Rating Action Overview

• Aurizon Operations Ltd. (AUO) has completed the integration of One Rail Australia (ORA)'s bulk business and the divestment of ORA's coal business.
• We anticipate AUO's ratio of funds from operations (FFO) to debt will remain subdued at about 33% in fiscal 2023 (ending June 30, 2023). It should improve toward 43%-47% over the next two to three years, supported by capital management initiatives to reduce debt.
• At the same time, the consolidated Aurizon group's FFO-to-debt ratio is likely to improve to more than 25% from fiscal 2024 onward.
• We affirmed our 'BBB+' long-term issuer credit rating on AUO, a subsidiary of Australia-based integrated freight railway operator Aurizon Holdings Ltd. (AUH).
• The stable rating outlook reflects our view that AUO will maintain its dominant position in the above-rail coal freight market over the next 12-24 months, with an increased contribution from the bulk business.

Rating Action Rationale

AUO's EBITDA to improve to A$700 million-A$850 million over the next two to three years, from our estimate of A$630 million-A$650 million in fiscal 2023. The company will benefit from the integration of ORA's bulk business and the securing of new contracts. The acquisition, completed in July 2022, significantly expands the geographical footprint of AUO, establishing its presence in South Australia and Northern Territory.

With the integration of ORA's bulk business and organic growth over past two to three years, we estimate the bulk segment now contributes about 40% of AUO's revenues (and about 30% of EBITDA), compared with 25%-30% of revenues (and 15%-20% of EBITDA) in the past two to three years.

AUO's earnings would also benefit from ramp-up of its 11-year containerized freight deal with Team Global Express Pty Ltd. The ramp-up would offset some variability in volumes and add diversity to the business away from coal. Although the bulk segment derives about half of its revenues from iron ore and agricultural products, it is diversified with contributions from alumina, manganese, gypsum, copper, other minerals, as well as from containerized and rail services.

We expect AUO's FFO-to-debt ratio to improve to well over 35% from fiscal 2024, a year earlier than we anticipated.  This is despite a delay in conclusion of the ORA acquisition compared to our previous expectation. The faster improvement in leverage will be primarily due to: (1) proactive capital management of the dividend payout ratio, which is likely to continue for the next one to two years; (2) proceeds of A$435 million from the sale of ORA's coal business in February 2023 (including a deferred consideration of A$125 million); and (3) receipt of additional capital returns from Aurizon Network Pty Ltd. (AUN) to fund the acquisition.

These measures should support the increased growth capital expenditure pipeline for the bulk segment over the next two to three years.

Coal will remain a core part of the AUO's business.  We expect volumes in this segment to stabilize as mine production improves. The reduction in volumes over the past one to 1.5 years was due to adverse weather conditions, derailments, and mine-specific production issues. These are likely to abate as La Nina conditions subside, and production stabilizes. We forecast coal volumes will return toward 200-210 million tons per annum (mtpa) over next two to three years from our estimate of 180-190 mtpa in fiscal 2023.

Our outlook on Australian coal continues to be supported by its high quality, as well as strong demand from Asian markets. Metallurgical coal (and by extension steel) will benefit from economic growth in the region, while demand for thermal coal will gain from escalating energy requirements that are unlikely to be fully met through renewable sources.

We expect Aurizon group's consolidated FFO-to-debt ratio to improve toward 25%-28% over the next two to three years, following a decline to about 22% during fiscal 2023. This improvement is consistent with our assessment of the group's 'bbb+' credit profile. The ratio is slightly below our expectation for fiscal 2023 due to debt raised for the ORA acquisition and weaker operating performance during the year. The group's cash flow continues to benefit from stable below-rail operations, where take-or-pay and revenue cap mechanisms support coal volume variability. An increase in weighted average cost of capital for upcoming tariff resets will also flow through AUN. We believe the management remains committed to maintaining its credit profile and will undertake proactive management of the dividend payout ratio, with no share buybacks likely for the next two to three years.

Our view of the consolidated group would continue to drive the rating on AUO.  In our opinion, both AUO and AUN are material contributors to AUH. They are interlinked and are a core part of the parent's business. We believe AUH will support both subsidiaries if needed. This has been demonstrated through the ORA acquisition and group's capital management initiatives. Consequently, we equalize our rating on AUO with our view of the group credit profile.

Outlook

The stable outlook on our rating for AUO reflects our view that the company will maintain its dominant market share in the above-rail coal business over the next 12-24 months, with increased contribution from bulk freight.

