Twelve months ago I highlighted Transurban as a company with an attractive, sustainable dividend profile. The two key planks to the thesis were high cash operating margins and double-digit operating cash flow growth over the next three years as development projects come online. This resulted in a good starting yield of about 5% with solid long-term growth. I also noted that near-term distribution growth would be diluted from the Westconnex transaction.

Transurban has since returned over 40% including dividends, so Livewire recently got in touch and asked me to provide an update on my thesis, and identify another company with a sustainable dividend.

How has the thesis played out?

Consensus dividend expectations have been stable for FY19 and FY20, suggesting Transurban has delivered on our expectations of divided sustainability.

The share price has done well, increasing by a bit under 25% while the index is up closer to 8%. So, has it played out exactly as we expected? Well, yes and no.

Apart from the dividend story, we owned Transurban because we thought it was attractively valued on a long-term basis. But is that why the share price went up?

It is clear that the change in interest rate expectations in early 2019 and the RBA cuts more recently put a rocket under the Transurban share price. While we did express the view last year that rates could face downwards pressures, that was not the core of the thesis for Transurban. As bottom-up, fundamental investors, we buy companies that are attractively priced without necessarily trying to work out when or why a share price may rise.

In our 20-year history, we have had investments “come good” for a whole range of reasons that were not necessarily predicted at the time. Our Transurban investment fits that pattern nicely.

The road ahead for Transurban

Our view of Transurban as a business is pretty much the same as it was 12 months ago. Not much has changed in terms of Transurban’s asset base, capital structure or earnings outlook and neither has our valuation. However, what has clearly changed is the share price. A starting yield of 5% a year ago is now closer to 4% today. At the risk of stating the obvious, this means that someone buying Transurban today is not going to make the same return as someone who bought 12 months ago.

An opportunity for double-digit dividend growth

I'll stick with the toll road theme and nominate Atlas Arteria (ASX:ALX). The company’s key asset is an effective 25% stake in the APRR toll road network in France, with ownership in three other roads in Virginia (Dulles Greenway), Geneva (ADELAC) and Rostok, Germany (Warnow). The Atlas Arteria share price is near all-time highs and the forward dividend yield is in line with Transurban at about 4%, so what is so exciting?

In recent history, there have been several events that have led us to materially increase our valuation for APRR. These include a reduction in the French corporate tax rate, better traffic than expected, as well as value-adding capex on the network as part of a ‘stimulus package’.

In terms of the future, we expect dividend per share (DPS) growth well into the double digits for the next few years even on our conservative assumptions. These include traffic growth at the key APRR asset more than halving from current levels, no more value-adding capex projects at APRR which have been a consistent feature through history, two more years of negative traffic growth for Dulles Greenway (the second largest asset value wise) meaning it remains in equity lock up until 2024, and lastly the repayment of debt rather than refinancing as maturities come due.

It is quite feasible that reality will turn out more positive than our assumptions. This means that all else equal, we will need to further increase our dividend expectations and valuation.

There are risks to every thesis, and one here is clearly the political and economic reality in Europe, which could impact APRR. We take comfort from the fact that APRR showed positive EBITDA growth in the wake of the GFC and the “European crisis” that followed. APRR is a high quality asset.

Atlas Arteria is now a “normal company” having ended the management relationship with Macquarie Bank, but there are some remaining complexities further down the structure closer to the assets. Without straying too far into the weeds, it is worth mentioning that if these are resolved, APRR could hold a lot of appeal for a corporate, sovereign wealth fund or pension plan.

When discussing Transurban, I mentioned that we do not require a specific catalyst in order to find an investment case compelling. That is true. However, if our value for Atlas Arteria is realised through M+A activity we would not be completely surprised.

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