Beware overpaying for Transurban

There's nothing better for leveraged income stocks than low interest rates. Take a seemingly boring infrastructure company like Transurban (ASX: TCL), which owns a geared-to-the-hilt portfolio of toll roads. The company's $12bn of debt ensures that as interest rates fall, its interest costs fall too, allowing it to increase dividends to shareholders. What's more, investors fed up with measly term deposit rates are willing to pay more for the inflated dividend stream, leading to big jumps in the share price.

The intoxicating blend of yield and capital growth has lit up steady dividend payers like Transurban. Over the past three years, the S&P/ASX All Ordinaries Index increased around 5% while Transurban is up more than 73%, and up 21% in the past six months alone.

The iron law of investing, though, is that every stock is a claim on a future stream of cash flows. It follows then that the price you pay and the return you get are two sides of a seesaw – as your purchase price increases relative to the future cash flows, your return on investment goes down.

So what might investors in Transurban expect from here? The return equation is easy enough: you take next year's dividend yield and add its growth rate. Pinning down that last factor is the tricky part.

A tale of three drivers

Management expects the company to pay a total dividend of 45.5 cents in 2016, so you have a starting yield of 3.7% (only partially franked). There are three main drivers of growth: increasing traffic, increasing tolls, and cutting costs.

Over the long term, traffic growth tends to move in line with population growth, which is a bit over 1% a year in the areas surrounding Transurban's roads. Lower petrol prices might encourage a few more drivers in the short term, but low single digit growth is all we can bet on over a 20-year stretch after smoothing out the bumps.

Toll increases are pegged to the consumer price index (CPI) or, for Citylink, the M2, Cross City Tunnel and Eastern distributor, escalated at the maximum of CPI or 4–4.5%. This could be an issue for Transurban, as inflation unexpectedly fell 0.2% in the first few months of the year. Persistent deflation would be a disaster as the company wouldn't be able to raise prices on many of its roads. Still, let's assume that the RBA achieves its target rate of 2–3% in the long run and Citylink, the M2, Cross City Tunnel and Eastern distributor (which account for around 56% of revenue) hit their maximum escalation.

Then there are 'synergies'. Management has a great track record of improving the profitability of newly acquired roads by integrating them into the existing network to improve traffic flow, and centralising operations to cut costs.

But this can't go on forever either. With the purchase of Queensland Motorways in 2014, Transurban now operates almost every major toll-road on the eastern seaboard. Perhaps management will – gulp – start to expand its US portfolio, but its history abroad has been sketchy.  

The Brisbane network still has a reasonable amount of fat to cut, with an earnings before interest, tax, depreciation and amortisation margin of 70%, compared to 80% and 86% for the Sydney and Melbourne networks respectively. Let's assume that Brisbane eventually achieves a similar margin, which would add a percentage point or so to earnings growth each year.

To be sure, we have historically underestimated this last variable. Maybe synergies will add 2% to growth. Maybe 3%. And who's to say management won't successfully expand overseas, adding yet more. These are all possibilities, but they require a much greater leap of faith.

The magic number

Adding it all up, we have a partially franked yield of 3.7% and a normalised growth rate of 5.5% (1% population growth 3.5% toll rises 1% margin improvement). It's hard to imagine investors getting much more than a 9% return.

I know, I know. Interest rates are low, and if they stay low for a long time that return starts to look acceptable. But it's not risk free. Rising interest rates would give you a double whammy, taking a bite out of operating earnings due to higher financing costs, and lowering the multiple investors are willing to pay for those earnings. Every 1% increase in interest expenses would slice roughly 10% from Transurban's free cash flow.

We're not predicting trouble – and certainly not predicting interest rate movements – but given the market's preoccupation with yield, you're more likely to find bargains by looking at what the market is not interested in: stocks that don't pay high dividends but offer capital growth for a reasonable amount of risk.

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