Aurizon and Brambles: 2 undervalued dividend-paying industrials

Haulage king Aurizon Holdings and global pallet maker Brambles are both trading at significant discounts and pay a healthy dividend, according to Morningstar analysis.

At midday on Tuesday, Aurizon (ASX: AZJ) was trading at $3.56, a 24 per cent discount to the $4.70 fair value estimate set by Morningstar senior analyst Adrian Atkins. It carries a narrow moat rating—which implies a ten-year competitive advantage—and trades on a low forecast P/E ratio of 14 times and offers a big mostly franked yield of over 7 per cent, Atkins says.

Brambles (ASX: BXB) was trading at $10.68, an 18 per cent discount to the $12.90 fair value estimate set by Morningstar senior analyst Grant Slade. It carries a wide wide rating—which implies a 20-year competitive advantage—and trades on a forecast P/E ratio of 20 times and offers a dividend yield of 2.5 per cent.

In this article, we outline the prospects and risks of these two industrial names.

Source: Morningstar; data as of 25 May 2021

Aurizon’s grip on haulage volumes

Aurizon is Australia’s largest rail freight operator, each year transporting more than 250 million tonnes of Australian commodities such as coal and iron ore to domestic and global markets.

As one of the largest exporters of coal in the world, Aurizon accounts for around a third of global coal exports. It has a dominant share of the global export market for metallurgical, or coking, coal, which is used in steelmaking. This is sourced mostly from Queensland, where Aurizon owns the rail track and is the leading hauler.

“The coal-haulage market is highly concentrated, with few competitors and a few large customers,” says Atkins. “Aurizon holds major positions in the domestic coal-haulage market (70 per cent market share in Queensland and 30 per cent in NSW).”

Haulage volumes are down this financial year, but Atkins says strong prices for thermal coal—used to generate electricity—and other commodities suggest volumes should improve.

“Unfortunately, Australian coking coal prices are depressed because of the China ban but underlying demand is strong, as evidenced by high prices for coking coal from other parts of the world. We think eventually Australian prices will move higher.

“We expect coal haulage volumes bounce back in fiscal 2022 as most Australian coal is already diverting to customers outside China and as rail track and ship loading facilities are repaired. We forecast coal EBIT falls about 8 per cent this year before fully recovering over the next few years.”

And if demand dips?

Aurizon carries a high uncertainty rating because of a few key factors. As it depends on global demand for steelmaking coal and iron ore, Aurizon could suffer in the event of a slowdown, particularly in China. Then there are the risks of bad weather, contract expiry, and an increase in government regulation in the form of tariffs, which could also crimp haulage volumes and profitability.

Over the long term, Atkins says, thermal coal faces declining demand in the western world, but Asian and Indian demand is likely to rise.

“Coking coal demand is likely to be similarly balanced by falling demand in China and growing demand in India and Southeast Asia. This underpins moderate growth in Australian coal exports and a solid outlook for Aurizon.”

Iron ore haulage generated almost 10 per cent of Aurizon’s profit in prior years, but Atkins says the outlook is weak given its customers are high-cost junior miners, in stark contrast to the customers for its coal haulage operations.

Aurizon Holdings (AZJ), Brambles v Morningstar Australia GR Index - Growth of $10k

Source: Morningstar Premium; data as of 25 May 2021

Brambles

Brambles is the largest and only global provider of reusable pallets and containers. It operates this circular business model in 60 countries throughout the Americas, Europe, and Asia-Pacific under its ubiquitous blue CHEP brand, which makes pallets, containers, bins, and beverage trays.

Brambles' developed markets businesses underpin its enterprise value estimate—delivering US$12.4 billion or about 90 per cent of Brambles' enterprise value, Slade says.

CHEP USA, for instance, is the US market leader, operating the largest pooled pallet network in the US, with a market share of 40 per cent—much larger than the other two national pooling players: PECO pallet and iGPS.

The CHEP Europe pallets business is Europe’s largest pallet pooling network. Brambles estimates its share of the European pallet market at 28 per cent.

Brambles uses a “hub-and-spoke” model under which used pallets are returned to hub service centres for repair and redistribution within the network. This circular model allows the company to save money and extend its customer base, which in turn helps generative attractive margins, and high average returns on invested capital.

Brambles’ major competition comes from non-rental pallet manufacturers/recyclers. Non-rental pallets are known in the industry as “white wood” pallets.

Slade says the long-term growth prospects for undervalued Brambles remain bright in both developed and developing markets.

“We continue to anticipate improving penetration of Brambles’ pallet pools North America and Europe over the coming decade to drive strong earnings growth, underpinning our expectations for a robust 10-year EBIT CAGR of approximately 9.5 per cent.

“Longer-term expansion opportunities exist in key emerging markets including China, Russia and India, with the option to expand in these geographies valuable to Brambles.”

Another advantage is that most products moved on CHEP pallets are nondiscretionary items, so volumes remain relatively stable during downturns.

“With secular growth of Brambles' share-and-reuse model unlikely to abate within these markets any time soon, strong earnings growth will emanate over the coming decade,” Slade says.

Loss of market share unpalatable

The potential for loss of market share in regions where Brambles’ existing network is dominant—the US, Europe, and Australasia—represents the largest risk to Brambles’ valuation, Slade says.

“Failure to continually invest in the business and maintain pool quality can lead to customer losses in the medium term and would provide an environment where existing competitors or new entrants have the potential to make inroads into Brambles’ dominant share in pooled pallets.”