EUR 850.00 For Business Accounts Only

Morningstar | Aurizon’s Poor 1H was Mostly Expected; No Change to FVE

Aurizon’s earnings have been hit hard after implementation of new, lower regulated tariffs in the network division. Group underlying EBIT fell 16% to AUD 406 million and NPAT fell 19% to AUD 227 million in first-half fiscal 2019. Interim dividends fell 19% to AUD 11.4 cents per share, based on a 100% payout ratio. Earnings are tracking below our prior forecast, but this just reflects timing of tariff implementation. We downgrade our fiscal 2019 earnings forecasts but our longer-term forecasts are largely unchanged. We keep our AUD 3.80 fair value estimate and consider the stock marginally overvalued. Aurizon has a tough outlook and is not a preferred investment. The firm has a narrow economic moat, but its competitive advantages are weakening because of tough regulation and increasing competition. We believe there is a risk the firm may raise equity in 2019 to get gearing back to target levels.

The above-rail haulage division--comprising coal and bulk--is tracking in line with expectations, and full-year EBIT guidance of AUD 390 to 430 million is unchanged. EBIT in the coal haulage business fell 6% to AUD 210 million. Volumes were down 1%, with strikes and bad weather mainly to blame, while operating costs rose 8% because of increased maintenance and higher operating costs to support new contracts. The second half should see improvement in volumes as new contracts start, with guidance for 215 to 225 million tonnes in fiscal 2019 reconfirmed. Ongoing operational efficiency improvements and new contracts should drive earnings growth from fiscal 2020, though we are mindful of tough competition and an increasing number of Aurizon’s contracts coming up for renewal in the next few years. Downward pressure on pricing is evident, and Aurizon could lose some of its core Queensland coal haulage contracts over the medium term.

Bulk haulage EBIT fell 30% to AUD 14 million after Cleveland-Cliffs Inc ceased iron ore mining in Australia and terminated its haulage contract with Aurizon. Grain volumes were also down as the drought continues without respite. Second-half earnings will be even worse on the full period impact of the Cliffs termination and closure of one of Mt Gibson’s iron ore mines. Longer-term performance should improve on cost-out initiatives and new contracts. The turnaround of the bulk business has a long way to go--EBIT margin in the half was just 5%. To put in perspective, EBIT margin was 34% in the coal haulage business.

The network division was the worst performer in the first half, with EBIT down 18% to AUD 203 million after the regulator cut tariffs. The regulatory environment is tough and we don’t believe allowed returns adequately compensate the rail network for substantial longer-term risks stemming from its complete reliance on the coal industry. Unfortunately, Aurizon has limited ability to dispute regulatory decisions. Management considered various revenue recognition scenarios when providing fiscal 2019 EBIT guidance of AUD 380-485 million, depending on the timing of the start of new, lower tariffs and the related true-up for overearning in fiscal 2018. We downgrade our 2019 EBIT forecast to the bottom of guidance to reflect the timing of new tariffs, but longer-term forecasts are largely unchanged.

Guidance is for capital expenditure of AUD 480 to 520 million in fiscal 2019, and around AUD 500 million in maintenance capital expenditure in 2020. On the surface, Aurizon’s financial position appears sound with forecast net debt/EBITDA of 2.4 times in fiscal 2019. However, gearing is above management’s 40% target ratio and heading in the wrong direction, rising to 42.4% from 41.2% a year ago. Management is currently reviewing the firm’s capital structure, which is often a precursor to an equity raise. Perhaps a little extra equity needs to be injected into the network division to keep the credit rating agencies happy, given Moody's was close to downgrading it after the tough regulatory decision. We expect to find out later in the year. It wouldn’t be ideal for the firm to raise equity after buying back shares last financial year and paying out 100% of earnings as dividends. Nonetheless, an equity raise of a few hundred million dollars wouldn’t surprise.