Railways are the conveyor belt for Australia’s export driven economy

With an uncertain economic and market outlook, our primary strategy at this point in time is to look for companies that have monopolistic or oligopolistic assets as well as assets that hold inflation pass through characteristics. This made us take a look at railroads.

Perhaps the most famous advocate of investing in railroads is Warren Buffet.¹ Railroads are an essential part of an economy, especially one like Australia which is driven by the export of commodities that are mined in very remote parts of the country. In addition, railways are fuel efficient when compared to trucking, which saves costs as well as benefiting the environment.² Aurizon (ASX: AZJ) is Australia’s largest rail freight company and displays many characteristics that are favourable in both current market conditions and also the long-term.

Aurizon transports coal and also operates the Central Queensland Coal Network (CQCN) which connects more than 50 mines to five major export ports. The company also transports non-coal commodities such as iron ore and base metals and provides various specialist rail services such as railway planning, engineering, construction, maintenance and supply chain solutions.³

Now a company that has a high level of coal exposure may keep some investors wary of stranded asset risk due to the seemingly inevitable long-term decline in coal. However, a deeper dive into the company will reveal its future isn’t so bleak. Currently, half of its coal exposure is to metallurgical coal, or coking coal, which is an essential component of the steelmaking process.⁴ There is a lack of economically viable alternatives to metallurgical coal in this process, despite the investment in making green steel more viable.⁵ Due to this, we are optimistic about the demand for metallurgical coal in the medium to long-term.

However, we acknowledge that the demand for thermal coal will plunge in the long term, but management are also well aware of this. The company is spending on growth capex to grow its Bulk segment, which focuses on hauling non-coal commodities such as iron ore, base metals and agricultural goods. These are commodities that will be in demand in the long-term, in which this segment should replace the eventual reduction in demand for thermal coal.⁶

Iron ore remains an essential commodity and is Australia’s largest source of export revenue, whilst ‘green commodities’ such as copper, nickel, lithium and rare earths should see a growth in demand due to its pivotal role in the transition to a low carbon world.^{7 8} These commodities are essential in renewable energy infrastructure and electric vehicles. Demand for agricultural commodities will be supported by a rising global population as well as Australia retaining a competitive advantage in producing many agricultural goods.^{9 10}

The latest example of this strategic shift is its recent divestment from East Coast Rail (ECR) and acquisition of One Rail Australia (ORA) which helps Aurizon diversify from coal and add to Bulk capacity.¹¹ Aurizon has used a proportion of the $425 million in proceeds from the ECR sale to invest in higher growth capex, focusing on its Bulk segment.

ECR is a coal haulage business in New South Wales and Queensland and ORA has bulk rail haulage and general freight assets in South Australia and the Northern Territory, including the approximately 2,200km railway line from Tarcoola to Darwin. Aurizon is looking to leverage these new assets to further expand volumes by exploring the possibility of building new railway lines to connect the routes.¹² This includes expanding its containerised freight capacity in response to accelerating containerised freight trends. For example, The Bureau of Infrastructure and Transport Research Economics projects that domestic freight is expected to grow 26% from 2020 to 2050.¹³

Although the investment in growth will temporarily impact the company’s dividend payout, we believe it is a more prudent use of capital to invest in its future rather than pay out as much dividends and accept a decline in the company’s earnings in the long-term. In fact, the investment now should uphold dividends in the future. After all, you can’t expect a company to keep up or grow its dividend payments if its earnings are in decline. Despite Warren Buffet’s well known affection for companies that pay good dividends, he actually prefers it when a company can invest cash back into a company to produce a reasonable rate of return, and only paying out dividends when the company has excess cash.¹⁴

Even with this temporary prioritisation of capital away from dividends, the company has a forward dividend yield of 4.6%.¹⁵ This is still a solid dividend yield, not to mention that it is fully franked. After this investment phase, management will be able to reallocate additional capital back to dividends, which in FY25 it has a forward dividend yield of approximately 7%.¹⁶

As previously mentioned, the company operates the Central Queensland Coal Network, which is leased from and regulated by the Queensland Government. The benefit of this is that it provides a level of stability to earnings, and as a regulated asset the government grants its inflation protections. Most recently, the company was given a WACC (weighted average cost of capital) reset, in which its higher WACC due to rising costs will be offset through an increase in its Maximum Allowable Revenue (MAR). Through this, the regulators have essentially provided Aurizon with a $120 million revenue uplift for FY24.¹⁷

As it is still primarily a coal haulage company, we still have to analyse this part of the business. Aurizon is well positioned to benefit from the return of China’s demand for coal, as the nation looks to move on from its restrictions on Australian coal imports.¹⁸ Before the restrictions were imposed in 2020, China imported over 30 million tonnes of metallurgical coal from Australia, which accounted for approximately 40% of the nation’s total coal imports.¹⁹ Whilst we don’t expect China’s demand for coal to return to these levels immediately due to supply from neighbouring countries such as Russia and Mongolia, we still believe there will likely still be significant demand for quality Australian metallurgical coal which is crucial for steelmaking.

India is another source of strong metallurgical coal demand in the long-term. India is experiencing a period of expansion and change, in which there is a growing middle class, a large shift towards further urbanisation and a country that requires a huge investment in infrastructure development. The World Bank predicts that almost 300 million Indians will move to cities in the next few decades, which will require more than 10 billion square metres of new housing. This will require 1 billion tonnes of steel which requires the use of more than 500 million tonnes of metallurgical coal.²⁰ The CEO of Tata Steel, one of the world’s largest steel producers in India, claims that Australia doesn’t produce enough metallurgical coal to meet their demands.²¹ India’s steel minister also stated that India aims to double its steel production to 300 million per annum tonnes by 2030.²²

In short, we believe Aurizon are undergoing an important transition to solidify its future away from thermal coal, which is demonstrated by recent investments and divestments. Operating some of the nation’s significant railway assets in a commodity export-orientated commodity is something we like to have exposure to, especially in a company that is projected to pay out healthy dividends and has inflation pass-through characteristics.