Brokers Optimistic On Aurizon’s Earnings

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

-Opportunity for ruling on higher costs
-Some reduction in revenue forecasts
-System in slower growth phase
 

By Eva Brocklehurst

The Queensland Competition Authority has released its draft decision on the maximum allowable revenue for Aurizon's ((AZJ)) rail network for the next four years. A final decision is expected in May 2015 and submissions from interested parties will be received until December 12, 2014.

Why is this rail network decision so significant? Aurizon is formerly QR National and maintains, manages and operates the fixed rail infrastructure for the central Queensland coal network. The network provides rail infrastructure from the major mines in the coal regions to the export terminals. The distribution network is regulated by the Queensland government, with Aurizon providing open access to all accredited rail operators. Hence, this regulated asset base (RAB) has a defined value on which the charges Aurizon can levy on users, and thereby obtain revenue, are determined by the regulator. The regulated return is subject to periodic review. 

Aurizon submits an access undertaking to the QCA at regular intervals, 3-5 years, to seek approval for pricing and other terms regarding its network. The present undertaking, UT3, expired on June 30, 2013, and transitioning arrangements have been in place. Aurizon replaced the UT3 with the UT4 undertaking, submitting this for consideration in August. In this submission, the company details its costs and claims for providing the network. Now QCA has provided the draft proposal and will engage and consult with the industry for a final determination.

The weighted average cost of capital (WACC) allowance included in the draft of 7.17% was well below Aurizon's proposal of 8.17%. This difference in the return on capital is significant, but Citi believes the market's forecasts were more realistic than Aurizon's, being in the 7-7.5% range. Macquarie also suspects Aurizon made an "ambit" call, and expected the allowance to be more around 7.4%. As expected, allocated costs and tax allowances were heavily scaled back.

Of most surprise to brokers, and the main difference in expectations, was the lower maintenance costs accepted by the QCA. The ruling is open to re-negotiation and this provides Aurizon with an opportunity to provide further evidence for closing the gap to its claim. Citi believes no user would welcome a reduction in the maintenance of the network that may impact performance, and remains optimistic some of the gap may be closed. If not, there is a 2% downside risk to the broker's earnings forecasts for FY15-17. In addition to potential upside from a reassessment of maintenance costs, Citi observes this undertaking will last four years and therefore envisages benefit from moving to a new undertaking in FY18 compared with prior expectations of FY19.

UBS also notes the regulator has left the door open for this claim to be reassessed, especially if Aurizon provides more evidence regarding ballast undercutting. This is an important element in Macquarie's view too, as Aurizon currently capitalises this expense and amortises it over time, thus the impact on the company's profit and loss account is significant.

UBS expects the revenue outcome might settle around $4.2bn over the four years to FY17. The draft ruling implies $4.0bn which compares with UBS forecasts of $4.4bn. Macquarie is optimistic on this front too, observing that history suggests the draft is always worse than the final ruling. The net impact to Macquarie's forecasts over three years from FY16, if the draft recommendation is ruled in, suggests a reduction to Aurizon's earnings of less than 2%. The impact could be larger in FY15, depending on the final outcome.

Macquarie expects a better outcome with more detail and justification from the company. With the draft ruling, the potential for a large shock on this front has been reduced in Citi's view, and the focus for Aurizon should shift to labour negotiations with the Queensland unions, as well as firming up the tariff for the West Pilbara iron ore project in the next six months. Citi forecasts strong earnings growth and improving returns for Aurizon and upgrades to Buy from Neutral.

Another part of Aurizon's rail network, and the UT4 arrangements, that needs explanation is GAPE and WIRP. These are two expansion projects on the network and Aurizon has negotiated additional returns from users to compensate for the risks inherent in construction, financing and capacity. The Goonyalla to Abbott Point extension (GAPE) project contract provides a fixed return and is less affected by regulated outcomes, while with the Wiggins Island Rail (WIRP) development Aurizon agreed to an allowed return of a 2-3% margin on the RAB. Therefore, the WIRP performance is more dependent on the regulatory re-set.

Macquarie observes the majority of the lower volume forecasts across the system centre on GAPE and WIRP. This indicates the system is entering a slower growth phase than previously anticipated. Whilst lower coal volumes are a potential threat to Aurizon's outlook they are yet to emerge as a significant factor. Macquarie is mindful that Aurizon does haul coal for some mines which are under risk from the coal price squeeze. UBS concurs. Weaker demand for coal could impair the investment dynamics of the coal export industry. Citi also notes increased competition, with Asciano's ((AIO)) Pacific National Coal expanding its haulage business in Queensland.

FNArena's database contains four Buy and three Hold ratings for Aurizon. The consensus target price is $5.25, suggesting 15.9% upside to the last share price. Targets range from $4.96 to $5.50. The dividend yield on consensus FY15 forecasts is 4.2% and on FY16 it is 4.9%.
 

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