Investment Insights

Toll Roads: En Route to Income

15 June, 2020

The Case for toll roads

Transportation infrastructure is usually taken for granted and has become an indispensable part of the domestic and international trading economy. The movement of people, goods and services is needed both during an economic boom and downturn. This underlying inelasticity is an opportunity for investors, especially those looking for relative predictability.

Toll roads are prime examples of how transportation real assets can meet the needs of income investors. In its simplest form, traffic volume is generated by daily personal and business commuters who choose to use less crowded toll roads because travel becomes dependable and efficient.

These seemingly boring highway toll roads are very expensive to construct, operate and maintain. The need for large capital and relevant capabilities create a high barrier to entry, ensuring a natural competitive moat that usually has a lengthy life cycle. Hence, the toll road business is often monopolistic in nature and has the potential to deliver strong dividend income from reliable revenue streams, underpinned by long term contracts and favorable regulatory structures.

In addition, due the unspoken reliance commuters have on toll roads, revenues tend have a natural inflation hedge as toll road operators can peg price increases to how quickly the economy is growing.

Location is key: Australia fits the bill

Population growth is a key driver of traffic volume. In recent years, Australia experienced strong population growth. One reason is being the destination of choice for immigrants encouraged by the prolonged economic expansion, a stable government and employment opportunities. The favorable climate and lifestyle are also amongst many plausible reasons.

Contributing to population dynamics is also interstate migration. While some residents of Sydney have left to pursue a slower pace of life, internal migration has picked up in Melbourne and Brisbane where some could argue offer a more desirable balance of work and play.

Lastly, the natural increase of the resident population has also added to the growth of Australian cities by meaningful amounts. These three factors interact to create the ebb and flow of population growth in Australia (Chart 1).

CHART 1: Components of population change by capital city

Chart 1 Source: Australian Bureau of Statistics, Regional Population Growth, Australia, 2018-19. 25 March 2020. 

Another driver of traffic volume and a natural economic consequence of a growing population is a rising fleet of vehicles. Chart 2 shows that vehicle growth in Australia has been very consistent at about 10% every four years. These are not just passenger cars but also vehicles that transport goods and services through the network of roads within Australia. 

CHART 2: Growing number of registered vehicles over the last 20 years

Chart 2 Source: Australian Bureau of Statistics, 29 May 2020.

Thirdly, government willing to spend on infrastructure also plays a large role in determining the success of toll roads.

The Australian government outlined in its recent budget strategy and outlook paper that infrastructure spending will increase to $100 billion over 10 years with road transport expenditure rising sharply by 17.3% in real terms between 2019–20 and 2022–23. This includes new funding under the “Infrastructure Investment Program”, such as the “Urban Congestion Fund” and the “Roads of Strategic Importance project” (Chart 3). 

CHART 3: Road transport is the cornerstone of Australia’s infrastructure spending

Chart 3 Source: Australian Government, Budget strategy and outlook: budget paper no. 1: 2019–20, 2019. 

Finally, traffic is coming back as the economy re-opens post COVID-19 lockdown measures in Australia. The federal government announced a three-stage plan in May to ease restrictions across the country. It is up to each state and territory to decide when and how far they will relax restrictions. As a measure of traffic flow, congestion is steadily increasing through the severe lockdown phase. Congestion numbers from Sydney, Melbourne and Brisbane looks on the mend and poised for further recovery as the global and domestic economy comes back online. Congestion numbers from Guangzhou look encouraging (Chart 4).

CHART 4: When compared to 2019, traffic congestion has picked up in Sydney, Melbourne, Brisbane and Guangzhou 

Chart 4 Source: TomTom Traffic. Data as at 7 June 2020. Daily and weekly differences are based on weighted averages derived from hourly data. Each week starts on Monday and ends on Sunday. The daily standard congestion level for each weekday represents the daily average for that weekday over 2019. The weekly standard congestion level represents the mean of average weekly congestion levels in 2019. Week 1 refers to 30 Dec 2019 to 5 Jan 2020. Week 25 refers to 15 Jun 2020 to 21 June 2020. A reading of "0" implies that there is no change when compared to the same weekly period in 2019. A reading of "+0.2" implies that there is a 20% more congestion when compared to the same weekly period in 2019. 

Transurban Group (TCL)

Transurban Group owns and operates urban toll road networks. The Company has core capabilities in network planning and forecasting, operations and customer management, project development and delivery, technology application, and community engagement. Transurban operates in Australia and North America. Within Australia, TCL operates about 82% of all toll road kilometers which services circa 50% of Australia’s population.

Working closely with the authorities, it continues to benefit from a three-part strategy that has boosted its earnings – 1) higher tolls, 2) more traffic on each road and 3) more roads. The rising populations of Melbourne, Sydney and Brisbane have translated into growing traffic numbers for Transurban’s roads. It has also benefited from falling bond yields and more attractively priced debt. TCL’s dominant market position means asset expansions are also typically contracted on advantageous terms.

Due to the reasons highlighted above, investors into TCL have experienced relatively high and stable yield which out-pays several traditional asset classes (Chart 5). A large part of that stability is grounded in TCL’s growing free cashflow and growth in distributions paid (Chart 6). 

CHART 5: TCL’s dividend yield has been stable and relatively high

Chart 5 Source: Bloomberg. Data as at 11 June 2020. Asia Pacific ex Japan Equity refers to MSCI Asia Pacific ex Japan Index. Europe Equity refers to MSCI Europe Index. US Equity refers to MSCI US Index. Global Equity refers to MSCI World Index. US Corporate Bonds refer to Bloomberg Barclays US Corporate Total Return Value Index. Global Bonds refer to Bloomberg Barclays Global-Aggregate Total Return Index. 

CHART 6: TCL’s free cashflow and distributions are growing. 1H2020 results show TCL is on track for a successful FY2020. 

Chart 6 Source: Transurban 1H20 Results Investor Presentation, 2020 Investor Briefing presentation, 4 May 2020.

The bottom line

Real asset companies like toll road companies are an integral part of everyday life. Their demand profile is therefore relatively inelastic and not entirely pegged to the business cycle, hence these companies have more predictable free cash flow and dividends. The typically long-term nature of their cash flows (underpinned by long term contracts and favorable regulatory structures) also offers protection during market downturns, as well as upside growth potential from population growth. This means real asset companies, like toll road owners can provide a less volatile and more regular income stream. Their strong market positions, and the growing demand driven by population growth, mean that they can raise prices, in some cases above inflation, irrespective of the business cycle. These characteristics make toll roads ideal for that long term, risk averse, income focused investor. 
Source: Legg Mason and Martin Currie. Data and estimates as at  29 May 2020 unless otherwise stated. 

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