Transurban finalises West Gate Tunnel

Toll road operator Transurban has announced an agreement with the Victorian Government to build and operate Melbourne's new West Gate Tunnel.

The $5.5bn tunnel will provide a direct freight link to the Port of Melbourne, alleviate congestion on the West Gate Bridge and ease traffic in surrounding residential areas. As part of the project, Transurban will also upgrade Monash Freeway to improve access to the port.

Transurban will have the right to toll and operate the tunnel from its expected completion in 2022 through to 2045. Tolls will escalate at a generous rate of 4.25% from opening through to 2029 and will increase at the rate of inflation thereafter.

This will extend Transurban's Victorian revenue by around a decade as Melbourne's Citylink – which accounts for almost a third of total revenue – only has a concession through to 2035.

Sydney's Orbital Network and Queensland Motorways, which contribute a further 60% of total revenue, have concessions through to around 2050. Like a miner depleting its mine, Transurban will need to continually buy or build new roads if it hopes to plug the holes that appear in its earnings as these concessions end.

However, Transurban already controls all major toll roads in Victoria, New South Wales, and Queensland, so finding new acquisitions will be tough – particularly if the company wants them at a decent price, given that interest rates are low and asset prices high. Expansion projects such as the new tunnel, as well as Transurban's $2.5bn pipeline of upgrade projects, are vital to maintaining growth over the long term.

Capital raising

The West Gate Tunnel project is expected to cost $5.5bn. Transurban will pitch in $4.0bn of that, with the remainder provided by the State.

Transurban's share will be funded by debt and a $1.9bn equity raising: a 3-for-37 accelerated renounceable entitlement offer at $11.40 per share for shareholders on the books before 15 December. 

Being a renounceable offer, if you do forgo your rights, you'll still receive the proceeds in excess of the offer price when your allotment is sold to institutions in a bookbuild process. This is why renounceable entitlement offers are generally our preferred way of raising capital. Given that the offer price is close to our Sell price, it probably makes sense to take this option rather than participate in the offer. 

Management has flagged a first-half dividend of 28.0 cents per share (9% franked, ex date 28 December), with an expected full-year total of 56.0 cents for a forward dividend yield of 4.6%. If interest rates stay low or fall further, that kind of yield isn't too bad. Rising interest rates, on the other hand, would smack current shareholders by taking a bite out of earnings as financing costs rise and probably lower the multiple investors are willing to pay for those earnings. The share price could be hit hard under that scenario so we don't want to be caught overpaying. For now, we're sticking wth HOLD.