Investing in a toll road asset, how much to pay for it? (Part II)

In the first past of this post, I mentioned that toll road concessions in developed nations have been recently traded at EBITDA multiples of between 18 X and 36 X with an average value of 26X. The post argued that the valuation differences can be traced back to a set of key variables: the remining concession length, the stipulated toll adjustment mechanism as part of the concession agreement, the expected growth in traffic and the leverage levels achieved by the acquiring party. 카지노사이트

On this post, I will illustrate with real numbers how changes in these variables can materially increase or decrease the valuation multiples achieved by these assets. The first step in the analysis is to quantify the impact of increasing the length of the concession from a relative short one (20 years) to decidedly long period as the one observed in the US (up to 100 years). The Concession length is the most relevant variable as the impact of changes in all the other factors are augmented as we consider longer concession frames. This will be clear when we look at the numbers.

But before jumping into the numbers, a brief disclosure and explanation of all the key assumptions underlying the baseline case which will be then flexed to show the impact of modifying any of the other factors.

The Baseline

For the baseline, the following assumptions have been made:

• Traffic growth: A moderate growth rate in line with rates observed across developed nations. A 2.5% annual growth rate for the first five years, declining to 1.75% per annum over the following ten years, further reduced to 1.25% over the subsequent 10 years and flat at 0.65% per annum thereafter until the end of the concession. 안전한카지노사이트

• Road capacity constrains: no capacity constrains are assumed.

• Toll adjustment rate: Assumed to grow in line with inflation.

• OPEX: Assumed to grow in line with inflation plus a real growth element equivalent to 0.6 of each point of growth in traffic volumes.

• EBITDA margin: Assumed to start at 70% in line with the ratios observed across the industry. EBITDA margin is modelled to increase when traffic goes up and/ or toll fares are augmented in real terms. EBITDA margin is capped to not exceed 85% in the long term.

• CAPEX: Assumed that no major expansion works are required. CAPEX is only related to maintenance purposes and it is assumed to represent 7.5% of the revenue line. This number is based on the expenses incurred by large toll operators operating mature assets.

• Inflation: A flat 2% rate in line with long term inflation forecasts for developed nations.

• Taxes: A flat effective rate of 19%.

• Cost of Capital: An initial capital structured assumed to be comprised of 45% debt and 55% Equity, with a cost of debt of 3% and required capital return of 8% resulting in a WACC rate of 5.5%

Other caveats and elements to keep in mind:

• The capital structure has not been optimized to maximize equity returns.

• No refinance mechanism has been put in place.

• Debt repayment capacity has not been implicitly modelled but for the baseline capital structure, the debt metric ratings fall within a conservative envelop.

• However, when modelled long concession periods (+90 years) and increased the gearing levels, it is possible that the proposed capital structure may neither be achievable nor sustainable. 카지노사이트 추천

The concession length, a deal breaker!

The remining concession length is the most important factor behind the valuation multiple for a toll road as the impact of all the other variables augment with the length of concession. A short-length concession is expected to achieve a multiple in the region of the low tens between 11X to 15X.

Doubling the length of a concession, especially for relative short ones, it can have a material impact on the valuation multiples. In our baseline example, doubling the concession length from 20 to 40 years, increased its EBITDA multiple from 13X to 21X. An increment of more than 8 multiple points. The impact of increasing the concession length weakens over time as cash flows generated further out in time are discounted more intensively than early stage ones, especially when considering higher required capital return rates.

The chat below illustrates how very long-term concessions, even with rather conservative traffic, tolls and gearing assumptions, can reach multiples in excess of 30X.

The takeaway here is that when comparing the valuation of a toll road asset against previous or similar transactions, it is vital to factor in the differences in the remining concession lengths. Otherwise, the results of the comparison can be seriously misleading.

Traffic growth better get your forecast right!

The baseline case was developed to reflect traffic growth rates for developed markets with high motorization levels where traffic is generally driven by increments in population/ employment levels plus traffic switching from congested free roads to tolled alternatives. But would happen to the valuation metrics if traffic forecasts were more aggressive or more pessimist? To answer this question, I prepared one upside and one downside traffic case.

The underlying assumptions for each case are presented in the table below.

Neither the upside case is particularly aggressive, nor the downside is strongly pessimistic. However, the chart below will show how reductions/ increments in traffic growth rates of 1% in the early years and subsequent changes of even smaller magnitude (+- 0.75 to 0.25) can have a material impact on the valuation a toll road asset.

Increments (reductions) in traffic forecasts increase (reduce) valuation multiples between 1 and 3 units for concession periods ranging between 20 to 40 years. The differences augment to almost 6 multiple units when looking at 100-year concessions. These results have two main implications for investors:

• Toll roads with higher traffic growth potentially, for example, in urban congested areas like in proximities of Toronto in Canada, can achieve and deliver higher valuation metrics.

