Magellan Financial Group Limited (MFG) Earnings Call Transcript & Summary

Welcome, everyone, and thanks for joining us this morning for Magellan's live audio broadcast on the infrastructure market and our strategies in particular. We do appreciate just how busy you are as we all try and make sense of the impact of COVID-19. We also hope that you and your loved ones are safe. These are unprecedented times, and so for the past 3 weeks, all Magellan staff have been working from home. But I'm pleased to say that the BCP is working seamlessly and it's very much business as usual for the entire Magellan team. In today's broadcast, we will be providing our current observations of the impact of COVID-19, specifically as it relates to the infrastructure sector. We'll then address the most common questions that we've received. Please note, there are no slides. This is an audio-only broadcast.

Gerald, welcome, and thanks for joining us. Maybe let's set the scene with how have the different segments of the infrastructure will perform through this crisis.

Thanks, Frank, and thanks for everyone else to -- for listening. So to begin with, let's think about what our investment universe comprises. There are 2 major sectors: regulated utilities, which is water utilities, gas, electricity utilities; and infrastructure companies: toll roads, airports, communications, infrastructure, energy infrastructure and rail. Now overall, the crisis to this point has impacted infrastructure businesses in a much more significant way than it has utilities. For the year-to-date, that is the 3 months to the end of March. We measured the share prices for regulated utilities as having declined by an average of approximately 10%. While we measure the share prices, the infrastructure companies is having declined by an average of approximately 21%. If I think about the different segments of the infrastructure and utility sectors, when we see further return dispersion, for the infrastructure sector, airports are down something like 41% according to our analysis, toll roads are down 25%, energy infrastructure is down 12%. And communications infrastructure, for the first 3 months of the year, is actually up 4% on average. Within our infrastructure universe, the airports, toll roads and rail segments face significant short-term declines in patronage. We remain of the view that airports, toll roads and rail provide essential services, and we expect the demand for these services will return over time. However, the duration of the lockout and any following economic downturn will be key to how these businesses recover. The energy infrastructure companies in the portfolio generate earnings by typically storing oil, gas and chemicals or transporting oil and gas across their pipeline networks. The revenues they earn from transporting oil and gas can potentially change with movements in volumes, but underwritten take-or-pay volumes usually account for the majority of revenues. So we assess the potential risk to volumes to be quite low. Indeed, for many customers of infrastructure companies, access to the energy infrastructure services is essential to their ability to earn revenues. Of course, in the event that customers have solvency issues, and this could cause problems for energy infrastructure companies, but we'd note that the overwhelming bulk of customers these companies serve are investment-grade credit quality. We believe the energy infrastructure companies are well placed to cope with the economic consequences of the virus over the medium term. While the pace of development of the infrastructure networks of telecommunications infrastructure companies may slow, we expect the earnings of telecommunications infrastructure companies to be highly defensive in response to the crisis. The demand for data across mobile telephony and the Internet will continue to grow, and continued investment in telecommunications infrastructure is necessary for that demand to be satisfied. It's that investment in infrastructure demand that ultimately plays to the strength of telecommunications infrastructure companies. For the utility sector, there are 4 separate segments: water utilities, transmission distribution, regulated gas and integrated utilities. Water utilities, when measured, is down roughly 5% year-to-date. Transmission and distribution utilities has been down approximately 2%. Regulated gas utilities has been down roughly 15%. And integrated utilities has been down approximately 14%. Regulated utilities may face some short-term declines in earnings, but we don't expect significant changes to their long-term earnings outlook. The earnings of regulated utilities ultimately are robust over the medium term. They're highly defensive, and the regulators generally allow for losses due to issues outside of their control of the regulated utility to be recovered over the near to medium term. So in general, regulated utilities have performed better than infrastructure assets over the period, and those infrastructure assets that rely particularly upon the transport of people and goods have suffered significant share price declines. We remain confident about the long-term prospects of both infrastructure companies and regulated utilities, notwithstanding that the crisis may impact short-term earnings.

And so Gerald, with that framework, how have you positioned the investment portfolio right now?

