-Capex impact on valuation
-Growth remains attractive
-Clarity required on expenditure

By Eva Brocklehurst

Aurizon Holdings ((AZJ)) has revealed higher capital expenditure going forward with no compensatory changes in the revenue outlook. Such numbers from the FY14 results disappointed brokers, given just six months ago the company had guided to sustaining capex of $350m, but now expects $600m over FY15-17.

The company indicated it needs to take out a further $20-70m in operating expenditure to achieve its FY15 revenue and earnings target, coupled with a 50% increase in capex guidance for FY16 to $600m. There was no corresponding change in the FY16 margin guidance and this disappointed JP Morgan. The broker estimates a total return of 5.6% based on a June 2015 price target of $4.96. The earnings increase in FY14 was skewed to the first half, with a 12% increase followed by just 4.7% in the second half. The final dividend of 8.5c was unfranked in contrast to an 80% franked dividend in the first half but the company does expect to fully frank the final FY15 dividend.

BA-Merrill Lynch observes the market was primed to expect a beat on further cost cutting and did not receive it. While costs were okay in FY14, coal revenue missed forecasts which gives rise to questions around pricing flexibility. As the stock is valued on a discounted cash flow basis, the increased capex guidance is significant in terms of its impact on the broker's valuation. Moreover, capex increases appear to be about maintenance and not linked to revenue increases. Merrills ponders whether a cynical investor might ask to what extent there is an opex-to-capex classification switch going on.

The broker also queries operating expenditure in the coal division. Increases in payload, better turnaround times and fuel efficiencies have not translated into a materially better cost base. Overall, improvements going forward are less than what Merrills expected. What was positive was the reiteration of long-term targets and the broker expects some clarification on the changes to capex over coming weeks. Meanwhile, Merrills sticks with a Neutral stance.

The additional maintenance capex surprised Citi too, but the broker concedes it does provide a better platform for operating ratio improvements. Citi observes the additional spending will be allocated to IT costs and rolling stock. The broker is supportive of capex investments with a quick pay-back but acknowledges, with this result, the promise of delivering returns from doing more with less has been delayed. Otherwise, most of the FY14 miss for Citi was explained by one-off costs or investment in growth options. The broker does not expect a reduction in dividends but envisages fewer options for capital management.

UBS has incorporated some additional benefits from the increased capex forecasts but found little transparency regarding the drivers of expenditure, or the incremental returns. The miss to expectations and the higher capex means a 4-5% downgrade to forecasts and a commensurate reduction in valuation. The broker acknowledges the majority of earnings come from export coal, and Aurizon is partly protected by earnings from the regulated track network while contracts have provisions for downside. Furthermore, there is also potential for optimisation of capital through higher gearing and divestment of minority stakes in network assets. All up, the broker believes the stock remains attractive, given the expectations for 20% per annum growth in dividends and 13-15% growth in earnings per share over the next three years. Nevertheless, UBS also observes capital management potential is further diminished.

The increase in sustaining capex guidance is also detrimental to Macquarie's valuation. Still, the broker notes the stock has already reacted to the news and there is upside around cost reductions, repricing of the BMA volumes and restoring some volume in freight. A draft network agreement on UT4 will be a positive, while indications of any progress on growth options could provide a necessary catalyst. Hence, the broker retains an Outperform rating.

CIMB believes cost cutting expectations are now largely factored into the share price and there are risks overhanging the stock such as labour and regulatory issues which may limit the upside in the next 12 months. The broker considers a Hold rating is in order, ahead of more clarity on the outcome of these issues. While free cash flow was a feature of FY14, the broker now expects this to reduce in FY15 and the profile from FY16 onwards will largely be determined by timing and quantum of of capex for the Pilbara and Galilee projects.

In summary, brokers still expect a positive year of earnings growth in FY15 but tread with a little more caution. On FNArena's database there are three Buy ratings and four Hold. Targets range from $4.96 (JP Morgan) to $5.50 (UBS) and the consensus is $5.24, suggesting 7.8% upside to the last share price. This compares with $5.37 ahead of the results.
 

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- Consumer sentiment slump hits airlines
- Market over-optimistic of earnings rebound
- Travel service companies taking off

By Greg Peel

The latest data from the Australian Bureau of Statistics showed short-term international departures from Australia in May were down 4.5% on April, seasonally adjusted, and the annual growth rate to May fell to 6.6% from April’s 7.0%.

