Fighting fit. Transurban (TCL) is well placed for a period of higher inflation/ interest rates with long-dated hedging in place on its debt.
Higher bond yields present a clear danger to toll road asset valuations and share prices of long-duration infrastructure assets. TCL can significantly grow its asset and earnings base over the next five years, which is best line of defensive against valuation pressures.
Revenue is significantly linked to inflation. TCL has a strong revenue linkage to rising inflation via road toll escalation clauses. TCL has actively extended its interest rate hedging profile. The spread between revenue and interest cost growth is critical for distribution growth.
Portfolio 20 toll roads, with 19 growth options. In our view, the best mechanism to minimise the impact of valuation compression that higher interest rates bring is to have multiple project growth options, giving TCL the ability to grow earnings from an expanded asset base.
TCL currently has 6 projects representing almost 15% of the asset base (by dollar value) under development and due for completion by 2025. These projects can be funded internally, without the need for additional equity capital. Large-scale project growth beyond the current project pipeline would likely require additional equity funding or more aggressive asset recycling.
High dividend growth into 2025. Traffic volumes have returned to pre-covid levels in early 2022, but dividends have lagged. In the August results, TCL lowered dividend expectations for FY23E. In our view, this was TCL looking to retain additional cash on balance sheet, to provide optionality for further growth projects. As it stands, TCL offers ~13% dividend CAGR into FY25E with dividends backed by operating free cash flow.
Investment view. TCL is a well-managed vertically integrated toll-road company, with several large-scale growth options. Rising bond yields have pressured the share price over the last 12 months. Earnings multiples have fallen 25%, whilst M&A multiples for toll-road transactions in 2022 have remained in line with long-term averages. TCL offers a dividend yield of 4.5% (vs S&P/ASX 100 index at 4.8%), with the prospect of top quartile dividend growth into 2025. We rate TCL a Buy.
Growth and recovery
Toll Road traffic across TCL’s network has surpassed 2019 pre-Covid levels in May/June 2022, after falling almost 30% in the depths of COVID.
The Group’s NSW roads (52% of assets) data clearly shows that in 12 hrs of the day with heavy use, traffic volumes have recovered. Toll road volume recovery far outstrips the recovery seen in other modes of transport (public roads and public transport), and remains well ahead of petrol sales volumes in Sydney, Melbourne, and Brisbane (which are ~10% below pre-covid levels).
Public transport volumes are yet to normalise to pre-covid levels, predominately explained by Work from Home (WFH) trends (which can see in office occupancy levels), particularly in Sydney and Melbourne. It’s difficult to know how enduring this behavioural shift in commuter behaviour will be, and whether this will be sustained particularly as workplaces normalise with a reduction in WFH vs 2020/21 levels.
Figure 1: NSW toll road traffic back above 2019 from June this year
Figure 2: NSW traffic numbers in other forms of transport are still 20-50% below 2019 levels
In the short term, any downside risk in traffic volumes is likely to be more than offset by the inflation-linked revenue increases. 68% of TCL’s revenue has CPI linked tolls. When combined with heavy vehicle toll multipliers, this allows revenue to grow ahead of traffic volumes. If we are in a period of higher inflation over the next 2-3 years, revenue estimates across the market carry upside risk.
Longer-term, traffic growth and toll-road volumes across TCL’s roads should be able to grow ahead of GDP. The key drivers are urbanisation and the associated negative externality of traffic congestion. Motorists continue to show a preference to pay for convenience and time savings. This is particularly the case in Australian cities which have 86% of the assets.
Figure 3: TCL tolls are almost 70% linked to CPI, ensuring revenues can grow in real terms
Valuation debate - Rising interest rates vs distribution growth
Investors look at three valuation factors on TCL; 1) dividend yield, 2) dividend growth; and 3) EV/EBITDA earnings multiple. The peculiarities in accounting standards with infrastructure companies mean investors tend to downplay measures of net profit and EPS, which tend to be low and underestimate the economic returns of the assets (particularly when the asset base is growing).
A proxy for total shareholder's returns over a 12-month period is adding the expected dividend yield plus dividend growth together.
At present that is a 4.5% yield, plus 10% dividend growth in FY23E. Over the last decade, TCL has grown its dividend by 3.5% CAGR (or 10% CAGR excluding COVID impacts), implying a total return of 12-15%. The total return from TCL since 2013 has been 8.3% CAGR. This suggests the share price is offering good value <$13.00 per share.
Yield alternatives
TCL offers one of the highest (top quartile, at 17%) 3-year CAGR distribution growth in the S&P/ASX 100, driven by toll road/earnings growth and new toll roads.