So the portfolio today comprises approximately 45% in utilities -- in regulated utilities, approximately 40% in infrastructure companies and approximately 15% in cash. By comparison, at the end of January, the portfolio was approximately 55% in infrastructure, 43% in utilities, and 2% cash. So we've become significantly more defensive in the way that we position the portfolio. In particular, we've moved from roughly 55% infrastructure to 40% infrastructure. Of the allocation to infrastructure of 40% today, approximately 7% is allocated to airports, 13% to toll roads, 10% to energy infrastructure and approximately 5% to communications infrastructure and also to rail. At the end of March, the allocations to defensive sectors such as regulated utilities, communications infrastructure and energy infrastructure, and I say defensive sectors within what is a defensive space, combined with the 15% allocation to cash, accounts for approximately 75% of the total portfolio. The remaining 25% of the portfolio is invested in toll roads, airport and rail. So airports and toll roads do face some significant challenges in the coming months. In our forecast and our valuations, we've allowed for a significant drop in passenger movements, car trips, and we assess that our companies on that basis have significant cash flow and liquidity to cope with that crisis. While we expect that some of those companies will reduce their dividends and some have already announced this, our experience of previous demand shocks in the transport industry gives us confidence that demand for transport is an essential service and will recover over the longer term, which will lead to long-term resilient earnings and dividends. The rail companies we've allocated to are in the U.S. and Canada. We expect those companies are likely to similarly experience a significant drop in volumes across their networks. The U.S. and Canadian rail business is diversified across a range of different segments. We'd expect volume losses due to interruptions to supply and economic decline to be recouped as the U.S. economy recovers that on the medium term.

The next question, Gerald. While airports have previously been a reliable source of earnings, they now appear to be under significant pressure. How has the reduction of passengers affected valuations in the short term?

So as I've already touched on, we estimate the share prices for the major investable listed airports have fallen by an average of approximately 41% for the 3 months to the end of March. To give you a sense of what that means, we estimate that if we allow for a 3-month lockout, so significant declines to passengers, to give perhaps an 80% to 90% reduction in airport passengers for 3 months, followed by a gradual return to a passenger level in December of this year, some 10% below where it was in the prior December, followed by a progressive recovery over the following 3 years to a level 5% to 10% below where our previous forecast were, then the combined impact on airport values comes to somewhere in the range of 15% to 20%. That is our valuations. And that forecast would drop somewhere at the order of 15% to 20%. Now of course, if the lockout continues beyond 3 months, then the impact on value will be more extreme. So the impact of the crisis on airport share price has been significant, and indeed, more significant than the case that I outlined. And clearly, significant uncertainty remains about the length of the lockout, and therefore, the pace and scope of the recovery. But as I've already said, we remain confident that over the medium term, airport passengers will return and the value of these businesses will be robust.

Thanks, Gerald. Do you think the current environment of forced isolation, travel restrictions and changing working arrangements will have a longer-term impact on your conventional views and expectations of particular assets? And if so, which assets?

So the demand patterns established for transport infrastructure, airports and toll roads have historically been quite consistent and predictable. However, the current circumstances are clearly extraordinary, and we do expect to see the crisis lead to some changes in the frame of reference, if you like, for communities. And as a result, there could well be changes to the pattern of consumption of the transport infrastructure. Isolation, travel restrictions and working from home have become commonplace, and we expect this will lead to changes in the pattern of demand in the future. But let's think about the specific situation for toll roads and airports. For toll roads, we don't expect the core proposition to be significantly affected. Toll roads essentially sell time, and we expect that as economies and communities recover from the crisis, we will once again be confronted by traffic congestion as foreign as that might seem today, and that the value proposition for toll roads, a time-saving, will continue to be evident. Ultimately, long-term traffic is a function of population and housing formation, and we don't see those variables changing sufficiently to affect long-term traffic trends. So while the current environment may lead to some changes in behavior, we don't expect the long-term value proposition for toll roads to significantly change. We expect it to remain compelling. For the aviation sector, the level of aviation traffic has historically been very resilient to demand shocks. In the last 20 years, we've seen failure of airlines. We've seen regional health crises, terrorism and economic crisis, which have all led to significant reductions on occasion in the demand for aviation. But the reduction has proven to be short-lived. In each of those situations, aviation passenger numbers have returned to the trend line in a relatively short period of time, say, something less than 18 months. Now this crisis is sufficiently dramatic that it may have significant effects upon the aviation and travel sector and certainly more -- it might take longer than it has in the past for it to recover. But we remain confident that aviation will ultimately recover, albeit we're cautious is the pace at which the sector responds.

