Airports in a new
World of Risk
The Covid crisis has exposed unexpected weaknesses in European airport business models and contradictions in the regulatory regimes, revealing that airports are as risk-prone as airlines, maybe more so.
In 2019 PWC, in a report on airport valuations and investments, confidently stated:
“Airports are a uniquely appealing class of asset for investors. While they typically offer strong growth fundamentals, diverse income streams, asset resilience and cash distributions, they also provide the potential to realise significant capital gains upon disposal”.
A year later ACI-Europe reported a collapse in 2020 airport revenues of €32bn or 66% from the previous year. It warned that 200-plus European airports faced insolvency. It also complained that airports, in contrast to airlines, had received relatively little government support: according to ACI-Europe airlines received €32.1bn in state support in 2020, airports a mere €2.2bn.
One of the reasons for government reluctance to fund airports in the Covid crisis is that taxpayers’ funds would in many cases end up with the airport shareholders — construction and engineering conglomerates, private equity, pension and sovereign wealth funds and so on — supporting multinational capital rather than national assets.
The history of airports as investable assets, as opposed to public utilities, is relatively brief, starting with the privatisation of BAA in 1986 followed by the sale of UK regional airports in the 1990s and 2000s then in quick succession Western European, Asian and South American airports in the 2000s. US airports, by contrast, have not been part of the privatisation trend.
The chart below summarises PWC’s tracking of European airport values as measured, by Enterprise Value (EV — Equity plus Net Debt) divided by operating cashflow (EBITDA).The prices paid for airports have varied with financial cycles — peaking at around a multiple of 25 in the period leading up to the global financial crisis, a decline during the recession then a recovery in recent years to around 22 in 2018/19. The background was a reassuring constant increase in passenger traffic, interrupted only by what now look like minor blips like September 11 and the global financial crisis.
The Covid-19 catastrophe is of a vastly different order of magnitude, bringing airport transactions to a near halt in Europe. A full traffic recovery is even more important for airports, which require traffic volume and revenue to cover their high fixed costs, than for airlines, some of which will be able to adjust to the world and operate profitably in a downsized market, especially if inefficient competitors are forced out. What is the value of airports now is just unknown, given that debt is swamping equity and cashflow is so reduced.
Latest thinking on traffic recovery pushes the 2019-equivalent year out to 2024 or 25, with the prospect that, in the European market at least, Summer 2021 will be another write-off as international travel restrictions will remain in place. Thereafter, some form of fairly rapid S-shaped traffic recovery seems likely, with pent up leisure demand being unleashed but the recovery then levelling off until a resumption in business travel causes a second shift in the curve.
The members of the consortia that have bought and sold airports assets have different priorities — construction companies see the potential of massive building projects, airport groups look to diversify risk and sell their operating expertise, private equity makes cyclical plays and pension funds are attracted by the long-term nature of the investment — but until 2020 all were comforted by the solidity of airport investment. The pandemic, however, has exposed the fragility at the core of airport values.
Traffic forecasting mythology
At the base of any airport valuation exercise is the traffic forecast. Projected passenger throughput drives, directly or indirectly, just about every revenue item — aeronautical (passenger handling charges, landing fees, CUTE and CUSS, etc) and commercial (car parking fees. Concessionaire contracts, etc). The forecast also drives Opex, with employee numbers being linked to traffic via various elasticities. Most critically, the traffic forecasts determine the timing for Capex decisions.
Traffic methodologies have become more sophisticated over time, but, pre-Covid, the forecast traffic CAGR almost always worked out at 3.5% ±1%. There are basically two elements to any forecast:
In the short term, a focus on airline plans, which in normal times works well for larger airports but is questionable at smaller ones when an unexpected decision to downsize by an airline (usually Ryanair) totally undermines the numbers.
In the long term, the traffic numbers are linked to and driven by some form of GDP forecast, which depends on finding someone to make an accurate long-term GDP forecast. And then there is a conceptual problem. The relationship between GDP and air transport is a correlation not a causation; to produce a forecast for a whole economy, one must input assumptions, explicitly or implicitly, about the growth in sectors like travel, communications, leisure and indeed aviation.