TCL’s dividend yield compares favourably with alternative mature growth companies in the S&P/ASX 100 across consumer staples, telcos, infrastructure, and A-REITs. In our view, TCL’s dividend yield will be attractive for investors looking to hide from the challenging macroeconomic conditions (particularly if we see lower bond yields in 2022/23),
Figure 4: TCL’s dividend growth is much higher than other dividend growers like supermarkets, telcos, and REITs.
Rising bond yields
For much of the last 10 years, TCL’s valuation multiple has benefited from falling bond yields. This allowed TCL access to cheaper debt and equity capital, facilitating organic growth and M&A.
Valuation multiples expanded from ~20x to peak of 30x EV/EBITDA. Today, TCL FY23E EV/EBITDA sits at 22x. A direct response to higher interest rates. TCL’s share price has fallen from $15.00 to $12.50 in response.
Just when inflation and bond yields peak in this cycle is difficult to forecast. Any sense that bond yields have peaked is likely to see TCL share price outperform the market.
Figure 5: TCL EV/EBITDA valuation multiple fallen by a third as interest rates have risen.
Could Transurban be worth more in different hands?
In recent years, ASX-listed domestic infrastructure assets have seen a wave of M&A activity resulting AusNet Services (2022), Spark Infrastructure (2021) and Sydney Airport (2021),
moving into private ownership. At its peak, the ASX had 15 listed infrastructure companies, today that stands at just six.
The purchase of Sydney Airport (SYD) for ~A$20bn by a consortium of super funds in 2021 showed size in itself does not present a barrier to assets moving into private hands. The transaction also highlighted the longer time horizons of private investors, and their willingness to look through periods of business and earnings disruption. Interesting one of SYD largest shareholders at the time of the takeover, Unisuper, is TCL’s largest shareholder at 11%.
TCL’s portfolio of toll roads is without peer in terms of size (335kms), >A$40bn asset value, CPI+ revenue linkage and exposure to traffic growth. Whilst TCL’s portfolio concession life of ~30 years is not particularly long, relative to single asset toll roads, TCL does have a good track record of being able to extend concession periods.
The key issue for any owner of TCL is the requirement to fund further growth in assets, which comes in large multi-billion-dollar increments. In our view, this is one reason why TCL has not been targeted for M&A in recent years. TCL rejected a takeover bid from its three largest shareholders in 2010.
TCL’s current development pipeline on projects underway has a CAPEX bill of ~A$5bn between FY22-26, or just over A$1bn per year. This can be funded through internal cash flows, capital releases and balance sheet liquidity. Growth requiring capital ahead of this run rate is likely to necessitate new equity capital, like the A$4bn equity raisings in 2019 and 2022. Sanctioning of large greenfield developments would be the most likely reason TCL would need to raise additional equity.
This continued requirement to tap external funding would well be suited to large private pools of capital, like what is found in industry super funds. This funding requirement is one reason the TCL share price has gone sideways since 2017.
Takeover valuation for Transurban?
A takeover of TCL would need to see the Group valued at A$50-60bn to have any chance of being successful in our view. The current market cap of ~A$40bn, plus a control premium of 20-30% equating to a further $10-15bn. At a A$60bn valuation, that would be almost x3 larger than the SYD takeover event, suggesting a narrow field of potentially interested parties. SYD’s Enterprise Value (EV) at of time acquisition was $32bn, this compares to TCL’s current EV at A$61bn.
On current earnings estimates, a A$60bn offer would imply a forward EV/EBITDA multiple uplift from 23x FY23E to ~30x earnings. This would present a relatively large 20-30% premium to toll-road assets sales globally over the 20 years when compared to the toll-roads concession length (TCL has a relatively short concession length at 30 years. SYD for example was 99yrs).
Could a 20-30% control premium be achieved? We can’t identify globally a toll-road portfolio of more than half a dozen assets being sold at once over the last 20 years. And nothing near the asset size of TCL.
So whilst TCL may be able to argue an M&A premium given; A) size/scale of the portfolio; B) integrated road and tolling; and C) attractive regulatory and traffic growth profile, these all remain untested valuation assumptions.
The bottom line is TCL’s size, scale and valuation make any M&A transaction unlikely in the short term. If the TCL share price was to become significantly detached from valuation norms, or the business significantly disrupted (like SYD in COVID), that would be a potential trigger for M&A.
Figure 6: TCL typically trades a premium to take over multiples of (single asset) toll roads. Premium due to size and portfolio at >$40bn asset value
Earnings and interest rates
Earnings recovery from COVID disruptions is now complete with 2H22 EBITDA ahead of FY19 performance (assisted by the opening of North Connex and West Connex in Sydney). Looking ahead EBITDA is forecast to grow at a 3yr CAGR of ~16% as the CPI escalations and new developments open.
