Major infrastructure investments appear to be the order of the day around the world.
The new Economic Report of the President of the United States presented by the White House in February lists the woes of national infrastructure, quantifies the gruesome hours lost in traffic congestion, and emphasizes the need for a remedy. In an interesting note in the 568-page tome, the president’s economists promote the use of a 12.9 percent return on capital as their “preferred estimate” for the myriad projections they proceed to make. The figure is a lynchpin for Donald Trump’s highly-publicized infrastructure plan, which promises $1.5 trillion in investments over the coming years.
At a time when there is talk of a “new normal” of meager productivity gains, any government able to achieve such returns should invest as if there’s no tomorrow! And here’s the rub: President Trump’s plan invites private investors to put up 80 percent of the funds required. That suggests retail households should call their brokers right now!
Of course it’s not that simple. But the White House report offers a host of assurances, promising to tackle regulatory hurdles and emphatically announcing that “user charges” will become more common, as these allow for better and more functional signals to consumers and producers alike than “decisions made by tens of thousands of distinct governmental entities based on little or no price information.”
Elsewhere in the world – notably in Europe where “freeways” long ago were supplanted by toll roads – infrastructure is the word of the day, and a reasonably buoyant global economy offers wind in the sails for those promoting it.
“Economic and inflation growth will boost volumes and revenues across all (global) regions,” said Mar Beltran, an analyst for Standard and Poor’s.
Even countries battered by the global financial crisis are back in the driver’s seat and enjoying robust gross domestic product growth. That, along with significant road-expansion campaigns in France and Spain, buoys the whole euro zone, which is poised for an ongoing “strong cyclical rebound that will increase domestic demand and investment” and in turn lift traffic volumes and consequent revenues, she added.
European toll road operators, Beltran said, should go further in a trend toward higher EBITDA – earnings before interest, taxes, depreciation and amortization, a proxy for gross operating profit and ultimately free cash flow.
Growing EBITDA is an important prediction as, globally, transport infrastructure concessionary firms have been lowering their leverage in recent years. Median debt-to-EBITDA ratios peaked at a multiple of around 5.0 in 2015 and have dropped since, to 3.8. That drop is now over and a rise should be visible by next year, according to S&P’s house forecasts for the sector.
Bigger may be better
Uncertainty has hardly been abolished from the world, and numerous risks loom over the sector. Obviously a relapse into recession would be an unwelcome blow to the top and bottom lines of infrastructure operators in mature economies. Disruptive technologies may also burst in to their dining rooms, although major breakthroughs in self-driving vehicles don’t seem likely in the near term.
What’s interesting is that the whole world is interested in major infrastructure spending. China’s Belt and Road Initiative projects vast amounts, and India’s government is mulling a plan to nearly double its highway network in the next few years which would mean adding about 20,000 kilometers.
Given the hefty capital needs, different phases of economic development and emerging technological opportunities and challenges, diversification has a natural appeal – and if synergies are available, all the better. On top of that, governments such as Mr. Trump’s, who wants to delegate the national infrastructure overhaul to third parties, will be keen to partner with investors with a track record.
That means technical expertise and financial heft on both the equity and debt fronts matter, says Wilson Magee, who manages a fund devoted to investing in listed infrastructure companies for Franklin Templeton. He sees growth prospects for global toll road operators as particularly exciting.
A theme warranting special attention, says Magee, is the prospects for tolling technology, especially in the U.S. where more and more toll roads are likely to be built. New toll roads are opening this year in five important U.S. state, including Colorado, Florida, North Carolina, Texas and Virginia. Much attention has been paid to “dynamic pricing” techniques on the I-66 highway leading to the nation’s capital, which has led to shock-and-awe moments when it costs $40 to travel 10 miles.
There is a lot of experimentation going into what the industry calls “electronic toll collection”. A new GPS-based tolling “LinktGo” app rolled out in Australia allows drivers to benefit from a pay-as-you-go system that not only eliminates the need for a tag but – intriguingly – is associated with the driver rather than the vehicle.
Still, while technology-driven disruption has had major impacts in many sectors – remember Nokia – most analysts feel that the risks for transport infrastructure networks are low for now, even if operators are busy scouting for new ideas.
“Self-driving cars, smart phones, Uber and so forth are all clever but in the end someone has to operate the actual roads that people and goods travel about on, and they tend to know a lot more about the business than clever start-ups,” said one investment analyst whose employer doesn’t allow to be identified.
It’s a widely held view that the urgent need to deliver on a host of fronts – construction, repair, management, regulatory compliance and, as Trump’s plan notes, actual capital expenditure – means that bigger players are likely to do better, as effective managers will be best placed to achieve operational efficiencies able to drive up operating margin growth.
That likely explains the flurry of mergers-and-acquisitions activity in the sector lately.
Will tighter money spoil the party?
Along with a general macroeconomic consensus that GDP is growing, comes the question of whether and by how much central banks will raise interest rates – and whether sovereign and corporate borrowing costs will rise in tandem.
It is a standard view that infrastructure operators in mature economies, which tend to be amply leveraged, are vulnerable to monetary tightening.
But times have changed. First, if interest rates rise along with GDP and inflation-adjusted revenue, the effects tend to offset each other, so only a rate crunch in a distressed situation poses a major worry. That is not on anyone’s horizon.
In fact, global listed infrastructure securities may now be a way to protect a portfolio against inflation, according to Magellan Asset Management.
Craig Balenzuela of QIC, a wholesale funds manager also based in Australia, says that those who worry about central bank tightening crunching infrastructure players is oversold. Many toll price formula offer automatic adjustments, he notes, and more importantly, the secular trends that have pushed rates down have hardly gone away. Official interest rates will likely go up, but slowly and ultimately stopping before they reach historic levels, as signaled by the forward guidance from many central banks. “There are no secrets,” he says.
What that means for investors is that any potential negative shock to asset values from discount rates – which would factor in the impact of higher interest rates over longer time horizons – may be offset by cash flows. That’s because infrastructure managers have in recent years been especially actively managing their capital structures, opting for longer-dated bonds that drew in investors when yield opportunities were scarce. Financing itself has become the source of “value-add”, he says, so smart investors will be looking not just at balance sheets but at managerial track records and the amount of optionality companies have built into their dashboards. Sustainability and flexibility are the key positive attributes.
That may be one of the reasons that Moody’s Investors Services, the rating agency, has segmented out Europe’s toll-road sector as a category of its own – with a stable rating at the outset of 2018 – rather than lumping it with the transport infrastructure sector in general.
Such considerations suggest that geographic diversification and overall size are positives, as more and distinct assets allow for managers to engineer more financial flexibility and resilience. On the other hand, as several analysts noted, pricey acquisitions to acquire such profiles could effectively cook the goose meant to lay the egg.
Another way to embed balance sheets with greater financial flexibility is for a corporate to spin off minority stakes in actual operating companies. Such deals give long-term investors such as pension funds or insurance companies a way to stick closer to the underlying revenue stream and worry less about volatility at the holding company level – where the fresh cash can be used to optimize balance sheets, dividend policies or pursue strategic acquisitions.
For institutions able to invest in unlisted infrastructure assets, that’s interesting. For those oriented towards listed securities, that probably means that the Q&A part of conference calls will be more important than the slide shows!