Australia & Rails (ETC) Update: High Noon for Over-Regulation?

August 13, 2018

Greetings:

Showdown Down Under?  In my opinion a regulatory battle is brewing in Australia that has impacts on future freight railroading (and privatizations, etc) globally.  As we here in the USA continue to try to understand future trade policy and enjoy our one-quarter benefit from the tax cut, our railroad futures continue to intersect.  First, some “news you can use”:

  • North American railway earnings beat expectations and the broader market, although margins were flattish and overall service was sub-par (which, given the unprecedentedly tight overall transport capacity situation, especially on the highways, makes me think of “lost opportunity” rather than “job well done”) – more in Q2/18 Review in a day or so.

  • Good financial results from generally well-regarded big carriers such as Union Pacific and Norfolk Southern have not prevented a much tougher set of analyst questions (almost Australian in their critical attitude!) nor rumors of circling activists….

  • Genesee & Wyoming (separate note last week) had a good quarter (even if the majority of the earnings growth came from the lower tax rate), with NA volumes running up 5% and “everything looking good in Australia”. GWR has an active buyback program and noted that while it is in the M&A (and capex) market in all three regions, the valuations on rail properties have gotten so high that share buybacks look very, very attractive (though it has the dry powder and partnership capability to do both). Down Under, the GWR JV is buying train sets and employing them into the spot coal market, and then focusing on moving that to contract….

  • Rick Webb’s “retirement” from CEO of Watco very likely means a more intense focus on deals, in NA and Oz, as day-to-day handled by his trusted team

  • US ag exports running ahead of dreary expectations – some may be pre-tariff moves, but also helped by what seems to be poor-to-drought level wheat crops in most other growing areas

  • Rails, etc not reporting any major trade-war impact – yet. All oppose. The $12B farm relief bill doesn’t equal the possible lost ag exports (soybeans and corn to China, corn to Mexico, wheat – see above) – nor the secular boost it gives to “more reliable” competitor nations such as Brazil

Australian rail regulation – High Noon?
Do not forsake me oh my darling on this our wedding day
Do not forsake me oh my darling wait wait along
I do not know what fate awaits me I only know I must be brave
And I must face the man who hates me
Or lie a coward a craven coward or lie a coward in my grave”

-Theme song from the 1950 western, “High Noon"

It is impossible to not be fascinated by what’s happening D/U in Aurizon’s two-front war with rail and general regulators.  I have long advocated an aggressive lobbying (etc) effort to replicate the North American and, specifically the US freight rail deregulatory experience (see One Chart below) – lower prices in constant dollars and full recovery of the rail industry – win/win; I have spoken at AusRail and the ALC Rail Forum on numerous occasions to that effect.  Over the past few years and six visits, I have learned more and more about the decentralized nature of Australian governance (meaning the power of the States vis a vis the federal government in Canberra) as I followed, for example, the Inland Rail or the safety standardization issues.  I have noted the similarities with our NAFTA (so far) neighbor, Canada, whose railroads, particularly CN, are the world’s standard.  And I heard the refrain “we’ve only got 23mm people….” – well, now its 25mm, maybe time to, as they said in “The Godfather”, go to the mattresses! Maybe the “Freight on Rail Group” can take the lead on this….

UT-5 and the ACCC – the 1930s called and they want their economic rules back!

AZJ has lost 18% of its value this year, and seemingly been abandoned in its fight by its customers, rather than united in a once-and-for-all (not to mention in the name of free markets, all-for-one) fight.  AZJ highlighted their position recently in an Investor Conference that actually received a decent reception in the Q&A (aside – not having a replay instantly available signals to the broader markets that AZJ is an Australian-only company, which follows the pattern of the slimming-down, more inwardly focused company but ignores huge pools of NA and global fund money that have had success with rail investment – and potential allies in this fight).  For those of you D/U I don’t need to remind you of the major issues, but for the rest:

  • “UT-5” - AZJ received a bizarre negative regulatory ruling by the QCC regarding the WACC and risk-adjusted allowed (!!) return in its Queensland, vertically-integrated coal business (that didn’t match up with other states, notably NSW, similar rulings, for example).

  • With the reduced available ROI, AZJ took the aggressive but impressive step of supporting its own shareholders and changing its MoW practices and amounts – with the follow on impact of slowing the network.

  • The powers-behind-the-throne that are the big mining companies had a choice – use their enormous political clout on behalf of free markets (which reward high ROIC capex – see chart 2 & 3) – or, focus only on their short term interests and attack AZJ to the Queensland government….which do you think they chose?

