Is Aurizon Becoming A Yield Play?

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

-Growth mainly from cost cutting
-Challenges for West Pilbara
-Yield becoming valuation driver
 

By Eva Brocklehurst

Bulk haulage and rail network operator, Aurizon Holdings ((AZJ)), has found further opportunities to reduce costs, updating investors on its transformation plans and providing more detail to underpin its targets.

The cost savings program is expected to deliver $310-380m in additional reductions by FY18. The target margin of 30% in FY18 is unchanged. JP Morgan observes a 20-25% improvement in labour productivity and 15-20% improvement in locomotive utilisation are two of the areas where the benefits of reform are being demonstrated.

Further detail was provided on the West Pilbara project development. Currently, in terms of the infrastructure, this is expected to be comprised of 60% Aurizon, 20% Baosteel and 20% others. JP Morgan notes that Baosteel is motivated by growing demand for flat steel products and the need for certainty, which requires it to self supply iron ore above current levels around 7.0%.

Aurizon may lack revenue growth but its cost focus should deliver earnings growth in the next three years, Macquarie contends. The broker acknowledges that the prospect of spending in excess of $1.1bn developing the West Pilbara project will unsettle investors in the current iron ore market. The critical point in time will be April 2016 and Macquarie suspects there is a low probability of it proceeding.

In the current environment, Deutsche Bank is questioning what the project's long-term iron ore price assumptions are, given the current price is around the same level as the indicative operating cost. Investors need to be comfortable that given the mine life is just 16 years, that other producers will use the infrastructure. Citi asserts the necessary level of confidence remains a key hurdle in the current market.

The company does not believe the Wiggins Island rail project industrial dispute is the start of a trend and does not expect other stakeholders will try and negotiate better terms. JP Morgan highlights the comment that around 11% of the company's coal customers are cash-flow negative at current prices, which is a significant improvement compared with July 2014, when that percentage was 30%.

UBS was underwhelmed by the forecast of an average return on investment capital of 10.5% over the next three years as it compares with the 10.4% achieved in FY15. The broker believes this is symptomatic of the $500m in capital expenditure that is being used to achieve the cost savings. The broker envisages a number of earnings headwinds which will neutralised the $70-90m in earnings from the Wiggins Island ramp up so cost cutting, therefore, becomes the only real driver of earnings growth.

Moreover, there are risks associated with the West Pilbara iron ore project. UBS maintains the potential $1-1.5bn equity requirement that has been flagged taints the rating of the stock and is likely to remain an undercurrent until at least late 2016.

On a positive note, the company recently raised its pay-out ratio to 70-100% and although UBS can envisage Aurizon generating just 5.0% earnings growth per annum for the three years to FY19, the broker's forecast dividend in FY16 of 26c equates to a 5.0% yield which should grow at 9.0% over the three years.

There is also potential for re-gearing beyond this time frame but unlocking that relies on the West Pilbara project not proceeding and a more lenient view by ratings agencies, given the reliance on its network for cash flow. Meanwhile, UBS observes a low share capital balance limits the tax effectiveness of a large buy-back.

Citi also contends the downside risk to earnings is not alleviated, given the challenging environment. Management's cost savings are key to its 30% earnings margin forecast for FY18 and the broker wants to witness further confidence in the growth projects, or an acceleration of revenue, to rule in further valuation upside. On the other hand, Morgan Stanley concedes organic growth remains a challenge but considers consensus expectations are already low and execution on the cost front should be supportive.

There is little wriggle room in the margin target but the extra cost cutting has removed Morgan Stanley's concern that the market was becoming too optimistic. Given the company's track record, Morgan Stanley believes the margin profile is fair. The broker continues to believe Aurizon is progressing towards a yield play which will become a key driver of valuation, outweighing weak organic sentiment. Assuming an 85% pay-out ratio from the guidance, the broker expects the dividend yield to grow to 6.0% in FY16.

Aside from the cost savings benefits, Macquarie observes the company has $1bn in property assets and an estimated $400-500m in surplus real estate which can be realised. There would be little impact on earnings but the broker envisages it could fund an extended buy-back for investors. The real issue is that there are few alternative uses for the properties, given their location, and there is unlikely to be significant profit on the sale.

There are four Buy ratings and four Hold on FNArena's database. The consensus target is $5.55, signalling 7.2% upside to the last share price. Targets range from $5.30 (UBS) to $5.93 (Macquarie). The dividend yield on FY16 and FY17 forecasts is 5.1% and 5.6% respectively.
 

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