AZJ - An express train or stopping all stations?

Aurizon Holdings (ASX:AZJ) (Formally Queensland Rail) is an often misunderstood company, owing to the fact a large part of their revenue is derived from a sate regulated contract/lease to operate the Central Queensland Coal Network (CQCN).

AZJ operates one of the largest rail networks in Australia and transports a comprehensive range of commodities, including mining, agricultural, industrial, and retail products for a diverse range of customers across Australia.

This includes retail goods and groceries in containerised freight to cities and towns across their national footprint; including commodities such as grain, phosphate, critical minerals, high-quality Australian coal and iron ore. They also operate and manage 5,100 kilometres of track infrastructure that supports domestic and export industries. This includes the Tarcoola to Darwin railway, a vital supply chain for central Australia that feeds into the nation’s closest port to Asia; and the CQCN. AZJ’s operations comprise of four categories: Network, Coal, Bulk and Containerised Freight.

Network: The CQCN, a 2,670-kilometer coal rail network in Australia. It is the largest coal rail network in the country and connects over 40 mines to five export terminals across three ports. The primary source of revenue for the company is from providing access to the CQCN and is regulated by the Queensland Competition Authority (QCA). Over the years negotiations have resulted in significant share price fluctuations as they can adversely or favourably impact AZJ’s earnings and costs. I would encourage any potential investor in AZJ to thoroughly understand this process and its effects on AJZ before investing. CQCN contributes about 32% of revenue and 68% of profits and has been problematic in terms of trying to achieve revenue growth.

Coal: AZJ’s Coal business provides a critical service to Australia's $110 billion export coal industry (ABS Statistics); the nation's second largest source of export revenue in FY2022. As a supply chain partner for their customers, AZJ transported 194 mt of coal in FY2022 (185mt FY23) and hauled around half of Australia’s exported coal by volume.

Bulk: AZJ’s Bulk business offers integrated supply chain services, including rail and road transportation, port services, and material handling. It serves various industries in different regions of Australia and has the capability to transport bulk commodities safely and efficiently.

Containerised Freight: AZJ’s Containerised Freight business provides rail line haul services for customers in Australia’s growing interstate east-west and north-south containerised freight market. This includes the transport of vital supplies for communities across Australia, including retail and supermarket goods, perishables and refrigerated goods, vehicles, machinery and equipment. The impact of non-coal earnings is growing now comprising 45% of non-Network revenue.

Source: Company’s FY23 annual result presentation

AZJ has invested heavily in the growth of this business and purchased and upgraded wagons and terminal and port services infrastructure and new locomotives. AZJ’s see containerised freight as a key plank in their strategy to diversify revenue away from the CQCN moving forward. This includes the One Rail Australia acquisition in 2022 which now provides strategic depot and operational facilities across Australia.

Overview of Aurizon’s National Rail, Port, Freight and CQCN.

Image from: https://www.aurizon.com.au/company

As AZJ is a stock leveraged to our export market which has been strong in recent years, what has gone wrong – and is it likely to get back on track?

StockRank:

FY23 was a tough year for AZJ with prolonged wet weather in eastern Australia significantly impacting volumes. This was compounded by mine production issues, a major third-party derailment and labour shortages emerging for critical roles such as train drivers.

This resulted in FY23 underlying EBITDA coming in at $1.4bn, at the lower end of their revised forward guidance of $1.42-1.47bn. Coupled with tightening margins, and dividends, it’s clear to see why their StockRank and individual Factor scores are where they are and why they have taken a significant hit through the 2023 calendar year.

Start of 2023

22 August 2023

To add further to this, we can see their cash position has deteriorated significantly from FY22 to FY23 decreasing from $172m to $92m. This has increased their net-debt position from $3.7bn in FY22 to $5.1bn in FY23.

Also not helping their overall StockRank, and more specifically the Quality score, is the increase in net-gearing, from 75.8% at the start of 2023 to 121.2% currently. Indicating that along with the decline in cash balance they have also increased debt. Joining the dots on all this and considering the decline in earnings, margins, and profits, it’s easy to understand why their F-score and Z2-score have performed the way they have.

Start of 2023

22 August 2023

To add some comfort and help ease the nerves of the direction of these numbers, AZJ still reported positive free cash flow in FY23 of 16.5c per share (though it is still significantly down from FY22’s 41.8c) and has a current interest coverage ratio 3.09, although this has fallen from an impressive 6.8 at the start of 2023 as debt increased, it still remains at a relatively healthy level and indicates that AZJ can meet their debt repayments comfortably. Even within a rising rate environment.

