How exposed is Sydney Airport to price correction?

Infrastructure plays like Sydney Airport Holdings (ASX: SYD) tend to trade on high earnings multiples due largely to the sustainability of its cash-generation, and below-average returns on government and other investment grade debt have continued to attract the airport to institutional investors chasing yield, especially with 10-year US treasuries currently offering a return of just 1.893%.

But having driven the share price of Australia’s busiest airport 36% higher over the last 12 months – to an all-time high of $7.18 – an 87% premium over intrinsic value (IV), a price to earnings (P/E) multiple of around 54x, and only 10% shy of an $8 upper end target price – the stock looks increasingly susceptible to a share price correction.

Adding to the likelihood of future turbulence in the Sydney Airport share price is the inevitability of gradual cash rate hike by the US Federal Reserve (The Fed) over the next 12-18 months.

While a rate hike by the Fed now looks less likely in June, there’s still a high expectation that the first increase will kick off well before the year’s end. How much a steepening in the yield curve – as medium-to-longer-term debt offers better returns – reduces institutional investor appetite for holding onto Sydney Airport remains to be seen.

But investors’ who like the stock’s underlying income story – with a yield of 4.23% in 2016 – are likely to find more attractive entry points into this stock later in the year, especially if there’s a wave of profit-taking ahead of any future ‘big investor’ exit.

But despite any likely downward pressure on the share price, it’s also important note that the airport’s fundamentals continue to improve.

Due to strong growth in international passengers, following additional seat capacity offered by multiple airlines, the airport’s earnings per share (EPS) and dividend per share (DPS) are forecast to grow from $0.13 in 2016 to $0.18 in 2018; and from $0.30 in 2016 to $0.36 in 2018 respectively – giving it a yield of 5.05% by 2018.

Since 2006 Sydney Airport has averaged return on equity (ROE) of 9.09%, and this is forecast to jump from 19.95% in 2015 to 26.08% in 2016, 45.94% in 2017 and 119.92% in 2017.

Adding to the sustainability of future growth is a long-term trend in visitor numbers, especially from Asia, with Chinese visitors up around 20% for the FY16 year to date.

Like most infrastructure plays, Sydney Airport carries a fair bit of debt, and high net-debt to equity has been on the increase (to 592% in 2015). However, based on the quality of its underlying earnings, the stock has strong cash flow relative to reported profits and a cash flow ratio of 2.07%.

Equally encouraging, the airport recently announced it had raised US$900 million ($1.2 billion) on debt capital markets to repay bank debt, unlock liquidity and fund investment.

Adding to attractiveness of owning strategic infrastructure assets like Sydney Airport is its poll-position as the most likely builder and operator of a second Sydney airport.

In addition to high profit margins in both aeronautical and car parking activities, Sydney Airport continues to enjoy the highest profit per dollar (50.1 cents) for aeronautical revenue of all the monitored airports, and return on assets (ROA) from aeronautical services was also highest at 12.4%

While the airport should be able to organically grow earnings and reward investors with consistent distributions over the long term, investors need to keep an eye on debt levels, especially if it does become the builder and operator of Sydney’s second airport.

While RBA rate cuts have added to attractiveness of Sydney Airport’s yield-play story, defensively-minded income investors should also be rewarded with a sustainable yield, and future growth over the longer term.

Those chasing yield here should try to enter the stock on any future corrections and watch for any future signals that the first of the Fed’s rate increases is getting closer.

Those with an appetite for shorting should also watch the share price closely.