The business model for toll roads follows a well-worn path. In exchange for investing in critical infrastructure and helping support capacity on the roads, governments allow the toll-road operator to collect tolls for a defined period and to increase those charges on a regular basis to allow for inflation.
The traffic on these roads is highly reliable. Time has shown that when tolls rise, even if only in line with inflation, some users decide to switch to the toll-free alternative. The customers who switch have the effect of increasing congestion on the alternative toll-free routes, which in turn makes the tolled route appear more attractive to drivers as it now flows faster than its toll-free alternative. This difference leads drivers back to the tolled road. These dynamics explain, for instance, why traffic on Sydney’s Eastern Distributor grew 118% over the 18 years to 2018 despite tolls increasing 151% over the same period. Such is the value to motorists of the time savings toll roads deliver combined with the benefit motorists place on knowing roughly when they might arrive somewhere.
The Eastern Distributor is a six-kilometre stretch that is majority owned by Transurban, the ASX-listed stock that benefits from similar steady increases in revenue from its other 16 toll roads in Australia, Canada and the US. A progressive climb in revenue and earnings from these roads is the main reason why Transurban has been a great company to own over the long term. The other reason is that these long-term earnings increases have been higher than the investment market expected. That is to say, investors have consistently underestimated Transurban’s long-term earnings growth.
Infrastructure and utilities companies are expected to generate reliable low-risk earnings streams but they are not often expected to generate such healthy earnings growth. That some infrastructure and utility companies can grow their revenue by more than expected, year in year out, means that investing in these assets holds the potential for higher investment returns than might be expected at face value. It means that those who invest in well-chosen infrastructure stocks such as airports, toll roads, railway operations and regulated utilities can benefit not just from reliable earnings but potentially also from long-term earnings growth delivered in the predictable way that investors expect from this investment option.
To be sure, it’s not easy to judge that stocks are mispriced. Magellan seeks to take a long-term view of the assets it invests in and this perspective can differ in important ways compared with the view of the broader investment market, which typically focuses on a shorter-term outlook. It must be said that many infrastructure stocks are labelled as substitutes for low-yielding fixed-income investments. This reputation of infrastructure and utility stocks as ‘bond proxies’ or ‘yield plays’, however, is pertinent only over the short term and misses this valuable long-term growth thematic.
The fact is that many companies providing essential services offer much growth potential over the long term. Utilities such as American Water Works and US electricity grid operator WEC Energy have generated an average compounded annual growth in earnings per share of more than 7% from 2010 to 2018. Infrastructure companies have achieved similar results. The combination of growth and income is what makes a well-chosen portfolio of infrastructure and utilities an appealing investment option.
Utilities are natural monopolies providing essential services. Due to this competitive strength, they are regulated to ensure they don’t abuse their monopoly position. This economic regulation provides for a fair and predictable return to the utility owners on the capital they have spent to build the utility. Under this regulatory framework, utilities can increase their earnings by investing in new capital expenditure projects, approved by the regulator, as the utility will be permitted to increase its earnings to reflect this additional investment. At the same time, regulators are conscious that any price increases can lead to frustrated consumers. A regulator’s job is to balance this, ensure that investment is truly essential and ensure utility bills are kept under control.
The tension between a utility’s desire to invest and the regulator’s desire to keep prices low is a key issue. A valid question to ask is: How can regulated utilities grow earnings given the resistance to boosting prices for users? The solutions can be that the regulator is willing to let utilities invest more to improve their services – say, to improve the reliability and safety of their networks. Or it could be that utilities are benefiting from declining costs of the resource they offer to users, which helps keep down costs for customers and gives regulators more room to allow companies to invest on the understanding they will be allowed to increase earnings. Another is that companies prune their operating costs, which similarly reduce the pressure on customer bills and again allows for more investment in networks.
