Can Aurizon Increase Shareholder Returns?

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

-Acquisition growth limited
-Coal, iron ore weakness continues
-Could a divisional spin off work?
 

By Eva Brocklehurst

Bulk haulage and rail network operator, Aurizon Holdings ((AZJ)), had a disappointing March quarter, mainly stemming from a weaker-than-expected coal price. Yet brokers are mindful of the options for improving the company's capital structure, given investment opportunities are limited.

On this basis, Credit Suisse initiates coverage with an Outperform rating and $5.80 target. Aurizon's joint venture West Pilbara iron ore project, for which Aurizon would partner in rail infrastructure development, is not expected to proceed in the short term, based on the iron ore price remaining weak, and returning the $2bn in capital earmarked for the project to shareholders would improve efficiencies. Furthermore, it would provide over 11% in earnings accretion, lifting the rating of the shares. The company could maximise shareholder value by returning capital through share buy-backs and a higher dividend pay-out, which is currently guided at 70%.

Moreover, the potential for terminating restrictive labour agreements for half its employees, following the Fair Work Commission's ruling, could help Aurizon achieve an earnings margin above 29% by FY17. An appeal on this ruling is to be heard on May 21. On this subject, Macquarie, too, expects Fair Work's favourable decision should support the share price. Nevertheless, Macquarie envisages the NSW storms will have an impact on both coal and freight volumes in the June quarter.

The company has high exposure to coal haulage in both Queensland and NSW but is largely protected with take-or-pay contracts. In the current low price environment, coal miners are maximising volumes to cover fixed costs. Once current reserves are exhausted, maintaining or increasing volumes will require further investment and higher prices are required for that to happen. Hence, as long as the coal price is low, the long-term growth potential for coal haulage is weak. Credit Suisse cites evidence for this in the recent de-rating of the company's shares relative to the market.

The search for a new chairman is ongoing and the new appointment is likely to initiate a strategic review and renewal of the board, Credit Suisse's suggests, potentially adding more infrastructure and regulated utility experience which the broker considers is lacking. The broker considers it appropriate to place an aggressive growth strategy on hold in the current commodity price environment and return capital instead.

Morgans expects minimal volume growth over the next few years and, while the company's cost reductions can generate 11% earnings growth over the next four years on estimates, there is only minor upside envisaged for the current share price. Hence, Morgans retains a Hold rating. JP Morgan views the outlook in a similar vein, with a Neutral rating, believing the positive developments such as the Fair Work Commission's ruling and recent new contracts are offset by weak volumes.

UBS is more positive, while acknowledging iron ore risk is spreading through the market and there is a possibility take-or-pay provisions could be tested. The broker estimates Cliffs Natural Resources' Koolyanobbing mine accounts for half the business from iron ore haulage and this is the largest risk for Aurizon, given that company's intention to divest its Australian assets.

The other large iron ore haulage contract is with Karara mine. Despite producing a higher grade ore, this mine has been unable to generate positive cash flow in the current environment. The broker is somewhat comforted by the fact the owners of Karara have continued to support the mine with attempts to de-bottleneck production in order to protect sunk capital.

There is potential for Aurizon's capital structure to be optimised through higher gearing and a divestment of minority equity stakes in the network assets, in UBS' opinion. This would allow for the redeployment of capital into higher growth projects.

Deutsche Bank suggests there would be some merit in selling a minority stake in Aurizon's network and funding a buy-back or special dividend, or even separately listing the network as a stand-alone business. Given the recent underperformance in the share price the broker has analysed whether the company's two divisions could stand alone. In essence, if the company sold a stake, it could very quickly demonstrate value and close out the stock's underperformance.

The broker considers the network stacks up well and could offer a stand alone yield of more than 7.0%, which would be attractive in the current market. The remaining transport business would also have zero debt and be able to undertake acquisitions. Given the ongoing attraction to yield and a lack of listed transport infrastructure stocks, Deutsche Bank believes a separately listed network with Aurizon retaining a minority stake would be preferable to a one-off sell-down of a minority stake. Deutsche Bank believes Aurizon would be cheap, in either infrastructure or transport, and retains a Buy rating.

FNArena's database has a consensus target of $5.34, suggesting 3.7% upside to the last share price. There are five Buy ratings and three Hold.
 

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