Transurban takes on Queensland

Winning an auction is always bitter-sweet. You take home the prize but have paid more than anyone else thought it was worth. We’re still scratching our heads, though, as to how even Transurban’s management could justify its $7.1bn winning bid for Queensland Motorways, which was pre-approved by the ACCC a month ago (see Transurban approved to buy QLD Motorways from 7 Apr 14 (Hold – $7.22)).

Toll roads are fantastic assets due to their stable and inflation-protected earnings. Queensland Motorways, in particular, is very valuable indeed. Its 74km network of motorways, bridges and tunnels has a history of strong traffic growth, limited competition, and its tolls rise at the rate of Brisbane’s CPI, which exceeds the national average. To cap it all, Queensland Motorways has a 38-year government concession – far superior to Transurban’s other networks which average 22 years.

Toll roads also churn out cash. Queensland Motorways had $353m of revenue in 2013, $242m of earnings before interest, tax, depreciation and amortisation (EBITDA) and free cash flow of $136m, a margin of 38%.

So our qualms aren’t with the quality of the asset, it’s all a matter of price.

Growth at any price

Queensland Motorways was valued at just $3.1bn as recently as 2011 when it was bought by the Queensland Investment Corporation to be held on behalf of the state’s public servant superannuation fund.

QLD Motorways' network (in green)

Since then, traffic numbers have grown from 216,000 to 290,000 per day and the average toll price is now about 20% higher.

But is Queensland Motorways really worth more than twice as much today as it was in 2011? How could management possibly justify paying 29 times EBITDA and 34 times free cash flow?

One way would be to use more optimistic growth forecasts, but with inflation running at roughly 3% and Brisbane’s population growing at a bit over 2%, mid to high single digits is about the most you could expect.

The other way is to lower your required rate of return. The difference between requiring a 10% return, which is pretty reasonable for most investors, and adjusting your models to require only 7% would inflate the implied value of Queensland Motorways by more than $2.5bn.   

Empire building

Management may have stretched this far for a couple of reasons. Interest rates are at rock bottom which makes it increasingly tempting to chase diminishing returns. Then there’s the ever present incentive for managements to go on ‘empire building’ shopping sprees. A bigger company validates a bigger pay packet, and when your short-term performance incentive is to grow EBITDA, not EBITDA per share, overpaying for growth comes more naturally.  

In 2012, the board took a commendable step towards aligning management’s interest with that of shareholders by basing the long-term incentive framework on the growth rate of free cash flow per security and shareholder returns relative to comparable companies. We hope it next focuses on improving the short-term incentive structure.  

Share purchase plan

The purchase will be funded by $2.5bn of asset level debt, and the remainder as equity. Transurban will provide $2.7bn for a 62.5% stake in Queensland Motorways and will also be responsible for managing the roads. The remaining equity will be provided by AustralianSuper (25% share) and Abu Dhabi’s Sovereign Wealth Fund (12.5% share).

To pay for its share, Transurban is raising $2.3bn in a 10-for-43 accelerated renounceable entitlement offer at $6.75 per share (record date 1 May 14). If shareholders renounce their rights, they’ll get the proceeds in excess of the offer price when their allotment is sold to institutions in a bookbuild process.

For this reason, renounceable entitlement offers are generally our preferred way of raising capital, but Transurban’s offer isn't entirely fair. The bookbuild for existing institutional shareholders is being held a month prior to that for the retail shareholders. The ability to sell your rights at a premium depends on demand, which is likely to be higher in the first bookbuild. This would result in retail shareholders earning a lower premium, should there be one.

Recommendation guide

The dilutive capital raising and high price paid for Queensland Motorways isn't to the benefit of shareholders. So it may look incongruous that we’re slightly raising our price guide.

There are, however, two components to the price guide change. The first is that the Queensland Motorways acquisition reduces our estimate of intrinsic value per share, all else being equal.

The second is that we think we’ve been underestimating Transurban’s ability to grow EBITDA above the rate of population growth and inflation, and it’s time to correct that mistake.

We misjudged management’s ability to cut costs as the network expanded, which has resulted in EBITDA margins increasing from 71% in 2004 to 85% today. Management thinks there are more savings to be made with the Queensland Motorways purchase and we’re inclined to believe them.

The balance of these two components is a slightly higher estimate of intrinsic value. However, the share purchase plan’s offer price is still a far cry from our adjusted Buy price and we don’t recommend participating.

Management has flagged a second-half dividend of 18 cents, bringing the yearly total to 35 cents (20% franked), for a current dividend yield of 4.8%. The share price is flat since 7 Apr 14 (Hold – $7.22) and we’re sticking with HOLD.