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Infrastructure stocks overpriced, high rates may bite

Nicki Bourlioufas  |  23 Jun 2017Text size  Decrease  Increase  |  

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While their defensive characteristics may make them attractive, investors should look at the current valuations of ASX-listed infrastructure plays before splashing out.


Infrastructure stocks are considered defensive investments as they are likely to weather an economic downturn relatively well compared to other stocks that rely more on economic activity, such as consumer spending.

A key feature of infrastructure operators is that the regulatory frameworks governing the essential services they provide generally ensure fair and predictable returns for owners. That's why they are considered defensive stocks.

But before you splash money on infrastructure companies listed on the ASX, caution is warranted. Adam Fleck, the director of equity research at Morningstar Australia & New Zealand, says many infrastructure stocks and related building and engineering companies are overvalued.

Building, construction, and infrastructure companies rallied after the federal government allocated $75 billion in new infrastructure spending in the 2017-18 Budget, including Australia's biggest construction group CIMIC Group (ASX: CIM) (formerly Leighton holdings), and engineering and infrastructure group Downer EDI (ASX: DOW), and engineering group WorleyParsons (ASX: WOR).

"We have a pretty negative view on their valuations," says Fleck, who included Sydney Airport (ASX: SYD), and Transurban (ASX: TCL) in the group.

Fleck puts a fair value of $6.50 on Sydney Airport, compared to its current level around $7.40. The stock has jumped this year from around $6 in January.

"I would estimate that about 50 per cent to 60 per cent of our value estimate for Sydney Airport would come from its international traffic," he says.

"Not only do international passengers spend more at Sydney Airport than domestic ones, but the company also charges international carriers higher fees [to land at the airport], which would help support the company if they were in an economic downturn.

"There's still a lot of room for further growth in international passenger numbers, particularly from Asia, and in a scenario where there is a domestic downturn, that would help to protect its earnings, most of which come from domestic passengers."

Fleck is more optimistic about Auckland International Airport (ASX: AIA), which he says has a wide economic moat. Like Sydney Airport, the company has benefited from growth in international passenger numbers from Asia.

However, it is more affordable. Auckland International is currently trading around $6.70, close to its fair value of $6.40.

"Auckland International has a wider moat than Sydney Airport, with the latter to face competition from Badgerys Creek Airport. Its competitive advantage may be diminished over the next 10 years with Badgerys Airport going ahead, which could take away some of its traffic," he says.

The federal government recently confirmed it would build Sydney's second airport at Badgerys Creek, after Sydney Airport declined an option to take on the project.

Auckland International also has the advantage of lower debt than Sydney Airport, which is highly geared, like many infrastructure companies, which makes them vulnerable to rising interest rates.

"While a rise in bond yields is partially already priced into these stocks, these companies will have to attribute more of their income to servicing their debts rather than paying out income to shareholders over the longer term," Fleck says.

"So, as the debt of these companies comes up for refinancing, it will likely be refinanced at a higher interest rate."

However, Gerald Stack, a portfolio manager with Magellan Asset Management, says the impact could be limited.

"If interest rates were to jump then history suggests that infrastructure stocks would be likely to lag. But experience has been that this is a short-term phenomenon. Over the longer term, the relationship between infrastructure assets and interest rates is muted whether rates are rising or falling," he says in a recent research note.

"If an increase in interest rates or in some other variable cost threatens profitability, then utilities are able to increase their prices so that they can maintain their return on equity.

"The essential nature of their services means that higher prices don't reduce demand and dent revenue. All up, higher interest rates pose limited or no burden for regulated utilities."

Stack also says many infrastructure companies are well protected from higher rates because they have taken advantage of low interest rates over the past five years to lock in cheap debt for long periods.

In terms of toll road operators, they too are considered defensive.

"With Transurban, there is a risk that the market is too optimistic about the fact that passenger traffic could be steady through most economic situations. We believe that its road traffic could feel pain during a downturn because its truck traffic, from which it derives greater tolls, could be impacted if there is less consumer spending," he says.

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Nicki Bourlioufas is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.