The shunned ASX player offering attractive value
Making the case for coal amidst a tough few years for investors
Mentioned: Aurizon Holdings Ltd (AZJ)
Recently featured in our 10 defensive ASX stocks to own in an expensive market, Aurizon Holdings Limited (“Aurizon”) offers a contentious investment opportunity.
Aurizon Holdings Limited (ASX: AZJ) ★★★★
- Fair Value Estimate: $4.50
- Share Price: $3.39 (as at 4/12/24)
- Moat Rating: None
- Uncertainty Rating: Medium
- Price to Fair Value: 0.75 (Undervalued)
The Company transports more than 250 million tonnes of Australian commodities each year, connecting miners, primary producers and industry with international and domestic markets. The Company also owns and operates coal rail networks, linking approximately 50 mines with three major ports in Queensland.
Tumbling ~40% in the past five years, it appears investors have lost confidence in Australia’s largest rail freight operator. Despite posting strong results in August, Aurizon’s share price dipped 8% amid worries about the future of coal.
As James Gruber notes, Aurizon has an over-reliance on coal which ties its performance to supply and demand dynamics for the material.
However, Morningstar analyst Adrian Atkins takes an alternative view to the market outlook for the shunned fossil fuel.
Emerging markets to offset declining western demand
Metallurgic Coal
As growth in emerging Asia offsets falling demand in developed markets, seaborne demand is likely to remain strong in the long term. Economic development in Asia will drive significant growth in electricity and steel demand per capita. Population growth in developing markets continues to dwarf Western nations and may have a material impact on the seaborne goal market.
Morningstar sees rising Indian steel production as a key driver of demand for Australian metallurgic goal which is a critical input in steelmaking with limited viable alternatives. Aurizon’s largest exposure is metallurgical, or met coal, which comprises about 70% of volumes on the rail network and 50% of volumes in the coal haulage business.
Growing demand from India and Southeast Asia can be expected to offset China’s falling steel production as its economy matures. Unlike China, India is heavily reliant on imported supply as its coal is generally not suitable for steel making.
Therefore, rising Indian steel production will have an outsized impact on seaborne met coal markets. India has a large population, and we expect steel production per capita to double by 2050 from current low levels.
Reinforcing our perspective, Commodity Insights forecasts modest growth in seaborne demand for metallurgical coal to 2050 as a doubling of demand from India offsets falling demand in China and developed markets. The chart below shows metallurgical coal import demand forecast (million metric tons).
Thermal Coal
Despite coal-fired power generation being likely to lose market share to renewables and nuclear on emissions concerns, we think this will be broadly offset by significant growth in emerging market’s electricity demand. Emerging nations are investing in both renewables and traditional fossil fuel power stations with an increasing preference for high-quality coal to minimize emissions, benefitting Australian exports.
Electricity demand in emerging Asia is set to grow materially in the coming decades with the International Energy Agency expects global electricity demand to increase 75% by 2050 in its “stated policies” scenario on electrification of transport and other industries and on growth in developing markets.
Despite the west pivoting away from coal-fired power, the same can’t be said for emerging Asian nations with young coal power stations. On average these stations are less than 20 years old whilst the typical useful life spans 40 – 50 years. Given this, less-affluent Asian nations are unlikely to abandon these assets early to invest significantly in alternatives.
Western nations whose power stations are closer to their end of useful life are more likely to replace them with more palatable alternatives such as wind and solar.
Commodity Insights forecasts demand for high-calorific-value thermal coal, such as coal exported from Australia, will rise until 2040 on increasing demand from China, Southeast Asia, Pakistan, and Bangladesh.
Tailwinds are rising electricity demand and an increasing preference for high-CV coal that can be used in modern, low-emission power stations. In developed Asian nations, the outlook for high-CV thermal coal is flat to 2040. They are expected to close older coal power stations but maintain their newest, which typically run on high CV coal.
Performance outlook
In contrast to bleak investor sentiment, Atkins believes Aurizon has a favourable medium-term outlook with the two haulage segments—coal, and bulk and containerized freight—as the key growth drivers.
Earnings growth in coal is underpinned by recovering volumes and profit margin expansion as asset utilization improves. In bulk and containerized freight, growth is driven by the ramp-up of new services and ongoing investment.
Morningstar forecasts earnings before interest, taxes, depreciation and amortization, (“EBITDA”) compound annual growth rate (“CAGR”) of 3.7% for the five years to fiscal 2029. Further, we expect an earnings per share CAGR of 8.2%.
In fiscal 2024 Aurizon hauled 189 million metric tons of coal out of a contracted capacity of 230 million reflecting an 82% utilisation rate. This is likely to increase back to a more normal 90% over the next few years as mines recover from unusually wet weather. As contracted volumes increase to 235 million metric tons from fiscal 2025, we forecast Aurizon’s coal haulage volumes increase to 211 million metric tons by 2029.
In an attempt to diversify away from coal, Aurizon is expanding the bulk and containerized freight business (currently ~10% of group EBIT). Due to competition from trucks, structural impediments to efficiency from hauling a wide range of products, and greater demand uncertainty for new services, Morningstar believes this is a relatively low-quality business and is not overly optimistic. Returns in this business are poor at present but likely to improve.
Contributing nearly 60% of fiscal 2024 EBIT, the Central Queensland Coal Network is key to Aurizon’s defensive nature. These earnings are highly defensive between regulatory resets. The CQCN is leased from the Queensland government with competitor access and access charges strictly regulated by the Queensland Competition Authority.
Valuations looking cheap
At our current fair value estimate of $4.50 per share, Aurizon trades at a 25% discount with attractive valuation metrics and solid medium-term growth. For the income investors, Aurizon pays out 75% of underlying net profit after tax as dividends which we deem appropriate as they retain earnings to help fund growth of the bulk division.
Valuation metrics compare favourably to fairly valued logistics and rail peers and we expect Aurizon’s earnings to grow at a similar pace in the medium term.
Looking beyond coal
Morningstar emphasise the importance of investment in non-coal businesses to diversify away from thermal coal and maintain support of Western lenders. In addition to diversifying away from coal, Aurizon has sensibly broadened its lending base by adding several Asian banks.
We expect noncoal projects to generate reasonable returns given expectations for long-term growth in containerized freight and commodities useful in the renewable transition. With more modest growth capital expenditure in future and a sound financial position, Aurizon’s high dividend yield is maintainable and likely to grow with earnings.
Atkins attributes the 25% discount to fair value as driven by uncertainties around long-term coal demand and concerns about capital allocation. He believes those fears are excessive and instead, present an opportunity for contrarian investors.
