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Toll road operator Transurban (TCL) is not a cheap stock, and the forecast distribution yield of 4.8% (85% unfranked) is not particularly attractive. However, it is a monopoly provider with guaranteed price increases that is growing earnings at 10% pa. Further, it has an excellent track record in execution, a strong current project pipeline, and several prospective projects to consider. And if you believe in the future of driverless cars or automated vehicles, then down the track, there may be a massive opportunity for it to boost capacity on its current toll roads. It is a low risk, annuity-style stock with strong growth prospects, which arguably makes it a core portfolio stock for many investors. If you don’t already own it, the question is not whether to buy it, but rather, when to.
Let’s come back to this question – but first, let me make the case to own it.
Transurban operates on the eastern seaboard of Australia and North America. It owns or operates on long-term concessions 15 toll roads in Sydney, Melbourne, Brisbane and the greater Washington area.
Revenue growth is derived from traffic growth and inflation protected toll escalation. Operating scale allows Transurban to drive cost efficiencies and margin uplift, and it unlocks further value through investment in the underlying assets.
In 2017, Transurban grew EBITDA by 10.1% to $1,629m. This came from a revenue increase of 10.6% to $2,153m, built on an increase in average daily traffic of 4%. The Transurban portfolio of toll roads, together with their contribution to total revenue, are shown in the table below.
CityLink in Melbourne is Transurban’s biggest single asset, accounting for 31.9% of total toll revenue – about twice the size of the six road assets in Brisbane. In 2017, major road works with the widening of the Tullamarine freeway led to a reduction in average daily traffic of 1%, however revenue still increased by 4.1% and EBITDA by 5.3%. This highlights a little-known fact that under some government concessions, Transurban is allowed to increase toll prices at rates higher than inflation. For CityLink, it is currently the greater of CPI or 3% p.a.
Transurban has a $9bn development pipeline, which includes projects such as the widening of the Tullamarine freeway and the construction of North Connex in Sydney. It is also in exclusive negotiations for the West Gate tunnel project in Melbourne.
For unit holders, this combination of traffic growth, toll increases, portfolio expansion and a benign interest rate environment has allowed Transurban to increase its distribution from 29.5 cents per unit in 2012 to 51.5c per unit for 2017. This translates to a compound annual growth rate (CAGR) of 10.5%.
The company has forecast a distribution of 56c per unit for FY18, an increase of 8.7%.
To finance projects and drive unit holder returns, Transurban carries $13.7bn of debt. The debt has a weighted average maturity of 9 years and comes at a cost (for the $A debt) of 4.9%. Funds from operations as proportion of total debt stands at 8.6%, up from 8.0% at the end of FY16. Transurban’s corporate debt is classified as investment grade, being BBB+/Baa1/A- from S&P/Moodys/Fitch respectively.
The most obvious problem that could beset Transurban is an increase in term interest rates. Transurban is considered by many to be a “bond proxy” because of the leverage it carries and the fact that the amount it can pay in distributions is so dependent on its net interest costs. It was the fear of the impact of higher bond rates that led to the sharp sell off in Transurban and other “bond proxy” stocks in November last year.
Source: nabtrade (data as at 21 August)
Transurban hedges its debt into fixed rates, and as at 30 June 2017, some 99.4% was hedged. So while a movement in bond or short-term interest rates has no immediate impact on Transurban’s earnings, as debt matures and needs to be refinanced, Transurban will pay higher rates. In 2018, $1.17bn of maturities are due, of which $300m has already been re-financed.
If Transurban is successful in its bid for the West Gate Tunnel Project, or acquires some or all of the NSW Government’s stake in the West Connex project, then more debt will be required. It is also likely that if either of these scenarios eventuates, Transurban will raise capital through the issue of new units.
Project management and traffic forecasting risks could also have a material impact on Transurban’s market valuation.
According to FN Arena, of the six major brokers who cover the stock, three have buy recommendations and three have neutral recommendations. The consensus target price is $12.58, an 8.3% premium to Friday’s closing price of $11.62.
While the brokers are in the main quite favourable in regards to Transurban managing its growth pipeline and constructive about the portfolio’s traffic outlook, the guidance from Transurban of 56c per unit for FY18 was marginally below the consensus expectation of 56.5c per unit. Higher corporate costs and the event risk around West Connex, with possible equity raising, are considered to be potential issues.
While I have been largely wrong so far, I think bond rates will head higher over the next six to 12 months as the US economy expands and the US Federal Reserve tightens interest rates and winds back its balance sheet. This will affect bond proxies such as Transurban, although the lesson from last October/November is that dips will be well supported.
If you can afford to be patient, look to buy Transurban in market weakness or on the next blip up in bond rates.