Transport Sector Trundles Along In Low Gear

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This story features AURIZON HOLDINGS LIMITED, and other companies.
For more info SHARE ANALYSIS: AZJ
The company is included in ASX100, ASX200, ASX300 and ALL-ORDS

-Coal production keeps haulage up
-Airline demand affected by lower AUD
-Qantas alliance benefit seen in FY15
 

By Eva Brocklehurst

Transport, overall, is suffering from an uncertain outlook. Domestically and globally. Domestic freight volume is subdued. Airline capacity may have moderated but demand is still soft.

Asciano ((AIO)) expects difficult market conditions in the coal haulage area to continue in FY14, guiding to container volume growth of a bare 1-2%, while intermodal volumes are expected to be flat. Given the high fixed cost nature of the terminal and rail businesses the company is highly leveraged to any improvement in volume. Despite this, Deutsche Bank can see potential for Asciano to be re-rated if the company continues to execute as well as it did in FY13. Nevertheless, much of the near term growth in coal volumes is being driven by contracted volumes. Goldman Sachs assumes some growth will come organically, amid improved contract utilisation. The broker does remark that 95% of the coal haulage contracts are take or pay, with an average duration of seven years.

Asciano has reported that some miners have sought contract relief and has been developing new services to address these changing customer requirements and increased competition. Asciano has emphasised it will only make concessions where they enhance value but Goldman suspects any concessions will have a short term earnings impact.

Aurizon ((AZJ)) surprised several brokers by delivering a final dividend of 8.2c in FY13. Given the majority of Aurizon's volume is still on legacy contracts, Goldman Sachs expect some margin improvement as contracts roll over. Aurizon's management has stated that coal haulage volumes started FY14 strongly. Production and export volumes for the industry support this, in Deutsche Bank's view, with production up 18.1% for the four largest Australian producers in the final quarter of FY13 against a rise of 10.1% in coal exports.

Linked to this strength in Aurizon's haulage, is Royal Wolf Holdings ((RWH)), which has won a contract in the freight division to supply Aurizon, with a total sales value of $12m. Deutsche Bank notes that this contract alone will mean a doubling of revenue for the division in FY14, although it will be at much lower margin than the rest of the business as Aurizon will want competitive pricing. Otherwise, this company has also indicated underlying conditions remain difficult with average utilisation of the lease fleet down to 82%.

Similarly, Toll Holdings ((TOL)) noted activity levels to date are yet to show any sign of improvement, highlighting that weak business confidence and a tough competitive environment represent ongoing challenges. Toll is also being more disciplined on costs and strategy but what clouds Deutsche Bank's view is this company has less earnings visibility than either Aurizon or Asciano. The three making up Deutsche Bank's Buy recommendations in the large cap transport sector are Asciano, Aurizon and Toll.

Above ground level, moderation in domestic airline capacity continues but demand remains soft, according to Goldman Sachs. Domestic system capacity growth was 3% in July, continuing the more moderate capacity growth seen towards the end of FY13. Given the softer trends in passenger numbers at the capital city airports, soft demand means that the capacity added over FY13 will take some time to absorb and hence weigh against yield growth, in the broker's opinion.

Deutsche Bank notes Qantas ((QAN)) was the best performer in the three days after the results, given strong cash flow, and Brambles ((BXB)) the worst, because of the FY14 outlook. Brambles is yet to see any incremental consumer demand in the US but expects new business won in FY13 will contribute over US$60m in revenue in FY14. The Recall de-merger is on track and is planned for December this year. Brambles is no longer a top pick for Deutsche Bank and is now a Hold recommendation. Qantas continues to be rated a Buy.

JP Morgan recently attended the Centre for Aviation's (CAPA) Australia Pacific summit. The broker retains an Underweight on Australian airlines Qantas and Virgin Australia ((VAH)) and Sydney Airport ((SYD)). In the airline sector presenters highlighted the opportunities to capitalise on the growing middle class population in many Asian countries and emphasised that China should be seen as a number of discrete large markets. Most presenters believe that Australia and New Zealand are well placed to benefit from the growth in the middle class demographics across the Asian region over the medium to long term. Australia currently captures only a small percentage of the targeted growth markets of China, India, Philippines, Malaysia, Indonesia and Vietnam.

Nevertheless, there are short-term head winds. The 15% devaluation of the Australian dollar has already seen a 15% reduction in forward bookings. Many foreign carriers increased capacity on routes to Australia after the GFC, reflecting the relative strength of the Australian economy. This resulted in a high percentage of tickets originating in Australia, in Australian dollars. CAPA estimates that 70% of bookings for international flights to/from Australia originate from Australia and foreign carriers would be starting to see lower US dollar translated revenues as a result. They could decide to reduce the frequency of services and even cut routes if the routes ultimately become unprofitable. This may not happen straight away but should be positive for Qantas and Virgin Australia, in JP Morgan's view. It may not be so good for Sydney if passenger growth slows.

The CAPA summit also talked about partnerships and global alliances. Airlines are taking a more realistic and pragmatic approach to creating networks. The partnership between Qantas and Emirates was one example cited, where Qantas' membership of the One World Alliance did not prohibit Qantas from forming a partnership with a non-member. A similar example is the partnership between Virgin Australia with both Singapore and Air New Zealand, which are members of the Star Alliance. The creation of extensive virtual networks is expected to be a feature of most international carriers in the future. JP Morgan notes there is a divergence of opinion as to whether a low cost airline can co-exist alongside a full service airline and it appears to be mostly a phenomenon of the pan Asian region.

On the Qantas alliance with Emirates, Deutsche Bank observes benefits are not expected to fully arrive until FY15, whereas previous guidance indicated that a large part would be delivered in FY14. No specific benefit targets have been given but the broker estimates that for Qantas International to reach a break-even point by FY15, around $100m in contribution from the Emirates alliance is required. As for Virgin Australia, FY14 should see a better financial result, but Deutsche Bank thinks it will struggle to achieve more than break even because of the tough underlying conditions and high fuel prices. Despite operating cash flow EBITDA conversion of 97%, the company has sought a shareholder loan from its three major shareholders for $90m to bolster liquidity. If economic conditions worsen or an industry shock occurs then the broker thinks Virgin Australia will be left with little option but to undertake sale and lease back transactions, or raise equity.

The other aspect of domestic air travel is the mining sector. As much as 25% of the mining workforce is fly-in-fly-out (FIFO), approximately 100,000 workers. Travel management companies are now doing a lot of the logistics behind rostering and providing a duty of care for the mining companies. JP Morgan observed the FIFO sections of Virgin Australia and Qantas commented that, whilst the construction phase of the mining boom was largely over, the mines were going into an operational phase where the actual passenger movements will become more regular. That is, fewer people are travelling but those that are, fly more often. The broker notes the speed and size of the mining boom made for a huge increase in capacity in the FIFO market that was becoming unsustainable. Now, the focus is on efficiency.

A last word on another transport stock – mid tier K&S Corp ((KSC)). The company's earnings are tied to the resources sector, primarily through its Western Australian-based Regal Transport business. K&S is seen more exposed to a resources slowdown than other similar sized transport providers. Deutsche Bank will monitor this area very closely as it continues to be a source of risk for the company. The broker retains a Buy rating.
 

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