow. The latter expectation is not being driven by lower volumegrowth, with consensus Coal haulage estimates indicating the reverse.
ii. The fleet composition withinAurizon Coal has increased from 311 active locomotives in 2H23 to 321 as at1H24.
iii. While broader quarterly coalguidance by producers has been flat, the recent change of mine owners isboosting medium-term production expectations. In addition, new mines are comingon line.
iv. The thermal coal outlook ispositive as energy transition takes longer. This suggests that demand will lastfor longer. Metallurgical coal demand is also robust.
Challenging Outlookfor Aurizon Bulk
The performance of the Aurizon Bulksegment has concerned the market. Underlying EBIT was ~15% below consensusestimates and continued the string of weaker performance relative to marketestimates. The 1H24 period represented the 3rd half in a row of below-expectationresults. While AZJ is successfully winning contracts, headwinds from apermanent loss of NSW/Queensland grain volumes and specific customer resultshave limited growth.
Overall, the outlook for the AurizonBulk segment is likely to be under budget, given that the 3Q24 period washeavily affected by the weather. In addition, the high-value Northern Ironcontract has also had construction delays due to weather, such that firstvolumes are now in FY25. Weather is also likely to impact FY25 earnings as WAagain appears to have a very dry season, with volumes at one-third 2023.
Further, iron ore volumes are lower.In context, iron ore is considered the most significant segment for AZJ;accounting for ~25% of the EBITDA of the Bulk group.
Capital ManagementAppeal Increasing
Gearing (on a net debt to EBITDAbasis) as at FY24 is expected to be ~3.1x, which is only slight elevated incomparison to recent levels. Accordingly, AZJ has flagged a capital positionthat allows for more ‘flexibility’ to increase capital returns. The potentialscale, duration, and nature of capital management (dividends or buyback) remainunclear. This is partly because the Company is early in its container strategyand is increasing growth investment in its Bulk segment.
Having said that, the more likelycapital management option in the near term is increasing dividend payments. Thedividend payout ratio (which was 75% In FY23) is not expected to return to thetop end of the 70-100% range for at least two years. To this end, it is worthnoting that gearing has still not returned to pre-One Rail levels when thedividend payout ratio was ~100%.
It is worth noting that there are twoalternative avenues of capital management. Aside from increasing the dividend,AZJ can implement on-market share buyback, given the limited franking creditsavailable. Alternatively, it can re-investing surplus capital back into thebusiness. The Company benefits from lower tax payments as a result of a portionof the CAPEX qualifying for the instant asset write off.
Fundamental View
At current levels, the shares aretrading on a 1-year forward P/E multiple of ~13x, which broadly in line withthe trading range over the last two years. Against this multiple, AZJ has anattractive medium-term earnings profile, as evidenced by an EPS growth profileof +9% over FY24-26 on a CAGR basis.
The more imminent capital managementhas improved AZJ’s yield appeal (6%). Notwithstanding, the key factor limitingfurther upside in the shares is the continued underperformance of the Bulksegment. It still remains unclear as to whether the Company can generate asufficient return on invested capital for the Bulk segment.
Charting View
AZJ remains range-bound and right nowit is in the middle of that range. Investors can therefore be patient and waitfor the stock to retrace back towards lower levels under $3.50. Otherwise, anupside break beyond $4.10 would be the other possible buy signal.
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