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Morningstar | Tax Cuts and Interest Rates, More Than Revenue Growth, are Driving Earnings; Atlas is Overvalued

Like most income stocks, narrow-moat Atlas Arteria is overvalued on a long-term view. From the January lows, Atlas’s security price is up 30%. Further upside is possible if global bond yields continue to fall, with central banks increasingly dovish. However, yields on 10-year French government bonds are already at zero, after falling from 1% a year ago as investors bet the new head of the European Central Bank, Christine Lagarde, restarts the money printing presses with a new round of quantitative easing. With inflation hovering at about 1%, investors in French government bonds are accepting negative inflation-adjusted returns. We believe this is unsustainable and continue to expect bond yields to normalise over the long term. This eventual retracement will detract from income stocks. Despite being overvalued, Atlas is a good quality firm, owning a 25% stake in a major French motorway network, known as APRR. APRR’s relatively short concession life of 16 years precludes a wide moat.

We upgrade our fair value estimate 5% to AUD 6 per share after lowering medium-term assumptions for French interest rates. At current prices close to AUD 8, we consider the stock substantially overvalued. At the end of concessions, motorways are handed to the government for no consideration and after repaying all debt. The requirement to repay debt and the short life mean Atlas is more expensive than it appears, based purely on current free cash flow and distribution yields. The main difference between our view and that of the market is likely our assumption that interest rates rise over the medium term and our scepticism over how far French corporate tax rates will fall. These two factors are key earnings drivers for Atlas.

Atlas Arteria’s new internal management is focused on growing the business and extending average concession length. While growth by acquisitions, particularly in the current hot market can be a definite way to lose money, we like Atlas’s focus on opportunities adjacent to existing assets. By leveraging existing operations, the firm has a good chance of generating excess returns. One such project is the upgrade of 90 kilometres of roads in the Allier region in France to motorway standards under a 48-year concession to 2067. APRR and its consortium partners are preferred bidders for the EUR 500 million project, which is subject to negotiations. However, considering APRR has assets of EUR 8.2 billion, this project is too small to move the dial.

Traffic growth at Atlas’s underlying motorways has been mixed. Core asset APRR was a solid performer in 2018, with traffic up 2.2%. The March-quarter 2019 was significantly weaker, with traffic rising just 0.1% compared with the same quarter in 2018. APRR contributes 85% of proportionate EBITDA, and neighbouring ADELAC motorway contributes 2%. Interestingly, in 2018 and so far in 2019, truck usage has grown more strongly than cars. Truck volumes rose 4.7% in 2018 and 2.2% in first-quarter 2019, while car trips grew 1.7% in 2018 and fell 0.4% in first-quarter 2019. Car traffic growth was hurt by the yellow-vest protests and economic issues such as a plateau in disposable income and tourism, while truck traffic volumes are benefiting from a strong growth in imports. This slant toward trucks helps APRR’s revenue as trucks pay higher tolls, although this can cause higher maintenance costs because of greater wear and tear on roads.

APRR revenue growth was strong in 2018 at 4.7%, but softened in first-quarter 2019, rising just 2.4%. Tolls increased 1.8% in February, supporting expectations for moderate revenue growth in 2019. Besides being able to leverage fixed costs, earnings should benefit from lower tax and interest rates. During the next five years, we forecast APRR’s net income to grow at an annual average rate of 6%. Growth will be even higher if French corporate tax cuts are as much as currently planned, although we are sceptical the government will continue to support big business long-term given its unpopularity. The yellow-vest protests were prompted by fuel taxes hurting the poor, particularly in rural areas, at the same time as plans were put in place to progressively cut the effective corporate tax rate from 39.4% in 2018 to 25.8% in 2022.

Dulles Greenway in the United States has been a poor performer recently, with traffic falling 4.5% in 2018 and 1.9% in March-quarter 2019. Greenway contributes 11% of proportionate EBITDA. Traffic has been hurt by upgrades to nontolled competing routes, the U.S. Federal Government shutdown and major snowstorms. Additionally, tolls on the Dulles Toll Road, which Greenway feeds directly into, increased 30% at the main toll plaza and 50% for on- and off-ramps in January 2019. This likely diverted more traffic to competing routes. Tolls on Greenway increased 2.9% in April, which should help revenue improve through the rest of 2019. Increasing congestion on competing routes should drive better performance at Greenway over the longer term, though upgrades to public transport is a key threat.

Atlas was negotiating a restructure of Greenway’s toll schedule, which would have seen tolls lowered for short trips in exchange for greater certainty over toll price increases through to concession end in 2056. But negotiations broke down and Atlas must continue to apply to the regulator every five years for toll increases.

Greenway is highly geared--net debt/EBITDA or 11 times--and operating performance is subpar. Lenders have blocked it from paying dividends until credit metrics improve, with all free cash flow kept within the business. We forecast earnings should improve as traffic volumes recover and because of ongoing toll increases, helping credit metrics exceed lock-up levels and allowing Greenway to start paying dividends from 2021.

Atlas’s other asset, Warnow Tunnel in Germany, has grown strongly recently, with revenue increasing 13% in 2018 and 15% in first-quarter 2019 because of roadworks on competing routes. Once roadworks are completed, traffic and revenue are likely to subside. Regardless, Warnow is too small and highly geared to matter. It contributes just 1% of proportionate EBITDA and net debt/EBITDA is very aggressive at 15 times. We attribute no equity value to this asset.