TCL currently has 6 projects representing almost 15% of the asset base under development due for completion by 2025. This will provide TCL with one of its strongest organic growth profiles both toll-road km and EBITDA for over 10 years.
Transurban plans for the WestConnex Link and the Fredericksburg (US) extension are delivered in FY23 which should provide a notable uplift to group revenue.
Figure 7: TCL is entering a period of high EBITDA growth into FY25E, as new roads across 5 assets are delivered.
Development
TCL’s new development pipeline contains 6 greenfield projects and 12 brownfield developments. These are split into three groups; 1) sanctioned term development; 2) likely commencement within 5 years; 3) potential commencement greater than 5 years.
The sanctioned projects add 15% of the asset base (by value) by 2025 and are fully funded.
Combined with inflation-linked revenues, the market forecasting a +55% increase in group EBITDA between FY22 and FY25e.
Longer-dated development options are in various stages of concept/project feasibility. This pipeline is more heavily weighted toward the US, where the group continues to see large-scale opportunities. These projects would likely require external funding (equity raisings) or partial asset sell-downs.
Naturally, the development of fixed assets like toll roads is a long-dated and capital intense process.
Australian dollar weaknesses may provide some pressure on US developments in the short term. In our view, this is negligible given the ability to raise local currency capital.
We believe that the development pipeline should sufficiently support the longer-term earnings growth outlook above GDP, however, the capital intensity of the projects will need to be well managed particularly if higher acquisition and build costs eat into available project returns.
Figure 8: Asset Split 2013
Figure 9: Asset Split 2022
Capital Structure
TCL runs a relatively aggressive capital structure, with a leverage ratio currently of 8x. That is for $1 of equity, there is $7 of debt. This is 2-3x higher than industrial companies.
The leverage ratio averaged 7-9x over the last 10 years, allowing the group to maintain its investment-grade credit rating.
The stability of cash flows and long-dated asset life in what is viewed as a ‘growth infrastructure’ asset gives the ability to fund the business significantly via debt.
This means that large-scale development projects will require equity to fund growth. TCL is not opposed to issuing equity to facilitate the development pipeline.
Shares on Issue have almost doubled in the past 10 years (92%), similarly, the asset count has grown 90% in the same timeframe. We would expect this to remain the case in the future, particularly against large multi-billion-dollar projects.
Figure 10: TCL Financial leverage has typically been in the 7-8x range. With strong forecast EBITDA growth, leverage should drop to low 6s by 2024
Capital Efficiency
Despite group road length growing by ~3x over the past 10 years, the Return on Assets (ROA) of the TCL has remained flat.
The capital intensity of large, fixed asset bases (i.e. toll roads) combined with revenue limits that governments place on tolling makes it difficult for TCL to become more capital efficient.
Partial assets sell downs/joint venture structures may be a way to optimise at the margin although there limit only so much which can be sold down.
Dividend Recovery
At the FY22 Results, Transurban changed its dividend policy to paying distributions out of operating free cash flow. Previously TCL’s policy would allow payments to be topped up from capital releases.
The change in dividend policy allows TCL to retain additional cash ahead major new projects wins and avoid (or reduce) the requirement for an equity raising.
The impact of this change was too lower FY23E dividend estimates across the market by ~10% from 60cps to 54cps. The lower base effect provides for higher growth into FY25E. The market has been factoring in 3-4cps of capital release in FY23E.
Risks to investment view
Upside Risks
- Stronger than expected growth in Australian, US and Canadian traffic volumes.
- Potential for M&A, noting other the recent SYD transaction in 2021
- Inflation remaining elevated for longer than market expectations (CPI linked tolls).
- DPS accretive additions to the portfolio
- Concession length extensions across major road assets
Downside Risks
- US development/pipeline conversion takes longer to convert
- Traffic growth slows
- Bond yields move higher (with inflation falling)
- Higher interest rates applied on any new debt issued
- Equity capital raising dilutes near term distribution growth
Investment thesis
TCL is a well-managed vertically integrated toll-road company, with several large-scale growth options. Rising bond yields have pressured the share price over the last 12 months.
Earnings multiples have fallen 25%, whilst M&A multiples for toll-road transactions in 2022 have remained in line with long-term averages.
TCL offers a dividend yield of 4.5% (vs S&P/ASX 100 index at 4.8%), with the prospect of top quartile dividend growth into 2025. We rate TCL a Buy.
Figure 12: TCL dividend yield 4.5% with dividend expected to grow >15% CAGR into 2025e
Figure 13: TCL yield vs 10-year Australian government bond. Spread has closed has bond yields have risen.
Figure 14: TCL debt is hedged against the movement in interest rates for 7yrs.
Figure 15: TCL dividends are expected to match free-cash-flow into FY25e
