-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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-Significant momentum
-10% return target on capital
-Benign domestic market
-International more competitive
 

By Eva Brocklehurst

Qantas ((QAN)) is making progress. Brokers hail a disciplined approach to spending and efforts to generate returns ahead of the cost of capital. The company is on track to deliver over $875m in transformation benefits in FY15 and its latest investor briefing exuded confidence.

Qantas has guided to a $3.9bn FY15 fuel bill, with FY16 capped at a similar level and 74% participation in lower fuel prices. UBS expects debt to be reduced by $1.4bn in FY15, ahead of forecasts, and this rapid de-gearing should make way for capital management to be announced later this year. The broker expects this to be initially in the form of a buy-back, given a lack of franking.

As the stock has outperformed the ASX200 by 183% over the past 12 months, JP Morgan suspects the positive outlook is well understood. That said, the stock is still cheap relative to other airlines and the broader industrials, while the broker envisages further scope for upgrades to forecasts over the next 12 months. Hence there is upside for the share price and JP Morgan upgrades to Overweight from Neutral.

The data suggests there is significant momentum in the business, with rational capacity growth and strong sales demand, which contributes to a 115 basis point improvement in domestic load factors, in JP Morgan's calculations. The broker believes the capacity war domestically may be coming to an end and a more rational duopoly will emerge. UBS continues to expect the recovery in domestic market revenue will be the biggest contributor to group returns.

Qantas is targeting a return on invested capital greater than 10% through the cycle. All business units, except the Jetstar joint ventures, are expected to exceed this hurdle in FY15. Most of the current initiatives are seen as removing some volatility from the earnings cycle. On JP Morgan's estimates the airline fulfills the credit requirements for an investment grade rating by the end of FY15, which might open the door to capital management, probably a buy-back.

Deutsche Bank notes Qantas is rapidly moving to use data to market to customers. This not only helps operational efficiencies but, as the analyst notes from a personal experience, enables the airline to target and cross reference a great deal of information from loyalty cards about spending behaviour. While Qantas expects to maintain positive free cash flow the broker cautions that it will need to retain funds for increased expenditure on new international aircraft from FY17, particularly in order to develop more point-to-point services into Asia. Hence, any resumption of dividend payments is expected to be small.

There is scope for $350m in capital management, in Morgan Stanley's view, even at the FY15 result, with the quantum increasing sharply thereafter as debt is paid down. This could accelerate a multiple re-rating in the broker's opinion. Morgan Stanley considers the stock is cheap and retains an Overweight rating.

Fuel pricing and a lower Australian dollar are providing a tailwind but company has learnt from the crisis in 2013, in Citi's view. Customer engagement has improved and management is also expecting a salary freeze to benefit by an additional $125m in FY17. Qantas' international operations are in a stronger position now with a lower cost base and, with international carriers expected to increases capacity by only 1.0% in FY15, Citi suspects the lower Australian dollar will have lowered their revenue on Australian routes by around $1.5bn.

The main outcome from the briefing, from Macquarie's perspective, and aside from the performance benchmarks, was the continuing benefit of a benign competitive environment domestically and a more competitive international offering from Qantas, with a significant opportunity to leverage the brand and loyalty program across the group. While the possibility of capital management becomes more likely, this will be delivered in conjunction with capital discipline, Macquarie suggests. Critical to this premise is the 10% return on invested capital target along with cost cutting and debt reduction targets. On that basis the broker envisages clear sky to dividends from FY16.

Qantas has a suite of seven Buy ratings on the FNArena database. The consensus target is $4.28, suggesting 20.8% upside to the last share price, which compares with $3.94 ahead of the update. Targets range from $3.65 to $5.40.
 

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-Efficiency benefits continue
-Scale gains from rail integration
-Port Botany activity to ramp up
 

By Eva Brocklehurst

Rail, terminal and port contractor Asciano ((AIO)) revealed some positive trends in its March quarter update while brokers welcomed an affirmation of FY15 guidance. The company continues to expect free cash flow to improve and drive dividend growth.

Guidance was reiterated for underlying earnings growth to be higher in FY15 than FY14, supported by the efficiency benefits from the integration of PN rail, along with modest volume improvements. Coal tonnage increased 3.1% on the prior corresponding quarter although volumes did slow heading into March. Management has signalled automation of Port Botany is complete and activity is ramping up. Container lifts increased 3.7% year to date. Deutsche Bank anticipates increased regional footprint and scale emanating from the joint venture between Patrick and ACFS, as this is integrated with the existing logistics capabilities.

