Is Transurban another expensive yield trap?

Chief Investment Officer and founder of Aitken Investment Management
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With Telstra (TLS) shares crashing to $2.78 and Ramsay Healthcare (RHC) under $58.00 and down 25% since August 2017, it does remind you that not all “defensive” stocks prove defensive in share price terms.

I am particularly bearish on Australian listed ‘defensive’ stocks in general. I think REITs and hospital stocks, in particular, look overvalued, and I also continue to believe pure infrastructure stocks are potentially wildly overvalued, especially as interest rates rise.

My views on interest rates, bond yields and inflation are well known. I think they will rise faster than expected in the second half of 2018, as full employment drives wage rises. If that proves right, it will pull the rug from beneath overvalued “defensive” stocks and also bring an end to the so-called “yield trade”. The yield trade basically means buying any equity with a decent short-term dividend yield due to the alternative in cash and fixed interest being so low.

In reality, you’re meant to buy equities for capital growth and bonds for yield. Over the last seven years, due to highly unconventional central bank policy, investors were forced to buy equities for yield/income.

However, as cash rates and fixed interest rates rise, the marginal demand for equity dividend yield will fall. As you can see in the Telstra example, if the market also believes your dividend is at risk, the share price damage can be catastrophic.

What is defensive and safe really?

If you’ve gone down with Andy Penn’s Telstra ship, and the vast bulk of Australian SMSFs have, then you should be thinking about the other stocks in your portfolio that you thought were ‘defensive’ and ‘safe’. They may not prove to be in the new interest rate environment we are entering.

Last week I wrote I wouldn’t be buying Australian banks, Telstra or AMP because their earnings are still being revised down. Bank earnings were again cut -5% by Morgan Stanley earlier this week. I also strongly believe most Australian SMSFs are already way too exposed to those stocks and DO NOT need more of them. However, I did NOT say to sell your banks, Telstra or AMP. I said you don’t need more of them. I believe you need to diversify by country, sector and currency, but also remove Australian stocks from your portfolio that have potentially large capital loss risks in the years ahead.

The funny thing is when you warn on a well-owned and loved Australian stock, the response from SMSFs is something akin to criticising their favourite child. It generates a very heated response, but in my time in writing equity strategy, I’ve often found the most violent reactions to ideas, both buy and sell, were actually the best ideas.

Take a recent example of being cautious/short Ramsay Healthcare (RHC). The stock has lost close to 25% of its value, and now we are seeing analysts starting to downgrade. However, at the time, the pushback to my cautious/short RHC idea was extreme.

I got quite a similar response in recent weeks that Sydney Airport (SYD) could fall -20% in the years ahead. Time will tell if caution is warranted on SYD but being cautious on very expensive stocks is a good place to start.

Transurban sell? 

On that basis, it was very interesting to see Citi Research initiate coverage on Transurban Group (TCL) with a sell recommendation this week. Yes, an investment bank used the “S” word on a leading Australian stock. They also set a 12 month’s price target of $10.52, around 11% below the current share price.

The summary of Citi’s view on Transurban is all based on the sustainability of the distribution payout ratio. Below I’ve reproduced the front page of the Citi Research report on Transurban.

Transurban Group (TCL.AX) Is the payout ratio sustainable?

  • Initiate at Sell; PT A$10.52; Mounting pressure on the payout ratio. TCL currently distributes 100% of free cash flow and we believe this is unlikely to continue beyond FY20. We forecast a reduction in TCL’s FY20 payout ratio to 90%, 87% in FY21 before stabilizing in FY22. This has resulted in our FY20 DPS forecast -7% below consensus.
  • Three factors driving our view on TCL’s payout ratio. #1 TCL has already levered the balance sheet – Net debt to equity has increased from 96% as at 30 June 2011, to a record high 220% as at 30 June 2017, while net debt to EBITDA increased from 5.0 times to 7.6 times over the same period. #2 Interest coverage has remained relatively low despite a 190 basis point reduction in debt costs and #3 TCL is committed to a A$6.3 billion development pipeline, which is yet to be funded, and could add further pressure to the balance sheet and credit metrics, particularly if interest rates increase as expected. 
  • Growth in net debt has outpaced DPS growth 2:1. From FY12 to FY17 TCL has delivered a strong 12% DPS CAGR, but net debt over the same period increased from A$4.2bn to A$12.8bn, or 25% p.a. Given our view that balance sheet pressure is mounting, we anticipate TCL’s future DPS growth profile is unlikely to benefit from the same degree of financial leverage, and either increased equity funding or a payout ratio cut could be required, both scenarios are likely to result in DPS growth disappointment.  
  • Where are we different? Our Sell rating is the only one on the street and our FY20E DPS is -7% below consensus as we forecast a reduction in the payout ratio. Our FY19 and FY20 EBITDA forecasts are -1% and -2% below consensus.
  • Risks to our view. Winning WestConnex could be materially positive and a lower for (even) longer interest rate environment could push out potential balance sheet and payout ratio concerns. 
  • Our $10.52 price target is a 50/50 blend of our DCF ($11.32) and EBITDA multiple ($9.72) approaches. Our DCF assumptions include a 5% risk free rate for Aus (and 3% for US), 5% market risk premium, asset betas in the range of 0.3-0.7 and equity betas in the range of 0.4-0.8.

While I absolutely acknowledge that Transurban has a wonderful suite of monopoly toll-road assets, it is interesting that the ACCC may well have now ruled out any further major acquisitions for them in Australia by looking into their proposed WestConnex bid.

However, on 56.8 times FY19 earnings with negative 22% EPS growth, you could hardly argue that TCL is priced “defensively”. With analysts now starting to question the sustainability of high distribution payout ratios, I expect to see TCL shares de-rated in the months ahead.

From a technical perspective, TCL recently bounced back to the 200-day MVA (moving average) but couldn’t exceed it, a classic example of a stock that is now entering a downtrend cycle.

So the question becomes: Is Transurban an expensive “yield trap”? It’s certainly not as clear a yield trap as Telstra, but I agree with Citi Research that the capital loss risks far outweigh the short-term attractions of the current distribution yield.

I think it’s prudent to be cautious on Transurban at current prices and I remain strongly of the view that the biggest capital loss risks lie in perceived defensive sectors in Australia that will not prove defensive in share price terms.

Don’t get me wrong, I still think there are plenty of stocks to own on the ASX, but the vast bulk of them are NOT defensives or high yield plays.

My focus is only companies that are structurally growing their revenue and profits. That then leads to dividend growth. The dividend is an output, not an input, and should NEVER be the sole reason you buy a stock.

Unsustainable dividends/distributions are dangerous. Extremely high dividend payout ratios are also dangerous. Just look at the Telstra example. If the yield looks too good to be true, it most likely is a mirage.

Next week I’ll cheer you all up with a stock I like. 

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 regard to your circumstances.

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