We maintain our $12.50 per share fair value estimate for wide-moat Transurban (ASX: TCL). First-half fiscal 2024 proportional earnings before interest, taxes, depreciation and amortisation (“EBITDA”) lifted 8% on the previous corresponding period to $1.3 billion.

With interest costs contained, free cash flow, excluding capital releases, grew 18% to 32.5 cents per share, fully covering Transurban’s interim distribution of 30 cents per share. We maintain our total fiscal 2024 distribution forecast of 62 cents per share, in line with management’s reaffirmed guidance. Shares in Transurban look fairly valued at current prices, with an implied yield of 4.7%.

Average traffic volumes were up 2.1% versus the prior period ("PCP"), with improvements across all markets. In aggregate, we estimate like-for-like traffic volumes have broadly recovered to prepandemic levels.

However, volumes in Sydney, which account for almost half of Transurban’s toll revenue, are tracking below our expectation, up a modest 1.2% due to disruptions from construction activity. Reflecting the softer start to the year, we reduce our full-year forecast for Sydney toll revenue, which lowers our fiscal 2024 group EBITDA growth forecast to 11% from 14% previously. Our long-term forecasts remain intact.

Cost discipline continues to be a focus for Transurban. Operating cost growth of 1.7% versus the PCP was pleasing, particularly against the inflationary backdrop, with the consumer price index rising about 4% over the period.

We expect cost growth will pick up in the second half and maintain our full-year fiscal 2024 operating expense growth forecast of 5.5%, toward the upper end of management’s revised 4%-6% target. We think revenue growth will comfortably outstrip costs for the full year, resulting in an EBITDA margin expansion of around 1% in fiscal 2024.

Business strategy and outlook

Transurban is a major toll road investor with concessions to operate 14 Australian and three North American motorways. Concessions grant the right to operate the roads and collect tolls for predetermined amounts of time.

The core Australian roads are integral parts of the motorway networks in Australia's three largest cities: Melbourne, Sydney, and Brisbane. The roads benefit from strong competitive advantages, and the assets generate attractive returns on initial investment, warranting a wide economic moat rating.

Granting toll road concessions allows governments to use private capital and expertise to provide necessary improvements to road networks. Typically, concession life and toll profiles are set in negotiation prior to the road's construction, with the intention of providing a fair return for investors.

Tolls increase in line with the consumer price index or at an agreed fixed rate, though some roads with meaningful competition have dynamic tolling, such as Transurban's U.S. investments. When concessions end, the company returns the roads to the government for no consideration, after repaying all related debt.

Operating cash flow should increase strongly during concession lives, as solid revenue growth, driven by rising tolls and traffic volumes, is leveraged over a mostly fixed cost base. Cash flow available for distribution to investors increases in line with a road's operating cash flow until about 10 years before the concession life ends; thereafter, a portion of operating cash flow is used to repay debt.

Cash flow stops when concessions end. Concessions on the Australian roads are set to end between 2026 and 2065. Including the long-life U.S. assets, the weighted average is 30 years. To extend its existence, Transurban will look to build new roads or undertake road upgrades that may require new equity issues or increased financial leverage, given that the firm currently pays out all free cash flow as distributions to investors.

Typically, cash flow is defensive and grows strongly, but returns are lower than they appear at first blush, given that the roads are handed over to the government for no consideration when concessions end.

Our moat rating

Read more about how identifying a company with a moat impacts investment results.

Transurban has a wide economic moat, underpinned by efficient scale and other competitive advantages in existing markets. While the firm may invest in new markets where competitive advantages are unlikely, we are comfortable with the view it will continue to make excess, albeit lower, returns in 20 years.

This view is reinforced by the firm's long-weighted average concession life of around 28 years and large pipeline of attractive development opportunities in existing markets.
Generally, one toll road should suffice for a given catchment. The core Australian roads benefit from strong barriers to entry, with new entrants deterred by relatively inelastic demand and substantial upfront construction costs.

A lack of available space and meaningful town planning restrictions further deter new entrants. However, like many natural monopolies, the firm does not control pricing. Rather, pricing is determined by concession terms agreed with government prior to building the road.

Traffic volumes are the main unknown when concessions are agreed, leaving the firm with usage risk. Being major arterial routes in Australia's largest cities, core assets have benefited from strong volume growth, underpinned by rising populations. We estimate Transurban's current collection of toll roads will generate an equity IRR of 10%, comfortably above its 7.5% cost of equity.

We expect limited competition for existing assets, given demand growth can be met most cost-effectively by upgrading existing motorways. Widening projects are agreed with the State government as roads become congested, and further concession terms--higher tolls and/or concession extensions--are granted.

