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Morningstar | Transurban's Traffic Growth Is Slowing Faster Than Expected; Trimming FVE to AUD 11

Traffic growth was fairly soft in most markets in the September quarter 2018. Slowing growth appears to be more than just related to roadworks and other one-offs. Some assets are maturing faster than expected while others are likely impacted by cost of living pressures, leading us to downgrade our medium-term growth expectations modestly. We trim our fair value estimate 4% to AUD 11. At the current price, the stock is fairly valued. The firm's wide moat rating remains intact. We also adjust forecasts to consolidate the M5 from fiscal 2019 as Transurban is now the majority owner, though this doesn’t impact our valuation. The M5 was previously equity accounted.

Melbourne was the strongest performer, benefiting from completion of recent upgrades on CityLink and feeder routes. Traffic volumes increased an impressive 5.5% in the quarter, and strong growth should continue for at least a couple more quarters. The CityLink Tulla widening is essentially complete, including the state's section, with an extra lane in each direction between Melbourne Airport and the CBD. The Monash Freeway upgrade has also completed while the large West Gate Tunnel project is on track to complete in 2022.

Sydney traffic growth in the September quarter was solid, though weaker than expected at 2.5%. To put in perspective, growth was more than 3% in fiscal 2017 and 2018, and more than 7% in 2015 and 2016 after major road upgrades. Cost of living pressures, including higher mortgage rates, higher fuel prices, higher insurance premiums, higher utility bills, and of course, higher motorway tolls, combined with a negative wealth effect from falling house prices may be starting to hurt demand. NorthConnex is progressing, with completion likely in 2020 despite minor delays. The massive WestConnex project continues, and Transurban bought another 7.15% of the M5, which will bring its total ownership to 65.39%.

U.S. roads were weakest and below our expectations. Traffic volumes fell 0.4% on the 95 Express Lanes and fell 1.2% on the 495 Express Lanes. Even backing out the impact of Hurricane Florence, which we understand detracted around 0.8% from growth, the results are disappointing. Average tolls also disappointed on the 95 Express Lanes, with an increase of just 0.9%. Toll increases on the 495 were better at 3.2%.

Revenue grew quickly at the U.S. Express Lanes after opening, driven by strong growth in both traffic volumes and average tolls. For example, the 495 grew toll revenue at a compound annual rate of 25% during the past five years. Now revenue growth has slowed dramatically--a continuation of the September quarter trend would suggest mid-single digits at best in fiscal 2019. The express lanes, which are extra tolled lanes added to existing freeways, have matured quicker than Transurban's traditional roads, and quicker than we expected. We downgrade our near-term revenue growth forecasts for both to mid-single digits from high-single digits. Nonetheless, the firm is generating good returns from these roads and we look forward to more developments in the greater Washington area. The 395 Express Lanes project is on track for completion in late 2019, and Transurban is well placed to win the Fredericksburg Extension deal. Further projects are likely in this highly congested area. In Montreal, the newly acquired A25 recorded traffic growth of 7.5%, beating expectations.

Our main concern is that Transurban is expanding too aggressively late in the cycle. With so many current and potential developments in existing markets, where the firm should generate good risk-adjusted returns, we'd prefer Transurban stopped buying more, expensive roads. Too many expensive acquisitions will sap financial strength and dilute returns.