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Morningstar | Corporate Action: Take Up Entitlements to Fund Transurban's 25.5% WestConnex Stake

Wide-moat Transurban is raising AUD 4.8 billion in equity to fund its successful bid for a stake in WestConnex in Sydney. We remain comfortable with our AUD 11.50 fair value estimate. The 10 for 57 entitlement offer price of AUD 10.80 represents a 6% discount to our valuation and a 9% discount to the theoretical ex-rights price. We believe the equity raising is decent value and recommend taking up entitlements as long as it is in line with your investment goals. Investors need to be quick if they want to partake as the retail offer opens Sept. 7 and closes Sept. 18, 2018.

Transurban, with its consortium partners, bought 51% of the strategically important road tunnel project from the NSW Government for AUD 9.4 billion, including transaction costs. Transurban owns 50% of the consortium and will operate the roads. The purchase price is substantially above government and market expectations and is based on Transurban's rosier view of long-term Sydney traffic growth. The acquisition is fully funded by equity, reducing risk but causing dilution in the medium term.

It is impossible to asses whether Transurban is paying a fair price given most of the roads haven't been built yet and financial details are very limited. While Transurban may have overpaid, we don't think there's any material risk of the project going bankrupt because it is conservatively funded and comprises major arterial routes with well-established traffic demand. We also gain comfort from management's mostly good long-term track record of value-enhancing expansion.

Fiscal 2019 distribution guidance of AUD 59 cents per security is unchanged, with management targeting mid-single-digit growth in 2020. However, distributions are unlikely to be covered by underlying free cash flows for the medium term because of equity dilution. Fiscal 2018 distributions were close to 100% of free cash flows, and the equity raising will dilute free cash flow by around 20%.

WestConnex cash flows will ramp up over time as stages complete, with fiscal 2028 the first full year of earnings from all assets. In addition to contributing earnings, we expect WestConnex to take on higher gearing after the roads open, allowing capital returns to Transurban and other investors.

While there's uncertainty over the value of WestConnex, there's no denying these are high-quality assets. Once all stages complete, WestConnex will comprise the M4, the M5, and easterly extensions of these motorways, including a tunnel linking them. In addition, there will be a link, known as the Rozelle Interchange, to the Anzac Bridge and the planned Western Harbour Tunnel. These are congested traffic corridors with relatively strong population growth.

Cash flows will step up as each stage completes. Currently, cash flows will come solely from the recently widened M4. From late fiscal 2019, the M4 easterly extension will open to traffic and start contributing toll revenue, followed by the M5 easterly extensions in mid fiscal 2021. Late fiscal 2023 will see the tunnel linking the M4 and M5 open, followed by the Rozelle Interchange in early fiscal 2025. The M5, which is currently part-owned by Transurban, will be included in WestConnex after its current concession ends in December 2026. Tolls will be based on distance traveled, and will escalate at the greater of CPI or 4% per year to 2040, and at the greater of CPI or 0% per year thereafter until concessions end in 2060.

In fiscal 2028, management believes WestConnex Stage 1, comprising the M4 and its easterly extension, will contribute 37% of WestConnex revenue, Stage 2, comprising the easterly extensions of the M5, will contribute 22% of revenue, Stage 3, comprising the M4-M5 link and Rozelle Interchange will contribute 16% of revenue and the M5 will contribute 25% of revenue. Further, Transurban believes EBITDA margins will be similar to its Sydney network's current margins of 81%, which seems realistic given the mix of open roads and tunnels.

Construction of the entire project is estimated to cost AUD 16.8 billion, with AUD 5 billion left to spend. This will be funded by the government, WestConnex debt and a small equity contribution from Transurban and its consortium partners. Transurban's share of the equity contribution is AUD 350 million. After the acquisition completes, WestConnex will hold AUD 6.5 billion in non-recourse debt, increasing to AUD 8.2 billion at construction end.

Loyal investors who partook of the late 2017 equity raising to help fund the West Gate Tunnel project may be frustrated that the firm is now raising equity at a price 5% lower. With a focus on expansion and plenty of opportunities in Australia and North America, the risk of more equity raisings at potentially lower prices remains.