Goldman Sachs points to the sharp, budget-related fall in consumer sentiment in May and subsequent failure to rebound in June as an argument to support lower travel demand. This has created a challenge for Australian airlines, as has ongoing aircraft capacity growth from Middle Eastern and South East Asian carriers servicing Australia.

Bell Potter nevertheless points out that there is on average a three-month lag from when a booking is made to when a passenger departs, hence the weaker departure numbers evident in May reflect bookings made earlier in the year or even late last year. This would suggest departure numbers are destined to fall further from here, assuming weak consumer sentiment in May-June translates into lower bookings for three months hence.

Bell Potter suggests this weakness should ultimately prove transitory, however, as history suggests consumers tend to adjust their expenditure patterns quickly after such sentiment shocks.

We note that Westpac’s July consumer sentiment survey, released yesterday, does not suggest evidence of any meaningful return to consumer spending in the short term. The 1.9% increase in July takes sentiment only to 2% above the May level, which represented a 7% fall from April. Sentiment is sitting 14% below its level of last November, when people were actually excited about an Abbott government, and 10% below the 2013 average.

While consumer sentiment provides a guide to holiday travel, Morgan Stanley can see little growth in corporate travel ahead either, be it international or domestic. Australian corporates, and indeed corporates across the world, remain very heavily focused on cost reductions as a means of supporting earnings in a challenging environment while continuing to deleverage in the wake of the GFC. On the domestic front, the peak in mining construction also means a peak in FIFO construction workers, and as mining companies join the cost-cutting spree, a peak in FIFO mine workers. There will continue to be less F going on, and less so again as the big LNG projects begin to reach completion over the next few years.

This writer has never heard mention of this in airline analysis but I have long assumed one of the biggest additional threats to airline ticket sales is the internet. Specifically, the exponential improvement in face to face communication afforded by faster and broader broadband. Time zones notwithstanding, corporate meetings can be held with offshore executives or clients on screen as if they were in the room, undermining the need to fly half way around the world to achieve the same result. Even family members can catch up cheaply on platforms such as Skype, also undermining the need for expensive air travel.

I would therefore suggest that when one lists downside risks to Australian airline and travel-related stocks, the NBN should be included.

A glance at one-year chart indicates Qantas ((QAN)) has rebounded out of the depths of its annus horribilis, which culminated late in 2013 with the infamous grounding episode. The market has assumed things could not possibly get worse, and a subsequent end to the internecine race between Qantas and Virgin Australia ((VAH)) to increase capacity has provided support to this assumption. But Morgan Stanley believes the market is too optimistic, citing the aforementioned cost-reduction and resource sector headwinds.

Indeed on Morgan Stanley’s analysis, 12-month forward multiples for Qantas and Virgin are 20-30% “expensive”.

Within the sector, Virgin continues to take market share away from Qantas, the broker notes. Forward booking numbers suggest this trend is ongoing. While this should suggest a preference for Virgin over Qantas, all else being equal, Morgan Stanley wonders just what it is costing Virgin to facilitate these market share gains. The company is thin on capital and is not expected to reach breakeven on free cash flow until FY17. Virgin’s share register is tight, so there is some price support inherent, but the broker will not rule out another capital raising being required.

Morgan Stanley is not prepared to wait until the upcoming earnings result season to assess if its assumptions prove correct (QAN August 28; VAH August 29). The broker has downgraded Qantas to Underweight, and is maintaining its existing Underweight rating on Virgin.

Deutsche Bank maintains Hold ratings on both stocks, while noting domestic passenger growth has lagged its long-term average since December 2012. Yet forward fares for domestic travel are trending upward in July and into August.

The broker suspects that having called a truce in the capacity war, the airlines also see price wars as destructive and would rather keep ticket prices more stable while shifting volatility onto load factors. That said, Qantas still enjoys an average 30% price premium over Virgin in economy class and 20% in business.

The challenge now for the airlines, within an otherwise challenging environment, is getting these price increases to “stick” with passengers.

The Australian travel sector as a whole does not consist exclusively of two airlines but includes travel agents, corporate travel managers and travel insurers. These businesses do not care who you fly -- Qantas, Virgin, Emirates or Aeroflot -- just so long as you fly. Hence they are removed from any Qantas/Virgin woes but very much beholden to Australian consumer and business sentiment, the ups and downs of which have been discussed already in this article.

