AZJ has been unable to grow its coal volumes hauled along its rail networks in the 13 years since listing. AZJ “above rail” revenues in 2023 are expected to be down -9% versus 2010. Weather explains most of the lost volume, which suggests volumes should return in 2024. A lack of volume growth comes against Asian GDP growth that has averaged >7% pa since 2010, whilst coal fired electricity production has grown >4x over the same time.
Coal volumes in NSW, QLD have not grown over the last decade. AZJ can only haul what its mining customers produce. Production volumes have been flat over the last decade and are expected to remain flat into 2030. This places the onerous growth for AZJ into areas outside of coal. AZJ move into bulk transportation speaks to that. More capital will be needed in the coming years.
Aurizon (AZJ) faces an existential crisis over the long term. Coal volumes exported to Asia face the clear threat of long-term structural decline as the world pivots away from fossil fuels.
When this manifests itself into the cash flows of AZJ remains to be seen. In our view, this is likely to be long dated (>15 years), given the growth in coal-fired electricity production across Asia over the last decade, and the ongoing demand for steel across Asia.
Investment View
We believe the market is too bearish on AZJ and is capitalising on the soft weather-induced volumes of 2022/23 into the future. Poor operational performance has been coupled with much higher bond yields and ESG concerns. We see the prospects of >25% earnings growth and 30% dividend growth in FY24E. The dividend will remain a key attraction for investors in the medium term.
To be sure, AZJ faces a long-term existential crisis in coal volumes declining over the long term. We don’t see coal volumes declining this decade. ESG concerns overhang AZJ with coal-linked revenues and is part of the reason AZJ trades on a depressed multiple.
We rate AZJ Buy. The key short-term catalyst is the first guidance on FY24 volumes expected in August where we look for a strong rebound to ~205Mt. A peaking of global interest rates over the next 6 months should begin to remove the valuation headwind that AZJ has faced from rising long bond yields.
Share Price Catalysts
Before 31 July 2023. Final decision on UT5 WACC is expected. The preliminary reset suggested a lift from 6.30% to 8.18% for the period FY24-27. This could equate to ~$100m in additional revenue into FY25. We see upside risk to the WACC given higher bond yields through June 2023.
18-19 July: Investor Day. First strategy day since 2021. We expect AZJ will demonstrate the return profile and merits of the move in Bulk transportation. The return profile from new customers like TGE (signed an 11-year contract February 2023) and acquisitions like One Rail Australia (ORA) remain unknown.
August 2023: FY23 Results. AZJ lowered EBITDA guidance by 4% February 2023 to $1.42bn-$1.47bn, given wet weather and train derailment. Coal volumes are expected to be lower in 2023 vs 2022. The market is currently assuming $1.44bn in EBTITDA and a dividend 16.1cps.
Return of coal volumes/additional acquisitions. Coal volumes for AZJ have remained unchanged for over a decade. A return to more normal weather conditions should see a pick-up in volumes in 2024. Additional Bulk focused acquisitions are likely, as AZJ pivots away from coal.
Aurizon Overview
Aurizon transports over 250m tonnes of Australian commodities annually, providing freight and logistics solutions through a national rail and road network. It also owns and manages a vast coal rail network of >2,500km, connecting about 50 mines with three major ports in Queensland.
AZJ was originally established in 2004-05 by bringing together coal, bulk, and container transport divisions from Queensland Rail. In 2010 under the banner QR National banner, AZJ was privatised, listing on the ASX.
Between 2012-2016 the company investigated the development a greenfield iron ore port and rail business in the West Pilbara (WA) with Asian JV partners. This was subsequently abandoned in 2016, with AZJ taking a A$240m write-down.
In 2021, Aurizon announced plans to acquire rail operator One Rail Australia subject to the divestment of its coal-haulage business in New South Wales and Queensland. The deal was valued at A$2.35bn, or A$1.95bn less the forced divestment of East Coast Rail (ECR). This was the first significant strategic move to reposition the business away from coal focused activities.
The acquisition was approved by the ACCC, and the sale of non-divestment assets took place in July 2022. The remaining assets were divested to Magnetic Rail Group in February 2023.
Earnings for AZJ consist of three main components.
- Network or “Below Rail” charges for the provision of the rail network primarily in QLD. In many cases, the AZJ rail network has monopoly-like characteristics, being the sole rail line into each coal mine. The Queensland Competition Authority (QCA) sets the allowable return AZJ is allowed to charge each customer.
