Dividends expected to grow 30% next year for this industrial

Given we are now living in a post-pandemic world, my guess would be that you are reading this article from your home office. After all, research from the ABS shows that 40% of people now work from home regularly, up from 30% pre-pandemic.

One might assume that sort of statistic would be a blow for this ASX-listed company, but that’s far from the case.

Changes in the way people commute, a sharp bounce back in traffic post-pandemic, concerns about the health risks from taking public transport, and the simple fact that commuter trips only make up a small portion (16%) of Transurban’s (ASX: TCL) total traffic have meant the toll road operator has powered forward.

Despite suffering the impacts of the tail end of the pandemic in FY22, TCL’s average daily traffic volumes fell only 0.5% over the past 12 months. 

Along with the quick rebound in traffic and reluctance from some people to use public transport, there has also been peak spreading. This is where people travel earlier or later to get into the office, given the flexibility work from home offers. This is quite beneficial to the economics of a toll road, as it allows greater overall capacity. 

These factors helped revenue grow 18% in FY22, with free cash flow up 19.8%. The full-year dividend came in 12% higher than last year, whilst the company forecast a 30% growth in dividends in FY23.

Whilst the results and outlook were solid, there were a couple of elements that disappointed the market. Costs were higher than expected, and expected dividend growth – even at 30% – left the market wanting more. 

The share price was down as much as 5% earlier today but Ofer Karliner, portfolio manager in the Infrastructure team at Magellan, sees such a move as an opportunity.

In this wire, Karliner shares his insights into Magellan’s largest holding in its infrastructure fund, which they have held since inception, and why nothing from today’s result changes his outlook.  

Transurban (TCL) FY22 key results

  • Revenues up 18% to $3.41
    billion
  • Net profit down 99.5% to $16 million
  • EBITDA up 4.9% to $1.90 billion
  • Free cash flow $1.53 billion, up 19.8%
  • Balance sheet: $3.9 bn in corporate liquidity
  • Capital expenditure (CAPEX) down 24% to $882
    million
  • End-of-year dividend of 41 cps, up 12% year on
    year- paid 23 August
  • Expects FY23 DPS of 53 cps, up 30% year on year

Note: This interview took place on Thursday 18 August 2022. Magellan Infrastructure Fund currently holds TCL and has done so since the inception of the fund. 

Managed Fund

Magellan Infrastructure Fund

Ofer Karliner, Portfolio Manager in the Infrastructure team at Magellan

What were the key takeaways from this result?

The key takeaways were the resilience of the traffic, inflation protection, and the continued execution of the monetization of the option value. There’s obviously a lot of option value inherent in the asset that’s hard to value from an outsider’s point of view, so to see them executing that is really good.

The data I’ve seen prior to the result in terms of traffic has suggested a very strong bounce back and that is indeed what we saw. They were very good numbers, particularly in Sydney, given the weather impacts and the Omicron waves we’ve had here. 

Scott Charlton (CEO of TCL) did an excellent job highlighting the inflation protection and protection from rising rates inherent in the business. 

And finally, the M7 – moving forward on that really highlights the value inherent in the assets. No one else can widen a road that you own. So there’s a lot of option value inherent in those businesses.

What surprised you the most?

In the context of infrastructure, it should be boring without too many surprises. On the negative side, I think the costs at the asset level were a bit higher than I expected. Part of this is around bringing forward a maintenance cost that doesn’t really affect value too much. The speed of the traffic recovery is fantastic. And again, probably a positive surprise there for me, particularly in Sydney, as I mentioned.

What was the market’s reaction to this result? Was this an overreaction, an under-reaction or appropriate?

When it was down 5%, it was definitely an overreaction. It probably deserves to be down a little bit, but not much, because there’s not a huge amount of impact to value from the results. I think it missed consensus earnings, largely due to the bringing forward of costs. There was guidance for higher cost growth in 2023 – a lot of that is development costs. So to the extent TCL is creating new opportunities and generating value from that, then you have to offset the slightly higher cost with increased revenues in the future. So not a huge amount of value destruction there. Down 5% is certainly too much of an overreaction.

Based on the analyst call, people were disappointed with the dividend. So 53 cents a share, 30% growth, but the market was expecting more. 

