Transurban a toll road bonanza?

There's nothing better for leveraged income stocks than low interest rates.

Take a seemingly boring infrastructure company like Transurban, which owns a geared-to-the-hilt portfolio of toll roads.

The company's $12 billion 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 per cent. Transurban has risen more than 70 per cent and is up 15 per cent in the past six months alone.

The cast iron law of investing is that every stock is a claim on a future stream of cash flows.

It follows 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.

What to expect

What might investors in Transurban expect from here?

The return equation is easy enough: take next year's dividend yield and add the expected growth rate to it. Pinning down that last factor is the tricky part.

Management expects the company to pay a total dividend of 45.5¢ in 2016.

That's a starting yield of 3.7 per cent (only partially franked).

As for growth, there are three main drivers: 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 per cent 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.

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 per cent.

As inflation unexpectedly fell 0.2 per cent in the first few months of the year this could be an issue. 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 per cent in the long run and Citylink, the M2, Cross City Tunnel and Eastern distributor (which account for around 56 per cent of revenue) hit their maximum escalation.

Hitting limits

While management has a good track record of improving the profitability of newly acquired roads this can't go on forever.

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 per cent, compared to 80 per cent and 86 per cent 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.

Maybe synergies will add 2 per cent to growth. Maybe 3 per cent. And who's to say management won't successfully expand overseas, adding yet more. These are all possibilities, but they require a greater leap of faith.

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

Of course, interest rates are low, and if they stay low for a long time that return starts to look acceptable.

Risk remains

But it's not risk free. Rising rates would deliver 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 per cent increase in interest expenses slices roughly 10 per cent from Transurban's free cash flow.

This is not to predict trouble but it is a signpost pointing away from value.

The market's preoccupation with yield means 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.

Disclosure: The author does not own shares in Transurban.