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Aurizon Holdings: Update a costs reduction story

Aurizon held its investor day on October 7th, at which it outlined its transformation program to deliver further cost reductions and productivity benefits totalling $310-$380m for the 3 fiscal years FY16 to FY18, which are crucial to achieve its target of delivering an Operating Ratio (OR) of 70% by FY18, ie an EBIT margin of 30% (versus an OR of 74.3% achieved in FY15).

The $310-380m can be broken down between:

  • Operations ($250-300m)
  • Corporate Support ($60-80m)

Aurizon’s FY16 results will be impacted by the removal of nearly $200m of non-core revenues (i.e some legacy contracts ) plus an overall slow-down of the mining sector. As the company sets itself some ambitious targets, the only upside will come from its success at decreasing costs and improving productivity. Aurizon’s investor presentation was divided into 3 parts,  the first two in regard to Operational transformation and Centralised support cost reductions. The third part was spent on a potential development project in the West Pilbara.

Key metrics to achieve by the end of FY16 to FY18 period are:

  • Costs reduction in $m to decrease by 4 to 7%
  • Average payload in Coal, measured in tonnes to increase by 6 to 9%
  • Headcount reduction, measure in Full Tim Equivalent (FTE) to decrease by 10 to 14%
  • Number of active Locomotives to decrease by 5 to 8%
  • Locomotives availibility to improve by 2 to 3%
  • Number of active Wagons to decrease by 3 to 5%

Productivity ratios to improve over the FY16 to FY18 period are:

  • Labour productivity, measured in terms of Net Tonne Kilometres (NTK)/FTE, where it expects between 20 to 25% improvement
  • Locomotives utilisation, measured in terms of NTK/ actual locomotives, where it expects between 15 to 20% improvement
  • Wagon utilisation, measured in terms of NTK/ actual numbers of wagons, which should improve by 12 to 15%
  • Fuel consumption which should decrease by 7 to 10%

To achieve these ratios, Operational transformation has 6 pillars:

  • Improve integration of operations
  • Rollingstock Engineering & Maintenance (RSEM) transformation
  • Operations Technology
  • Process Re-engineering
  • Footpring rationalisation
  • Standardisation and Continuous improvement

During its presentation on Operational transformation, Aurizon spent most of its time on 2 key areas: Labor productivity and RSEM transformation. Regarding Labor productivity, Aurizon put the emphasis on its new Enterprise agreements, which would render the company more competitive (improve service levels), provide flexibility and give them more freedom in regard to redundancies, pay and relocations. In RSEM transformation, Aurizon dwelled on how new technology and work processes enable  automatic rollingstock inspection or on-train repair, which at a company level increases asset utilisation, reliability and availability but also reduces unplanned failures and maintenance, spare-part inventories and at the end of the day costs (labour, materials etc…).

While gross transformation benefits won’t be as much coming from Corporate Support ($60 to 80m), three areas are being targetted: restructuring of Support functions (HR, Finance, Safety, Health and Environment) mostly through headcount reduction, a restructuring and refocus of Procurement through a reduction of supplier base as well as a streamlining of operations. The third area is Real-Estate, which it wants to consolidate and rationalise, however Aurizon did not shy away from explaining its challenges in this area as the timing of real estate disposals is impacted by the weak commercial and residential property markets in regional areas, as well as the highly fragmented nature of its properties  many of which are outdated.

The last part on the West Pilbara Iron Ore (Mining) Project, in contrast to the first two, addresses some growth and development potential. Aurizon is doing a staged assessment of its involvement . While the project has strong partners (Baosteel, 4th largest global steel maker and Posco, 5th largest), macroeconomic conditions are challenging. The proposed structure would separate the Infrastructure company from the mining one and Aurizon would hold a majority (60%) of the infrastructure company, with BaoSteel owning 20% and the other partners the remaining 20%. It would be 40% equity funded with an estimated value of $4.5bn based on capital costs. The timeline is to have a definitive feasibility study in April 2016 with a target of late 2016 for financial close and construction to begin in 2017.

Overall the Investor day presentation  is very informative and underlines the many challenges of Aurizon post the mining boom. The company has a good track record of achieving cost reductions but the marginal improvements are always more difficult. While it is hard to assess the quantification of all the benefits  to come from cost and work-force reductions, the Company is being realistic as to the challenges ahead. It is trying to make structural changes and does not count on a commodity rebound.

On October 5th, Aurizon  received notices from 7 out of the 8 Wiggins Island Rail Project customers. These notices, if deemed valid, would allow these customers to reduce their financial exposure regarding the Wiggins Island Rail Project. Aurizon is disputing them on the basis that as per the agreement, Aurizon Network achieved the development of the project on time and for a lower than forecast cost. The dispute relates to the readiness of the port. If  not resolved commercially, the dispute goes to expert determination  or otherwise to the Courts.

Aurizon’s guidance as to the estimated impact on EBIT is a range of $0 to $27m per annum over the 19.5 year life of the above regulatory return component, with impact on this FY16 financial year to be at a maximum of $10m.

On October 20th, Aurizon published its quarterly 2015 Above Rail Volumes statistics, which showed:

  • Coal volumes from Queensland dropping 5% compared to the quarter ending September 2014 due to a contract expiring and the ramp up in volumes from a 3rd party operator.  Coal volumes from NSW increased by 6%. As a result, total coal volumes at 52.6mt dropped 3%.
  • Iron ore volumes at 6.3mt dropped 7%
  • Freight volumes at 11.7mt dropped 8%

Aurizon maintains its FY16 tonnage guidance at 210-220mt.

What does all this mean for bondholders? Due to the challenging environment for Aurizon customers in correlation with depressed commodity prices, we expect credit metrics to slightly deteriorate as costs reduction and productivity improvement should offset to a large extent the fall in revenues. Management is focussing on what it can control, mainly costs and headcount reduction rather than hope for a rebound and is changing the company structurally. We believe Aurizon’s story is above all a cost story and with $1bn in liquidity from cash and undrawn facilities with no debt maturities before FY2017, Management can focus on its transformation plan. With a running yield over 5%, Aurizon bonds offer a decent income stream, we therefore maintain our HOLD recommendation on the Aurizon 5.75% 2020.