Atmos Energy, the US's largest fully regulated natural-gas-only distributor, is benefiting from both an improvement in its services and from the current low levels of the cost of natural gas they deliver to customers. What’s unusual about the US natural-gas market is that much of the country’s network needs renewing because, due to an historical lack of maintenance, it has become dangerous – in 2010, a gas pipeline exploded in San Francisco and levelled 35 houses and killed eight people. But it takes time and money to improve the network.
Of prime importance in our investment thesis is that Atmos has sanction to spend US$8 billion from 2018 to 2022 to (mostly) upgrade its pipelines. From this, it is expected that the company’s invested capital will nearly double over that time and we expect that the regulator will be more amenable to higher prices on Atmos connections as this expenditure will improve safety. At the same time, Atmos can keep costs down for users because national gas prices have fallen to about 25% of where they were in 2008 due to the US fracking revolution boosting supply. Atmos has posted average annual earnings per share growth of 8.3% from December 2010 to December 2018.
Infrastructure companies, which often face regulation over the prices they can charge, secure earnings growth from rising demand for their services. As with the Transurban example, toll-road revenue and earnings grow in line with increased patronage. Economic regulation of toll roads is typically focused on price, rather than earnings, and most contracts allow the toll road to increase prices to compensate for inflation. Patronage usually rises over time as the population rises and wealth increases.
Airport operators also benefit from higher patronage. In 2018, aeroplanes carried more than four billion passengers worldwide through the world’s airports, up from about two billion in 2006 as the world got wealthier and flying became cheaper. Improving wealth and declining travel costs reflect underlying structural trends that we expect to boost airport patronage for the foreseeable future.
ADP, a 51% government-owned group, is one of the companies benefiting from more flights because, among the airports it owns around Paris and outside France, it operates Charles de Gaulle airport from where a plane leaves or arrives every 30 seconds. ADP has posted average annual growth in earnings per share of 8.3% from 2006 to 2018. Aena of Spain, which is the world’s biggest operator of airports, is benefiting from the same growth in aviation passengers. Aena was only privatised in 2015 but has posted average annual growth in earnings per share of 17.9% from 2015 to 2018.
Companies that own telecom towers have benefited from the enormous surge in demand for wireless data from the internet and mobile devices in recent years. Worldwide there are an estimated 3.4 million telecom towers. One of the biggest tower operators is Crown Castle International of the US, which owns more than 40,000 communications towers in the US that provide co-location space to wireless carriers. The company has been a major beneficiary of the growth in data transmission and remains well positioned to benefit from continued growth in mobile data traffic, which is forecast to increase tenfold in the next five years. Crown Castle adopted a real estate investment trust structure in January 2014 and has posted average annual funds from operations per share growth of 12.6% from December 2013 to December 2018.
Railway operations in North America is another part of the listed infrastructure universe enjoying robust growth in demand. One reason is that demand has risen for commodities easily moved by rail such as potash, grains and oil. The other is that a shortage of truck drivers boosted trucking costs, which meant that rail operators could charge more per load and still be the more economical and reliable option. Another boost to the profitability of these stocks is that railway operators have become more efficient. By doing more with less – in what’s known as ‘precision scheduled railroading’ – railroad operators are reducing congestion on major routes through better traffic management, decreasing the number of trains and investing in better infrastructure. Operators are now running fewer but longer trains at faster average speeds and have reduced unnecessary headcount. The combination of volume growth with improved operating efficiency enables the railway operators to generate earnings growth and the outlook is for these trends to continue over the long term.
Canadian Pacific is one railroad operator benefiting from higher demand and improved efficiency. The company that operates across Canada and into the US Midwest and northeast has generated average annual growth in earnings per share of 11.8% from 2006 to 2018.
Such is the longer-term growth offered by everyday infrastructure such as toll roads, railways, airports and telecom towers. Where such growth can be expected well into the future for structural rather than cyclical reasons, this provides potentially attractive investment opportunities that offer not just reliable earnings but also reliable earnings growth.