But listening to Scott on the call, I think they’re being pretty conservative. They’ve gone through a pretty rough period with COVID-19 causing lockdowns and disruptions to traffic. And it sounds like they’re being pretty conservative in that guidance. So it doesn’t seem to reflect any weakness in the underlying business.

Would you buy, hold or sell Transurban on the back of these results?

Rating: BUY

Transurban is the biggest holding in our fund and nothing that I have seen today would change that. 

If anything, it reinforces what a great set of assets Transurban actually has. 

You just have to look at, again, how quickly traffic bounced back, even though there are impacts from Omicron, impacts from weather. Most of the roads are back to 2019 levels in Q4. And the ones that weren’t were mostly the ones feeding to airports. 

So again, I think a lot of investors are getting spooked by what looks like a very high PE stock. If you’re not a specialist, there’s a misunderstanding here that accounting profit doesn’t equal cash flows. And to put that in context, Transurban had $87 million in proportional cash maintenance costs last year, depreciation was over $1.5 billion. 

When you get your head around the fact that the economics don’t relate to the accounting profit, you can get excited by the amount of cash flow this thing throws off and that’s a key driver of value for this business.

I think it’s one of the best infrastructure companies out there, if not one of the best businesses out there. It has such strong pricing power and underlying favourable dynamics in terms of urban toll roads. It’s very, very hard to replicate.

What’s your outlook on TCL and the industrials sector over FY23?

I remain pretty positive on Transurban and again, looking at ’23, we get clear air from COVID. And what we’re seeing thus far is traffic has been resilient. We’re seeing option value at Transurban starting to be realised again with the M7 widening. More broadly, infrastructure, I think, it’s an excellent place to invest in ’23. 

First of all, it’s going to be business as usual. We like infrastructure to be boring, which it should be. If it’s exciting, you’re doing it wrong. 2020 and 2021 were pretty exciting, but economies across the globe are going to slow down next year, with central banks raising rates. That’s why they’re doing it. They’re trying to slow economies down. 

When you have a really high-quality infrastructure company, you’re able to generate resilient cash flows. You are less economically sensitive than most companies. You have a better pricing power. So infrastructure, for me, is a very good place to be over the next couple of years.

Are there any risks to TCL and the industrial sector that investors should be aware of given the current market environment?

The obvious one for Transurban and infrastructure more broadly is spikes in interest rates; to the extent that headline rates jump. That creates volatility. 

But the real rate or the inflation-adjusted rate doesn’t move very much. It actually creates an opportunity. 

So to an extent, again, you think about what infrastructure is and we define infrastructure very conservatively. We’re probably the most conservative people out there in the way we think about it. 

Because they have excellent pricing power, Transurban can pass through inflation very directly. If interest rates go up because of inflation, you’re protected on the revenue side. 

In fact, you get a benefit in the short term because your debt book is largely hedged. Transurban has seven years average duration of debt with rates that are locked in, that’s debt locked in. So the rates are locked in for seven years. Across our portfolios, it’s closer to nine. So you get a cash flow benefit. In the short term, you can increase prices, your costs don’t go up as much. So there’s a benefit there. 

But regardless of the underlying economics, what we’ve seen through history is when headline rates spike, infrastructure stocks get hit. This tends to be a short-term phenomenon. It has generally been short-term because, to paraphrase Benjamin Graham, “In the short run the market is a popularity contest, but in the long run it is a cash flow weighing machine.” The strength of the cash flows will come to the fore over time.

From 1-5, where 1 is cheap and 5 is expensive, how much value are you seeing in the market right now? Are you excited or are you cautious on the market in general?

Rating: 3

That’s fair value. But there are significant pockets of overvaluation and undervaluation. For infrastructure more generally, and bearing in mind that we have a conservative definition, it’s looking cheap to fair value. On your scale, about two. 

I think in a lot of cases, the market is missing the inflation protection, the pricing power, and the assets, and they’re very, very high-quality businesses. Or the market is extrapolating very short timeframes into the very long term. So there are still some very good opportunities out there. And moreover, for infrastructure in particular, what we’ve seen is where the market continues to misprice these things for a long time, the private players are stepping in and buying the assets. 

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