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Morningstar | Aurizon Sidesteps Unfavourable Regulatory Decision, Lifting FVE to AUD 4

Some good news for narrow-moat-rated Aurizon, with management signing agreements with the vast majority of coal mining customers to amend the too-harsh regulatory decision on its Queensland rail network. In return for improved profitability, Aurizon will invest in the network to increase volumes. We see this as a win-win for Aurizon and the miners, with Aurizon earning more money and the miners exporting more coal to take advantage of strong prices. We also like the long tenor of the agreement--to mid-2027--as it provides greater certainty. The agreement is also good for the Queensland government as royalties are linked to volumes.

We expect the regulator to approve the proposed changes. We upgrade medium-term earnings and lift our fair value estimate to AUD 4.00 per share from AUD 3.80. While the agreement improves the medium-term outlook for Aurizon’s regulated rail track, we remain concerned by the firm’s almost total reliance on the cyclical coal mining industry. At current prices, the stock is overvalued.

An independent expert will be jointly appointed by Aurizon and the miners and tasked with determining existing rail network capacity. Aurizon will then be required to invest up to AUD 300 million to address bottlenecks identified by the independent expert, and an additional AUD 30 million annually to expand capacity if customers want it. This investment adds to Aurizon’s regulated asset base and generates additional profits. It should also benefit Aurizon’s coal haulage business, which should see increased demand.

The agreement increases Aurizon’s allowed return on capital from 5.7% under the UT5 regulatory decision to 5.9% once the regulator approves the agreement in coming months. Then allowed return increases to 6.3% after the independent expert completes the capacity review in around a year.

Compared with allowed returns under the regulatory decision, network revenue increases by around AUD 35 million from fiscal 2021. Network revenue will also benefit from higher allowances for maintenance and other things. All up, network revenue is expected to increase by AUD 40 million, or 4%. The allowed return will be adjusted in mid-2023, taking into account changes in interest rates and inflation, and apply through to contract end in mid-2027.

While Aurizon gets a higher return, it also faces more risk in that if the availability of its network falls below target rates, it must pay rebates to affected customers. This isn’t a major concern as availability is measured annually, which should give the firm time to rectify shortfalls in most circumstances.