- Volume-related or “Above Rail” earnings are derived from commercial negotiations between AZJ and mining customers.
- Bulk rail haulage is AZJ’s new rail transportation business focused on the movement of containerised freight across Australia. In time, AZJ is looking to grow this segment of the business to displace coal as the largest component of earnings. AZJ has an aspiration to grow non-coal haulage to be >80% of the “Above Rail” volumes. Today, non-coal haulage is less than 25% of total volumes.
Cornerstone Questions
1. WHAT IS AZJ’S CAPITAL ALLOCATION STRATEGY, AND WHAT RETURNS WILL IT DELIVER?
AZJ has been through three distinct periods of capital allocation since listing in 2010.
- Phase 1 2010-2015 | Dividends Moving to a 100% dividend payout ratio. In the early years of public ownership, cost savings were returned to shareholders via share buybacks. The company walked away from an ambitious plan to build a new private rail line in the Pilbara (WA).
- Phase 2 2015-2021 | Buybacks. Over the 7 years, AZJ undertook 7 buybacks, which allowed 20% of AZJ shares on issue to be cancelled. During this period, the company continued to pay a 100% payout ratio and the return of FCF was prioritized over any growth ambitions. Growth CAPEX was paired back to an absolute minimum.
- Phase 3 2022 – 2030 | Transitioning. The current period is the most ambitious for AZJ. Close to $2bn of acquisitions have been debt funded on the balance sheet. This has necessitated a cut to the dividend payout ratio from 100% to 80%-100%. The change in strategic direction was necessitated by falling share prices and investor pressure to see AZJ reduce its reliance on Coal. AZJ generates >80% of its revenues from the movement of coal (split evenly between thermal and metallurgical coal). AZJ’s ambition is to lower coal-related earnings to ~40% by 2030. This will be done by growing the non-coal revenue through acquisitions.
Figure 1: The three phases of AZJ capital allocation program since listing
Figure 2: The three phases of AZJ’s dividend payout policy since listing
2. CAN GROWTH RETURN TO COAL VOLUMES?
2024 VOLUME OUTLOOK
AZJ has earnings leverage to the volume of coal transported along its rail infrastructure. Since listing in 2010, AZJ coal volumes have averaged 200Mt. Deviation in coal volumes is primarily due to weather, with a lesser impact from rail issues like derailments.
The QLD floods in 2011, which significantly impacted both mining operations and caused significant damage to the AZJ’s rail work, resulted in volumes falling to 180Mt. Volumes in FY23E are also impacted by weather and derailment in early 2023. AZJ are guiding to 190Mt for FY23E.
Figure 3: QLD coal port capacity vs AZJ haulage volumes
For FY24, haulage volumes have the potential to bounce back strongly to the 205-210Mt level. This is dependent on weather, given the La Nina impacted 2022 period. A 30Mt volume uplift in FY24E we estimate add >$50m to revenue.
Figure 4: La Nina has ended. Bom is suggesting increased likelihood of dryer weather across 2023/24
LONG TERM OUTLOOK FOR COAL VOLUMES
Looking further ahead, we see limited opportunity for AZJ to materially grow haulage volumes. Over the medium to long-term (next 10 years) coal volumes are likely to continue to fall relative to GDP as the world transitions away from using coal for both energy generation and steel making. On a longer-term outlook (greater than 10 years) there remains risk that coal volumes structurally decline as alternative sources of energy gain market share.
The number one constraint in growing haulage volumes is mine supply, not fading demand. QLD coal mines are not likely to grow volumes this decade. Any new volume is likely just offset by the decline in existing volumes. We see limited prospects for net new volume growth from QLD coal.
- We estimate port capacity at QLD coal ports is 230-250Mt pa (Dalrymple Bay Coal Terminal, Hay Point Coal Terminal). This is the theoretical maximum volume that AZJ could deliver. The Ports have never operated at volumes like that in the past. Sustained volume throughput would risk operational reliability. None of the ports are considering adding to coal capacity.
- AZJ’s rail network capacity well exceeds 250Mt pa by running the trainsets more frequently. There are limitations here – safety, handling and rail infrastructure and availability of labour.
- Coal mine capacity is the real limitation for AZJ’s above rail volumes. QLD coal volumes have not grown for over a decade. New mines and expansions simply replace lost volume as mines reach the end of their mine life. Bringing new coal supply to market remains extremely difficult, and time consuming given the numerous approvals required. The mining industry looks at 5-10 years approval processes for new greenfield coal mines.
