Infrastructure investment following the GFC

Geoff Frankish takes a fresh look at Australian infrastructure and investor sentiment since the global financial crisis.

Easy credit conditions leading up to the global financial crisis (GFC) created a bias towards more leverage. Paying distributions above underlying cash flows, for example, became commonplace.

With hindsight, strategies like these no longer appear sustainable and investors are increasingly sensitive to high levels of leverage.

Investors are now raising questions about the merits of infrastructure investment, and justifiably so.

The asset class is characterised by high levels of gearing and large capital requirements. Investors were, however, attracted to the sector for its underlying earnings certainty and resilience to prevailing economic conditions.

These defensive attributes have been put to the test over the course of the GFC, but just how well did they fare?

Research conducted by Goldman Sachs Asset Management reveals the performance of these underlying characteristics and provides some insight into the investment outlook for Australian listed infrastructure.

One compelling attribute of infrastructure investment is earnings certainty. As providers of essential services, infrastructure assets should reflect resilient demand in economic weakness. Resilient demand combined with monopoly-like positions should in turn lead to strong pricing power.

The recent GFC provided an excellent opportunity to test this hypothesis empirically. So how did the results stack up?

In an environment where earnings before interest, tax, depreciation and amortisation (EBITDA) for the S&P/ASX 200 declined by 7.5 per cent, infrastructure stocks achieved a 6 per cent increase and utilities a 0.3 per cent increase.

When we delved deeper into the numbers on an asset-by-asset basis, the general theme was that volumes were only modestly affected by the economic weakness.

Revenue was higher, demonstrating strong pricing power, and earnings grew even faster, showing a combination of operating leverage and cost control. So the empirical results from this gave an overwhelming tick to the earnings resilience of these assets.

The severe constraints on credit markets that were characteristic of the GFC were clearly a challenge for industries with a high proportion of debt in the capital structure, like infrastructure.

Across the board, de-gearing was taking place through distribution cuts, equity raisings and, to a lesser extent, asset sales.

This phenomenon was not confined to infrastructure stocks but was evident across all forms of equities.

On a benchmark weighted basis, proportionate gearing across the sector fell from 56 per cent in June 2008 to 40 per cent in March 2010.

Likewise, Net Debt/EBITDA fell from 7.4x to 4.5x. And this de-gearing process resulted in substantially improved balance sheets.

Investors are attracted to infrastructure investments because of their strong yield. Distribution shaving did result in a decrease in yield for the sector, however, the current yield, at approximately 5.2 per cent, remains comparatively attractive and is also accompanied by tax benefits.

Approximately half of the distributions from the sector are tax effective in the form of either franked dividends or tax deferred distributions.

Our estimates suggest that this could be worth as much as an additional 0.7 per cent per annum to domestic investors, a benefit that does not accrue in offshore infrastructure.

Thanks to the substantial de-gearing across the sector, we believe that the risk of further significant cuts to distributions is modest, and the sector is poised to return to an environment of distribution growth.

As the economy returns to a growth trajectory, concerns about inflation tend to follow suit. Now that inflation appears to have troughed at levels well above those thought possible in the depths of the financial crisis, the Reserve Bank has already moved to increase interest rates from their lows.

Infrastructure assets tend to have revenue that is linked to inflation, either through regulation or written into contracts directly.

As such, these assets have an excellent natural hedge to elevated inflation for long-term investors who are worried about their future purchasing power, particularly superannuation investors.

Another question that is sometimes asked is whether growth in listed infrastructure investments is just a fad or whether growth opportunities remain.

In our view, the answer is an emphatic yes. Governments are facing tighter budgetary constraints after boosting spending to stimulate the economy.

We are now witnessing further privatisations, such as NSW electricity retailers and Queensland Motorways, as well as an increased propensity to turn to private sector funding for new projects.

In addition, environmental legislation is likely to lead to substantial investment in renewable electricity generation and boost investment in transmission.

While unlisted investors will also play a role in financing the huge amount of investment required, it is likely that the listed market will fund a substantial portion.

The listed infrastructure sector has demonstrated earnings resilience through unprecedented market conditions, has de-geared balance sheets, retains an attractive tax-effective yield with a natural hedge to inflation and growth opportunities are evident.

Now, more than ever, the Australian listed infrastructure sector is poised to deliver on the characteristics that can enhance an investor’s portfolio. 

Geoff Frankish is head of infrastructure for Goldman Sachs Asset Management.