Narrow-moat-rated Aurizon (ASX: AZJ) reported a strong first-half result on higher tariffs and, to a lesser extent, volumes. Management expects a softer second half because of wet weather impacts in recent weeks and other minor issues and maintained full-year earnings guidance.

We leave our earnings forecasts unchanged and maintain our $4.70 fair value estimate. We continue to think the stock is attractive, trading on a forward P/E of 16 and with solid growth potential from recovering coal haulage volumes and investment in noncoal bulk haulage.

The firm offers a forecast 4.6% mostly franked dividend yield, with upside from earnings growth and a likely higher payout ratio from fiscal 2025 as financial health strengthens.
Aurizon’s first-half earnings before interest, taxes, depreciation and amortisation (“EBITDA”) increased 26% to $847 million and net profit after tax increased 40% to $237 million, supporting a 39% increase in interim dividend to 9.7 cents per share, 60% franked.

Full-year EBITDA guidance of $1.59 billion to $1.68 billion was maintained, and we maintain our $1.63 billion forecast, representing growth of 14% on last year. The rail network and the coal haulage business were the main drivers of the strong recovery in the first half.

The noncoal bulk haulage business eked out relatively modest earnings growth. While a little disappointing given the significant investment to grow this business in recent years, we continue to think it has solid long-term prospects. Regardless, investment in noncoal businesses is necessary to shrink the proportion of group earnings from thermal coal and thus maintain the support of lenders and investors, in our opinion.

Business strategy and outlook

Aurizon is a narrow-moat business operating in efficiently scaled markets. Its rail operations hold significant cost advantages over other forms of bulk commodity transportation, though the industry is highly cyclical. Coal prices have recovered but downward pressure is likely to remain on haulage rates and volumes due to intense competition.

The coal-haulage market is highly concentrated, with few competitors and a few large customers. Aurizon holds major positions in the domestic coal-haulage market (70% market share in Queensland and 30% in New South Wales).

Commercial contracts, which are typically five to 12 years in length, underpin defensive revenue with customer commitment to take-or-pay (around 60%), pass-through of rail network access fees, and annual consumer price index increases. These contracts have helped insulate the firm from volatility in coal demand and supply factors to date.

Aurizon's non-coal bulk-haulage operations are typically low-margin and extremely variable, with customers based in the volatile agricultural, manufacturing and mining sectors. While a relatively large operation, the contribution to group earnings is small.

Aurizon's iron ore customers are typically higher-cost juniors. The long-term outlook remains challenging for these firms, despite recent iron ore strength, as low-cost majors continue to bring on new supply, despite China slowing. Aurizon's earnings from iron ore haulage could disappear over the medium term.

Aurizon's Central Queensland Coal Network, or CQCN, provides essential transport infrastructure for the main metallurgical-coal-mining region in Australia. The CQCN is leased from the Queensland government until June 2109, with competitor access and access charges strictly regulated by the Queensland Competition Authority.

Despite being highly regulated and needing large capital investment, the CQCN is a monopolistic rail system that provides Aurizon with highly predictable long-term revenue.

Typically, regulated tariffs are the main source of Aurizon's revenue from the CQCN, with the access undertaking set every three to five years. However, until 2027 network tariffs are set under an agreement with customers.

Moat rating

Read more about how identifying a company with a moat impacts investment results.

Aurizon has a narrow economic moat, underpinned by cost advantage and efficient scale. While the firm is more likely than not to generate excess returns in 10 years, as required for a narrow moat, we lack the certainty required for a wide moat, given the subdued longer-term outlook for commodity demand as China slows and the risk of competition from major customers' in-house haulers or other transport companies.

The core rail-haulage and rail network businesses hold significant cost advantages over road transport for bulk commodities, particularly coal. Additionally, the limited market size and high capital costs for a new entrant act as formidable barriers to entry.

These traits give substantial bargaining power in contract negotiations with powerful mining customers, and should allow the firm to make reasonable returns unless Australia's major coal mines—in particular the metallurgical, or met, coal mines—enter a secular decline. This is not our base case.

While difficult to predict accurately, Morningstar forecasts relatively flat global demand for met coal—Aurizon's most important commodity—as China's investment spending tapers off and as it starts recycling more scrap steel. Higher cost supply is likely to come under pressure but as a relatively low-cost producer, met coal volumes exported from Australia should be relatively flat, given cost advantages from high-quality mines and short distances to port.

Australia is one of the largest exporters of coal in the world, accounting for around a third of global coal exports. It has a dominant share of the global met coal export market, which is sourced mostly from Queensland, where Aurizon owns the rail track and is the leading hauler. Met coal is an important ingredient in steelmaking, but is not required if scrap steel is recycled in electric arc furnaces. Thus, the main drivers of demand are global steel demand and the availability of scrap steel. Australia is also a major exporter of thermal coal, which is used in electricity production, sourced mainly from New South Wales.

About half of group EBIT comes from Aurizon's Queensland rail track network, known as the Central Queensland Coal Network. The CQCN is an open-access regulated monopoly, which cannot be replicated. While this is an impenetrable barrier to entry, pricing is set by the regulator, negating most monopoly benefits. Aurizon's rail haulage division is the largest user of the CQCN, but it must allow other above-rail operators access, in accordance with access undertakings approved by the Queensland Competition Authority.

Tariffs adjust for changes in volumes to ensure CQCN earns a fair return, meaning tariffs would increase to offset lower volumes in an industry downturn. This structure makes earnings defensive, but only to a point. Should conditions deteriorate and major mines start closing, tariffs for remaining mines increase to offset the fall in volumes transported over the rail network, pushing the remaining mines up the cost curve and making them less economically viable.

In this situation, rather than increasing tariffs and potentially causing a downward spiral for the coal miners, we'd expect the regulator to write down the value of Aurizon's network, thereby reducing the amount Aurizon can charge. The rail network is essential infrastructure for the Queensland coal mining industry, and the industry is highly important to Queensland for the royalties, taxes, and employment it provides. Still, this scenario would only play out in a severe and prolonged downturn, and this is not our base case.

Close to 40% of earnings before interest and taxes (“EBIT”) comes from coal rail-haulage, which operates with few competitors. Aurizon is the larger of the two major competitors in the Australian east coast coal supply chain, which is the country’s largest coal-producing region. Its main customers are major global miners, with high-quality coal mines.

Coal is transported mainly from mine to port for export, with minor amounts of coal delivered from mine to domestic coal-fired power generators. Aurizon was the incumbent coal hauler in Queensland and Pacific National was the incumbent in NSW, but both have been encouraged by customers to enter each other's markets in the past decade to engender competition. Limited competition also comes from the smaller in-house rail-haulage operations of major miners, which have been developed to add competitive pricing tension during contract negotiations.

The firm's main focus is on growing the non-coal bulk haulage business, which currently contributes about 15% of group EBIT. This division mainly transports iron ore, alumina/bauxite, metal concentrates, and grain.

Aurizon's ESG risk is insufficient to impact its moat rating.