Outlook Cloudy But Aurizon’s Dividend A Key Attraction

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

-Likely to miss targets, volumes 
-Most customers meeting contract terms
-Can dividend and buy-back be maintained?

By Eva Brocklehurst

Brokers hold a mix of views about the outlook for Aurizon Holdings ((AZJ)) but irrespective of whether haulage volumes hold up over the rest of FY16, a buy-back and firm dividend should sugar coat the full year results.

The company's operating targets are likely to prove difficult in the current environment but brokers are more positive about Aurizon because of its cash backing.

While the profitability of customers has fallen, Macquarie observes Aurizon's contractual position should be strong enough to maintain revenue stability. Cockatoo Coal, in voluntary administration, is the only customer currently in contract negotiations. Aurizon has signalled that no other customers, besides Queensland Nickel which recently entered into voluntary administration, are running behind terms.

The company's transformation savings, instead of driving growth, are limiting the downward pressure on the revenue line, Macquarie observes. Even in a worst case scenario, where coal and iron ore earnings dive, capital expenditure can be cut further to ensure cash is retained.

Hence, while the structural challenges continue for the business, Macquarie believes the share price has more than captured this downside. The broker upgrades its rating to Outperform from Neutral.

Earnings were in line with the guidance provided in December, while the margin declined to 22.9% driven by lower revenue over the first half. Gearing rose to 35.4% but the interim dividend of 11.3c, 70% franked, was better than many expected.

Capex guidance for FY16 of $650-700m is a reduction of $50-100m on prior forecasts. Capex remains above Macquarie's prior estimates and, while the broker welcomes the reduction, this suggests the company could do more into FY17 if needed.

FY16 guidance is $845-885m, which assumes stable iron ore and freight volumes. The company does not expect to meet its FY16 operating ratio target (a measure of operating expenses as a percentage of revenue) of 73%, and suspects it will be a challenge to achieve 71.5% in FY17. The target of 70% for FY18 is retained.

Morgans lacks conviction in the stock, unable to envisage the company weathering the challenging operating environment completely unscathed. The broker retains a Hold rating until end-product market dynamics improve. Deutsche Bank, too, is sceptical of the targets and guidance and maintains a Hold rating, but acknowledges the company is financially sound and capex will fall, so it can continue to return money to shareholders.

Goldman Sachs expects earnings will increase in the second half, reflecting the absence of costs incurred in the first half. Cost initiatives are expected to support margin expansion despite soft revenue growth. Free cash flow should also increase over FY16-18, as the company moderates its capex profile.

Hence, Goldman Sachs expects gearing will remain stable and the company can continue with its buy-back and deliver a payout ratio at over 90% of earnings. The broker, not one of the eight monitored daily on FNArena's database, has a Hold rating and $4.15 target.

UBS does not find signs of any financial impact from the pressure on contract pricing, as yet. Revenue weakness is confined to some volume slippage and the passing through of lower performance fees and fuel prices.

The company has signalled that 68% of volumes come from investment grade miners and only 26% are neutral or loss making at current prices. There is no material contract expiry until 2021. Still, the broker notes this does not sway perceptions that pressure in contract pricing will ensue. While there is obvious risk from coal and iron ore haulage contracts, UBS points to the 50% of earnings that come from the regulated track network, which provides some stability.

UBS also points to the stock's high yield, with around $200-250m likely deployed to complete the current buy-back over the next few months. The broker does not believe earnings will grow beyond 2018 in the current commodities environment and acknowledges these concerns are likely to overshadow any bottom-up analysis in the absence of a valuation catalyst.

Morgan Stanley also points out that the subdued reception given to the results signals a significant lack of confidence in the risk profile. Sentiment will take time to improve, the broker asserts, despite an attractive and definable dividend.

Concerns which overshadow the results, Morgan Stanley suggests, include scope for the second half to be weak. Management's updated guidance now suggests earnings will be weaker than the first half rather than “in line” as per the December update.

There are also suggestions that the company cannot maintain the buy-back as well as deliver a 100% dividend pay-out ratio. Assuming only organic cash for distributions, Morgan Stanley calculates the dividend can be 95% cash covered form FY17 at a yield of 7.4%.

Citi suspects management will be hard pressed to achieve its targets but insists the yield on offer is attractive and investors ignoring this in favour of the earnings outlook are passing up an opportunity, albeit one for which they may need to be patient. Citi upgrades to Buy from Neutral.

FNArena's database shows four Buy ratings and four Hold. The consensus target is $4.29, suggesting 18.4% upside to the last share price. This compares with $4.78 ahead of the results. The dividend yield on FY16 and FY17 forecasts is 6.8% and 7.3% respectively.
 

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