Upgrading existing assets provides good risk-adjusted returns. Generally, the main risk toll road projects face is that of inaccurate traffic forecasts during the planning stage, but this is relatively low for upgrades, given the roads are already established and traffic patterns well known. Additionally, returns for upgrades are typically good, given the absence of competing bids on assets owned by Transurban. Unfortunately, brownfield expansion opportunities are limited relative to the size of the portfolio.

While Transurban's assets have strong and enduring competitive advantages, the firm only operates them under lease for a predetermined period. As such, it must continually invest in new assets to extend its existence. Processes to buy existing roads or bid on developing a new road are generally open to competition, suggesting excess returns are unlikely without a cost advantage. While returns could be strong for greenfield developments, forecasting risk is commensurately high.

In existing markets, we believe Transurban's ability to leverage existing operations give it the edge on new entrants in terms of operating costs. Additionally, it can reduce risk, and thus costs of capital, through novel funding arrangements such as subsidizing new projects with increased tolls and concession extensions on existing roads, if the government agrees.

A key issue for many new motorways in built up areas is the increasing reliance on tunnels because of a lack of space. Tunnels are very expensive to build and have destroyed capital in the past as motorists balked at high tolls for short distances. Transurban negotiated higher tolls and concession extensions on existing assets with government to heavily subsidize two current tunnel projects, in Sydney and Melbourne.

Risk reduces because extra cash flows from existing high-quality assets are highly certain. Additionally, these subsidies mean tolls on the new tunnels are set at relatively low levels and thus traffic numbers are less likely to disappoint. It would be difficult for competitors to copy this strategy unless they also own toll roads in the same city.

Roads also benefit from being part of a network, as a new addition or an upgrade to part of the network can drive higher use of adjoining roads. However, new roads can also cannibalize traffic in some cases. In most of Transurban's markets, it owns stakes in multiple toll roads that join to form a motorway network.

A new addition to the network, whether built by Transurban, the government, or a competitor, can increase usage of Transurban's existing roads because new catchments gain improved access. Adding a new motorway connects a new area to all catchments serviced by the existing network.

This creates multiple new routes to different destinations, which should encourage more motorists to choose to use the network. Similarly, a road upgrade such as adding extra lanes can significantly improve travel times and attract more motorists, some of whom will use adjoining toll roads they would otherwise not have used to complete their journey.

In new markets, Transurban lacks competitive advantages in our opinion, particularly as large global investors typically have lower funding costs. Additionally, risk is elevated by entering less understood jurisdictions, as shown by its initially disappointing foray in the U.S. Fortunately, the firm has a large potential pipeline of developments in existing markets, and we don't expect new markets to be a major target for the foreseeable future.

CityLink was the company's highly successful foundation asset, providing a solid earnings base to expand into Sydney via acquisitions and developments. As early pioneers, these roads generate strong returns on investment because of limited competition in the bidding process and few data points for the government in negotiating tolls and concession lives.

Additionally, these early motorways were compelling additions to road networks, being long, surface roads forming the backbone of Melbourne's and Sydney's motorway networks. The Brisbane assets are also of high quality, but returns are lower because of their high acquisition price. Organic expansion, such as widening motorways, generates good returns from higher traffic volumes, toll increases, and concession extensions, with flow-on benefits for traffic volumes on connecting motorways also owned by Transurban.

U.S. assets are located in and around Washington, D.C. Concessions in the U.S. are extremely long, at 75 years or more. Given improved performance of U.S. assets, further developments in the area are likely. The firm is also looking for development opportunities in Montreal after buying a toll road there recently, and may look to enter one more North American market.

There are also major greenfield opportunities in the company's core Australian markets. While the projects themselves are not particularly attractive, as tunnels often struggle to become financially viable, the firm can negotiate toll increases and concession extensions on existing assets to help funding, thereby reducing its reliance on achieving highly uncertain traffic forecasts on new roads.

In late 2015, Transurban began construction on a tunnel linking the Sydney-Newcastle freeway to Sydney’s orbital network, known as NorthConnex. The tunnel should feed traffic onto the firm's other Sydney roads, particularly the M2, the M7, and Lane Cove Tunnel--a meaningful synergy. Traffic volumes in the tunnel may disappoint but cross-subsidies from extending concessions and increasing truck tolls on other roads should ensure Transurban achieves a reasonable return from the project. The West Gate Tunnel project in Melbourne is being funded in a similar way.

Transurban's environmental, social, and governance, or ESG, risk is relatively low and does not impact our view of its moat rating.