Uncertainty tends to be dealt with by developing numerous scenarios and attributing P numbers, representing the percentage chances of that scenario being met or exceeded, to each one; so, for example, a very low traffic forecast would have a P95 rating while an aggressive forecast would be a, say, P50. A plausible narrative can be attached to most scenarios, but in the end practicality prevails and a middle-type forecast is chosen as the basis for discounting future cashflow and arriving at an approximate valuation that can be negotiated around.
This standard forecasting methodology in effect excludes catastrophic events and has created the misleading impression that airports are inherently low risk investments. At the start of the pandemic, we discussed the concept of the “Black Swan” as popularised by Nicholas Taleb (see Aviation Strategy, March 2020). It seems even more relevant now. Taleb observed that Black Swan events were not only unpredictable and improbable but they are also inevitable, and it is necessary to prepare for catastrophes.
But, as Taleb has pointed out, people, especially specialist forecasters, are psychologically very poor at accepting the inevitability of Black Swans and preparing for them. He is particularly dismissive about standard forecasting, which he sees as little more than a projection of “normal” times, with false security provided by statistical technique. (To be fair, Macquarie in the days when it was the innovator of airport privatisation transactions used to ask its traffic advisors to think about a repeat of the 1918 flu epidemic, an exercise that over-stressed the forecasting models and the forecasters.)
Airports vs airlines:
Dilemmas and conundrums
European LCCs changed regional airports, introducing the concept of trading guaranteed traffic growth for low — in some cases, negative — fees per passenger, rates that bore no resemblance to the official schedule of charges that airports continued to publish. Underutilised facilities began to fill up, revenue from commercial activities soared, expansion plans were drawn up, and governments, both central and local, realised that there was money to be made through privatisations.
Over time airports were able to regain some pricing power as the LCC sector matured and growth rates slowed; the European Commission also intervened, finding that some of the airport deals constituted illegal state aid.
In 2020 the balance of power inverted again. Airports were left viciously exposed to the collapse in traffic — as evidenced by the 200 airports facing insolvency according to ACI-Europe — while LCCs like Ryanair and Wizz and, to a lesser extent, easyJet had more than sufficient liquidity to weather the crisis. Pre-Covid contracts rapidly became unenforceable as the LCCs naturally used the crisis as an opportunity to lower costs; Michael O’Leary of Ryanair put it simply: “Aircraft numbers are going to move significantly to wherever we can get the best deals.” European regional airports have offered airlines “Recovery Incentives”, “Welcome Back Packages, “Airline Support Schemes”; in other words, they have discounted like crazy.
Larger, formerly congested airports have another dilemma. In order to preserve connectivity in the Covid crisis, and to protect flag-carriers, WASB (the Worldwide Airport Slot Board, which comprises IATA and ACI) has changed the slot utilisation rules. Instead of the standard 80% “use it or lose it” criterion for slot usage, a 50% rule was implemented in 2020 and extended to the Summer 2021 season.
It is unlikely that this rule change can be extended further, raising the possibility of LCC incursion into major hubs — easyJet could expand services at CDG and might enter Heathrow (it has in the past talked about its planned schedule there); Ryanair and Wiz would be interested in Amsterdam. There is the theoretical possibility of a new, more effective version of LHLCC.
For Europe’s largest regulated airports, the essential problem is how to respond to the traffic loss from global network carriers, in particular long-haul business orientated traffic that is going to much slower to recover than short-haul leisure-orientated traffic. In these unprecedented times the regulatory regimes tend to prompt airports into raising aeronautical charges, the opposite of what might be expected.
Andrew Lobbenberg, equity analyst at HSBC explained this issue as succinctly as possible in a recent research report: “Traditional airport charges regulation at economically regulated major airports, is designed to protect airlines and their passengers from the potential abuse of dominant position by the monopoly providers of airport capacity. The structures are typically designed to define charges that allow airports to earn a return on capital equivalent to their cost of capital: ROCE = WACC regulation.
