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Although inflation has been trending downwards in the US, last month’s inflation print in Australia saw an uptick in CPI growth from 6.9% to 7.3%. This serves as a reminder of the resilience of inflation in the current macroeconomic and structural environment. Although we still have faith in the ability of central banks such as the Reserve Bank of Australia (RBA) to tackle inflation, it may take some time. With this in mind, we are still focusing on companies that demonstrate inflation pass-through characteristics.
One area we like is toll roads. Toll roads are typically heavily regulated assets, operating under a concession agreement. This is a contract that stipulates when the concession agreement terminates and the basis on which tolls will increase. The basis for these toll increases is usually inflation-linked, which ensures the toll road operator’s cash flows and bottom line aren’t impacted by inflation. Whilst the most well-known toll road operator on the ASX is Transurban (ASX: TCL), we have taken a liking to Atlas Arteria (ASX: ALX). Atlas Arteria has much lower debt levels than Transurban on the balance sheet which is something we prefer in a high interest rate environment. Furthermore, we are more comfortable with its valuation, with ALX price-to-earnings (P/E) trading at around 22x.
Atlas Arteria operates toll roads including APRR (Autoroutes Paris-Rhin-Rhone) and ADELAC in eastern France, the Warnow Tunnel in Germany, and the Chicago Skyway and Dulles Greenway in the US. ALX’s revenue is primarily sourced from its 31.14% stake in the APRR toll road. Furthermore, its 66.67% stake in the Chicago Skyway was recently acquired, which has a very long concession out to 2104, as well as inflation-linked revenue uplift.
Toll road price increases at APRR are set to 70% of French CPI. Whilst other companies are faced with the prospect of having their margins crimped by inflation or raising prices at the risk of losing customers, ALX will see government-regulated price increases. Given the inelastic demand profile of toll roads, especially one as well positioned and high quality as APRR, ALX will be partially covered for inflation whilst not expecting to experience a noticeable drop in demand. Furthermore, any additional capital expenditure requirements, such as adding extra lanes, are negotiated with the government for a return. This includes further increases to tolls or a concession extension.
Inflation hedge aside, toll roads demonstrate many other characteristics that we prefer to see in an investment in current market conditions. Most notably are their stable and defensive earnings profiles. Toll roads are effectively ‘cash cows’ after construction has completed. There is limited capital expenditure for upkeep as toll roads continually bring in cash, particularly as there is limited competition due to high barriers to entry. They also tend to pay out a significant portion of their cash flow as dividends to shareholders. Furthermore, toll roads are highly regulated, so once a toll road is constructed, it has little to no competition in the same area to take away from its revenue. Meanwhile, people continue to drive on roads throughout the economic cycle, all making for a defensive earnings profile.
ALX demonstrates all these characteristics. In addition, they have high quality assets, particularly APPR. APRR is one of the largest toll road networks in Europe, connecting major cities, including Paris and Lyon. Significantly, it is a vital transportation corridor for Western European trade. Compared to non-toll alternatives, APRR saves drivers approximately two hours, or 30%, of their driving time. With such a drastic time reduction in a fast-paced world, for most people the benefit of paying the toll outweighs driving the longer distance for free, particularly when you factor in that more fuel will typically be used on non-tolled alternatives.
This gives APRR a strong base level of demand. Furthermore, APRR enjoys a monopolistic position among toll roads in the area due to the high initial investment costs required to build an alternative toll route. It just isn’t economically feasible to make such a huge investment in order to capture just a share of the market, so prospective toll road projects would be directed towards areas that lack a toll road.
It is no surprise that there has been takeover interest, with IFM Investors previously considering a takeover bid until ALX’s management sought to make this difficult. This is because the board of ALX recognises the value of its assets, and likely didn’t think a takeover would appropriately demonstrate the true long-term value that ALX has.
In essence, quality assets with a recurring revenue stream, relatively inelastic demand profiles, and inflation-linked revenue uplift are characteristics we are looking to have exposure to in 2023. With dividends forecasted to grow and a forward dividend yield of over 5%, we believe that ALX is a high-quality defensive yield stock to invest in and is something to hold onto.