And Gerald, can you discuss the risks that companies in the infrastructure sector default on their debt obligations and the consequent impact on equity holders?

Yes. This is very much in investor's minds, it has been a hot topic for us. Look, we've reviewed the balance sheet and forecast cash flows for all the companies in our portfolio, and indeed, for a range of other companies around our universe. And we believe they're generally in a very strong position in terms of solvency. That is the ability to fund their obligations for the next -- at least the next 6 months. If a lockout was to continue beyond 6 months, then we'd expect some companies in the transport space, notably airports, would need to either raise capital debt or equity to fund their obligations beyond that period. In recent weeks, we've seen us a large number of airports raise additional debt capital to fortify their balance sheets for an extended draw-down on their cash resources. They know what they're facing, and they're getting prepared for it. In addition, we've also seen debt rating agencies issued a number of downgrades of debt ratings. And while airports have suffered those -- a number of downgrades, the airport companies we're focused on remain firmly in investment-grade territory. So while, clearly, credit risk is an issue, we think the portfolio is well positioned as it currently stands.

And Gerald, what is the impact of higher credit spreads on the portfolio?

Yes. We think the impact of hyper expense will have a pretty limited effect on the portfolio. While credit spreads have increased, they remain at levels we consider reasonable, given the extraordinary circumstances. We've seen a number of companies in the portfolio raise debt in recent weeks, as I've just touched on. And the pricing of that debt, while elevated, compared to price at the start of the year, remains low compared to historical standards. We're not -- the companies that we have invested in typically have the debt maturities spread over 20 or more years. And so the debt coming up for refinancing in any single year is a small proportion of the total debt obligations they face. And as a consequence, their exposure to an increase in credit spreads over the short to even medium term is actually pretty limited. Clearly, if credit spreads remain elevated over the long term, then that's a different proposition. But over a 1- to 2-year time frame, we don't see that impact as being significant.

Interesting. Next question, Gerald. Does the strategy of using listed infrastructure to diversify equity exposure no longer apply?

Yes. We remain -- continue to believe it remains to diversify for an investment portfolio, notwithstanding that, in the face of this pandemic, the infrastructure sector has been highly correlated to broader equities markets. To construct a diversified investment portfolio, an investor needs to allocate to a range of assets whose earnings or income streams reflect different underlying drivers. Provided the drivers respond to events in a differentiated manner, then investment returns should be diversified. Given exposure to different drivers, the nature of a diversified portfolio is that at any given time, some of the investments will be winners and some will be losers. But overall, the investment portfolio should be structured to achieve its long-term investment objectives. In this particular situation, transport infrastructure, which represents a significant proportion of the infrastructure investment universe, is directly exposed to the key variable affecting broader equity markets, and that is the lockout of consumers from physical commerce. Now as a result, infrastructure investment performance through the first quarter of 2020 has been highly correlated with equity markets. But notwithstanding the performance of infrastructure through the initial period, we believe the investment returns from infrastructure do typically reflect different underlying drivers to broader equity markets. In particular, regulation is a key driver of infrastructure investment performance over the long term. It limits ultimate equity returns, but it also protects you on the downside. And it's that different -- the different underlying drivers that ultimately mean that infrastructure will diversify an investment portfolio over time.

And so Gerald, right now, what's your greatest concern for global infrastructure?