“In the present circumstances, these structures look out of place: we forecast five stockmarket-quoted European airports [AdP, AENA, Fraport, Vienna and Zurich] to report net losses in 2020, negative returns and wide gaps to their WACCs. If the financial regulator were to reset tariffs to allow ROCE to reach WACC in the short term, conceptually airport charges would need to rise rapidly …. challenging from a pragmatic perspective, given that the airlines have battled to survive the pandemic and many are only trading thanks to significant state aid injections.”
HAL: Regulatory ructions
Heathrow Airport Holdings’ (HAL) response to the 75% collapse in its traffic and £2.1bn net loss in 2020 has raised a number of regulatory issues as well as deeply upsetting its airline clients. In essence HAL turned to its regulator, the CAA, asking for a 5% increase in its airport charges from 2022 in addition to planned increases associated with the construction of the third runway. HAL had not got close to breaching its loan covenants. The request to the CAA, made last October, was prompted by concern about its cost of funding and its shareholders.
The consortium that owns Heathrow is led by the Spanish infrastructure conglomerate Ferrovial (25%); the other shareholders are the Qatar Investment Authority (20%), CDPQ, the Québec provincial pension fund (12.6%), GIC, the Singaporean sovereign wealth fund (11.2%), Alinda Capital, the US private equity fund (11.2%), the China Investment Corporation (10%) and the UK’s Universities Superannuation Scheme (10%) — an immensely wealthy group which in the pre-Covid years was extracting about £500m a year in dividends from HAL.
In order to raise fees HAL has asked the CAA — whose regulatory role is primarily to protect the consumer, ie the passenger, from the monopolistic power of the airport owner by setting maximum airport charges for five-year periods — to increase the Regulatory Asset Base (RAB). The RAB is a regulatory parameter defined as “representing the value of the investments that HAL has made in its regulated business that have not yet been fully recovered through airport charges” RAB is used by the CAA as the basis for calculating revenues allowed to HAL given an agreed return on the asset base. It is one of three building blocks — along with Regulatory Depreciation and Opex — which sum to the expected revenue for HAL given expected passenger volumes. But, as the bar chart below vividly illustrates, in 2020 actual revenue amounted to only about a third of the required revenue expected in HAL’s business plan.
Increasing the RAB, through adding in more future expenditure (£1.8bn), is therefore the mechanism through which HAL can justify a price increase to the regulator. The concept behind a RAB is to give HAL, or any regulated utility, a strong incentive to use its cashflow for capital expenditure to improve the asset. But HAL’s critics, including the dominant airline at Heathrow, argue that the RAB perverts the investment process.
HAL has been accused of exercising lax cost control, particularly, in its Capex because inflating the RAB automatically increases its own revenues through the return on investment the CAA allows the airport owners. These costs can then be passed on to captive airline customers through passenger charges.
Since Ferrovial took over BAA in 2006 the RAB has increased from £5bn to £16.5bn in 2020, and net debt has soared in parallel to £13.1bn, while book equity at the end of 2020 had turned negative, around -£600m (our estimate, this number has not yet been published). Again critics point to distortion caused by the regulatory regime: the company has become over-leveraged — a debt/equity ratio of over 14 in recent years — because debt providers have perceived the regulatory regime as a process that almost eliminates risk in funding capex.
All that has changed drastically with the pandemic, and the airlines are not being sympathetic. In its February 2021 report on HAL’s RAB application, the airlines’ opinion was summarised as:
“HAL’s current financial concerns are caused by its highly leveraged financial structure … HAL should be looking to shareholders, not passengers, to address these concerns. Airlines are particularly concerned by media reports that HAL would look to pay dividends to its shareholders in 2022 …. evidence that HAL is not directing capital towards supporting service quality”.
Former IAG CEO Willy Walsh was more pithy with his parting shot before leaving the airline group last year: “Heathrow is on a massive gravy train and will do everything to protect that. We have absolutely no confidence in its ability to deliver cost-effective expansion.”
