Aurizon’s Capex Increase Threatens Capital Management

This story features AURIZON HOLDINGS LIMITED. For more info SHARE ANALYSIS: AZJ

-Capex impact on valuation
-Growth remains attractive
-Clarity required on expenditure

By Eva Brocklehurst

Aurizon Holdings ((AZJ)) has revealed higher capital expenditure going forward with no compensatory changes in the revenue outlook. Such numbers from the FY14 results disappointed brokers, given just six months ago the company had guided to sustaining capex of $350m, but now expects $600m over FY15-17.

The company indicated it needs to take out a further $20-70m in operating expenditure to achieve its FY15 revenue and earnings target, coupled with a 50% increase in capex guidance for FY16 to $600m. There was no corresponding change in the FY16 margin guidance and this disappointed JP Morgan. The broker estimates a total return of 5.6% based on a June 2015 price target of $4.96. The earnings increase in FY14 was skewed to the first half, with a 12% increase followed by just 4.7% in the second half. The final dividend of 8.5c was unfranked in contrast to an 80% franked dividend in the first half but the company does expect to fully frank the final FY15 dividend.

BA-Merrill Lynch observes the market was primed to expect a beat on further cost cutting and did not receive it. While costs were okay in FY14, coal revenue missed forecasts which gives rise to questions around pricing flexibility. As the stock is valued on a discounted cash flow basis, the increased capex guidance is significant in terms of its impact on the broker's valuation. Moreover, capex increases appear to be about maintenance and not linked to revenue increases. Merrills ponders whether a cynical investor might ask to what extent there is an opex-to-capex classification switch going on.

The broker also queries operating expenditure in the coal division. Increases in payload, better turnaround times and fuel efficiencies have not translated into a materially better cost base. Overall, improvements going forward are less than what Merrills expected. What was positive was the reiteration of long-term targets and the broker expects some clarification on the changes to capex over coming weeks. Meanwhile, Merrills sticks with a Neutral stance.

The additional maintenance capex surprised Citi too, but the broker concedes it does provide a better platform for operating ratio improvements. Citi observes the additional spending will be allocated to IT costs and rolling stock. The broker is supportive of capex investments with a quick pay-back but acknowledges, with this result, the promise of delivering returns from doing more with less has been delayed. Otherwise, most of the FY14 miss for Citi was explained by one-off costs or investment in growth options. The broker does not expect a reduction in dividends but envisages fewer options for capital management.

UBS has incorporated some additional benefits from the increased capex forecasts but found little transparency regarding the drivers of expenditure, or the incremental returns. The miss to expectations and the higher capex means a 4-5% downgrade to forecasts and a commensurate reduction in valuation. The broker acknowledges the majority of earnings come from export coal, and Aurizon is partly protected by earnings from the regulated track network while contracts have provisions for downside. Furthermore, there is also potential for optimisation of capital through higher gearing and divestment of minority stakes in network assets. All up, the broker believes the stock remains attractive, given the expectations for 20% per annum growth in dividends and 13-15% growth in earnings per share over the next three years. Nevertheless, UBS also observes capital management potential is further diminished.

The increase in sustaining capex guidance is also detrimental to Macquarie's valuation. Still, the broker notes the stock has already reacted to the news and there is upside around cost reductions, repricing of the BMA volumes and restoring some volume in freight. A draft network agreement on UT4 will be a positive, while indications of any progress on growth options could provide a necessary catalyst. Hence, the broker retains an Outperform rating.

CIMB believes cost cutting expectations are now largely factored into the share price and there are risks overhanging the stock such as labour and regulatory issues which may limit the upside in the next 12 months. The broker considers a Hold rating is in order, ahead of more clarity on the outcome of these issues. While free cash flow was a feature of FY14, the broker now expects this to reduce in FY15 and the profile from FY16 onwards will largely be determined by timing and quantum of of capex for the Pilbara and Galilee projects.

In summary, brokers still expect a positive year of earnings growth in FY15 but tread with a little more caution. On FNArena's database there are three Buy ratings and four Hold. Targets range from $4.96 (JP Morgan) to $5.50 (UBS) and the consensus is $5.24, suggesting 7.8% upside to the last share price. This compares with $5.37 ahead of the results.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms