Bridges over troubled waters?

Investments

Anthony Aboud

Portfolio Manager

The utility and infrastructure sectors have performed strongly over recent years. In an environment where interest rates are low, it would appear that their dividend yields are competitive with deposit rates - and there is the potential for capital growth. Some have steadily growing dividend yields of between 4% and 5% (unfranked).

But is too good to be true? I happen to think it is. That’s because none of the Australian infrastructure and utilities companies I’ve looked at have sustainable long-term dividend policies. I am not forecasting imminent disaster, but these companies are selling at very high multiples. They are priced as if their dividends are guaranteed for the long term. I don’t think they are – which means these stocks are riskier than they appear. 

Yes, these are high quality assets

I agree with the general premise that there are high quality businesses in the infrastructure space, when talking about toll roads, airports, gas pipelines or transmission lines. Some attributes of these businesses are very attractive: 

  • Very hard to replicate 
  • These assets usually have high up-front capital costs. This means these businesses have little or no competition and very strong pricing power (insofar as their respective Government concessions allow). 
  • Inflation protection
    Many of these assets have pricing agreements which enable them to lift their prices (eg. tolls) along with inflation. This is an important attribute when comparing their yield to cash rates. Inflation can quickly erode the value of cash returns.
  • Strong cash generation
    Once a toll road or airport is built there is relatively little capital required to maintain it – which helps explain why most toll roads have margins north of 75%. High margin businesses with strong cashflow are the sort of businesses I normally like to own and these assets are even more attractive in environment where growth is harder to find. 

A mortal mistake with amortisation

While these attributes make infrastructure businesses attractive, serious questions need to be asked.

Companies with finite assets like toll roads deserve particular scrutiny. People tend to forget that at the end of the concession, the company has to hand the road back to the government debt-free. So there is no asset at the end of the day.

Given there is a lot of debt held against the asset, at some future date the company is going to have to start paying down the debt. This is an area where I believe the accounting standards have got it right. The way the accounting rules work, the company has to amortise the toll road’s reduced worth over time. The rules rightly account for the fact that a toll road company with a concession of 20 years is worth far less in year 19 than it was in year one.

Given that the share prices of many infrastructure companies are trading at multiples of their asset value, the true market value required to replace these assets is much higher. Sometimes this creates a vicious cycle - companies taking on more debt to purchase new assets to cover the hole in their earnings caused by the falling value of existing assets. It’s a catch-22 situation with inherent risk.

My point is that while the end of concessions is beyond most investors time horizon, the falling value of the toll road (or other asset) is a real cost. Paying out dividends without taking into consideration either the need to pay down big debts or the ever-falling value of the toll road is in my view unsustainable over the long term.

Chickens looking for somewhere to roost

My fear is that while these dividend repayments are sustainable in the current environment, they are unsustainable over the longer term. At some point the chickens will come home to roost. When companies need to raise equity or borrow money to sustain the business and pay out all their free cashflow in dividends, it rarely ends well.

So why haven’t these issues been raised more often?

Unsurprisingly, given the amount of corporate work handed out by infrastructure companies through equity raisings and acquisitions, many market players have positive recommendations on these companies.

Remember, too, that company management is incentivised to maximise the cashflow available for distribution during their tenure as this helps to bolster the (short-term) share price. A higher dividend has a positive impact on a CEO’s short and long term monetary incentives.  These short-term pressures are likely to influence subjective decisions on what cash is paid out as distributions.

There’s more than one kind of stability

Currently, the price of infrastructure and utility stocks are going up because people are happy to pay more for companies that produce regular income. My point is:

  • this income is not guaranteed
  • their ability to fund those distributions will change over time – and could get markedly worse
  • the value of the assets in these companies will not always be rising.

I also believe that loading up on debt in a low-rate world is not a sustainable way to fund the high income your investors demand from you – or indeed to stay in business at all.

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This article is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable for your circumstances. The views expressed in the article are the opinions of the author at the time of writing and do not constitute a recommendation to act.  Any information referenced in the article is believed to be accurate at the time of compilation and is provided by Perpetual in good faith. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.

The author is an employee representative of Perpetual Investment Management Limited ABN 18 000 866 535 AFSL 234426.