12 May 2007, Financial Adviser

Intending to be secure, steady income plays, infrastructure investments have generated market-beating total returns. Eric Uhlfelder explores this underheld asset class to determine if its stellar performance can continue.

In June 2006, the Spanish developer Grupo Ferrovial startled the market when it bought Britain’s BAA–the world’s largest airport operator–for $29.3 billion. By September, BAA was contributing more than 30 percent to the company’s 1.64 billion 9-month EBITDA. By year’s end, Ferrovial’s 2006 EPS was up by more than 57 percent. And as of early May 2007, its shares had soared by more than 50 percent over the past year, driven by the company’s shift away from domestically-focused construction and real estate activities to less cyclically-minded global infrastructure and services company.

Much of the developed world outside of the US, from Canada to the United Kingdom to Australia, have regarded infrastructure as an attractive investible asset for quite some time. But many US financial advisors have been reticent to embrace infrastructure because there hasn’t been a whole lot of domestic opportunity and because it’s assumed that the rest of world pretty much learns from us–not the other way around.

But the flatter the earth gets, to steal a phrase from the author Thomas Friedman, the more we see that the learning process is a two-way street–or more aptly put, a multi-freeway interchange. And advisors who are early to discover ideas from abroad–like infrastructure–are likely to reap the greatest benefits.

Tradition of Infrastructure Finance

There is nothing new about financing airports, highways, bridges, and tunnels. Wall Street has been underwriting municipal bonds that support these enterprises for decades. And institutional and individual investor portfolios are chock-full of them.

But some of the big brokerages [along with city, country, and state pension plans] are taking a page from their foreign counterparts, like Australia’s Macquarie–who pioneered infrastructure securitization–and Swiss bank UBS. These have firms realized it’s more profitable to own such assets outright. And as cities and states struggle to pay for maintenance and capital improvements, a growing number of governments appear all too happy to pass the financial and management buck over to companies with deeper pockets.

Sounds like a panacea.

Well, maybe. Sales or very long-term leases of key public trusts into private hands whose primary focus is on the bottom line can raise conflicts of interest. That potential was why government was originally empowered to build and maintain essential monopolistic infrastructure in the first place. And after having paid taxes and tolls for decades to amortize the cost of these projects, some folks may have a problem paying fees to corporations for services for which they’ve already paid. The politics of infrastructure could affect the entire game.

But the bottom line is that privatization of infrastructure is a necessary reality. And given its character, perhaps it’s no surprise to find that this new evolving asset class so far is behaving like a cross between government bonds and stock. Growing inelastic demand for these services generates predictable cash flow. Regulatory oversight ensures rates adjust for inflation. And realization that such securities are pretty good ways to meet the investment criteria of many public and private funds–especially pension funds–has sparked demand for these securities that’s producing capital appreciation.

Just as appealing is the nuts and bolts character of infrastructure that can be easily understood and measured. It stands in stark contrast with the investment rages of the previous decade–the latest technological innovation and all things dot.com–where it almost seemed like the less transparent and comprehensible the product, the cooler it was to own, until investors rediscovered the merit of Warren Buffett’s adage, if I don’t know how it works, I don’t want it.

Benjamin Tal, an economist for CIBC World Markets in Toronto, consolidated the performances of four leading infrastructure indices: Lazard, UBS, Macquarie, and Standard & Poors. He found that over the past two years this amalgam of listed toll roads, water utilities, ports, and communication networks has soared 60 percent in US dollar terms through early 2007, exceeding the MSCI World Equity Index by roughly 20 percent. At the same time, the consolidated benchmark’s standard deviation was 10 percent lower than that of the global market.

Given such long-term performance, advisors may wonder if they may be too late to join in.

Michael Wilkins, managing director of S&P’s European Infrastructure Finance Group in London, reports that $100 to $150 billion has been raised globally to target infrastructure investments, while debt raised on some infrastructure deals is peaking close to 30 times EBITDA. To Wilkins, the potential of overvaluation and excessive leverage are ingredients of an asset bubble.

But other industry observers are more sanguine, believing the combination of adequate global liquidity and increasing pace of privatizations, especially in the nascent US and emerging markets, should enable supply to keep pace with demand.

Srikant Dash, S&P’s Index Strategist in New York, reports that his company’s Global Infrastructure Index has sustained its overall valuation despite having realized annualized returns of 24.8 percent [in US dollars] over the past five years through May 4, 2007. “We have found PE ratios have held steady around 18-19, Price/Book has held around 2.6, and yields have remained around 3.1 percent,” observes Dash.

How is that possible?

Dash believes the key is annualized rebalancing. “By keeping a constant industry balance–30 utilities, 30 transportation shares, and 15 energy shares–the index has generally prevented soaring prices in any one industry from dominating the index.” Specifically, he points to the gravitational pull that takeovers and new issuances can have on maintaining the index’s overall valuation.

Based on the compelling characteristics of infrastructure and the current outlook, Dash recommends that well-balanced portfolios should include 5 to 10 percent exposure to such activity.

