I have spent some time today working out the impact of this...

I have spent some time today working out the impact of this newly announced WGT deal on the fundamental value of TCL’s securities, for the following reasons:

1) To decide whether I want to participate in the Entitlement Offer and
2) To determine at what price I’d be prepared to further increase my holding in TCL (which already represents a hefty 8.5% of my investable capital).

First of all, when it comes to valuation, there is the non-obvious fact that a 10-year extension (to 2045) of the CityLink concession is included as part of the deal, which by itself adds some 3.7bn A$ in PV terms to the value of the Company, according to my calculations. It could be argued, though, that the market was already expecting an extension of the concession in that order of magnitude, and therefore it was already priced in.

So, under the assumption of a 10-year extension of the CityLink, what I wanted to compare was the difference in PV between my base case (for modelling purposes) of a fully debt-funded deal with no change to the toll escalation schedule (i.e. plain indexation to CPI from 2017 to 2045) and the deal that has just been announced, namely 1.9bn A$ of equity funding with new shares issued at 11.40A$, and with 4.25% pa toll escalation between 2019 and 2029 (between 2022 and 2029 for the WGT component).

While the 4.25% pa toll escalation is FCF-accretive (at the current implied level of long-term break-even inflation, which is 2.41% pa), the issuance of new securities is FCF-dilutive; therefore, it is not immediately obvious whether the PV per share of all the existing concessions is affected positively or negatively as a net result.

I started with an overall underlying FCF assumption of 1.40bn A$ for FY2020, which corresponds roughly to 10% pa underlying FCF growth between FY2017 and FY2020 (as a result of new project pipeline coming into play), constant revenue growth thereafter, and solved for the discount rate R that gives:

[PV of all future Revenues minus Costs] = [Market Cap] + [Net Debt] + [Future Funding]

In other words, I calculated the rate R that present valued all future cashflows to the last traded price of 12.00A$/share (ex-dividend), without factoring in the new issuance of shares (i.e. counting the whole cost of the WGT under Future Funding) and the change to the toll escalation schedule of CityLink+WGT.

R is obviously a function of the terminal revenue growth rate assumption; for instance, if I assume a terminal revenue growth rate equal to the current long-term break-even inflation rate of 2.41% pa (i.e. zero terminal real growth), I see R = 5.29%, whereas if I add a 3.00% pa terminal traffic growth (in line with the historical trend) I get R = 7.98%. Whichever assumption is made doesn’t really matter, though, because what I wanted to calculate at this stage was a PV difference, not an absolute level.

Then, I repeated the same PV calculation with the discount rate R previously identified, but also factoring in

a) The 4.25% pa escalation between 2019 and 2029 on the Citylink+WGT toll revenue
b) An addition of 1.9bn/11.40 = 0.167bn to the total number of outstanding shares (and a subtraction of 1.9bn A$ from Future Funding)

That gave me a new PV per share of 12.95A$, i.e. a value accretion of 0.95A$/share, or +7.90%.
Therefore, I see this deal as being significantly value-accretive for TCL security holders, on a net basis.

Then I calculated the implied IRR at the Entitlement Offer price of 11.40A$/share. Under the assumptions of 1.40bn A$ FY2020 FCF, 2.41% LT break-even inflation, and 3.00% pa terminal traffic growth, I see an IRR of 8.54% pa at 11.40A$/share, which looks egregiously attractive to me for this type of business, on a risk-weighted basis. I am therefore going to fully participate in the Entitlement Offer.

In actual fact, I see anything corresponding to an IRR above 8.00% pa (corresponding to a purchase price of 12.89A$ ex-dividend, according to my calculation) as being very attractive, so I suspect I will be adding further to my holdings over the next few days, perhaps up to 10% of my total investable capital.

From an underlying macro perspective (past and future direction of interest rates), I can’t help noticing that the back-end Australian real yield (corresponding to the 2040 indexed ACGB) has dropped from 1.04% (when I first bought into TCL in December 2016) to 0.69% as of today; while that may look like a big move, and a very low real yield to end up with, I am of the view (as the followers of my TCL posts may remember) that real yields will continue to drift lower (with some volatility, of course). Therefore this is an exposure that I do not mind keeping.

At any rate, even under a zero terminal real growth scenario, I see the spread between TCL’s IRR and the LT ACGB real yield as being big enough to provide the investor with a comfortable buffer. Which is why I see these securities as providing outstanding relative value vis-à-vis inflation-linked bonds, for the portion of investment portfolio that one wants to have hedged against lower real yields.

All IMHO & DYOR, hope this helps.

Cheers