Inflation is proving sticky with Aussie CPI increasing over the past quarter. It is the same story in the US where tariffs are starting to push prices higher. Inflation impacts shareholders in two main ways. Firstly, higher inflation eats away at real capital gains and dividend yields. Secondly, inflation may complicate the operating environment of a company which in some cases impacts profits if higher costs can’t be passed on.

This second point highlights two of Porter’s Five Forces which demonstrate the importance of bargaining power with customers and suppliers. Bargaining power for customers focuses on how effectively a company can increase prices without losing customers. High switching costs and a lack of viable competitors are good examples of situations where customers have lower bargaining power.

The bargaining power of suppliers focuses on how effectively the suppliers can pass on price hikes to the company. This can inflate a company’s costs if the supplier has too much bargaining power through a monopoly or specialisation. Ideally, low bargaining power from both suppliers and customers ensures a company can maintain profitability which ultimately benefits shareholders.

What does the world’s largest toll road operator and a mining royalty business have in common? They both benefit from sticky inflation. Let’s explore these two ASX companies in more detail given the current inflationary environment.

Transurban (ASX:TCL)

  • Fair Value Estimate: $14 (5% premium at 10 December)
  • Rating: ★★★
  • Moat: Wide

Transurban’s underlying business model has attractive attributes for an inflationary environment. Toll road contracts allow Transurban to pass along annual price increases either by inflation or by a fixed amount annually (4% or higher). The company negotiates pricing contracts with State Governments before committing to the funding of a new road’s construction.

Transurban benefits from higher inflation for three reasons. The obvious reason is that higher inflation increases the toll price which drives higher revenues. The second reason is majority of the debt Transurban carries is either fixed or hedged against short term interest rate movements. While revenue increases with higher inflation, the debt repayments remain steady which improves the profit margin. Lastly, Transurban has demonstrated strong operational efficiency. The company is adept at keeping costs relatively stable while growing revenue in inflationary environments. This operational leverage drives bottom line returns to shareholders.

The biggest risk to Transurban is the impact of inflation on traffic volumes. Major disruptions to traffic volumes are rare but can be catastrophic considering the high levels of debt the company carries.

While exposed to traffic volume risk, the company’s revenue is ultimately defensive and well positioned for an increasing population in Australian major cities. There is also room for expansion in its existing network of toll roads in North America which our analysts see as a growth option to generate further returns to shareholders. These returns include a current dividend yield of 4.4% (no franking) which has been steady since COVID.

Deterra Royalties (ASX:DRR) 

  • Fair Value Estimate: $4.40 (6% discount at 10 December)
  • Rating: ★★★
  • Moat: Wide

Deterra manage a portfolio of royalties in the resource sector. In my recent article on “Finding Value in the Mining Sector” I mentioned Deterra’s business model is likened to a toll road with leverage to the iron ore price. The majority of earnings are derived from BHP iron ore operations in Mining Area C (MAC) in WA. As part of the royalty, Deterra receives a percentage of the revenue earned from the mine. This protects Deterra from cost increases that reduce profits.

This protects Deterra from incurring any margin compression from inflationary pressures on operating costs. BHP also bears the brunt of any capital expenditure on the MAC iron ore mine. For example, if BHP wanted to expand in the MAC area for greater iron ore production it would require no additional capital from Deterra.

Similar to Transurban, Deterra benefits from stickier inflation. This is because the royalty revenue stream is likely to increase during an inflationary period when iron ore prices are pushed higher. At the same time, minimal overhead costs means the company is protected from the inflationary pressures that other capital intensive companies face. This is ultimately beneficial for shareholders as more profits are returned to shareholders.

The biggest risk for Deterra is the exposure to iron ore prices. Deterra currently has a yield of 5.7% fully franked which is supported by a payout ratio of 75% of earnings.

Bottom Line

Inflation is a key risk that all investors need to consider. This consideration is done by evaluating a company’s ability to pass on price increases while maintaining real cost control. Both Deterra and Transurban have a natural hedge against inflation and derive benefits from sticky CPI and may be worthwhile for investors worried about inflation to consider.