They are also beholden to market share, in their domestic markets and vis-a-vis global online peers. Morgan Stanley notes the locals are winning share from their offshore counterparts and are also more exposed to high growth in domestic small and medium enterprises. Agents are also benefitting from market fragmentation, the broker suggests, which is ongoing as Australian passengers turn more towards overseas carriers for international routes and low-cost carriers for domestic routes.

To that end, Morgan Stanley retains Overweight ratings on travel agent Flight Centre ((FLT)) and corporate travel solutions manager Corporate Travel Management ((CTD)).

Corporate Travel Management remains Bell Potter’s preferred stock in the sector as the broker is increasingly confident the company will deliver material earnings growth in FY15, driven by domestic market share gains and the incremental impact of recent acquisitions. The broker is nevertheless bullish on international holiday travel in general, given its expectation for a rebound in consumer sentiment, as noted above.

To that end, Bell’s top picks also include Flight Centre and travel insurer Cover-More ((CVO)).

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-Tight focus on cost reductions
-Well placed for economic upturn
-Increased pay-out from FY16
-Lower coal tonnage offset
 

By Eva Brocklehurst

Rail, terminal and port contractor Asciano ((AIO)) has dug deeper into its cost reduction program and brought forward efficiencies, largely on the back of the integration of PN Rail and PN Coal. The company presented its updated business improvement program at an investor briefing and also took the opportunity to address concerns about any loss of coal volumes, given the downturn in that market.

The company's success just rolls on, in CIMB's view. The broker increases FY15 and FY16 earnings forecasts by 3% and 4% respectively to reflect the improvement in margins gained from enhanced cost cutting. Volumes may be challenged by the downturn in coal prices and sentiment, with risks around additional competition in terminals, but CIMB thinks the market is now sufficiently conservative to enable upside surprise for the stock over the next two years. Efficiencies should leave the company well placed for significant earnings growth when volumes do return.

Citi considers the business is undervalued and retains a Buy rating. So to does BA-Merrill Lynch. However, Merrills still has a query regarding the automation at Swanson Dock, which will be required at some stage and has not been included in capex guidance out to FY16. The broker is also cautious about the extent of the cost assumptions, doubting that 100% of the savings can be held, given the company's margins are well ahead of competitors.

Management has reiterated FY14 guidance for low single digit growth in underlying profit and announced higher one-off costs following an acceleration of the restructuring. Costs in FY14 are expected to be $120-130m, up from the $15-25m range previously announced. The key point brokers gleaned is that management is now confident of delivering on a business improvement target of $300m by FY16 - two years earlier than previously expected. This involves a re-commitment to a 10-15% compound annual growth rate out to FY16. Furthermore, management expects increased cash flow and this should allow for an increase in the dividend pay-out ratio to over 50% by FY16, from 30-40% currently. The company will continue to explore strategic opportunities and partnerships for terminals and logistics.

UBS considers the company's plans are credible. Capex should fall from the current 2.5 times depreciation to 1.0 times by FY16, paving the way for the increased pay-out ratio. UBS also envisages upside potential from monetisation of equity in the ports business, where selling a 50% stake at 10 times earnings could release a net $1.4bn in capital and reduce gearing by 40%. Acquisition of Xstrata's in-house coal operation is also a possibility in the broker's opinion, given miners are wanting to rationalise capital. With around 50% of earnings coming from a domestic cyclical freight business, with high fixed costs, the stock is considered a good play on the Australian economy when it picks up.

Asciano has bought time, in Deutsche Bank's view, as it awaits the underlying economic cycle to return to more normal levels. The broker thinks the improvement program will underpin earnings growth out to at least FY16 before the company needs to see further growth avenues emerge. The broker observes company assurances that coal customers are happy with coal haulage contracts and the service Asciano is providing. To date, the impact of renegotiated contracts has been minimal but the broker reminds the market these contracts are long-dated and there is a risk that returns fall when they are renegotiated.

