Coal volumes and the stoush with China hold few concerns for Aurizon Holdings, which is expanding its presence in bulk ports
-Bulk earnings continue to surprise to the upside
-Coal volumes being managed with diversion to India
-Record interim dividend, robust dividend yield
Aurizon Holdings ((AZJ)) is moving up the supply chain via port services as coal contracted volumes continue to decline. While coal exports are expected to be well-managed over the short term, heightened environmental concerns are likely to have a longer impact.
Coal volumes were -4% lower in the first half, which exposes the fixed cost leverage in this division where earnings (EBIT) were down -17%. UBS points out that FY21 forecasts have declined by less than -10% over the past 12 months and a significant amount of the decline will be recovered in a couple of years under the revenue cap provisions.
Hence, the broker considers the share price underperformance is overdone, although potentially quantifies the ESG (environment, social and governance) de-rating of the stock. The company has lifted FY21 earnings guidance by 4% at the mid-point, on the back of a non-recurring $40m catch-up in Wiggins Island revenue as well as gains from short-term grain volumes.
Citi upgrades estimates to reflect the recognition of the Wiggins Island fees and forecasts are revised to the mid point of the new $870-910m guidance. Nevertheless, the broker decreases FY22 numbers because of expected declines in coal contract volumes.
Jarden envisages further upside to earnings and cash if the schedule of fees for Wiggins Island is approved by the Queensland Supreme Court during 2021. The broker assesses bulk earnings are continuing to surprise to the upside and the division can increase its earnings over the forecast period, anticipating a 3-year earnings growth rate of 3.4% out to FY24.
Macquarie points out bulks offset the drag on earnings from coal, noting additional iron ore contracts, yet remains concerned that contracts for bulks are competitive and often involve smaller volumes that could easily be moved by truck.
Contract length is also a lot shorter, creating renewal risk. The company is managing the risk, with the cascading of older coal equipment that still has useful life and this development will lower the risk of stranded assets.
TrainGuard, which has been developed to improve safety, has experienced some delays. Deployment on the Blackwater line is scheduled for the second half of FY22. Macquarie suggests benefits will not occur before 2023 but should be material.
Beyond FY21, Credit Suisse suspects conditions will normalise and coal volumes will be redirected to destinations other than China, filling a global supply gap, should geopolitical tensions persist.
Aurizon calculates around 10mt of the 18mt being exported to China has already been re-allocated. Forecasting volumes to China is difficult but a cut of -5% appears reasonable to UBS. Management remains confident of volume growth in FY22 as a result of better contracted utilisation.
Citi has a relatively optimistic view on the short-term outlook for coal but still expects contracted volumes will decline. In FY22 NSW and south-east Queensland contracted volumes are expected to decline to 63mt from 71mt.
To date, it appears the coal originally bound for China has been diverted to India, with that country importing a record high 6.75mt from Australia in January. There has also been an uptick in coal imports to Japan, the largest importer of Australian coal.
Moreover, Citi notes Aurizon's major coal customers have relatively unchanged production plans. Macquarie still expects miners will reduce their contracted capacity to meet the independent review of track capacity on the network rather than spend money to increase capacity.
The broker anticipates coal volumes will return and in tandem improved productivity will emerge. System volatility on a weekly basis means it's impossible for Aurizon to downsize. Hence, volumes must recover for productivity to also resume an upward trend and this is likely to be driven by a resumption of trade with China.
Macquarie assesses medium-term demand for coal is secure, underpinned by steel manufacturing growth in India as well as thermal demand for power generation in Asia.
Morgan Stanley notes the company is building on the momentum in bulk with its acquisition of Conport, a copper and zinc bulk export terminal at Newcastle. This is the second acquisition in this segment following the Townsville Bulk Storage and Handling acquisition in March 2020.
Citi considers the acquisition a signal that the company intends to move up the supply chain into port services, although Aurizon already has a major share of the bulks market and further acquisitions are expected to be small. Management has indicated customers are receptive to integrated port/rail solutions and this underpins its decision.
There was no expansion of the buyback and, while disappointed, Macquarie was not surprised, given the potential to bid for OneRail. OneRail remains an opportunity for a step-change, particularly in bulk ports where it would add scale to the South Australian network.
No formal sale process has commenced but the broker notes Aurizon is interested, although points out there may be some competition concerns. The Acacia Ridge sale proceeds will not contribute to additional buybacks as this was already included in surplus capital flagged some years ago.
Credit Suisse suspects further acquisitions may be behind the decision not to extend the buyback program at this stage and expects bulks will constitute a higher proportion of the business in future. Aurizon has indicated there is $900m in excess capital that can be deployed.
Citi considers the relative resilience of the business and capital management are appealing although a sustained recovery in coal market conditions is required for a re-rating back towards historical multiples.
As an increasing number of funds are inhibited by carbon concerns, Citi is taking a more pragmatic view of its valuation and incorporating an ESG discount into multiples. As a result the broker downgrades to Neutral from Buy on valuation and reduces the target by -16.8%.
A new record interim dividend was announced and the company continues to pay out 100% of earnings. A$1.2bn distribution to shareholders is on track as a result of the legal separation of the network. UBS considers the dividend yield sustainable which should appeal to yield-interested investors.
Jarden believes the recent decline in the share price presents a good risk/reward for investors over the next 12 months and the longer-term risks for coal demand are reflected in estimates.
The broker, not one of the seven stockbrokers monitored daily on the FNArena database, raises the rating to Overweight from Neutral and lifts the target to $4.30. The database has four Buy ratings and two Hold. The consensus target is $4.75, suggesting 17.2% upside to the last share price. The dividend yield on FY21 and FY22 forecasts is 7.0% and 7.3%, respectively.
FNArena is proud about its track record and past achievements: Ten Years On
All material published by FN Arena is the copyright of the publisher, unless otherwise stated. Reproduction in whole or in part is not permitted without written permission of the publisher.
© 2021 Acquisdata Pty Ltd., source FN Arena