Investors have good reason to be cynical about government infrastructure projects. There’s been more talk than action this decade, despite Australia’s largest cities becoming increasingly congested and badly needing infrastructure upgrades as their populations swell.
But some good signs this year suggest investors should pay greater attention to infrastructure-related companies. Those that build the roads, dig the tunnels, lay new rail track and repair existing lines, could have stronger earnings tailwinds in the next five years.
The market is aware of the potential. CIMIC Group (CIM) – formerly Leighton Holdings – UGL (UGL) and several other infrastructure-related stocks have rallied over 12 months, amid rising expectations of greater demand for their products and services and improving sentiment in the resources sector.
Even so, they look better value than infrastructure owners. As an aside, I have been bullish on infrastructure owners for several years, partly because a lack of new projects and urban densification playing into the hands of monopoly asset owners.
However, two of my long-time favourites, Sydney Airport (SYD) and Transurban (TCL), look fully valued.
I understand fund managers voicing concern about Sydney Airport and Transurban’s valuations, higher debt levels, and that they are benefiting from a low interest-rate environment. These are valid points but some fund managers have issued the same warnings for several years and missed out on two of the market’s best stocks.
It’s all a matter of timing and investment horizon. Investors should take profits on Sydney Airport and Transurban, and other interest-rate-sensitive stocks for that matter, as expectations for rate rises build. That seems some way off, with the Reserve Bank cutting the official cash rate again this week and the odds for another rate cut in 2016 shortening.
Nevertheless, I would not buy either stock at current prices. Existing investors have reason to maintain their holdings and prospective investors might wait for better value to emerge in the next market sell off or correction, or consider infrastructure-service providers.
This 2016 Federal Budget includes more than $33 billion for infrastructure projects over the forward estimates – if you can believe them. It is adding another $50 million a year to the Roads to Recovery Programme from 2019-20, and providing another $594 million in additional equity funding for the Brisbane-Melbourne inland rail project to acquire land and continue pre-construction and due-diligence activities. Another $115 million has been committed to fund preparation work on the Western Sydney Airport project – a sweetener to win votes there.
The Federal Government’s $1.5 billion Victorian infrastructure package, conditional on the state government matching it, will upgrade the Monash Freeway and other key transport infrastructure in Melbourne. The investment is long overdue in Australia’s fastest-growing city.
Some state governments, too, are getting their act together on infrastructure. The latest Victorian budget shows the state is in a strong fiscal position, not afraid to take on debt when interest rates are low, and finally cranking up some big transport projects.
The Victorian government’s decision to fully fund the giant Melbourne Metro rail project builds on its $1.46 billion investment to construct the Western Distributor and the controversial $1.6 billion Sky Train that rids Melbourne of nine of its worst road and rail intersections. However, perspective is needed. It will take years for some projects to kick in and a significant amount of federal government funding starts from 2019-20. Nevertheless, there finally seems to be more action and funding for real infrastructure projects.
That’s good news for engineering and construction companies. The trick is finding those with higher exposure to infrastructure projects in New South Wales and Victoria. Both states have stronger economies, faster population growth, and greater need for infrastructure. Asset-recycling strategies are starting to work and have potential to fund more new infrastructure.
NSW alone is expected to account for 40% of infrastructure construction between 2015 and 2020, according to Infrastructure Partnerships Australia. The mining states of Queensland and Western Australia are expected to lag on new infrastructure projects.
Stocks leveraged to infrastructure construction theme
A dozen or so larger stocks provide exposure to this theme. They include Adelaide Brighton (ABC), Boral (BLD), CSR (CSR), James Hardie Industries (JXD), Fletcher Building (FBU) and Brickworks (BKW) in building materials; UGL, Downer EDI (DOW) and CIMIC in the contractors; and Lend Lease (LLC) in construction.
Monadelphous Group (MND) and WorleyParsons (WOR) also provide infrastructure exposure, but it is a smaller percentage of revenue compared with specialist players in this area. DuluxGroup (DLX) is another with leverage to infrastructure activity.
Adelaide Brighton (ABC) and Boral (BLD) provide some of the strongest exposure to infrastructure activity and the latter is especially well positioned in the outperforming NSW economy. Both companies look fully valued after solid share-price gains over three years.
CIMIC has around 40% of its revenue exposure to transport infrastructure projects, on Macquarie Securities’ numbers. Although it has good medium-term prospects, CIMIC looks a touch overvalued after soaring this year on better-than-expected earnings growth and strong earnings guidance.
UGL and Downer EDI offer better relative value, although neither is cheap. UGL provides outsourced engineering, asset management and maintenance in transport and utilities infrastructure. About 40% of its revenue is in rail and defence projects – an interesting position as the federal and state governments show renewed interest in big-ticket rail projects.
UGL has plenty of exposure to rail tunneling and passenger rail operations, and should benefit from a ramp-up in oil and gas maintenance contracts. UGL has a history of volatility, but its new management appears to be building a more sustainable business that can capitalise on coming growth in infrastructure projects.
The market has a negative view on UGL. Two of nine broker firms that cover it have a buy recommendation, three have a hold, and four have a sell. A median share-price target of $2.79, based on consensus analyst estimates, suggests it is overvalued at the current $3.19. UGL is due for a share-price pullback and consolidation after racing from $2.20 to $3.20 in a matter of months, as the resource sector bounced. But its recovery has a long way to run and it deserves a spot on watch lists, with a view to buying below $2.80.
Chart 1: UGL
[1]Source: Yahoo!7 Finance
Downer EDI is another contractor that has had mixed fortunes over the years. Unlike most other infrastructure-related stocks, it has delivered a negative total return over 12 months (minus 22%). Its five-year average annualised total return (including dividends) is 3%.
Downer has good exposure to new projects through its infrastructure and rail divisions. The transport sector contributes about 22% of its revenue, as does the mining sector. About 10% of its revenue comes from the utilities sector, and its engineering, construction and maintenance divisions provide most of the rest.
Downer’s loss of Fortescue Metal Group’s (FMG) Christmas Creek mining-services contract, although not unexpected, was disappointing, given it was a sizeable deal. But Downer is in the running for some key rail projects that will be decided this year and, if successful, would boost its rail division and medium-term earnings visibility.
Three of 10 brokers have a buy recommendation on Downer, six have a hold and one has a sell. A median share-price target of $3.50, using consensus estimates, implies it is fully valued.
Like UGL, Downer is due for a share-price consolidation after rallying from $2.95 to $3.50 this calendar year. Also like UGL, it has a lot of lost ground to make up and has the right management in place to capitalise on stronger infrastructure demand in coming years.
Chart 2: Downer EDI
[2]Source: Yahoo!7 Finance
Neither stock is for the faint-hearted or deserves to be chased higher at current prices. Their exposure to resource projects adds a layer of risk.
Both stocks suit experienced investors with a 3-5 year horizon and who can tolerate volatility before a stronger period of infrastructure-related earnings growth kicks in. And most of all, watch and wait for better value in two unfolding turnarounds in the contractor space.
– Tony Featherstone is a former managing editor of BRW and Shares magazines. The column provides general information rather than specific advice or recommendations and takes no account of an investor’s individual needs. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at 4 May 2016.
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.