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Aurizon eyes rail and port expansion in the Pilbara

It’s well known that Warren Buffett’s company, Berkshire Hathaway (NYSE: BRK-A, BRK-B), owns a large network of railroads. Indeed, in his 2010 letter to shareholders, Buffett said that both he and Charlie Munger, “are enthusiastic about BNSF’s future because railroads have major cost and environmental advantages over trucking, their main competitor.”

Aurizon Holdings (ASX: AZJ), formerly known as QR National, is a publicly listed company that was privatised by the Queensland government in 2010. The company earns most of its money by hauling coal in Queensland, although it also has railroads in New South Wales and Western Australia.

At present, Aurizon’s railroads in West Australia only cover the southern half of the state. Rail in the Pilbara is owned by Rio Tinto (ASX: RIO), BHP Billiton (ASX: BHP) and Fortescue Metals Group (ASX: FMG). Access to rail is, of course, essential for a large mining operation, and the big three miners in the Pilbara maintain strategic control of their rail assets.

The Australian Financial Review has reported on speculation that Aurizon will be allocated port space at Port Hedland in the Pilbara. This move would make it more feasible for Aurizon to build independent rail in the Pilbara, potentially opening the region up for miners other than the dominant three.

For example, junior miners Brockman Mining (ASX: BCK) and Atlas Iron (ASX: AGO) both have projects in the Pilbara, and would be interested in securing railroad capacity with Aurizon. To that end, Aurizon has an agreement with Brockman to supply its infrastructure, contigent on Brockman securing funding for its Marillana project. Notably, the CEO of Brockman has recently had bribery charges laid against him in Hong Kong, highlighting the proliferate governance risk in the resources sector.

Between Brockman and Atlas Iron, there may be demand for about 50 million tonnes per annum. However, it is arguable that this would not be enough to generate satisfactory returns on the large capital investment required. It is possible that any project would depend, in part, on increasing activity in the region.

Aurizon shares currently trade at about $4.75, and are expected to pay a partially franked dividend of about 3.2% in FY 2014. Last year, the company generated about 40c of cashflow per share, so there is arguably scope for increasing dividend payments well into the future.

In the September 2013 quarter, Aurizon hauled just under 55 mt of coal, close to the record levels of September 2010. In the same time period, the volume of iron ore moved by the company has increased steadily but remains under 10mt. An expansion into the Pilbara could easily double the volume of iron or hauled by the company. The company has forecast that it will haul 200-205 mt of coal in 2013. This figure takes into account potential disruptions from the wet season and the loss of Rio Tinto’s Hall Creek contract.

Foolish takeaway

Aurizon is a defensive investment, and long-term returns will depend on the company increasing its dividend. Aurizon shares have the advantage of giving investors exposure to mining with less commodity price risk than investing directly in a mining company. I would consider buying Aurizon shares if the price was impacted by short-term sentiment.  A natural disaster or closure of a mine could be the catalyst for a share price shock.

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Motley Fool contributor Claude Walker does not own shares in any of the companies mentioned in this article. .

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