Macro headwinds are prevailing and challenging the top line in Morgan Stanley's opinion, although value is emerging and the company looks well placed to benefit from an economic recovery. Macquarie also considers revenue opportunities are limited in the near term but thinks the company is rightly focused on reducing the cost base. Still, Macquarie believes the jump in the share price post-update captured the excitement from accelerated cost cutting, noting the probability that if growth stalls in intermodal and ports operations, it leaves Asciano solely relying on cost reductions. The broker calculates the cost reduction program is now 9% of the growth outlook, acquisitions are 1% and there is a residual 1% for organic growth. This limit on growth is a negative, in Macquarie's view, but the re-investment in the asset base appears to be paying off.

In addressing market concerns, Macquarie also notes the company has emphasised the redevelopment of rail terminals in Sydney and Melbourne and does not feel threatened by the Moorebank development. Asciano has negotiated contract extensions with its coal customers and the contracted portfolio has grown by 18 months. This has most likely lowered the average price per tonne, in Macquarie's opinion, but is being offset by using idle capacity, particularly in NSW, to increase the tonnage hauled. The company reiterated an interest in forming a strategic joint venture with a global port operator but there is no financial urgency to do so, and Macquarie does not expect any developments on this front before the Autostrad roll-out is completed in Sydney in late FY15.

Macquarie stands out with the only Neutral rating on the FNArena database. The remaining seven are Buy ratings. The consensus target price is $6.45, suggesting 16.4% upside to the last share price. This compares with a consensus target of $6.30 ahead of the briefing. The targets range from $6.00 (Macquarie) to $7.10 (Deutsche Bank).
 

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-Modest cost reductions
-Margin pressures continue
-Relief regarding FY14 guidance

By Eva Brocklehurst

Brokers remain wary of Toll Holdings ((TOL)). The transport and logistics company is reallocating the five business units that comprise its Specialised and Domestic Freight (SDF) division to other divisions to reduce costs and improve efficiencies, with the result 100 jobs will go while savings of $10-12m are envisaged from FY15.

The company has reiterated earnings guidance for FY14 to be similar to FY13 and this highlights the difficulties Toll faces in achieving sales growth, earnings growth and margin expansion. Those brokers which have reviewed the stock so far in response to the news of the restructuring have moderated their earnings estimates for FY15. All note the background is one of subdued activity amid margin pressures.

The changes do not go far enough, in JP Morgan's opinion. The broker believes outright divestment of some segments is needed to make substantial changes in the company's earnings performance, given current market conditions. Rationalisation is a positive, of course, but several brokers consider there are still too many businesses. The company manages over 45,000 people across 27 units in 50 countries. This is inefficient and partly the reason why returns are sub-optimal in JP Morgan's opinion, hence a downgrade to Underweight from Overweight. Citi is confident the restructuring will offset margin pressures, somewhat. These pressures have been evident for a few years, so Citi also believes there needs to be a larger restructure to configure the competitive positioning of key businesses.

The SDF division will be merged with Domestic Forwarding. Hence the company will have five divisions instead of six. Changes will take effect from July 1 so the company will report its FY14 results under the existing structure. Domestic Forwarding will gain Express, NQX and Linehaul & Fleet Services. Toll Liquids and Toll Transitions will be moved to Global Resources because of the contract nature of the businesses. Specialised parts of Intermodal will be incorporated into Global Logistics and the Queensland freight forwarding business will be merged into NQX.

CIMB Securities has tempered earnings forecasts and likes further efficiencies, but does not expect real volume recovery any time soon. There are better opportunities in the logistics sector for the broker, including Asciano ((AIO)) and Brambles ((BXB)). BA-Merrill Lynch takes the guidance as a positive development, because many in the market feared Toll would downgrade earnings forecasts. A challenging market means the broker does not necessarily think the cost savings will add to the bottom line. Still, Toll has been criticised for not being vigilant on costs in a weak economy so Merrills expects the restructuring news will erase a few frowns.

 Goldman Sachs notes some risks relating to the re-tender of Singapore government contracts but found the reiteration of guidance a welcome relief, as it demonstrates Toll has been able to offset the challenges with some contract wins. Toll has never disclosed the significance of the Singapore contracts but Goldman calculates they could represent around 4% of group earnings.

On FNArena's database Toll Holdings has a mixed bag of ratings. There are two Buy, four Hold and two Sell. The consensus target is $5.42, suggesting 0.7% downside to the last share price. Targets range from $5.10 to $6.10. The dividend yield on consensus forecasts for FY14 and FY15 is 5.1% and 5.4% respectively.
 

