25 March 2024
Matthew Macreadie
An ESG Arbitrage Opportunity in the Wings
Credit
Pacific National (PN) is a key player in Australia’s infrastructure transportation sector. Pacific National’s strategy is to transform the rail freight industry across Australia, with a role in mitigating emissions and having a positive environmental and social impact. The company’s shareholders have been willing to forego dividends to protect their BBB-/Baa3 rating. Capital expenditure remains relatively low, and contracts are on a take-or-pay (ToP) basis, which protects the issuer from counterparty risk. A common misconception about PN is that it supports coal transportation only. This is inherently wrong, as the company has been diversifying out of coal and into rail freight. In fact, revenue from coal is expected to drop from 39% currently to 30% by 2025-2030 with rail freight to increase from 60-70% over the same period. The key many investors miss is that the development of the 1,700km Inland Rail Network will increase the competitiveness of rail against road transportation, meaning that rail freight relative to coal haulage will be well above 70% post 2030 diluting the coal exposure.
In our view, this remains a low risk, investment grade credit. We also like the fact there is an opportunity for the bonds to outperform other BBB corporates as investors start pricing the bonds without the significant ESG risk which is unwarranted in our opinion.
Relative Value
In terms of relative value, the PNHAU 3.8 31s look around 40bps wider than the new AZJAU 6.1 31s which were issued last week. Although, we note the AZJAU 6.1 31s are now trading at +190 (10bps tighter) and so the differential is now 50bps. Whilst there is a two-notch differential in credit ratings between PNHAU and AZJAU (BBB- to BBB+), we believe 50bps more than compensates investors for the additional risk. Furthermore, PNHAU has a stated strategy to diversify out of coal and into rail freight, which is markedly unique compared to AZJAU that has been slower to action. This has not yet been priced into the bonds and so there is room for PNHAU and AZJAU to trade on top of each other going forward which would equate to outperformance in the PNHAU 3.8 31s of 50bps (all-else-equal).
HISTORICAL BALANCE SHEET
Continuing operations before material items
(All figures in A$m unless otherwise stated).
Note: Data shown is based on June year end. The selected financial information set out above for the years ended 30 June 2021, 2022, and 2023 is presented before material items and has been derived from the Pacific National Group’s audited consolidated financial statements for the years ended 30 June 2022 and 30 June 2023. The selected financial information for the half year ended 31 December 2022, and 2023 has been derived from the Pacific National Group’s unaudited interim financials for the half year ended 31 December 2023. Financial and statistical information is presented consistent with the basis of preparation of their respective audited financial statements.
(1) Debt is shown as external debt at hedged values. Net debt is the sum of Debt and Lease liabilities less Cash.
(2) Net debt to EBITDA and EBITDA to Net interest ratios are both calculated from amounts disclosed in the tables on slides 28 and 29 of this presentation and reflect the continuing operations of the Pacific National Group.
(3) Net debt to Normalised EBITDA and Normalised EBITDA to Net interest ratios are both calculated from amounts disclosed in the tables on slides 28 and 29 of this presentation and reflect the continuing operations of the Pacific National Group.
ESG Arbitrage
Environmental factors are pertinent. The company has a large footprint in coal haulage rail services that contribute around 40% of its revenue. Of the coal business, about 47% stems from thermal coal and 53% metallurgical, both of which come from coal deposits in Australia that are of high quality relative to global suppliers. With no viable alternative to metallurgical coal for steel production, we see this segment as secure. Demand for thermal coal could present a challenge if Asian countries transition from coal-based generation to other forms. As one of the largest intermodal rail operators (contributing around 60% of revenues), PN is seeking to further the transition to rail-based freight from road. This helps to ease congestion within Australian cities by reducing truck movements and is much less emissions intensive than trucks. PN appropriately manages noise and air quality (diesel emissions and coal dust), factors that could affect its capacity to operate, and we expect the company to manage these appropriately under any changes to regulations.
Against BBB corporate universe
Pricing
