Infrastructure: Updating forward interest and inflation rates

About the author:

Nathan Lead
Author name:
By Nathan Lead
Job title:
Senior Analyst
Date posted:
02 August 2022, 10:15 AM
Sectors Covered:
Infrastructure, Utilities

  • We update our forecast inflation and interest rate assumptions applied in our modelling following two successive quarters of high CPI readings and a sustained increase in market interest rates (last done in October 2021).
  • We downgrade Transurban (TCL) from ADD to HOLD. Aurizon (AZJ) and Dalrymple Bay Infrastructure (DBI) remain ADD. Consider taking profits from overweight positions in APA Group (APA).

Overview

Since late 2021, government bond yields (typically used as a proxy for risk-free rates (RFR)) have been volatile. From a yield of close to 1% a year ago, the 10 year Australian Government Bond surged to over 4% in June 2022 before retreating to close to 3% pa currently. This yield is broadly in-line with the 3% pa long-term risk-free rate we have been assuming in our modelling, so no immediate change required.

Furthermore, the higher risk-free rates can't be viewed in isolation. Other variables are moving alongside the change in RFR that also impact valuations (eg. risk premiums, cashflows, terminal value growth).

Increased inflation expectations (as well as CPI in 2022 that is far above the RBA's target band) are partly a driver of the increased RFR. Infrastructure assets are renowned for the linkage of their pricing/revenue to inflation. We factor the higher CPI outturn and expectations into our revenue/cost forecasts.

The increase in RFR has contributed to an upward shift in the interest rate swap curve, implying an increase in market expectations for forward interest rates. Infrastructure assets can typically carry relatively large debt loads while maintaining investment grade credit ratings.

Treasury policies (staggering of debt maturities, hedging/fixing of interest rates) and revenue drivers mitigate against immediate refinancing and interest rate risk. For each stock, we model their existing debt arrangements, and apply forward rate expectations to new debt.

Stock view updates

APA Group (APA) – Target price increased, mostly driven by higher CPI expectations (+42 cps), higher long term interest rates (-27 cps), assumed higher corporate costs and sustaining capex (-51 cps), and extended growth investment pipeline (+65cps). HOLD retained given defensive and inflation-linked nature of cashflows, but consider trimming overweight positions.

Atlas Arteria (ALX) – Standalone/BAU valuation increases, with higher CPI offset by higher interest rates and spot FX. Share price in short term will be influenced by IFM takeover uncertainty. Target price reduced, reflecting a mix of takeover and BAU valuations. HOLD retained.

Aurizon (AZJ) – Target price has increased, mainly as a result of valuation roll-forward (+6cps), higher forward CPI and interest rate expectations (+9 cps), lower sustaining capex (+23 cps), assumed coal haulage contract loss (-10 cps). Existing business is worth $4.46ps, but One Rail acquisition is 25 cps value destructive. ADD retained, given strong yield and valuation support.

Dalrymple Bay Infrastructure (DBI) – Target price unchanged, as a result of higher CPI (+11 cps) expectations and the uptick in long-term interest rates (-11 cps). Recent higher interest rates are unlikely to benefit price negotiations, as the current regulatory cycle started last July (so WACC elements will be back-dated to that time). ADD retained, given 20% TSR.

Transurban (TCL) – Target price has decreased, mainly as a result of higher CPI expectations (+48 cps) more than offset by higher long-term interest rates (-78 cps). Downgraded to HOLD from ADD.

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Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.

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