Being fed up with paying road tolls is not a sound reason to invest in the owner of the toll road.  However, as I wrote nine weeks ago, I think Australia’s major toll road owner and operator, Transurban (ASX: TCL) should be a core stock in your portfolio.

Over the last nine weeks, Transurban’s shares have risen from $11.62 to $12.28 (Friday’s close), a gain of 5.7%. The market over the same period is up by 2.1%. Moreover, this has occurred in a period of rising bond yields.

Last Thursday, Transurban updated the market with first quarter traffic and revenue outcomes. Before turning to these, a quick re-cap on the Transurban story.

The Transurban story

Transurban operates on the eastern seaboard of Australia and in North America. It owns or operates on long term concessions 15 toll roads in Sydney, Melbourne, Brisbane and the greater Washington DC area.

Revenue growth is derived from traffic growth, traffic mix and inflation protected toll escalation. Operating scale allows Transurban to drive cost efficiencies and margin uplift, while investment in the underlying assets unlocks further value.

In 2017, Transurban grew EBITDA by 10.1% to $1,629m. This came from a revenue increase of 10.6% to $2,153m, built on an increase in average daily traffic of 4%. The Transurban portfolio of toll roads, together with their contribution to total revenue, is shown in the table below.

Transurban has a $9bn development pipeline, which includes projects such as the widening of the Tullamarine Freeway (due to complete at the end of October), The West Gate Tunnel project in Melbourne and the construction of North Connex in Sydney.

For unit holders, this combination of traffic growth, toll increases, portfolio expansion and a benign interest rate environment has allowed Transurban to increase its distribution from 29.5 cents per unit in 2012 to 51.5c per unit for 2017. This translates to a compound annual growth rate (CAGR) of 10.5%.

The company has forecast a distribution of 56c per unit for FY18, an increase of 8.7%.

To finance projects and drive unit holder returns, Transurban carries $13.7bn of debt. The debt has a weighted average maturity of nine years and comes at a cost (for the Australian $ debt) of 4.9%. Transurban’s corporate debt is classified as investment grade being BBB+/Baa1/A- from S&P/Moodys/Fitch respectively.

First quarter update

Transurban grew toll revenue by 11.4% in the September quarter compared to the corresponding period in 2016, better than expected. This came as a result of an increase in traffic, changing traffic mix (more trucks) and guaranteed inflation plus toll increases.

The table below highlights the results of some of the key assets. For example, revenue for the M7 in Sydney jumped by 17.8% following an increase in average daily trips from 183,000 to 190,000 (a growth rate of 3.6%). In Melbourne where the CityLink Tulla widening project is about to complete, revenue still rose by 13.4% despite a fall in average daily traffic of 2.3%.

All 15 toll roads experienced an increase in revenue, with only 1 (CityLink) experiencing a reduction in the number of average daily trips.

Transurban also announced that work on the CityLink Tulla widening would complete at the end of October, three months ahead of schedule and ahead of budget. NorthConnex is on budget and on time, and work has recently commenced on the $512m expansion of the Logan enhancement project in Brisbane.

What could go wrong?

The most obvious problem that could beset Transurban is an increase in term interest rates. Transurban is considered by many to be a “bond proxy” because of the leverage it carries and the fact that the amount it can pay in distributions is so dependent on its net interest costs. It was the fear of the impact of higher bond rates that led to the sharp sell- off in Transurban and other “bond proxy” stocks in November last year.

Transurban Share Price

Source: ASX

Transurban hedges its debt into fixed rates, and as at 30 June 2017, some 99.4% was hedged. So, while a movement in bond or short term interest rates has no immediate impact on Transurban’s earnings, as debt matures and needs to be refinanced, Transurban will pay higher rates. In 2018, $1.17bn of maturities are due, of which a material amount has already been re-financed.

If Transurban acquires some of the NSW Government’s stake in the West Connex project, or wins the right to build new toll roads, then more debt will be required. Transurban may also seek to fund part of these obligations through a capital raise and the issue of new units.

Project management and traffic forecasting risks could also have a material impact on Transurban’s market valuation.

What do the brokers say?

According to FN Arena, of the seven major brokers who cover the stock, four have buy recommendations and three have neutral recommendations. The consensus target price is $12.71, a 3.5% premium to Friday’s closing price of $12.28. Since August, the consensus target price has risen from $12.58 to $12.71.

While the Brokers are in the main quite favourable in regards to Transurban managing its growth pipeline, and constructive about the portfolio’s traffic outlook, their distribution forecast of 56.3c per unit is only marginally ahead of Transurban’s guidance of 56c per unit for FY18. Higher corporate costs and the event risk around West Connex, with possible equity raising, are considered to be potential issues.

Bottom line

Transurban (TCL) is not a cheap stock. The forecast distribution of 56c per unit gives a yield of just 4.6%, which is expected to be largely unfranked. In FY19, this is forecast to rise to 5.0%.

However, it is a monopoly provider with guaranteed price increases that is growing earnings at 10% pa. Further, it has an excellent track record in execution, a strong current project pipeline, and several prospective projects to consider.  And if you believe in the future of driverless cars or automated vehicles, then down the track, there may be a massive opportunity for it to boost capacity on its current toll roads.

It is a relatively low risk, annuity style stock with strong growth prospects, which arguably makes it a core portfolio stock for many investors. If you don’t already own it, the question is: not whether to buy it, but rather, when to?

If US bond rates head higher over the next months (as I expect them to), then Transurban will come under pressure as a “bond proxy”, notwithstanding that its debt is fully hedged. The lesson from last October/November is that dips will be well supported. If you can afford to be patient, look to buy Transurban in market weakness or on the next blip up in bond rates.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.