We expect the company's stand-alone FFO-to-debt ratio to be about 33% in fiscal 2023, after factoring in the acquisition of ORA's bulk business. The ratio should improve to well over 35% in subsequent fiscal years due to AUO's capital management initiatives. We also take into account our expectation that the management will maintain a reasonably well-capitalized group, with a 'bbb+' group credit profile.

Downside scenario

Given that the group's credit profile drives the ratings on AUO, we could lower the ratings if the group materially increases leverage on a consolidated basis. The group's FFO-to-debt ratio approaching 23%, after a one-off dip in fiscal 2023 due to the acquisition, would indicate such deterioration. This would indicate a higher risk appetite.

Our assessment of AUO's SACP could come under pressure if the company's FFO-to-debt ratio remains below 35%. This could happen if:

• the capital management initiatives are not adequate or timely, or if returns to shareholders are more than we expect.
• the company's earnings reduce or if demand for capital expenditure is higher than we expect.

Upside scenario

In our view, the credit profile of the consolidated group constrains upward movements in the rating on AUO.

We believe an upgrade over the next two to three years is unlikely. This is because the company will likely have low rating headroom in the period and will pass any upside on to shareholders.

Company Description

AUO is an unregulated above-rail haulage operator that is wholly owned by AUH. The company primarily operates coal haulage in the Bowen Basin in Queensland and, to a lesser extent, in the Hunter Valley region in New South Wales. It also transports iron ore in Western Australia, and bulk mineral commodities, agricultural products, mining and industrial inputs, and general freight across different regions in Australia. Post the acquisition of ORA's Bulk business in July 2022, AUO now also manages the Tarcoola-to-Darwin rail infrastructure, and the interstate rail freight network in South Australia

AUH is a publicly listed company that operates an integrated heavy-haulage freight railway in Australia. The group operates its above-rail business through AUO, and below-rail business in Queensland through 100%-owned subsidiary AUN (BBB+/Stable/--).

Our Base-Case Scenario

Assumptions

• Coal haulage volume for fiscal 2023 to fall to 180-190 mtpa before recovering toward 200-210 mtpa from fiscal 2024 onward.
• Share of bulk to increase driven by the ORA acquisition and new contracts.
• Synergy benefit from integration of ORA and costs associated with new contracts to keep EBITDA margins at 23%-26% over next two to three years.
• Capital expenditure to stay elevated at A$450 million-A$600 million, primarily driven by growth in bulk segment.
• Average interest costs to be 5.0%-5.5%.
• Proactive management of dividend payout with no additional capital returns over the next two to three years.

Key metrics

• FFO-to-debt to decline to 32%-34% in fiscal 2023, before improving toward 43%-47% in the subsequent one to two years.
• FFO cash interest coverage to remain at about 8% in fiscal 2023, before improving toward 9%-11% in the next one to two years.
• FOCF-to-debt ratio to improve to 8%-12% in the next couple years from 4%-6% in fiscal 2023.

Environmental, Social, And Governance

ESG credit indicators: E-3, S-2, G-2

Environmental factors are a moderately negative consideration in our credit rating analysis of AUO. As a rail freight operator with business largely from the coal industry, the company remains exposed to long-term demand prospects for metallurgical and thermal coal. Global energy policies and climate transition risks may affect demand, particularly for thermal coal, influencing the volumes carried by the rail network. However, the group has embarked on its transition story, and the diversification into bulk cargo and associated services will support earnings. The group proposes to significantly grow in the bulk space by 2030. The group has also implemented net zero policies by 2050, including an interim target of 10% emission reduction (scope 1 and 2) by 2030 from 2021 levels.

Ratings Score Snapshot

Related Criteria

• General Criteria: Environmental, Social, And Governance Principles In Credit Ratings , Oct. 10, 2021
• General Criteria: Group Rating Methodology , July 1, 2019
• Criteria | Corporates | General: Corporate Methodology: Ratios And Adjustments , April 1, 2019
• Criteria | Corporates | General: Reflecting Subordination Risk In Corporate Issue Ratings , March 28, 2018
• Criteria | Corporates | General: Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers , Dec. 16, 2014
• Criteria | Corporates | General: Corporate Methodology , Nov. 19, 2013
• General Criteria: Country Risk Assessment Methodology And Assumptions , Nov. 19, 2013
• General Criteria: Methodology: Industry Risk , Nov. 19, 2013
• General Criteria: Methodology: Management And Governance Credit Factors For Corporate Entities , Nov. 13, 2012
• General Criteria: Principles Of Credit Ratings , Feb. 16, 2011
• General Criteria: Stand-Alone Credit Profiles: One Component Of A Rating , Oct. 1, 2010

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