  • AZJ has taken a beating in the business press, etc

  • Another response by AZJ management was to “review (the very nature of their Queensland) integrated structure”! Now that would be a retreat – the rail industry D/U should ask for more, not less! If….the North America experience shows us anything, it’s the power of the vertically integrated railroad. The major, lasting competitive advantage the NAFR have over the highways is their privately-financed network, and their ability to spend capital as they see fit (IM development, longer trains and sidings, etc). It’s impossible to conceptualize PSR (Precision Scheduled Railroading), which AZJ referenced in their analyst conference, without network operational and financial control….

  • There have been discussions of falling back on a simpler, revenue cap model – which would aid in the timing process (very slow) and in clarity and reduction of complexity – but it’s only a half-start – see the Canadian prairie provinces example with revenue caps – and the huge lack of investment in a modern grain car fleet (and why would you?), loss of share to US rails and farmers, etc, which only just recently seems to finally, after decades, be resolved by the new (“C-49”) law….

  • Meanwhile, AZJ’s late 2017 decision to exit intermodal (a decision I have to admit I have some issues with – given the North American experience and the nature of truck-competitiveness) came with the sale of its Queensland IM ops as well as a major terminal (“Acacia Ridge”, which sounds like a healthy yogurt company) to its rival rail, Pacific National (PN)….but….wait for it….

  • The (national) Australian Competition & Consumer Commission, whose Orwellian name is shorted in the Aussie way (see below) to ACCC, not only rejected that sale but in addition sued AZJ (and PN) and issued an injunction against AZJ shutting down IM in Queensland….similar to the ICC here in the USA forcing the railroads to continue money-losing (and how) passenger rail while other branches of the Federal government were building ATC, airports, the Interstate Highway System, etc….

  • To say that looks insane from a NAFR perspective is….understating the situation. Here, intermodal is de facto the only freight commodity to be totally unregulated; its very nature (highway competitive – and really, subsidized highway competitive) makes regulation impossible to justify.

  • Is the timing right for a fight? CBH has protested government interference in the grain supply chain (for having – of course – a “chilling effect on investment”). So that’s one potential huge ally. But overall timing and support? Well, perhaps not – and for that you might thank the Aussie banks, whose foibles and scandals (the FT’s “Lex”: “It’s just not cricket!”) have led to actually “embedding” of regulators in their offices, and caused the FT to write again today that action is just the “latest example of a toughening regulatory environment in Australia”. Or Michael (how can you do it, mate?) Kilgariff leaving the ALC for Road Transport….

Other related business issue D/U as seen through American eyes:

  • Trade. Trump. Alliances. China. Ugh….So – EU & Australia; TPP-USA, etc.

  • The US and Canada are also beginning to better scrutinize Chinese investment (see Huawei, etc….)

  • …and China’s One Belt/One Road plan is getting serious pushback, starting in Asia….

  • Real estate – in Van (“Hong”) Couver and Toronto – and Sydney & Melbourne. The NY Times: “New York-like prices begin to cool in Australia”

  • The Economist – “It was a good run for Australia’s banks but it appears to be over….”; Blackstone is however increasing their stake in Aussie RE

  • WSJ “Outlook” – How to Keep an economic Boom Going _ “the Australian Economic ‘Miracle’” – 27 (versus our 10) years of sustained growth, caused by luck (as the saying goes), especially in FX; lower (relative) tax rates; proximity to China (et al); and “shrewd policy choices”, such as low national debt, room to maneuver in the national banking system (the RBA raising rates during the boom, etc)

  • Iron ore at/near $70 – “a sign of the ongoing restructuring of the Chinese steel industry” and the push to higher grade ores

  • And yet – the big payouts now promised by the big miners – a total of $7B by Rio (including $1B in share buybacks which I must admit seems rather paltry next to Union Pacific’s 3-year $20B plan) is actually getting some pushback from some in the financial community asking whether they are spending enough on growth, expansion and M&A! My, how the worm has turned….Rio’s results looked good initially but “underlying profits” fell short of expectations….

  • Congratulations to the Ettamogah Rail Hub, which received almost $8mm in government finding for sidings etc – a good boost to Australia’s nascent short line (sub) industry….

On the lighter side, our continuing fascination with all things Aussie:

Anthony B. Hatch
ABH Consulting
http://www.abhatchconsulting.com/