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Higher rates hitting these 3 infrastructure stocks

Nicki Bourlioufas  |  16 Apr 2018Text size  Decrease  Increase  |  
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Higher interest rates are hurting these large-cap infrastructure stocks, which are declining from their 2017 peaks and reverting to their fair values.

Infrastructure stocks including Sydney Airport and Transurban are well down from their 2017 highs. Auckland International has bucked the trend and outperformed this year with one expert describing it as undervalued.

Bond yields have moved higher around the globe as the US Federal Reserve tightens interest rates and ends quantitative easing. Higher bond yields are bad for infrastructure stocks, which tend to fall anyway as investors sell out to buy bonds or invest in cash instead.
Debt costs rise too. So, with higher interest rates have come softer prices for sometimes debt-laden infrastructure operators.

Sydney Airport, for example, is well down from its high of $7.80 struck in June last year, having fallen to around $6.55 in recent times, down almost 8 per cent this year.

Another popular infrastructure stock, Transurban is down more, around 10 per cent this year to $11.20, having fallen from its December high of $13.11. That compares to a drop of around 4 per cent for the S&P/ASX 200.

Auckland Airport, in contrast to Sydney Airport and the overall share market, is up almost 3 per cent this year, at $6.10, though down from a high of $7.05 last June.

Overheated since last year

Adrian Atkins, senior equities analyst at Morningstar, says infrastructure stocks were over-heated a year or so ago, with everyone pricing in lower interest rates for a longer period. That premium has now come out of the stocks.

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“Now, quantitative easing is ending, and interest rates are going higher. Transurban has high gearing, so rising interest rates will push up interest expense and hurt free cash flows/distributions, though hedging helps in the medium term,” says Atkins.

Atkins has a fair value of $11.50 on Transurban. “At the current price, the stock is fairly valued. Transurban is a high-quality company with good growth potential. Our main concerns are rising bond yields and the firm's rapid expansion late in the cycle,” he says.

Adam Fleck, Morningstar's regional director of equity research for Australia and New Zealand, says higher interest rates are generally negative for airport operators Sydney Airport and Auckland Airport. In the case of Sydney Airport, the company’s net debt of $8.4 billion is more than seven times earnings before interest, taxes, depreciation and amortisation (EBITDA), compared to a more-palatable 4.3 times for Auckland.

“In a rising rate environment, the airports are hit both operationally, through increased debt costs on their highly geared balance sheets, and on investor demand, given infrastructure stocks are bond proxies,” says Fleck.

“We don't anticipate major trouble for either company, and both are rated investment-grade, but the downside risk from a shock to the financial system is substantially higher at Sydney,” says Fleck.

Fleck says he sees average debt costs climbing above 7 per cent of EBITDA for Sydney Airport and 6 per cent for Auckland International, up from about 5 per cent and 4 per cent, respectively, last year. He places a fair value of $7.20 on Sydney Airport and $6.80 on Auckland. Fleck is much more upbeat on Auckland International given it has a stronger economic moat, or protection against competition.

“We assign Auckland Airport a wide economic moat, compared to Sydney Airport's narrow moat. This is principally because of the long-term potential impact of the upcoming Western Sydney Airport, scheduled to open in 2026, which will likely siphon some domestic passenger traffic away from Kingsford Smith,” says Fleck.

Although the second airport is still nearly eight years off or more, that is still enough to limit Fleck’s confidence that Sydney Airport will hold its high-returning monopoly position for at least 20 years, the threshold for Morningstar to assign a wide moat.

“Ultimately, Auckland Airport … is a wide-moat stock that looks undervalued, which is rarified air amongst our coverage. In the Australian listed market, we cover just 10 wide-moat stocks, beyond InvoCare and Auckland Airport, this includes the four big banks, Brambles, Transurban, Cochlear, and ASX. ... we believe these opportunities can form the basis for long-term value creation,” says Fleck.

“We prefer Auckland Airport at the current valuation. Whilst the stock's dividend yield is lower than Sydney's, and its near-term free cash flow is constrained by a massive capital spending program, balance sheet risk is considerably lower.”

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Nicki Bourlioufas is a contributor for Morningstar Australia.

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