• Getting your traffic forecast right, or at least not utterly wrong, it is crucial to avoid overpaying for assets, especially when concession periods are rather long.

It is not uncommon to see, toll road assets being handled back to their lenders by investors, when overoptimistic traffic forecasts do not materialize, and the cash-flow generated by the assets are insufficient to serve their debt commitments. Again, the point here, is that it is utterly important to use reliable and well-grounded traffic forecasts and forecasters to avoid falling into these situations.

The Toll adjustment mechanism.

Not all toll road concessions are created equal, some offer the possibility to observe, though not guaranteed, depending on the development of certain macroeconomic variables, real fare increments such is the case at Chicago Skyway, Indiana Toll Road or Pocahontas Parkway. Others, limit toll fare adjustments to recent CPI variations, with some contracts including an additional hedge against exchange rate fluctuations like is the case in Autopista del Norte in Peru. The latter element is a highly desirable feature when investing in developing nations with important macroeconomic fluctuations.

The third possibility, and the less favourable for investors, it is to observe reduction in toll fare prices in real terms when fare adjustments are established below inflation rates. This was the case with the privatization of the toll road networks in France in the mid-2000s.

The toll adjustment mechanism can have a material impact on the valuation of a toll road. A favourable mechanism which enables toll fare increments can add substantial value to this kind of assets as it has been observed during the privatization of various US concessions and their subsequent market transactions. Furthermore, the uncertainty around the magnitude by which the toll fares can be increased is significantly lower than the variability around traffic forecasts. This means that toll adjustment mechanisms are important source of additional value for toll road assets with limited downward risk associated to it.

To quantify the impact of having the possibility to increase toll fares or to have reduce them in real terms, I prepared two additional scenarios.

For the upside case, I assumed a real annual increment of 1% over the first five year, subsequently reduced to 0.75% for the following ten years, then to 0.5% for the next ten years, and 0.25% from then until the end of the concession. While for the downside case, the reductions are implemented also in a stepwise manner, but the magnitude of the decline are about half of the values assumed for the upside the case.

The underlying assumptions for each case are presented in the table below.

The chart above shows how relatively modest increment in real toll fares can result in important uplifts in the valuation of toll road assets, adding about 1 to 4 multiple units in relatively short concessions (20 to 40 years) up to 6 or 7 units for extended ones (80 to 100 years). The impact for the downside is less significant but this is mostly due to the reductions assumed here are about half of the increments planned for the upside case. This was intentional as toll fare reductions in low inflation countries are expected to have a modest magnitude, at least, at present.

The key takeaway here for investors is that the toll adjustment mechanism can add significant value to a toll road asset while the additional risk of non-observing those increments is materially lower than potential traffic uplifts.

Gearing restrictions and the cost of capital.

Like any other business, the valuation of a toll road asset is given by its future cash flows discounted at an appropriate risk adjusted rate. The discount rate is the result of combining the required equity returns, the cost of borrowing external funds and the proposed capital structure. The allocation between debt and equity is generally optimized to maximize equity returns subject to gearing restrictions imposed by credit agencies to minimize the risk of credit defaults. For some toll road concessions, at it was the case of the privatization of the French toll road networks, additional restrictions on gearing levels are imposed as part of the concession agreement limiting debt levels to sub-optimal levels.

By limiting gearing levels, the cost of capital, all else equal, it is increased as debt costs are generally lower than equity ones. Higher costs of capital, in turn, reduce the valuation multiples by discounting more intensively future cash flows.

In this section, I will show the impact of taking the gearing levels from a modest 45%-55% debt / equity structure to a 55%-45% and 65%-35% ones. It should be noted these calculations are for illustration proposes, looking to point out the impact of imposing restrictions on gearing levels rather than suggesting optimal capital structures. In fact, neither a capital structure optimization was conducted nor the compliance with standards debt covenants was tested as part of this exercise.

Not surprisingly allowing for higher gearing levels result in much higher valuations. Extended concessions achieve much higher valuation than shorter ones and the cash flows in early may not be sufficient to sustain gearing levels in the range of 65% Debt – 35% Equity making the possibility to observer valuation metrics in excess of 45X EBITDA fairly unlikely. However, for short term concessions, 30 to 40-year periods, higher leverage levels can add up to 5-6 multiple units to their valuations.

Bringing all together

In the second part of this post, I illustrated with numbers how the concession terms (length, restrictions on gearing levels and toll adjustment mechanisms) as well as traffic growth expectations affect the valuation metrics for toll road assets. The most important takeaways for investors are:

• The structure and terms of the concession agreement are utterly important when assessing the value of a toll road.

• Increments in concession lengths have a material impact on valuations.

• Favourable toll adjustment mechanism can add plenty of value with limited downside risks.

• Gearing restrictions can be a major drawback when trying to maximize equity returns.

• Getting your traffic forecast wrong can be seriously dangerous!! Make sure that you get the right advice from the right advisors.

Leave a Reply