Mispricings arise when sentiment causes Market Valuations to deviate from Fundamental Value (either on the high side, or the low side).
My sense is that, over its listed life, market sentiment towards AZJ has varied from:
A. "
Cyclically Max Bullish" - when it listed at the height of the commodity boom,
to
B. "
Mildly Enthused" - during the period between 2015 and 2019 (when it came to be viewed as a monopoly infrastructure business),
and then to
C. "
Disliked" - because of its association with coal... which is where we are today.
It is when businesses - particularly fundamentally good businesses - become disliked, and it impacts their fundamental valuations, that I become interested.
In AZJ's case, while it is a mature business which is not growing, it is still a fundamentally good business, with the ability to generate Free Cash Flow, at a rate of around $550m pa to $600m pa throughout the cycle:
View attachment 3219917
The chart - specifically in relation to the red Investment in PP&E ("Capex") bars - requires some qualifying comments in the context of the company's history.
The significantly elevated Capex between 2011 and 2014 (denoted by area "A") was due to the purchase of new locomotives and rolling stock for entering new markets in the Hunter Vally of NSW and the iron ore industry in WA.
And in 2015/2016 (corresponding to area denoted by "B"), Capex was again elevated due to the funding of the ill-fated Western Australia Iron Ore Project for which Aquila Resources was acquired. (That was a classic, supremely dumb, pay-too-much-at-the-top-of-the-cycle kind of acquisition and any investment in AZJ today is predicated on the board having been sufficiently embarrassed and chastised into not doing anything along those lines ever again.)
The past 5 years (so 2017 to currently) represents the normalised "stay-in-business"level of Capex, namely around $500m pa.
So, its a company with an EV of around $10bn (~$6.5bn Market Cap and ~$3.5bn in Net Debt), that generates around $550m pa to $600m pa of FCF.
So, a FCF Yield of 5.8% on EV and 8.5% on Market Cap.
Reasonably appealing in absolute terms.
But what about in relative terms?
Given the company is ex-growth and given the surplus capital it generates basically all gets distributed to shareholders, its stock should be valued as a fixed income security.
So comparing AZJ's FCF Yield to that of a benchmark fixed income instrument, namely the Australian 10-Year bond, we can see that the spread, of AZJ's FCF Yield over the 10-year bond yield, is currently 7.2%, which is a big number for a large-cap ASX-listed stock and is also an all-time high for AZJ:
View attachment 3220064
Valuation viewed on a more conventional way, namely EV/EBIT, also shows a business trading at a meaningful discount to its historical average:
View attachment 3220154
Conclusion:
It's a business for which not much - other than broader sentiment - has changed over the past 5 or so years.
It still has its rail infrastructure and locomotives and wagons hauling various products (yes, including coal) from one part of the country to another and charging a fee for doing so.
And I strongly suspect it will still be doing so in a decade's and two decade's time, and even longer.
[
Caveat Emptor: Its cheap, but it isn't what I'd consider to be back-up-the-truck cheap. That will occur if sentiment changes from "
Disliked" to "
Totally Hated", which may or may not happen. But the fact that we are not yet at the Point of Maximum Vitriol informs what should be prudent portfolio positioning.
Also, I sense there is likely to be some small amount of short-term volume-at-risk which the company might articulate at some point, to which there might be a bit of sticker shock, but I also sense that at least some of that is already priced into the stock.]
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(20min delay)