Gaining Exposure

Buying the index would seem a reasonable way for advisors to test the infrastructure waters. But investors will have to wait at least several months before an ETF that tracks the S&P index comes to market.

Advisors could consider buying shares of individual companies like Ferrovial to gain partial infrastructure exposure. Few firms, however, are pure diversified infrastructure plays. Moreover, such investments would require substantial due diligence and constant monitoring, tasks which are made more challenging given that the most compelling shares are foreign, and may only be available abroad or via over the counter.

For the moment, only Macquarie offers US investors nascent access to infrastructure funds through an ETF, a closed-end fund, and a trust.

In January, State Street Global Advisors packaged the SPDR FTSE/Macquarie Global Infrastructure 100 ETF. A composite of the broader 255-stock Macquarie Global Infrastructure Index, this large-cap focused ETF is heavily tilted to utilities [85.72 percent] and US shares [40 percent of assets]. But it has individual country weighting of between 8 to 9 percent in Germany, Spain, the United Kingdom, France and Japan.

Pro forma five-year annualized earnings growth exceeds 8 percent. Current yield is 2.8 percent, current P/E ratio is 16.8, and Price/book is 2.7. Expense ratio is 60 basis points. So far through early May, the ETF is up 12.84 percent, topping the MSCI World Index by nearly 4 full percentage points. Back-tested five-year annualized returns is running more than 20 percent.

The Macquarie Global Infrastructure Total Return closed-end fund, which IPOed in August 2005, is up a cumulative 60 percent, outpacing the MSCI World Index by more than 24 percent since its inception. Its portfolio is distinct form its ETF cousin. Its average market cap is much smaller [$35B vs $5B]. Its utility exposure is lower [around 55 percent], while its airport and toll road exposure is higher [7.4 and 6.9 percent, respectively]. Country weighting is also different, with less than 24 percent of its assets in the US and more than 17 percent exposure to Australia.

Like the ETF, its unhedged currency exposure has allowed it to benefit from the weakening dollar. Using leverage of approximately 30 percent, the fund is able to boost its yield to 4.59 percent. Its current PE and P/B are ____ and ___, respectively. And its annual expense runs 1.69 percent.

The Macquarie Infrastructure Company Trust IPOed on the NYSE in the beginning of January 2005. But unlike the above two securities which make passive minority investments in a variety of companies, this stock actively owns and manages a handful of US infrastructure ventures. Operations include airport services and parking, energy, gas production and distribution, and bulk liquid storage.

While combined P/B of all holdings is less than 2, the Trust’s composite trailing PE is close to 25. The stock, which pays out most of its earnings, currently yields 5 percent. Since its inception about two and half years ago, shares are up a cumulative 60 percent through early May, more than doubling the MSCI US Index.

Macquarie fund manager, Jon Fitch, who runs a total of 7 funds worth $2.2 billion also in Australia, Canada, Taiwan, and South Korea, believes that the prospects for forward performance remain positive as the pace of asset privatization remains strong. “The US is just in the early stages of securitizing infrastructure which could bring many billions of new projects into play,” Fitch posits, “and the same is true across emerging markets where rapid economic growth is requiring substantial infrastructure investment.”

Several basic risks Fitch sees include inflation and regulatory decisions. Many deals structure in rate increases to keep pace with inflation. But if maintenance and capital improvement costs were to soar, there are limits to how aggressively rate increases could be passed on. At the same time, regulators could take advantage of growing demand for infrastructure and take a harder look at rates of return.

The supply side is under increasing pressure from a rising number private equity firms, including the likes of Goldman Sachs, The Carlyle Group, and Kohlberg Kravis Roberts & Co. bidding for infrastructure assets. Peter Hobbs, global head of real estate and infrastructure research at Deutsche Bank, sees that “the risk premium has declined lately as investors have become more comfortable.” At the same time, Macquarie analyst David Rickards observes that “new deals coming to market has not kept up with the growth in demand, resulting in a rerating of assets.”

Today’s low interest rates help investors deal with rising asset prices. Last year, Macquarie teamed up with Spanish private transport developer Cintra to buy the 157-mile Indiana Toll Road for $3.8 billion with only 19 percent equity. However, a secular rise in long-term rates could challenge the current investment calculus that relies on substantial leverage to sustain attractive return on equity.

Despite such potential challenges, with proper due diligence and oversight, Fitch believes these are manageable risks. “Infrastructure is offering investors unique investment opportunity,” Fitch explains, “that can combine the relative safety of high-grade government bonds and equity-like returns without being correlated to either asset class.”

While that should remain true for the near term, if the supply of infrastructure opportunities fails to expand as rapidly as some predict, then there may be a musical chairs aspect to infrastructure. Early investors seated should do fine. But those rushing in, paying too much and failing to structure the right kind of deals may not end of up fairing as well. Discerning this difference will be the key for financial and advisors and retail investors trying to cash in on this evolving and compelling asset class.

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