The Terminals & Logistics performance was better than Citi expected. Coal tonnage was down by 6.8% in NSW but up 12.1% in Queensland. Coal export terminals recorded growth of 3.9% in NSW and 6.3% in Queensland. Citi continues to envisage strong free cash flow for Asciano, which should drive higher pay-outs ahead of any acceleration in economic volumes. As the company has strong market positions in each of its core business its re-rating is linked to an increase in economic activity. Despite some recent re-rating of the stock, Citi considers the current share price still offers attractive upside on a 12-month view.

UBS is pleased the automation of the Sydney container terminal will provide support for productivity targets in FY15 and FY16. Containerised divisions grew 2-4% in the quarter, despite the disruptions from the redevelopment of Port Botany. Despite the drop in utilisation, coal railings grew around 5.0%, reflecting a more sustainable growth rate after a period of strong contract momentum. UBS has maintained its forecasts and expects 7.0% earnings growth and 19.0% dividend growth going forward. The broker believes this stock is good value and retains a Buy rating.

Coal volumes were soft but freight was in line with Macquarie's expectations. NSW coal volumes were affected by a 5-day derailment in the Gunnedah Basin and other maintenance works which caused lower utilisation in the quarter. The highlight For the broker is that the terminals business and activity at Port Botany is expected to ramp up in coming months. The recent JV established with ACFS is expected to provide a growth platform, as the broker notes the company continues to experience low activity levels in metro areas. Macquarie expects the integration of the rail business will also continue to provide a positive input, with the market still likely underestimating the benefits.

With capex declining, JP Morgan estimates a free cash flow yield of 8.6% in FY16, up from 6.6% in FY15. The broker upgrades estimates to account for higher coal and bulk haulage and higher container lifts, as well as increased vehicle movements. While the company's cyclical exposures face near-term headwinds, a focus on reducing costs and improving operational efficiencies continues so JP Morgan believes the company will be well placed to leverage improved economic activity when it eventuates.

There are seven Buy ratings and one Hold on FNArena's database. The consensus target is $7.09, suggesting 8.0% upside to the last share price. The dividend yield on FY15 consensus forecasts is 2.9% and 4.1% on FY16.
 

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-Falling oil, cost cutting benefits
-Turnaround on FY14 first half loss
-Margin expansion to continue
-Capacity outlook benign

By Eva Brocklehurst

What a difference a fall in oil prices makes. As brokers ratchet down oil price forecasts a more flattering light is cast on the transport sector, none the least being Australia's major airline, Qantas Airways ((QAN)). That is not all. Qantas has defied the gloom merchants on several fronts, pulling out of a steep slump over a number of years to reveal a substantial return to profit and shaking off concerns regarding the competitive threats that prevailed in broker analyses a year ago.

Qantas has guided to pre-tax profit of $300-350m for the first half. This compares with the $364m Deutsche Bank had forecast for the whole year and has resulted in several brokers making substantial upgrades to estimates. UBS observes updated guidance is a significant turnaround on an underlying loss of $252m in the first half of FY14. The broker considers the stock is much more than just a play on falling oil, based on management achieving on its transformation targets. The company has outperformed expectations on cost cutting, while its restraint on capacity growth has stood it in good stead amid a soft domestic economy. A much lower oil price and expectations that oil will remain under pressure into 2015 add the final fillip.

Citi believes this is an accelerated turnaround for the airline and the increased pace of change should continue. Lower capacity additions in both domestic and international markets, coupled with lower Australian dollar fuel expense, reflect a positive operating environment and highlight the airline's significant operating leverage to higher yields, with increased revenue benefits also coming from passenger growth in key markets. Deutsche Bank calculates the reduced oil price will provide around $30m in benefit in the first half and provide upside leverage that should continue well into FY16. Nevertheless, while fuel reductions are important, the broker notes these really only kick in in the second half of FY15 while the company's transformation plan is on track to deliver a FY15 benefit of $650m.

What about those fuel surcharges that were brought into the equation some years ago? Qantas has said it generates around $1bn in fuel surcharges from international operations and has not yet recovered the previous fuel price increases. Still, Deutsche Bank has started moderating yield expectations over the next 18 months to include some reduction in these surcharges. Offsetting this is an increase in the forecast load factor.

Morgan Stanley acknowledges it was wrong just six months ago with a bearish outlook for Qantas. Instead, the airline is lauded for its capacity discipline, yield recovery, a weakened competitor and cost cutting. Morgan Stanley envisages few hurdles in the near term and upgrades to Overweight from Equal-weight. The broker does not believe the airline's margin expansion is done with yet and another $12.6bn in cost reductions is expected over the next 24 months. Material fuel benefits and a cash-flow starved competitor do the rest. Morgan Stanley's earnings estimates are upgraded by 20% over the forecast period.

