Cracks surface in Aurizon growth-story amid iron ore production fears
Following on from the nasty missive Aurizon Holdings (ASX: AZJ) offloaded two days before Christmas, when it warned of crucial coal volumes and earnings decline this financial year, the rail operator has thrown another incendiary at the market with fears that the stock will fall further on Karara Mining exposure to the iron ore price slump.
While the stock’s share price was already in decline when the bad news broke, it has since shed a whopping 25% since the share market darling peaked at $5.59 on 23 November.
Adding to negative investor sentiment were revelations of an impairment charge in the order of $215 million to $240 million for the six months to December 31 2015.
Having delivered investors a five-year average annual return of 20%-plus since listing on the ASX in November 2010 at $2.55 per share, the former QLD state government rail freight company (QR National) has revealed just how exposed its earnings are to the failings fortunes of iron ore miners.
The market has arguably been spooked by speculation that one of its biggest iron ore haulage customers could collapse. Gindalbie Metals, co-owner of WA’s Karara iron ore mine with Chinese group Ansteel, has revealed that Ansteel could withdraw its funding for the mine.
Best estimates suggest that around 3% of Aurizon’s group earnings before interest and taxation (EBIT) are derived from haulage services it provides to Karara, and the company has reduced its rail haul volumes guidance by a corresponding amount for the first half of full year 2016 to between $390 and $410 million.
This earnings adjustment may appear relatively modest, and Aurizon may be able to cut costs and redeploy its locomotives and wagons elsewhere. But there’s also growing market speculation that the slump in iron ore prices could force other Aurizon iron ore customers to reduce or even stop production.
Aurizon’s biggest iron ore haulage contract is with the US’s Cliffs Natural Resources, which last November advised the market it was going to temporarily idle iron ore pellet production.
Meantime, while Aurizon estimates its WA contracts with Cliffs’ mines accounts for around 5% of its group EBIT, the company’s (Cliffs’) CEO Lourenco Goncalves has hinted that it wants out of iron ore mining in Australia, having described seaborne trade as a “horrible business”.
Clearly the problems faced by Karara’s and other iron ore businesses remain a significant challenge for the rail operator.
While Aurizon says it’s on-target to achieve savings totalling $310-$380 million in operations and support costs from full year 2016 to full year 2018, concerns that the rail group’s costs are inflating faster than its revenues has forced some brokers to cut their target price to as low as $4.30.
Adding further uncertainty, Aurizon’s chief operating officer, Mike Franczak who’s been directly responsible for the company’s cost-cutting program is leaving the company in March.
With around 40% of EBIT coming from coal and iron ore haulage agreements, the market is understandably nervy over future earnings risk.
While Aurizon’s return on equity (ROE) has only averaged 6.32% since 2010, its earnings per share (EPS) growth has been good over the last five years and is expected to remain so.
But given the lingering uncertainty over the nature of its iron ore (and coal) haulage contracts, investors would be best served steering clear of this stock for now. Look for greater disclosure from the company on what’s it doing to replace any future loss of coal or iron ore haulage business.