3 ASX top picks to combat inflation

Tyger Fitzpatrick | Morningstar

Inflation remains a significant issue for Aussie investors. Higher inflation eats away at real capital gains and dividend yields by eroding purchasing power. Investors become more selective as the hurdle rate or required rate of return increases. It also complicates the operating environment for companies which can negatively impact profits if higher costs can’t be passed on.

In 1979, Michael Porter first published the well-known “Porter’s Five Forces” model which aimed to analyse the competitive forces within an industry. Inflationary pressures demonstrate the importance of two of these forces being: supplier bargaining power and customer bargaining power. Bargaining power for customers focuses on how effectively a company can increase prices without risking the customer. High switching costs and a lack of viable competitors are good examples when customers lack bargaining power.

The bargaining power of suppliers focuses on how effectively suppliers can pass on price hikes to a company. This can inflate a company’s costs if the supplier has too much bargaining power through a monopoly or specialisation. Ideally, low bargaining power from both suppliers and customers ensures a company can maintain profitability even in inflationary environments.

Given the current environment, let’s explore three ASX companies which have unique competitive advantages in inflationary environments.

APA Group (ASX:APA)

• Fair Value Estimate: $9.50 (5% premium at 27 May)
• Rating: ★★★
• Moat: Narrow

APA Group can be likened to a ‘toll road operator’ for Australia’s energy needs. The company owns a 15,000km network of gas pipelines connecting over half of Australia’s gas supply. The business generates revenues by charging energy & gas retailers a fee to transport gas through their pipelines to customers across Australia. Gas transmission and distribution is the company’s legacy segment which generates 80% of group earnings. APA is by far the largest gas pipeline firm in Australia and maintains a sizeable competitive advantage.

APA effectively passes on price increases through inflation linked, long term contracts with energy retailers. Due to the lack of direct competitors, the bargaining power for customers is low. The one caveat is that APA is also highly geared which means the company also incurs higher interest costs during inflationary periods as the RBA increases cash rates. However, APA’s economies of scale allow the company to keep costs somewhat constrained while revenues rise with inflation.

APA has more recently invested in sustainable energy through wind farms, solar farms and gas power stations which contribute 11% of total earnings. Other segments include electricity transmission, asset management and its investments arm which combined contribute the remaining 9% earnings. Over the long term, there are concerns surrounding the Wallumbilla gas pipeline which APA will cease operations in 2035. This pipeline represents roughly one third of earnings. Our analyst Adrian Atkins believes that APA must use the remaining cash flows from Wallumbilla to fund new projects and/or reduce its current debt.

APA is included in our ASX dividend top picks, credit to its high-quality earnings and its strong distribution record. APA is one of the few ASX listed companies which has successfully increased its dividend annually for the past 20 years. For income investors, defensive earnings especially through inflationary periods allows for greater cashflow visibility over peers. APA has a current dividend yield of 5.5% with distributions expected to increase over FY26/27.

Transurban (ASX:TCL)

• Fair Value Estimate: $13.30 (8% premium at 27 May)
• Rating: ★★★
• Moat: Wide

Transurban’s underlying business model has attractive attributes in an inflationary environment. Toll road contracts allow Transurban to pass on annual price increases either by inflation or by a fixed amount annually (4% or higher). The company negotiates pricing contracts with State Governments before committing to funding of new toll roads.

Transurban benefits in higher inflationary environments for three key reasons. The obvious reason is that higher inflation increases the toll price, driving steady revenue growth. The inflation linked price increases leave little to no price bargaining for customers given the lack of direct competitors.

The second reason is majority of the debt Transurban carries is either fixed or hedged against short term interest rate movements. While revenue increases with inflation, its debt repayments also remain predictable. Lastly, Transurban demonstrates strong operational efficiency. The company is adept at keeping costs relatively stable while growing revenue in inflationary environments. This operational leverage drives bottom line returns for shareholders.

The biggest risk to Transurban is traffic volumes. Major disruptions to traffic volumes are rare but can be catastrophic considering the high levels of debt the company carries. While exposed to traffic volume risk, the company’s revenue model is ultimately defensive and well positioned for an increasing population in Australian major cities. There is also room for expansion in its existing network of toll roads in North America which is a growth option for the company. Transurban has a current dividend yield of 4.6% (no franking) which has been steady since the COVID era.

Deterra Royalties (ASX:DRR)

• Fair Value Estimate: $4.40 (6% premium at 27 May)
• Rating: ★★★
• Moat: Wide

Deterra manages a portfolio of royalties in the resource sector. Deterra’s revenue model is likened to a toll road with leverage to the iron ore price. Majority of its earnings are derived from the BHP iron ore operations in Mining Area C (MAC) in WA. The terms of the royalty state Deterra receive a percentage of the revenue earned from the mine. Receiving revenue over profits protects Deterra from incurring the costs from higher inflation.

BHP bears the brunt of any capital expenditure on the MAC iron ore mine. For example, if BHP wanted to expand operations in the MAC area for higher iron ore production it would require no additional capital from Deterra. Our analyst Jon Mills notes that BHP plans to continue operations over the next 50 years.

Deterra’s royalty payments typically increase during an inflationary period as iron ore prices are pushed higher. At the same time, very minimal operating costs mean its profit margin is shielded in a period of high inflation. This allows Deterra to operate a slim yet steady revenue model that is highly unique. Deterra has no real customers to bargain while it also has minimal overheads which negates supplier bargaining impact.

The biggest risk for Deterra is the exposure to iron ore prices. A slowdown in China’s economic growth is likely to be bearish for iron ore. However, Jon notes the Chinese government will respond with increased stimulus should the country’s economic growth soften materially. Deterra currently has a yield of 5.5% fully franked and is in our top ASX dividend picks.

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