Morgans suspects lower oil prices should be around for some time while the capacity outlook should stay benign. Despite the re-rating in the share price over the past 12 months the broker considers there to be plenty of upside still to come, retaining an Add rating and raising its target to $3.50 from $2.37.

Goldman Sachs offers some cautionary words. While the operating environment is currently favourable, a deterioration in demand has potential to erode some of the benefits from cost cutting and lower oil prices. The broker's sensitivity analysis suggests a 1% change in group yield has a 25% impact on FY15 pre-tax profit. Goldman Sachs retains a Neutral rating and raises its target to $2.74 from $1.54.

On FNArena's database there are six Buy ratings with a consensus target of $3.02, suggesting 20.6% upside to the last share price. This target compares with $2.33 ahead of the announcement.
 

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-Targets are challenging
-Ferguson metrics stretched
-Cost pressures in the US
 

By Eva Brocklehurst

Brokers are watching pallet and container business Brambles ((BXB)) carefully. The company has set itself various targets for returns on invested capital and has updated its earnings guidance for FY15 to include the recent acquisition of container business Ferguson. Brambles now expects 9-12% constant currency growth across its business base in FY15. As macro economic conditions across many of the company's geographies are patchy, concerns centre on the near-term dilution of returns on investment in emerging markets and whether this is being offset by accretion in established businesses.

The update provided the first time the company has presented its strategy since the acquisition of Ferguson. Brambles has stated that it assesses acquisition targets against its organic investment profile and considers whether the acquisition will provide a head start in a new geography or industry vertical. The company is also seeking to redeploy excess cash generated in more mature businesses into more long-dated growth initiatives.

Management is confident regarding the projected returns at Ferguson but Macquarie suspects it will be a challenge, given the significant amount of capital required to be reinvested. Brambles expects Ferguson, consolidated from September 1, will contribute a return on capital employed of around 6.0%. The earnings multiple implied in FY15 by the acquisition is 14 times, which reinforces UBS' view that valuation metrics of the transaction are stretched. Brambles remains confident that value-adding strategies should improve the return on capital employed to 12.0% by FY19.

While Deutsche Bank can find some similar characteristics to the rental model in Brambles' core operations, the broker is yet to be convinced of the strategic imperative surrounding the acquisition of Ferguson. The company has outlined deep water production growth rates of 6.6% from 2010-2025 but Deutsche Bank suspects oil companies are likely to be very price sensitive at present. It is probable that other developments will be given priority. Once an operation is up and running it is less sensitive to daily oil price movements and then containers would likely be rented for long periods of time.

Brambles is looking to leverage customer relationships to move into the Gulf of Mexico, and Brazil on a longer-term horizon. Deutsche Bank notes current estimates for deepwater capex in Brazil through to 2018 account for 33% of global deepwater spending. Hence, the broker believes, on this basis, Brambles should be penetrating Brazil's market sooner.

Morgan Stanley also wants to see return on investment targets met before becoming more bullish, noting management continues to target base business returns of 20% by FY19. The broker believes the company deserves more than its current 6.0% premium to the ASX200 industrials. On the positive side, with capital being recycled in lower returning units like IFCO, CHEP Asia, the automobile and aerospace divisions, targets encouragingly imply significant and accessible expansion in the mature North American and European CHEP businesses. Morgan Stanley is still cautious about Ferguson, as the company's prior acquisitions have missed their targets, albeit in different divisions.

Brambles' valuation remains undemanding, in Morgan Stanley's opinion, given its exposure to growth in emerging markets and first mover advantage. Moreover, the broker considers capital recycling in emerging units is preferable, given the growth profile and expertise, to capital management, although admittedly there are execution risks with the former.

UBS takes a harsh view of the pallets business, noting cost pressures continue and management expects negligible operating margin upside. This reflects an ageing pool that is being worked harder. The US is experiencing inflation in road transport of around 10% which cannot be readily passed onto customers. The broker considers Brambles is a high quality, low risk growth stock but also fully valued and this justifies a Neutral rating. High maintenance capex, in order to replace 8-10% of the pallet pool each year, restrains equity free cash flow yield to only 4.0% and the broker envisages this will limit valuation upside.

FNArena's database contains five Buy ratings and two Hold. The consensus target is $10.02, which signals 4.1% upside to the last share price. Targets range from $9.10 to $10.62.
 

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-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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