Australia | Aug 27 2009
By Greg Peel
The theory behind investing in toll roads is a simple one. Drivers pay tolls to use the road and the profit from those tolls is passed onto investors as a distribution. Given the number of cars on the road tends to grow over time, the yield on the investment is a safe one and given governments allow toll prices to be adjusted to the consumer price index, toll roads provide a yield which is immune to inflation.
So why has toll road investment in Australia proved an absolute disaster for some over the last couple of years?
Well if you take the Queensland example, it’s really a case of being able to crawl before you can walk. Under the infrastructure fund model developed by Macquarie Bank ((MQG)) in the early nineties, which began when Macquarie Infrastructure ((MIG)) was listed as a toll road fund based on Sydney’s then new M2 motorway, the creator of the fund borrowed money for securitisation markets to fund distributions (or tolls if you like) from roads yet to be built. Investors paid to enjoy healthy yields and that investment was used to build the road. Once the road was built, tolls would then be used to pay back the original debt and eventually cashflows would cover the distributions themselves, reducing the need for debt.
It was a case of investing in a “safe” yielding investment before any yield was actually available.
But while toll roads themselves might be safe, borrowing money is not. The Macquarie Model was stretched to the limit as money became too cheap in the early noughties, and competition to create Macquarie-style funds became fierce. And any new road, recently constructed, still had to live up to its promise of patronage. One only has to look to Sydney’s Cross-City Tunnel to see just how far off the mark such estimates can be.
We now know of course that the whole thing collapsed in a heap in the credit crisis and the Macquarie Model is now dead. That’s alright for Macquarie – it’s a world-class investment bank with fingers in many pies. But it was a different story for the Babcock and Brown stable, and certainly a different story for one-off toll road funds like BrisConnections ((BRSCA)).
In between lies Transurban ((TCL)). Transurban has new toll roads or toll road expansions under construction using borrowed funds, but it is also the owner of “mature” roads in Sydney motorways M2 (which it bought from Macquarie), M4, M5, M7 and Eastern Distributor (ED), as well as Melbourne’s CityLink and the Pocahontas 895 in the US. There are few concerns here about numbers of cars versus estimates. The mature Sydney motorways are already car parks screaming out for more lanes.
But while Transurban’s assets are mostly mature, the company is not debt free. Gearing has been just as much of the Transurban model as that of new-road funds. So when the credit crisis hit in earnest and highly geared companies bit the dust, so too did TCL’s share price take a tumble – from over $7.00 in 2007 to around $4.00 today. And specific to toll roads, the assumption was that rising unemployment in the inevitable recession to follow would lead to fewer workers driving to work, meaning less tolls.
In the case of the latter, and despite analyst concerns, TCL’s toll roads have proven to be very recession-resilient. For starters, in theory we haven’t had a recession in Australia anyway, and unemployment doesn’t like reaching to figures above 8% previously forecast. But in reality, it also seems TCL’s roads are more “consumer staple” than “consumer discretionary”, which means “I don’t care if it costs me X – I’m going to use this road because the alternative free route is really just not an option”.
And so it is that analysts have found TCL’s tolls to be very safe. And to top it off, TCL has undergone a period of cost-cutting that has provided the company with increased margins, and thus ultimately an FY09 result that came in ahead of analyst expectations.
Transurban is considered to be a “defensive” stock given its attraction lies more in its yield than its medium term growth potential and tolls are a normally consistent but dull earnings stream. But while typical defensives like utilities and supermarkets rode out the crash of 2008-09 pretty well by comparison, any company tainted with the “gearing” brush was trashed. Then when the rally began in March, investors ignored defensives and went on a high-risk, high-beta, cyclical rampage.
What we now have in TCL is a stock which has underperformed the ASX 200 All Industrials by 39% in 2009, as Deutsche Bank notes. While the “defensive” tag accounts for why TCL has been left behind in the rally, the “geared” tag brought the stock price down in the first place.
But TCL has successfully refinanced both the M2 and ED recently, and refinancing totals $980m since May. No analyst sees any problem for TCL in its refinancing obligations in the next twelve months. JP Morgan notes TCL has reduced its reliance on domestic banks as part of the re-fi process and has staggered its debt maturities, lowering future re-fi risk. Macquarie notes, moreover, that “possibly for the first time since listing”, TCL’s operating cashflow (ie tolls) matches its dividends. In other words, on existing assets TCL is just about funding itself, before we start talking fixed costs and expansion plans. But Macquarie notes:
“The discipline demonstrated by management has not shown in the share price, meaning significant value remains”.
Macquarie rates TCL as Outperform, and five other brokers in the FNArena database agree. The market still sees gearing as a no-no, and from the “defensive” point of view can’t get excited about the slow growth of traffic numbers expected from economic recovery. Other investments offer more leverage to a return to growth. But TCL is safe, and various plans for road widening, new connections, and new assets altogether underscore growth potential.
There are a couple of problems, however, and that’s why four out of ten brokers rate TCL as Hold.
Growth in traffic numbers and subsequent toll receipts will be offset to some extent by the expiry of the NSW government’s M4 money-back concession in February, and by the imminent expiry of its hybrid bond issues. Future re-fis will also be more expensive than previous funding given a lower credit rating. And there’s the small matter of yield.
Given the extent to which all stocks have been knocked down over the past two years, there are some pretty impressive dividend yield opportunities out there. Some are high-yielding “junk”, but others are sound investments. Depending on which broker’s forward earnings estimates you use, TCL is offering a forecast FY10 yield of 5.3% to 5.9%. That’s not particularly exciting when the “risk-free rate” – the ten-year government bond – is currently yielding 5.4%.
Moreover, while TCL’s yield might be inflation protected due to CPI-adjusted toll prices, economists are forecasting a yield on the ten-year bond of up to 6.5% by mid next year. This will not be simply due to the RBA raising its cash rate as expected, but due to the heavy bond issuance required to cover the government’s fiscal deficit. In other words, monetary inflation rather than price inflation.
But such projections are six to twelve months hence. In the meantime, more than half the brokers in the FNArena database expect TCL to re-rate like a growth stock. It is offering an internal rate of return of 11.5%. BA-Merrill Lynch can have the last word:
“TCL is not capturing investors’ attention, but the company is meeting all its objectives. Traffic performance has been best in sector, cost cutting has beaten forecasts, and refinances have been dealt with.”
Transurban attracts a Buy/Hold/Sell ratio in the FNArena database of 6/4/0 and an average target price of $5.04 against a last trade of $4.16.