EUR 850.00 For Business Accounts Only

Morningstar | Aurizon's Earnings Recover in FY18 but Heading Lower Again in Next Two Years

Narrow-moat-rated Aurizon Holdings reported a good fiscal 2018 result with underlying NPAT up 10% to AUD 542 million, 3% above expectations. The result was driven by cost-out initiatives, improved volumes in the coal division, and closure of loss-making bulk operations. Earnings in the rail network division were flat. The outlook is weak, with earnings likely to fall over the next two years on headwinds across the business. We increase our fair value estimate 3% to AUD 3.80 after rolling our financial model. At current prices, the stock is overvalued considering the risks.

Fiscal 2019 guidance is for above rail underlying EBIT of AUD 390 to 430 million, down from AUD 479 million in 2018 because of cessation of iron ore haulage contracts and higher costs as the firm prepares for new coal haulage contracts. Above rail earnings should improve in fiscal 2020 as costs reduce and new contract revenue ramps up. Network EBIT will depend on when the new, lower regulatory tariffs are implemented. If the firm remains on transitional tariffs for the full fiscal 2019, EBIT should be AUD 470 to 490 million. However, if tariffs from the tough UT5 regulatory decision were implemented for the full year, EBIT would be AUD 340 to 360 million. Our forecasts, which are largely unchanged, assume UT5 starts in fiscal 2020.

Dividends comfortably beat expectations, but that's not a good thing. We recently downgraded our forecasts to factor in the need to retain more earnings to cope with rising gearing and major earnings headwinds. Instead, the firm declared fiscal 2018 dividends of AUD 37.1 cents per share, up 20% on last year and representing a payout ratio of 100% of underlying earnings--and that comes on top of a AUD 300 million share buyback earlier in the year. Meanwhile, group gearing--net debt/net debt plus equity--increased 270 basis points to 42.3%, and network division gearing--net debt/regulated asset base--increased 830 basis points to 62.4%.

With significantly lower earnings once the belated UT5 regulated tariffs start, the network division is likely to have its credit rating downgraded, in the absence of an equity injection. We continue to think dividends will fall, on a lower payout ratio and lower earnings, though it appears management is waiting until the regulatory appeal process finishes before making changes. We'll gain more clarity after the judicial review in October 2018.

Coal division EBIT increased 2% to AUD 429 million, though the result was a little better than appears at first blush as some added costs were to support future volume growth. This lays a platform for stronger earnings in time. The coal industry remains buoyed by strong coal prices, with both coking and thermal coal prices double what they were in the fiscal 2016 nadir. At these prices, customers should be making good money, though Morningstar has a bearish longer-term outlook.

Bulk division EBIT increased to AUD 50 million from a AUD 14 million loss last year after improving or exiting loss-making contracts. However, bulk will be back to breakeven in fiscal 2019 after cessation of iron ore haulage contracts, before recovery from 2020 as costs relating to these finished contracts get stripped out over time.

Network EBIT was flat at AUD 481 million, and we expect something similar in fiscal 2019. But once UT5 tariffs start, assuming the firm is mostly unsuccessful in its appeal, EBIT should fall nearly 30% to around AUD 350 million per year. Regulatory risk is one of Aurizon's main threats and we believe things will only get worse in the next coal industry downturn.

The Australian Competition and Consumer Commission, or ACCC, blocked the sale of the Queensland intermodal business and the Acacia Ridge intermodal terminal to key competitor Pacific National. In response, Aurizon is seeking to clear the sale of Acacia Ridge in the Federal Court, but has given up on selling the intermodal business, which it plans to close instead. For now, though, a court order prevents Aurizon from closing the Queensland intermodal business until the ACCC's allegations of anti-competitive behaviour can be heard in court. Judgments are expected prior to Christmas. If all goes Aurizon's way, it will sell the terminal to Pacific National for AUD 205 million. Otherwise, the asset is likely to appeal to other buyers, though the price would likely fall.