When it comes to quality assets, they don’t get much better than Sydney Airport and toll road operator Transurban. Both stocks are regulated monopolies and made it onto our recent list of Australia’s 10 best businesses. Each offers you a stable, growing income, and a dividend yield around the 4% mark.
Under the hood, though, are two very different companies – one we recommend you Hold and the other Sell. With low interest rates making these infrastructure stocks more attractive than ever, let’s compare the two businesses on three yardsticks – lease terms, financing, and growth potential.
1 – Lease terms
SYD has 81 years left on lease
Transurban more highly leveraged
SYD offers better value and growth
Toll roads and airports are the arteries of any city and, being monopolies, have significant pricing power. But there’s a catch. Neither Transurban nor Sydney Airport actually own their assets, which are instead held under long leases. At the end of the concession period the assets will be handed back to the Government, lock stock and barrel. Shareholders have a fixed period of time to earn their returns, so the longer that period the better.
On this measure, Sydney Airport is leagues ahead of Transurban. Transurban’s crown jewel – Melbourne’s Citylink – accounts for a bit over a third of its total revenue, and has a concession through to 2035. Sydney’s Orbital Network and Queensland Motorways, which account for a further 60% of revenue, have concessions through to around 2050. What that means is that in 34 years or so Transurban will cease to exist, at least in its current form.
Sydney Airport on the other hand has a concession that only expires in 2097, so shareholders have 81 years to milk the asset for all its worth. You might be thinking ‘I won’t be around then, so who cares’ but differences in concession periods have a huge impact on valuation – in the same way that a 19-year lease is worth much less than the freehold on a property. It can also affect management’s strategy. Like a miner depleting its mine, Transurban will need to continually buy new roads if it hopes to plug the holes that appear in its earnings as its concessions end. These will need to be paid for though and prices are currently very steep (more on this in a moment), so this adds to the risks.
2 – Financing
Despite these longer-term issues, both companies have reliable earnings streams for the time being so they can handle a lot of debt, particularly while interest rates are low. They both pay out all their earnings and use debt to fund their capital expenditure requirements, such as upgrading terminals and roads. Net debt currently stands at $7.4bn for Sydney Airport and $10.6bn for Transurban.
Transurban’s capital expenditure, in particular, is ‘front loaded’. Building a road requires significant upfront spending and that makes it more risky because traffic can be difficult to forecast. Before Transurban bought Sydney’s Cross City Tunnel, for example, the road had been in receivership not once, but twice since opening in 2005. Traffic flows never lived up to initial expectations.
Buying an existing road network is less risky than building one from scratch, but that also means more competitive bidding. Take Transurban’s mega purchase of Queensland Motorways in 2014 for 34 times its free cash flow at the time of the acquisition – an extraordinary sum, even for a high-quality toll road. Transurban’s net debt is currently 8.3 times underlying earnings before interest, tax, depreciation and amortisation (EBITDA), up from around 6.0 times in 2011.
Sydney Airport’s management, on the other hand, is focused on running one asset as efficiently as possible, rather than making acquisitions. Although its net debt has been increasing to cover its capital expenditure program, its operating leverage means that revenue is growing faster, so the debt becomes smaller relative to its earnings each year.
Significant borrowing means that both companies are exposed to changes in interest rates, though they hedge their short-term exposure using derivatives. However, the companies’ exposure to changing interest rates increases over time because as old hedging contracts expire, they must renew them at current prices. Sydney Airport has the more conservative approach and has hedged 61% of its debt through to 2021 compared to 50% for Transurban. With interest payments already consuming more than a third of each company's operating earnings, Sydney Airport's extra hedging offers a layer of comfort.
3 – Growth prospects
Regulation of Sydney Airport is considered ‘light handed’ by world standards, as the Australian Competition and Consumer Commission (ACCC) doesn’t set prices directly or impose pricing caps, as is typical for regulators in much of Europe and the USA. Aeronautical fees are negotiated directly with the airlines and non-aeronautical revenue, such as retail rents and car park fees, are subject to little more than monitoring.
|Concession period||81 years||19-35 years|
|Net debt ($bn)||7.4||10.8|
The airport expects to serve twice as many passengers by 2030 – an annual growth rate of a bit under 5%. Revenue growth, however, will almost certainly exceed this once you factor in rising aeronautical fees and retail rents. Earnings and dividends should grow faster still, as a large proportion of the airport’s costs are fixed, so a little more of each incremental dollar of revenue will fall to the bottom line. It’s conceivable that Sydney Airport could increase earnings in the high single digits.
Transurban, on the other hand, is heavily regulated: tolls can only increase in line with the consumer price index (CPI) or, for Citylink, the M2, Cross City Tunnel and Eastern distributor, at the maximum of CPI or 4–4.5%.
If we assume inflation averages 2–3% over the long run and that Citylink, the M2, Cross City Tunnel and Eastern distributor (which account for around 56% of revenue) hit their maximum escalation, then long-term earnings growth might be 6% or so after allowing for population growth and some margin improvement (see Beware overpaying for Transurban). Sensible acquisitions could add to this, but with few major roads left to buy in Australia, the company would need to expand overseas where management has a patchy record.
All up, Sydney Airport has more opportunities to take advantage of its monopoly position, which helps explain its superior return on capital employed of 8.0% compared to Transurban’s 4.5% (for details, see Take the ROCE road to bypass debt).
Quality ≠ risk
As Howard Marks put it: ‘Most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them.’
With investors starving for steady dividend payers, both companies boast lofty enterprise value to EBITDA ratios (see The case for essential infrastructure for why we use this metric). Transurban has an EV/EBITDA ratio of 27, whereas the equivalent measure for Sydney Airport is ‘only’ 23.
Put another way, Mr Market is willing to pay 17% more for each dollar of EBITDA churned out of Transurban. We are not. Transurban undoubtedly owns high-quality assets and is less exposed to shock events, such as terrorism, than Sydney Airport. But with inferior lease terms, financing and a high valuation, we recommend you SELL.
Sydney Airport, on the other hand, has an extremely long concession period, ‘light touch’ regulators and decent growth prospects. Management expects distributions of 30 cents per share in 2016 – an impressive 18% increase on last year. There are better opportunities on our Buy list, but with a forward unfranked dividend yield of 4.3%, we’re happy to HOLD.
Disclosure: The author owns shares in Sydney Airport.