So our key concern at the moment is really an increase in sovereign risk. That sort of -- by way of background, I want to explain how we think about the economic life cycle for infrastructure assets to explain why we see that as a key concern. The nature of infrastructure investment is that the owner of the infrastructure asset typically builds a big piece of capital equipment, an airport, a toll road, an energy pipeline, a water distribution network or an energy distribution network, and commits significant capital expenditure to build it. So a lot of money at the door day 1, significant initial cash outflow. The infrastructure asset provides an essential service, and so the initial cash outflow is followed by typically a long period of reliable and predictable cash flows to the infrastructure asset owner. Now it's that long period of cash inflows that means the key risks that an asset owner faces are those forces that are going to affect the likelihood of those cash inflows being collected by the asset owner. So there are 2 key risks we typically focus on: one is real interest rates and the second is sovereign risk. Now a movement in real interest rates can affect the present value of those reliable cash flows that the infrastructure asset owner expects to receive. In other words, if interest rates rise and the value of the future cash flows, the infrastructure owner who will receive will naturally fall. Given the current circumstances, we would expect interest rates to run at low levels well into the future. And so we don't currently see this as a major issue for infrastructure assets. However, the second issue is sovereign risk. Now the situation there is that this is something we're watching pretty closely. Infrastructure assets provide essential assets -- essential services, sorry, and we're likely to see a great deal of economic hardship. And as a consequence, we would expect that government action will be in place promoting the use of -- or the provision of these essential services in a comprehensive manner across the population. And that could ultimately act against the economic interest of the infrastructure asset owners. We've seen elements of this already. We've seen governments. And indeed the companies themselves indicate that they'll make sure that for economic hardship reasons, the provision of essential services remains on tap as it were. But we need to be careful that the regulatory regimes continue to protect them over the medium to long term against those sort of actions. So in essence, we think this risk is elevated. We're watching it closely. With regard to the regulatory regime, it's robust at this point, but it is an issue we're watching.

And so Gerald, what are the analysts doing to stay on top of their company's financial models right now?

Well, I guess, there's a few things, Frank. We've been iterating our base cases over time. And this crisis goes back really to mid-, late January for us when we first started seeing the impact on -- in China and expecting an impact on passengers for some of our airports. So we've had to iterate those -- that information over time. More recently, we're looking at the impact on businesses in different regions. Different regions have entered this crisis at different times, and therefore, we're seeing different curves or different impacts on the -- over the last couple of months on their underlying businesses. We're reviewing previous demand shocks. I've talked a little bit about airports already. We're looking to try and understand how those demand shocks are relevant in the context of the current one. And where we -- what we've seen is appropriate or not. We're talking with our companies and indeed with regulators on a pretty regular basis. Lines of communication have generally been very open, and we've had good transparency of information. We've -- obviously, we're adjusting our forecast and valuation through that period and running sensitivities. We have a base case, but we also need to be cognizant of what the downside case and indeed what the optimistic case is. So there's a range of scenarios that we've been running with a real focus on solvency and liquidity. And then finally, I guess we're revisiting debt agreements and reviewing covenants, making sure that we understand the detail on some of these issues. Infrastructure assets typically have a fair amount of debt in the capital structure. That's the nature of the infrastructure space. We're making sure that we understand those niceties.

And Gerald, any final comments?

Look, I guess, what I'd say is while the crisis, both health and economic, has been significant, we should remember that infrastructure assets provide essential services. The provision of water, the provision of energy, the provision of transport, the provision of communications, these are essential services. And the demand for these services does not go away. The companies we've selected for the infrastructure investment portfolio are businesses we regard as being of very high quality, and they face attractive long-term fundamentals. In the extraordinary circumstances we're currently experiencing, infrastructure companies may be suffering some short-term price falls, and that reflects both the crisis, the impact of the crisis, but also the associated uncertainty. But in the long run, I think we're confident that the -- over the long term, that investment returns to shareholders in these businesses will reflect the reliable earnings that we expect from these businesses under normal circumstances. Earnings will come back, and we remain confident that an investment in high-quality infrastructure businesses will reward investors as we expect over the long term.

Gerald, thanks for those insights.

Thanks, Frank.

And thank you all for joining us on this live broadcasting -- broadcast. A recording of this will be available later on our website today for you to share with clients or colleagues as you see fit. Additionally, we'll also be sending out the 2 broadcast, yesterday's global and today's infrastructure recordings, along with the new paper from Hamish on the current crisis in a special quarter-end update shortly. Once again, thanks for listening, and we hope that you, your loved ones and your families all stay safe and well. Thanks.