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Call us sentimental but a billion dollars just doesn’t buy what it used to. Transurban has announced an agreement to purchase the A25 toll road in Montreal, Canada, for CA$840m. The company is also taking over the road’s existing debt of CA$377m for a total valuation of CA$1.2bn (around $1.2bn in Australian dollars).
Toll roads are fantastic assets due to their stable, regulated earnings. The 7.2km A25, in particular, can lift its tolls at the same rate as general Canadian inflation and has a long concession period of 24 years.
There are other things to like about the A25. Traffic growth has been strong, rising 4% in 2017, and the Montreal metro area is similar to Transurban’s other geographies: a developed economy with stable population growth, high population density, and low unemployment. What’s more, the road has been operating since 2011, so there’s less risk of poor financial forecasting, as often happens with roads built from scratch.
Everything about the asset looks good, except for the fact that Transurban is paying through the nose for it. The CA$1.2bn price tag is 26 times earnings before interest, tax, depreciation and amortisation (EBITDA) of CA$46m. Even if the operating margin of 70% improves under Transurban – which, we must say, has a knack for cutting costs – management seems to be banking on much better traffic performance and revenue growth in future years.
With Canada’s inflation running at roughly 1.6% and Montreal’s population growing at 2% in the suburbs adjacent to the road, mid single-digit revenue growth is about the most we expect over the long term.
Unfortunately, the 2042 concession end date won’t do anything to extend Transurban’s life beyond 2050 either, when 90% of its current toll roads – including Sydney’s Orbital Network, Queensland Motorways and Melbourne’s Citylink – will have reverted to Government ownership.
Transurban itself has an enterprise value some 20 times EBITDA. Is the A25 really worth a premium to Transurban’s Australian monopoly, which is growing at a similar, if not faster, rate? We don’t doubt that it's a good asset and offers some strategic footing in a new country, but if Transurban continues to make bolt-on acquisitions at these kind of multiples, returns on capital will go down dramatically.
Management may have stretched this far for a couple of reasons. Interest rates are at record lows which makes it increasingly tempting to chase diminishing returns. Then there’s the incentive for managements to build empires at the expense of shareholder returns. A bigger company validates a bigger pay packet, and it's worth noting that this management's short-term performance incentive is to grow EBITDA, not EBITDA per share. Overpaying for growth may come more easily.
In 2012, Transurban's board took a commendable step towards aligning management’s interests with shareholders' by basing the long-term incentive framework on the growth rate of free cash flow per security and shareholder returns relative to comparable companies. We hope it next focuses on improving the short-term incentive structure. Management expects full-year distributions of 56.0 cents in 2018, a 9% increase on last year, for a partly franked yield of 5.0%. We’re sticking with HOLD.
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