AZJ's first investor day since 2021 outlined a pathway to further pivot earnings away from coal over the medium term. Central to the larger ambition is a greater monetisation of the recently acquired (and underutilised) OneRail assets which AZJ acquired for $2.35bn in 2021.
The Darwin-Adelaide rail link could play an expanded role in freighting containers from Asia to Sydney and Melbourne distribution hubs. AZJ claims a Shanghai (China) to Melbourne travel time of 17 days via sea freight can be dropped to 10 days if AZJ’s rail assets are used to move goods from Darwin into Eastern states.
This implies a radical change in behaviour from customers who use shipping ports along the East Coast at present. Inland rail container freight is something that has not been done at scale, despite numerous attempts over the last +20 years.
AZJ talked to an initial $300m capital requirements over 2024/25, with more to come to drive low double-digit, to mid-teens returns. The market will need more customer evidence that this ‘new’ freight model can be monetised in the way AZJ is thinking.
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.
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. This is a key part of the reason AZJ trades on depressed multiples.
We rate AZJ Buy. AZJ’s strategy to pivot away from coal-based earnings is likely to involve further capital over the medium term, which suggests a return to 100% dividend payout ratio near term is unlikely. We see the strategy as evolving and requires a degree of faith that AZJ can execute M&A, and new markets with a degree of success. A peaking of global interest rates over the next 6 months should begin to remove some of the valuation headwinds that AZJ has faced from higher long bond yields.
Inland Rail to Capture Container Freight Dreams
AZJ is using the recently acquired OneRail assets (Darwin to Adelaide) and AZJ’s 30-year lease on the facilities in the Port of Darwin to appeal to freight customers that potential 7-day transit saving on goods from China to Melbourne is value accretive for the same dollar cost for the customer.
We think the market will remain sceptical about the economic merits of this strategy.
In part because it has been discussed and attempted before without reaching an economic scale. There are also limits to the economic appeal given the Port of Darwin (NT) can only currently handle ships ~50% the size of Sydney/Melbourne, whilst time savings to Sydney (NSW) and Brisbane (QLD) will be materially less than to Melbourne given rail routes and containers will need to be double moved. The appeal of the inland rail transit route or ‘land bridge’ in AZJ speak, will be enhanced once trains can take double-stacked containers all way into North Melbourne (VIC).
AZJ talks to an additional $425m of growth capital over 2024/25 for asset enhancements (two mobile harbour cranes, rollingstock, terminals and crossing loops). This will be added too, if the opportunity grows as AZJ thinks it will. Whilst phasing the capital investment is prudent, we need to see customers of scale adopting this alternative route before baking it into our thinking for what this could look like by 2030 for earnings.
History suggests there is significant hesitance from freight customers. AZJ claim they have initial customer backing and are planning to take the inland rail route from 1 train service per week to 7 per week by June 2024. Early testing with prospective customers is underway.
AZJ suggests customers are interested in both the time saving (working capital benefit for end customers) and ESG benefits (rail has a lower C02 footprint vs road per tonne of freight moved, and improved safety vs road transport).
Figure 1: AZJ is rehashing the concept of moving freight via inland rail as an alternative to existing shipping and port terminals on the East Coast.
Figure 2: AZJ is aiming to make Darwin to Adelaide and beyond, and attractive route, particularly for Asian container freight into the into east coast markets.
Implied Market Share Assumption
AZJ are assuming that rail can lift its market share of containerised freight from 1m TEU per year to 1.7m TUE by 2030. Currently, there are 8.4m TEU through Australia’s Ports and ~6m TEU across road freight (TUE = Twenty-foot Equivalent Unit, a measure of cargo capacity).
Figure 3: AZJ’s freight “land bridge” from Darwin to East Coast markets assumes a large uplift in container movement onto AZJ rail assets.
Figure 4: Investor Day CAPEX profile implies a step-up in spending to secure new markets, ex coal. More will be needed in 2025 and beyond to reach AZJ ambitions of 500-750k TEUs by 2023.
Figure 5: AZJ dividend payout ratio was lowered to fund growth in 2021/22. We expect the market will need to push back its assessment of higher payout ratio post the 2023 investor day.
Our View on the New Capital Spend
In our view it remains too early to bake in expectations around a new sleeve of earnings for AZJ. The customer/and economic model need to be commercially proved up. In the short-term, there is additional CAPEX to be spent, which will lower free-cash-flow near term. $425m of additional growth capital for inland rail needs to put into the context of $500-600m of sustaining CAPEX pa.
There is a multi-year ‘J-curve’ payoff here. At the margin whilst bolder non-coal ambitions are welcome, the unproven nature and lower free cash flow are net negative to the investment case.
Earnings Guidance
AZJ gave earnings guidance for FY23, which equates to the lower end of the $1.42-$1.47bn EBITDA prior guidance range. The market is currently at $1.43bn.
First guidance for FY24 which assumes a normalisation of weather and rail disruptions is for EBITDA of $1.59 - $1.68bn vs the market at the mid-point of $1.64bn. The FY24 guidance assumes a favourable outcome at the Maximum Allowable Revenue for AZJ below rail assets (which is yet to be finalised by the Queensland regulator), whilst coal volumes return to 208Mt.
The monetisation of the inland rail will take some time requiring a degree of upfront investment before returns are generated.
Figure 6: AZJ is assuming coal volumes return to more normal levels of 208mt in FY24
Earnings Implications
Long-term aspirations need to be funded, and whilst AZJ gave details on a further $300m of capital which is required to be spent over 2024-25 to reach their ambition further additional capital will be needed over 2025-2030.
In our view, this is likely to see the market push back dividend growth estimates (which were based on a higher payout ratio medium term) as capital is directed into non-coal growth projects.
The other impact is that AZJ's free cash flow yield which is in the mid 7 %, is likely to see downgrades as capital spending remains elevated over the 2023-26 period.
In short, we are Buyer of the earnings and dividend improvement story into 2024 but remain unconvinced at this stage that inland rail can open a significant new earnings stream for AZJ medium term. New customer wins and backing will be crucial to the AZJ investment case in 2024.
Risks to Investment View
Recommendation
We have retained our Buy recommendation.
Figure 7: AZJ versus North American peers. Similar multiples, but lower EPS growth.
