Security recommendation: HOLD as at 16 AUG 2016
BondAdviser currently recommends the Aurizon 5.75% 2020 as a HOLD
Aurizon’s results reflect the current state of global coal markets. While haulage volumes have begun to stabilise (after a precarious start to 2016), management have outlined they expect volumes to remain flat over the medium term. This has forced the group to abandon their proposed share buy-back scheme, impair assets and focus on cost management to salvage any potential improvement in profitability. Although we take some comfort in the Network’s regulated revenue structure (which should continue its stable revenue growth) its credit rating remains capped by the parent. This means the credit profile of the Network is tied to that of the group. Given our outlook, we believe negative credit risk migration (or the deterioration of the credit profile) is likely over the coming periods.
Our valuation assumptions for this security are based on the security being redeemed (in full) at maturity (28 October 2020) and all interest payments being made in a timely manner. As Aurizon has a unique business model, we utilise comparably rated securities to determine fair value based on our fundamental view. Our analysis suggests the deterioration in credit profile is already priced into the security (at least partially) and we believe the margin offered is fair. For this reason, we maintain our recommendation at Hold but remain cautious of the challenging long term outlook the group and the network face moving forward (i.e. low global growth, viability of coal as an energy source).
The primary risk to our thesis is a sharp deterioration in earnings driven by either a demand or supply shock to the Queensland coal market. However, reduced capital expenditure, strong customer credit profiling, limited contracting risk and increased fixed pricing are all key strategies that will offer some protection from counterparty risk should a material deterioration in the Queensland coal market occur.
Positive / Negative risk factors
What factors would change the recommendation UP
- The Network’s monopoly position prevents the premise of competition and therefore, lessens the risk of earnings over time
- Take-or-pay contracts reduce the risk that Aurizon Network’s revenues will fall short of expectations. A take-or-pay contract protects Aurizon Network in the event of technical factors or demand conditions affecting a user’s shipments of coal. Within the period of the contract this protection will apply up to the point that the user defaults. Even in the event of default, a re-organised business would need to resume operations applying the same take-or-pay contracts. The proportion of take-or-pay contracts has risen considerably over the last decade, and the percentage of the contract to be paid in the event of relinquishment has increased to 50%
- Aurizon Network’s earnings risk is buffered by the regulatory framework in which it operates. This means it’s similar to regulated energy networks and water businesses. Not like Class 1 rail and airports whose revenues are highly sensitive to the economic cycle. While Aurizon Network’s infrastructure transports coal to the ports, the regulatory mechanisms offer protection from volatile coal prices (which impacts heavily on the coal mining companies)
- If counterparty risk occurs whereby certain mines become non-operational, the Maximum Access Revenue (MAR) specified by the regulator will be shared among the remaining access users to make up the shortfall. This will protect the Network against any short-term slowdown in Queensland mining
- Reduced capital expenditure, cost reduction, limited contracting risk and increased fixed pricing over the medium term are all key initiatives set by the group to offset poor expected trading conditions for 2017
- Higher Maximum Access Revenue (MAR) cap drafted and approved for UT5 (the next regulatory agreement) for the regulatory period starting mid-2017
- Higher than expected coal volumes triggering the turnaround in the Queensland economy
- Diversification away from commodity haulage into other goods. This will reduce the Network’s dependence on the Queensland’s coal market. We note that this would require substantial funding.
What factors would change the recommendation DOWN
- The Network’s credit rating is tied to group. This means that cost of funding of the low-risk ‘Below Rail’ business will ultimately depend on the creditworthiness of its high-risk ‘Above Rail’ counterpart. If a downgrade of the parent was imminent, bondholders would be risk of capital losses through mark to market adjustments
- Aurizon Network’s performance is tied to regulation. Any adverse change in the undertaking and subsequent access agreements, could cause a sharp deterioration in earnings and substantially increase liquidity pressure
- Higher-than-expected capital expenditure requirements for the Network will erode future free cash flow
- The Network is ultimately exposed to Queensland’s competitiveness relative to other global seaborne miners and long-term viability of coal. Although regulatory mechanisms should protect the network from short term market fluctuations, it is unlikely these mechanisms will shield the Network from a large-scale deterioration in the Queensland mining sector
- 100% dividend payout ratio continues to put pressure on the group’s cashflow
- Continuing slow-down of the Chinese economy leading to prolonged poor export demand and low commodity prices
- Unexpected changes to climate change policies by the Australian Government could have a negative impact on the Queensland coal industry
- Further asset impairments due to decreased contract value
- Wholesale energy prices remain elevated which would offset cost saving initiatives
- Further shareholder friendly activity such as special dividends or a renewed share buyback
- Management have outlined their disagreement over the weighted average cost of capital (WACC) proposed for UT5 with the QCA. This may disrupt revenue trajectory for the Network by increasing the uncertainty of MAR.
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