With Transurban (TCL) having recently reported and upgraded its FY17 dividend guidance, investors remain enamoured with what is widely considered one of the highest quality stocks on the market. The results were a timely reminder of TCL’s enviable position in the market. Its assets – some of the busiest toll roads in Australia and the US, are unique and largely inimitable. Its pricing – pre-set and loosely regulated, is guaranteed to grow at levels exceeding consumer price inflation (CPI). Its market share – bordering on monopolistic, continues to solidify, as TCL is recognised more and more as the premier operator in the country. None of these assessments are especially ground-breaking and TCL is widely considered one of the most defensive and predictable companies in Australia.
TCL Sydney Network
Figure 1. TCL’s Sydney Network
Source. TCL FY16 Results Presentation
In years past, such qualities may have been overlooked. TCL offered yield and unspectacular, long-dated growth but so then did the miners and the banks. How things have changed! In the yield starved world of today where interest rates creep towards 1%, an all but guaranteed >4% yield and the prospect of predictable long-dated growth are highly attractive. This has been reflected in the stellar price performance of TCL, which has risen sharply over the last few years. Though the valuation appears stretched at current prices, it is likely that if interest rates continue to fall, investors may be willing to take lower yields from defensive equities such as TCL, and hence bid the price up. Compounding this phenomenon is the mass migration of so-called bond market refugees pouring capital in utility style equities with attractive yields.
A useful tool to better understand this relationship is a yield spread model. Essentially, it looks at the average amount a stock’s yield has exceeded the cash rate (spread). Applying this spread to the current cash rate, the model calculates an implied yield. If we multiply this yield by the forecast dividend per share, we can derive an implied market price based on historical demand. This tool works well for understanding demand for stocks with prices principally derived from their forecast yield. In our view, it should only act as a guide and shouldn’t be used as a replacement for fundamental value.
TCL yield spread pricing model
Figure 2. TCL yield spread pricing model
Source: Clime research
Besides yield, we also view TCL as having an attractive project pipeline. In FY17, it will continue its CityLink Tulla widening and its Webb Dock Access projects. It will also commence Logan Enhancement Project and Inner City Bypass in Australia, and the 395 and 95 Express Lanes in the US.  The Monash Freeway upgrade is also set to commence this financial year in advance of the $4 billion Western Distributor project, commencing in FY18 in full. This pipeline provides a roadmap for TCL’s reinvestment over the next five years over which period they will spend $6.2 billion in capex. The bulk of this will come in FY18-FY20 and there may be a strong possibility of capital raisings during that period as a result.
TCL project pipeline
Figure 3. TCL project pipeline
Source: TCL FY16 Results Presentation
With growth clearly mapped out, TCL should be able to sustain strong dividend growth over the medium term with the 11% increase in FY17 likely to be indicative. We have reflected this in our valuation, which uses a 5% reinvestment rate. When combined with capital raisings, this will support the expanding asset base and hence dividends. Our NROE of 21% is a medium term average and reflects a base case view. A bear case scenario would likely involve significant project delays, capex blowouts, or changing to toll price escalation regimes. Conversely, a bull case scenario would involve projects completed under budget and/or ahead of schedule, or a positive change in toll pricing.
TCL valuation matrix
Figure 4. TCL valuation matrix
Source: StocksInValue
Our final caveat to investors is that TCL’s relationship with interest rates works both ways. In the event of a reversal in monetary policy, during a period of rising interest rates, TCL’s price would likely fall as investors demanded higher yields. While we view such a scenario as unlikely, it remains the biggest risk to shareholder returns in our view.