Aurizon Holdings: Trade sale for East Coast Rail

Author name:: By Nathan Lead
Job title:: Senior Analyst
Date posted:: 19 December 2022, 8:00 AM
Sectors Covered:: Infrastructure, Utilities, Banks

The trade sale of East Coast Rail is positive for Aurizon Holdings (ASX:AZJ) as it helps reduce balance sheet pressures from the debt funding of the One Rail acquisition and eliminates the risk of an unloved ASX spinoff of the business.
12 month target price reduced to (login to view), reflecting the sale price below our expectations and higher cost of equity (as per both higher government bond yields and the investor return expectations implied in the sale price).
Downgrade to HOLD, given the compressed potential returns at current prices.

Event

AZJ has announced the sale of East Coast Rail (ECR), targeted for completion in early 2023 subject to ACCC approval. ECR is the thermal coal rail haulage business that AZJ committed to divest when it acquired One Rail.

AZJ expects to receive c.$425m cash proceeds for the sale of 100% of the equity in ECR (of which $125m will be deferred for 12 months). The purchaser will also assume ECR’s existing (amortising) debt.

Analysis

AZJ’s last published EBITDA for ECR was $137m for CY21A. Given likely earnings growth from inflation-linked tariff escalation and operation of a new train set in Qld from mid-2022, we believe EBITDA may have grown to over $150m. On this basis, the sale price may have implied a high 5x EV/EBITDA and a mid-teen equity IRR.

ECR’s sale price was below our estimate of c.$660m at end-CY22. We think some of the factors explaining the difference may include the limited pool of potential buyers (we suspect there was only one bona fide bidder), the increase in interest rates since AZJ announced the acquisition of One Rail, and the price step-down in the Glencore haulage contract next decade (magnitude undisclosed).

If we were to apply to AZJ’s above rail business the same valuation metrics as we estimate for the ECR sale, it would imply a valuation for AZJ of c.$3.40 per share (assuming the value of Network is unchanged and Bulk is subject to the same valuation multiples as Coal haulage).

The AZJ bulls would say this discount is unwarranted given that AZJ’s above rail business has greater scale and incumbency and is more diversified by geography, business mix, and product haulage than ECR.

The bears may counter that ECR has relatively lower sustaining capex requirements, a younger rollingstock fleet, and higher quality revenues based on average counterparty credit quality and contract length than AZJ’s above rail business and thus is at least disserving of ECR’s multiple.

The ECR sale proceeds will initially be used to reduce AZJ’s debt and thus reduce balance sheet pressure which would have intensified from an ASX listing of ECR (including reducing the need for a hybrid issue).

However, AZJ noted a significant number of growth opportunities particularly within its Bulk business that may require capital investment. As such, we caution that there is a risk the dividend payout ratio (currently 75%) does not return to the top end of the 70-100% range; we now part-risk for this by assuming 85% payout.

Forecast and valuation update

Our modelling had assumed that ECR would be sold via a trade sale, but the lower sale proceeds results in higher forecast interest costs and marginally lower forecast earnings.

Price catalysts

New contract wins in haulage. Reset of Network revenues (WACC parameters) and actual cost of debt (interest rate hedge expiry) in 2024.

Increase to dividend payout in FY24 as per One Rail Bulk acquisition funding plan.

Risks

Resilience of coal export demand and extent of supply-side constraints. Above rail contract capture, pricing, and retention.

Network regulatory risks. Employee, cost and capital management (including M&A). ESG. Weather impacts.

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