Tapping Transurban's toll stream

With bank deposit rates now at low levels and unlikely to change in the short term, income producing equities have become a key investment target for self-managed superannuation funds in pension mode and those approaching pension mode.

In any diversified income producing portfolio infrastructure stocks need to be an important component. In Australia, one of our biggest problems for smaller investors is there are relatively few infrastructure opportunities. When Transurban acquired Queensland Motorways it came to dominate infrastructure opportunities in Australia, so today I will discuss Transurban.

In the past there have been three clear opportunities to invest in infrastructure. The first has been retail shopping centres, which have been a remarkably rewarding area for those seeking income. Unfortunately the growth of online trading has added a new dimension to the risk in this form of infrastructure investment.

The second area is power utilities, but these have been affected by regulation and face further danger as technology develops in the storage of power. I can see the day when people like me increase their solar generation and store it and/or take power at night, and again store power for the use in the day. Accordingly, the power stocks carry similar risks to shopping centres. Gas pipelines are a good investment if the contracts are secure. In some gas infrastructure assets there is heavy borrowing, and the rewards can be linked to the gas price adding extra risk.

In my portfolio I have considered Transurban to be an important part of my infrastructure sector. I got ‘hooked’ on toll roads as an attractive infrastructure investment for superannuation funds after talking with the Canadians some years ago. As a result I took a holding in ConnectEast, which operates a toll road in eastern Melbourne. At the time it was the best toll road opportunity in the country given the low share price caused by start-up problems, which have been overcome. Unfortunately in 2011 the Canadians, having earlier talked me into toll road investing, made a low-price bid for ConnectEast, which I tried to oppose but failed. At that time institutions did not understand the value of toll roads.

I switched to Transurban. Now Transurban has just secured the Queensland Motorways toll network in a deal which involves an outlay for Transurban of some $2.8 billion. By far the majority of that money will be raised by a 10-for-43 entitlement offer at $6.75.

That raising represents a substantial portion of the market capitalisation of Transurban and I don’t expect the stock to be a great performer in the short term because the market is being flooded with Transurban securities.

But I will take up my entitlement because I will receive a distribution of 18 cents a share around August, and in 2014-15 the return on the additional $6.75 a share investment will be about 6% on the basis of a 39 cents a share distribution, which has a small element of franking credits.

Transurban and its partners paid the full international price for Queensland Motorways, so I believe that it will take a few years for the growth in revenues and the lower costs to match existing assets. But in two or three years’ time it will be an important area of Transurban growth, especially as Queensland is growing faster than Victoria or NSW and the Queensland Motorways has lower margins than Transurban, which can be raised.

In their early stages toll roads can greatly disappoint initial expectations. We saw that with Brisconnections (not part of the Transurban purchase) and in the early days of ConnectEast. What happens is that the people who make the projections forget that as motorists use the toll road the ‘free’ roads are less congested, so there is no need to use the toll road. But with traffic growth that changes back and toll road patronage becomes very rewarding.

So once toll roads have got through that initial bad stage they represent a very stable income, particularly as the tolls are linked to the cost of living and they don’t seem to be greatly affected by economic downturns. The Queensland Motorways toll roads are through that bad stage, but still have 50% unused capacity.

Moreover, once you have a toll road network opportunities arise to increase the size of the toll road’s low marginal costs. That’s what Transurban is doing at CityLink in Melbourne. In addition, you can add additional connecting links into your network. Transurban is doing that with the Sydney toll road network. Transurban’s Sydney and Melbourne networks are therefore set to provide a rising income stream for the next three or four years . Free cash flow per share in 2014-15 was set to exceed 43 cents on the pre-Queensland acquisition capital. The addition of the Queensland assets might even reduce that cash generation per share but directors have forecast that the 39 cent distribution on the higher capitalisation will still be covered by free cash flow.

In the three years after 2014-15 without the Queensland acquisition Transurban was set to have free cash flow of around 50 cents a share, enabling brokers to predict that the distribution would rise to 43 cents a share in 2015-16 and even higher in subsequent years . Longer term the Transurban United States investment will start to kick in, and so there are even greater increases in distribution possible. This is a remarkable set of infrastructure assets that are now approaching the peak of their capability.

I suspect the high rates of distribution might be a little crimped by the Queensland acquisition in the short term, but Queensland will help the network power ahead as the decade proceeds. As far as I am aware, there is no other high-yielding infrastructure opportunity with that degree of growth prospect combined with a low-risk profile. Transurban’s gearing is a fraction high around 44% of total enterprise value – the Queensland acquisition actually fractionally lowers the figure.

There is an important caveat with all toll road investments. Your toll road must return to the state at a specific time, so it is really an annuity. Transurban’s main asset is Citylink in Melbourne and that is required to go back to the state in just 20 years. But Transurban is planning to substantially increase the Citylink capacity by a relatively small $850 million outlay, which will boost distributions after 2017. In addition Transurban gained an extra one-year extension to 21 years.

Later, further Citylink expansion will be required and Transurban will almost certainly require additional years to justify spending money to expand the toll road. If no deal is reached then the toll operation becomes a massive income provider as the company pays down the toll debt and effectively distributes the capital.

The acquisition of Queensland means that Citylink is now a much lesser proportion of the Transurban operation and the portfolio’s average length of occupancy has risen from 22 to 26 years by the 38-year life of the Queensland assets.

Like all infrastructure assets, if interest rates rise the value of these infrastructure assets will tend to fall, and Transurban acquired Queensland Motorways when rates were low. But interest rates usually only rise when inflation breaks out, and toll road revenues are linked to inflation. I don’t expect any huge gains on Transurban while it goes through the digestion process of such a big acquisition, but for those who want long-term rising income then it’s well worth considering as part of a total mix of assets in this sector.

The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.