CONTRIBUTORS
Simon Ong
Portfolio Manager
ClearBridge Investments
Key takeaways
- Despite headwinds to defensive stocks, infrastructure’s strong earnings growth, attractive valuations and predictable dividend stream make us quite constructive on the sector.
- Strong population and industrial activity growth in some regions are boosting toll road traffic, while corporate and Chinese air travel have yet to reach pre-pandemic levels, suggesting airports could see further liftoff.
- Regulated utilities are entering into an elevated capex cycle over the coming decades, and regulators, particularly in Europe, are broadening their allowed returns to help utilities finance that growth.
Strong earnings, attractive valuations
For most of 2023 and into 2024, infrastructure sectors have had a tough time keeping pace with the risk-on sentiment of the broader equity market rally. Rising interest rates and the more defensive characteristics of infrastructure have been headwinds, particularly when data in the United States continues to point to the strength of the economy. Notwithstanding this, we remain constructive on the outlook for listed infrastructure, given the strong growth outlook through the medium term, driven largely by secular factors, combined with attractive valuations.
User-pays infrastructure such as airports, railways, toll roads and energy infrastructure multiples have now normalized to levels consistent with historical trading ranges (Exhibit 1), while growth prospects for regulated utilities, especially renewables, seem overly conservative.
Regional dynamics urge selectivity in user-pays infrastructure
In toll roads, we continue to see strength across Europe and North America with traffic now at or above pre-pandemic levels. In some US regions, such as Dallas–Fort Worth, strong population growth and industrial activity are driving traffic to levels well in excess of 2019; this benefits companies with exposure to that service territory.
There is also strong traffic momentum in the airport sector, particularly those companies with higher exposure to leisure-based travel. Airport companies with more exposure to corporate travel and Chinese passengers, meanwhile are still below pre-pandemic levels, so we expect further normalization and recovery to come for those players. The return of the Asian traveler will be important for airports’ retail business globally, given their high propensity to spend at airports compared to other passengers.
Exhibit 1: User-Pays Infrastructure Consensus EV/EBITDA Multiples
As of March 31, 2024. Sources: ClearBridge Investments, FactSet. Past performance is not an indicator or a guarantee of future performance.
Cash flow generation for energy infrastructure and pipeline companies continues to grow modestly, despite the recent volatility in commodity prices. Midstream Infrastructure companies have revenue streams that are largely fixed fee-based and not tied to commodity prices, and they are remunerated by their oil and gas producer clients for the volume of molecules handled through their gathering, processing, fractionation and storage facilities. Given the expected production growth profile in coming years, these companies continue to expand their infrastructure asset base to support customer growth, while earning an attractive return for the capital invested, particularly for the brownfield expansion projects that leverage their existing footprint.
The communications sector has derated in recent quarters, largely due the inability of wireless communication tower companies to pass on the impact of rising interest rates in their long-term leasing structure. However, we believe that as we approach an environment of peaking interest rates, and if the Federal Reserve (Fed) does indeed begin an easing cycle toward the back end of 2024, that will become a tailwind for the sector. In the meantime, tower companies continue to grow revenues year on year as their telco customers roll out more 5G technology on their tower infrastructure.
Regulated utilities continue inflation pass-through, get little credit for growth
On the regulated side, rising interest rates have been a headwind for the share price performance and multiples of utilities in recent months (Exhibit 2). That is despite their ability to pass on higher rates to customers through their allowed returns, which are negotiated with regulators. Fundamentally, we see the sector entering an elevated capex cycle over the coming decades, particularly electricity networks companies, which are building out infrastructure to support the energy transition. We have seen regulators, particularly in Europe, broaden their allowed returns to help utilities finance that growth. Ultimately, we see higher investments, higher asset base growth and higher returns, which should translate to sustainably higher earnings and dividends for shareholders through the medium term.
Exhibit 2: Utilities Consensus EV/EBITDA Multiples
As of March 31, 2024. Sources: ClearBridge Investments, FactSet. Past performance is not an indicator or a guarantee of future performance.
Support continues to be strong across the United States and Europe for renewables, but recent weakness in the power pricing environment combined with rising interest rates have impacted investor sentiment for the sector. Many renewable companies are now trading at levels that only give credit for the existing assets that are in operation and factor in no value for future growth, which we believe to be very conservative. Therefore, we view the sector as being very attractive from a valuation perspective, especially given growth driven by long-term secular themes such as the energy transition, digitization and demographics.
While we continue to monitor short-term macro crosswinds, both user-pays infrastructure and regulated utilities look to provide stable, predictable cash flows through the medium term with a high degree of inflation protection through their contracts and regulation. Importantly, they provide essential services, which means cash flows are likely to remain resilient through a recessionary environment. This should provide for predictability of dividends to shareholders. A good portion of infrastructure returns is underpinned by that predictable dividend stream, while the capital component is underpinned by secular growth drivers that predictably drive earnings growth over the medium term—something to remember, as not every market is risk-on.
Definitions
Enterprise value (EV) refers to the entire value of a company after taking into account both holders of debt and equity.
The EV/EBIT multiple is the ratio between enterprise value (EV) and earnings before interest and taxes (EBIT).
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is no guarantee of future results.
Equity securities are subject to price fluctuation and possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
Diversification does not guarantee a profit or protect against a loss.
Companies in the infrastructure industry may be subject to a variety of factors, including high interest costs, high degrees of leverage, effects of economic slowdowns, increased competition, and impact resulting from government and regulatory policies and practices. Dividends may fluctuate and are not guaranteed, and a company may reduce or eliminate its dividend at any time.
US Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the US government. The US government guarantees the principal and interest payments on US Treasuries when the securities are held to maturity. Unlike US Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the US government. Even when the US government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.