- In AZJ’s most recent submission into the UT5 regulatory review for the Queensland Competition Authority, the company estimated coal haulage volumes would average ~208Mt pa across 2024-2027 period. Whilst the prospects for volume growth medium term look limited, the prospects of material fall in volumes is also small.
- We don’t expect AZJ will experience any impact from lower coal demand through this decade. AZJ’s coal mix is split 50/50 between thermal (Energy production) and metallurgical coal (Asian steel production). AZJ coal contracts with major miners are typically long dated. As at 30 June 2022, 37% of contracts > 7 years.
Figure 5: Australian coal export volumes are expected to be flat
3. WHAT IS THE OUTLOOK FOR REGULATORY RESETS IN A HIGHER INTEREST RATE ENVIRONMENT?
AZJ’s below rail (provision of rail track and associated infrastructure) earnings are regulated by the Queensland Competition Authority (QCA) which sets the price that AZJ can charge its customers. The current regulatory period ends 30 June 2023.
The new 4-year regulatory period, known as UT5 will set prices across 2024-2027. Whilst the framework of the pricing structure remains unchanged, the inputs have been adjusted given higher bond yields and inflation rates (and a range of other minor parameters). The net result is that the pricing structure or Weighted Average Cost Capital (WACC) is likely to rise from 7.2% to 8.2%. Final pricing will be confirmed at the beginning of end of July, referring to bond yields in June 2023.
The higher WACC will help AZJ to defray some of the cost pressures that AZJ is facing. The market currently assumes that the higher WACC gets absorbed by higher costs. In our view, AZJ is likely to able to be retain part of this additional revenue.
Longer-term, the higher WACC in combination with potentially lower inflation could see AZJ retain more of the additional revenue relative to its cost base. Whilst the earnings sensitivity to this benefit is not large, the benefit is more likely to be via an expanded valuation multiple. AZJ’s current PER is around 1 standard deviation cheaper than its ten-year average.
Valuation Considerations
ESG DISCOUNT
The rise of ESG investing over the last 5-7 years has seen the emergence of an ‘ESG discount’ in several S&P/ASX 100 companies. This is most measurable on Environmental grounds, although in the case of both Crown (CWN, before takeover) and Star Entertainment (SGR) Governance discounts emerged.
We observe that serval companies have clear long-term earnings risks in a decarbonising world with potentially lower structural demand for fossil fuels.
‘ESG discounts’ can be seen in companies like Ampol (ALD), AGL Energy (AGL), Aurizon (AZJ), Origin Energy (ORG), Santos (STO) and Viva Energy Group (VEA). In cases like AGL, CWN and ORG it was the ESG discount that attracted corporate interest.
Figure 6: “ESG discounts” range between 15-30% for companies with large exposure to fossil fuels.
Our positive stance on AZJ is not premised on the ‘ESG discount’ closing in the short term. Whilst most revenues over the next 5 years are derived from coal, this will keep AZJ on a “do not invest” for some investors for the foreseeable future.
NORTH AMERICA PEERS
AZJ is peerless on the ASX in terms of listed railroad operators. Canadian listed railroad operators provide a guide to both profitability and valuation multiples. Different regulatory and industry structures make cross border comparisons somewhat challenging.
Canadian operators transport a wider range of goods and have much stronger GDP+ credentials vs AZJ. The capital structure of the Canadian operators prioritises EPS growth over dividends, and hence you see much higher EPS growth and ROE. Despite the differences, EV/EBITDA multiples are broadly in-line between AZJ and Canadian operators.
Figure 7: AZJ versus North American peers. Similar multiples, but lower eps growth.
Since listing, AZJ has been able to lift its return profile from high single digits to early double digits. Returns beyond that have proved difficult, in part given the requirement to invest into the equity base, whilst earnings leverage to shipped volumes is much lower than in Canada. AZJ’s move into Bulk commodity haulage is unlikely to lift AZJ’s ROE over the short-medium term.
Figure 8: ROE AZJ vs Canadian railroad operators.
Investors don’t place the same level of discount on toll-road operators, which in some cases have short, dated concession lives.
Risks to Investment View
Figure 9: PER
Figure 10: PER REL
Figure 11: EV/EBITDA
Figure 12: Div yield to bond yield spread
