A new road to yield growth

Unlike higher-profile rivals, the path to dividend growth remains clear within the infrastructure sector - especially at Transurban.

By Ian Verrender · 12 Dec 2012

By Ian Verrender ·
12 Dec 2012

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PORTFOLIO POINT: Toll roads operator Transurban is providing a smooth ride for investors, with a rising share price and a reasonable yield.

For decades infrastructure sat way down the back of the investment bus, well behind high finance, gold exploration, dotcoms and biotechs.

But then along came Macquarie Group with its daring model that turned the millionaire’s factory into a gold mine, before it all unravelled in spectacular style in 2008 and infrastructure became a dirty word.

The excesses of those times, along with the flaws in the Macquarie model, are well known. But the attraction for infrastructure remains, particularly in times such as these when the entire world is focussed on defensives.

Usually large-scale monopoly enterprises with strong, steady cash flows that are relatively immune from the ebb and flow of the broader economy, if acquired at the right price, they can deliver the kind of consistent long-term yield now considered an essential part of a superannuation portfolio.

That’s precisely why international pension funds love them and are scouring the globe for opportunities. And it is why you should be looking at them too.

The problem is that there is a dearth of them available for small investors, ever since the financial meltdown forced a radical overhaul of Macquarie’s high-quality but hugely overgeared portfolio that included ports, roads, airports, waterworks and power poles.

In the past two years, courtesy of its spectacular deal with the NBN Co, Telstra has been elevated from dog to darling, and in the past year has been one of the strongest performers on the ASX. While it still is delivering a fabulous 9.2% grossed-up yield (after taking franking credits into account), there is nothing in the tank for future dividend growth, particularly after 2014. And the NBN deal effectively transforms the company, removing it from the realm of infrastructure.

There are the Real Estate Investment Trusts, which we looked at fortnight ago, along with toll roads group Transurban, Sydney Airport and Auckland Airport.

Of those last three, Transurban is perhaps the most appealing and one of the most interesting given it is more likely is to maintain a monopoly position. While paying a less attractive dividend than Telstra – a 5.4% fully grossed-up yield – it has far greater yield growth prospects. Right now, the entire market is being driven by yield and, more importantly, the potential for yield growth, or at the very least the capacity to maintain yield.

As was the fashion among infrastructure groups, utilities and REITs in the heady years leading up to 2007, Transurban sailed perilously close to the wind when it came to debt. And, like many others, it came close to foundering when debt markets dried up in 2008.

But some quick action from newly appointed chief executive Chris Lynch in 2009 restored the balance sheet, courtesy of a massive equity raising. He then set about transforming the toll road operator into what he described as a “fair dinkum company”, one that paid dividends out of cash flow rather than debt. (Who would have thought that could be considered a radical concept?)

Lynch left the company this year, and in July was replaced by Scott Charlton, a Texan-born engineer turned investment banker who has done stints as chief financial officer at Leighton and more recently Lend Lease. That experience has placed him in the unique position of being involved at some stage in every toll road in the country, either as an advisor, funder, constructor or operator.

Charlton has visited all the company’s operations and recently has briefed analysts. Most seem to like what they hear. The new boss is focussed on delivering dividend growth and believes that yield growth of 8% to 10% is entirely possible.

There will be no radical overhaul of operations and new projects will only be undertaken if they either are ridiculously cheap or if they connect into the existing toll road network and provide efficiencies.

Most of the gains will come from releasing value from the company’s existing network of roads in Sydney, Melbourne and the US by adding extra ramps and lanes, and extending the life of its concessions. It has a new project, the I 95 in Virginia and it has put forward a proposal for the NSW government to provide a link between the F3 and the M2. The East West link in Melbourne is also a possible project for consideration.

With few major investment initiatives, and therefore little in the way of capital cost, along with a focus on extracting extra value from existing assets, Charlton clearly is looking to maximise returns and capitalise on the company’s assets. That will raise the chances, as it repays debt, of a capital return in the next three to four years.

For the past 18 months, Transurban has left the ASX 200 eating dust. When global markets took a dive in the third quarter of last calendar year, Transurban headed in the opposite direction. It had been on a serious climb since midway through 2010, and barely blinked as the broader Australian market tanked.

Transurban Group vs ASX 200 Index

Click to enlarge

Source: ASX

During that period it has risen from $4.25 to more than $6.30. That has made the company expensive, no matter how you value it. On a pure price earnings basis, it is trading at a monumental 166 times next year’s earnings.

One reason for that is that infrastructure companies must balance the need to deliver immediate returns to shareholders with the long-term nature of the earnings flow. By definition, infrastructure is a long-term play with large upfront capital outlays, funded through debt and equity, that takes years before beginning to pay its way. As the assets mature and the debt profile is reduced however, they tend to deliver sweet returns as growing revenues overtake a diminishing debt.

That balancing act and the long-term nature of the business traditionally has meant infrastructure assets struggle on equity markets, particularly in their youth. Transurban is just entering adolescence.

Transurban’s motorway concessions are relatively long lived. Its 75% interest in the M1 concession – the shortest in the portfolio –runs until 2024, while its concession on the Pocahontas motorway in the US runs until 2105.

Revenue forecasts show toll revenues, cash flow and earnings before interest, tax, depreciation and amortisation all rising through to 2015.

In recent years, north American pension funds have been looking to hoover up as many global infrastructure assets as possible. The Ontario Teachers Pension Plan and the Canada Pension Plan teamed up two years ago to launch a raid on Transurban, offering $7.2 billion for the toll road operator.

The company twice rebuffed the consortium and attracted a great deal of criticism for doing so. The Canada Pension Plan eventually sold its 12% stake a year ago for $5.23 a share last year, giving it a handy capital gain.

Clearly, though, Transurban has prospered since then and shareholders have reaped the benefits. With a new chief executive looking to maximise earnings and dividends, that interest from offshore pension groups undoubtedly will persist.

JP Morgan values the company at slightly under $6, a reasonable discount to its current price, but still maintains an overweight rating on the stock. With a strong yield, dividend growth, capital return possibilities and the prospect of further takeover activity, it remains an attractive option on any price dips.

And, as a bonus, it may ease the pain of those monthly toll road statements.

Transurban Group (TCL)