Financials:

You have probably put two and two together by now and correctly deduced that AZJ’s financial performance over the last 5-8 years has not been fantastic. Basically, their share price has gone backwards, revenue levels have just returned to FY15 levels, and all other numbers have declined such as margins, profits and dividends.

However, in a sign that the Board does ‘consider” its shareholders, since FY2016 AZJ has returned approximately $5 billion in the form of dividends and share buy-backs, and we can see average shares since FY18 have declined from 2bn to 1.8bn in FY23. The current dividend yield is 5.2%, though this needs to be considered in context with the +$6 price the stock traded at in 2019.

Given AZJ have been implementing their earnings diversification strategy and spent significant amounts of capital doing so, (as can be seen in the increase in capex per share – which also impacted earnings), and FY23 earnings being impacted by factors outside their control (eg floods. Customer issues) we can be somewhat forgiving of their recent performance. But ultimately the money has now been borrowed and spent, and patient shareholders will be expecting tangible results and returns over the near to medium term. Similar performances to the most recent, I believe, will not be received well.

Also, being debt adverse in the current environment, I would like to see a concerted effort to improve their net-debt position and would consider this a priority rather than increasing dividends in the near-term.

Liquidity and Ownership:

Whether you want a small or large chunk of AZJ there should be no issue getting in or out of the stock as of the 1.8bn shares on issue 97.9% is classified as free float and can potentially be traded;

Their largest shareholder only holds 5% of the company, and top shareholders only hold 26.63% overall. A reason for this is following the privatisation by the QLD government in 2010, AZJ owns and manages key infrastructure within Australia which means the share register is closely watched and any takeover or significant shareholder movement is monitored and scrutinised by competition authorities and law makers at both a state and federal level. This makes AZJ less attractive to larger institutional investors.

Outlook:

AZJ in their full year result on 14th August 2023 they provided guidance for FY24 group EBITDA to be in the range of $1.5bn and $1.6bn an increase on FY23’s $1.4bn. Consensus has net profit, dividends and EPS increasing for FY24 and FY25, but these have both been revised down over the last 1-month and 3-months. Indicating consensus was expecting a stronger result and optimistic forward guidance for FY23 and FY24.

One may consider broker sentiment leaning towards the buy side, with 8 holding and 6 with a buy or strong buy and 2 saying sell, a good sign.

For me this is indicating that analysts believe AZJ is heading in the right direction and the demand for increased freight and bulk container transport is set to grow. One would suggest that after much pain, AZJ have positioned themselves to capitalise on this by diversifying earnings and profits away from that of the regulated CQCN, though significant earnings diversification is still some years away.

The fact of the matter is AZJ should do “alright”. On the positive side, in time, should the bulk and freight side do well, one could see them doing a demerger and spinning out the CQCN with some type of access agreement between the two. This would unlock value for shareholders, though there is plenty time before that train arrives at its destination.

Conclusion:

As mentioned previously any investor considering an investment in AZJ needs to have a good understanding of how their regulated earnings and profits are derived and how this can impact returns, and the earnings diversification strategy currently being implemented.

The Board’s willingness to return capital to shareholders through dividends and share buy-backs, is something to keep in mind as earnings and profits are forecast to increase. The significant and key infrastructure they own and operate puts them in a great position to capitalise on the forecasted increase in demand for bulk commodities and containerised freight. All the while still deriving significant earnings and profits from the CQCN.

Taking all this into consideration, I would be inclined to forgive the latest poor result and am comfortable in expecting steady as she goes results from here. It is obvious at the moment AZJ is stopping all stations rather than acting as a Japanese Bullet Train. While the thematic is solid, and a future demerger may provide some value down the track, short-term earnings downside risk always remains as external factors such as weather, and government are a constant shadow over returns.

---

Important Information: Stockopedia Ltd ABN 39 757 874 670 UK business registration number 0637267 (“Stockopedia”) is an Authorised Representative of Daylight Financial Group Pty Ltd ABN 77 633 984 773 (“DFGPL”) which is the holder of an Australian Financial Services Licence (AFS Licence No. 521404).

Information in this commentary is current as at date prepared unless otherwise stated. However, please bear in mind that investments can go up or down in value, and that past performance is not a reliable indicator of future performance. For more Important Information please refer to the Disclaimer section of this website.

This communication may contain general financial product advice. It has been prepared without taking into account your personal circumstances, and you should therefore consider its appropriateness in light of your objectives, financial circumstances and needs before acting on it.

If our advice relates to the acquisition or possible acquisition of a particular financial product, you should obtain a copy of and consider the Product Disclosure Statement (PDS) before making any decision.