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-Competitive advantages lie with Asciano
-Fragmentation of third port operators
-No concerns re Asciano earnings
 

By Eva Brocklehurst

The third international Melbourne container terminal operating licence, at Webb Dock, has been awarded to a consortium which surprised the market. The winners are Philippines-based International Container Terminal Services Inc (ICTS) with 90% and former P&O Ports management-backed Anglo Ports with 10%. Brokers had expected Asciano's ((AIO)) upcoming competitor, Hutchison, and Qube Logistics ((QUB)) could be the winners. While additional competition will provide a challenge for Asciano, most brokers believe the decision supports the stock, resulting in the fragmentation of the third operator across the Australian stevedoring industry.

Work on the new terminal is expected to be completed by late 2016, although UBS thinks mid 2017 is more realistic for start-up, given natural project delays. ICTS is a global port operator with terminal operations in a number of emerging markets. Hutchison has a presence in Brisbane and Sydney and an alliance may be possible between the two, but it will not be the same as being the sole operator. UBS thinks Asciano is in the strongest position of the port operators, with an estimated 30% of eventual industry capital employed versus 40% of capacity. UBS believes Qube will have been disappointed to miss out, and still thinks container stevedoring is a logical industry for that company to enter, given 35% of earnings relate to land logistics of import/export containers. The broker also thinks this announcement makes an operational or equity alliance for Qube with DP World Australia, or Hutchison, as more likely.

To CIMB, Asciano's competitive advantages lie in providing services across four major ports. The broker believes stock is attractively priced for a company with solid earnings growth and a significant step-up in free cash flow that's coming over the next couple of years, providing capital management opportunities. CIMB is also of the opinion that the fragmentation of the third operator helps Asciano. Any significant discounting that comes from the others should have minor risk to earnings. Asciano's management has indicated that 80% of contracted volumes are secured through to FY17/18, implying risk to only 20% of the volumes until that time. CIMB expects 1.5% industry container volume growth for FY14, 3% for FY15 and 4.5% from FY16 onwards. As containerisation has run its course and a substantial portion of manufacturing is already offshore, CIMB thinks container growth rates are more likely to reflect GDP and population growth.

CIMB thinks Hutchison's ramp-up will eventually pick off market share evenly from both Asciano and DP World. With Asciano's improved service focus, the balance of risks is seen more for DP World, which has more contracts expiring in the next couple of years. Hence, CIMB does not think investors should be concerned about any decline in earnings for Asciano. Aggressive pricing from ICTS/Anglo may be a risk but CIMB thinks, from recent surveys, that shipping lines see risks in untried terminal operators and this could act as an impediment to the consortium securing meaningful volumes for some time.

The winners surprised CLSA but now the decision is done and dusted the broker thinks Asciano can return to a more balanced risk/reward analysis. CLSA had maintained there was excessive focus on the risks from Hutchison entering the market and this ignored the opportunity for Asciano that's been created by the Sydney redevelopment. The broker also notes Hutchison's Sydney terminal is clearly still in ramp-up mode, while Asciano has locked away more than 80% of customers until 2017. Moreover, CLSA believes Asciano's customer service is now up to 50% better than DP World in terms of berth movements. Another positive for Asciano is that it can increase market share prior to Hutchison gaining real traction. Along the lines of CIMB this broker also thinks, while Hutchison can align with ICTS for Melbourne services, the fact that it doesn't control a terminal in Melbourne makes it more difficult to compete.

Moreover, Hutchison is expected to avoid an aggressive price war as the company is aware that turnaround times are more important to shipping company profitability. At this stage, Asciano will not be pressured by global giants at a national level and won't face competition from Qube across integrated supply chains. CLSA has fielded queries from investors regarding gearing at Asciano but does not think it's too high. The broker is comfortable that the quality of the asset base, and the capital expenditure on upgrading assets, means there's now ample scope to absorb increases in interest rates or shocks to volumes over the next two years, even with increased dividends. CLSA finds Asciano compelling value and rates it a Buy.

On FNArena's database there are seven Buy ratings and one Hold (Macquarie). The consensus target is $6.30, suggesting 12.9% upside to the last share price. Price targets range from $6.00 to $6.80.

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