Walsh was particularly exercised by the issue of prefunding the third runway, in which the CAA is supporting HAL. In essence this means the current Heathrow carriers will be paying for the new runway long before it becomes operational, with no guarantee of receiving additional slots, as they may be prioritised for new entrants, or indeed of surviving the financial fall-out from the pandemic.
HAL has been pretty dismissive of its biggest client’s opinions and has concentrated on arguing its position with the regulator. Its position boils down to the contention that if the CAA does not intervene in the exceptional circumstances of the pandemic to allow HAL to increase its RAB, and hence its passenger charges, then its financiers will take a radically different view of Heathrow as a fundamentally risky business, which will mean the cost of funding will soar, and in the longer term passenger charges will be significantly higher than they otherwise would have been.
For the period 2022-2026, HAL expects the passenger charge to average £32.76 if the RAB adjustment it has demanded is allowed, but warns that it will have to rise to an average of £42.44 if no RAB adjustment is made. The current maximum passenger yield is £23.56 (excluding a temporary Airport Cost Recovery Charge £8.90 surcharge to compensate for keeping underutilised check-in facilities operational.)
HAL makes a particularly interesting assertion with regard to the cost of its equity: it estimates that the impact of the Covid-19 pandemic on its cost of equity — unless the CAA intervenes — is an increase from 8.30% to 16.79% because of the increased riskiness of the investment (in technical terms, an increase in the beta value). This implies a halving in the equity value of Heathrow; for comparison, the stockmarket-quoted European airports have shown more modest declines in their equity values since the beginning of the crisis — AdP, -38%, Fraport, -25%, AENA, -16%.
Further, HAL appears to argue that the regulatory regime has misled investors as to the riskiness of the Heathrow investment, because an event like the pandemic could not have been factored into their calculations. It stated explicitly, “it is not appropriate for a regulated company to be expected to bear downside impacts that occur less frequently than once every 20-years.”
The CAA did not buy that, responding that the shareholders assumed all traffic risk when they invested. HAL’s view does, however, accurately reflect the Black Swan blindness described above.
Nevertheless, it is likely that when the CAA reaches its decision, sometime in March, it will allow some exceptional increase in charges related to the pandemic and may introduce some traffic risk element into the charging mechanism. But the pandemic has laid bare basic weaknesses in the regulation of Heathrow in terms of distortions on the perception of risk, a consequently over-leveraged capital structure, and an inflated expenditure programme. And it just seems wrong that the regime foments such acrimony between HAL and IAG (and other British airlines).
In all the pages of sometimes arcane arguments generated by HAL’s request to the CAA and the CAA’s responses, the elephant on the apron hardly gets a mention. What is the impact of the pandemic on the viability of the third runway? Are the former traffic forecasts still valid? (HAL, unsurprisingly, says yes.). What are the chances of more cost inflation given the changes in risk perception? Have the environmental arguments against the project hardened? All questions that raise the spectre of another Heathrow enquiry.
AdP: The Greening of Paris
In contrast to Heathrow, Aéroports de Paris (AdP) has embarked on what appears to a radical new strategy based on a much lower traffic profile. It does not expect traffic at CDG and Orly to return to the 2019 level until sometime between 2024 and 2027, noticeably later than the outlook from most other airports and airlines; so instead of a 2025 throughput of 126m, its previous planning assumption, traffic volume will be around 107m, according to the new plan.
The airport group appears to have embraced a green agenda: “Shifting from a high-growth model to a new profitable airport model in accordance with new environmental and societal challenges”.
The strategy has not yet been worked out in detail but encompasses these elements:
A marked reduction in capex: AdP has already made the decision to cancel the fourth terminal project at CDG, with the French Environment Minster noting that the expansion plan has been based on traffic forecasts that had been rendered meaningless by the pandemic. Only projects that have already been started are guaranteed.
An implied curtailing of international investments after the completion of existing projects in India and Kazakhstan (AdP has stakes in 24 airports worldwide including a 46% stake in the Turkish operator TAV).
Specific carbon targets: AdP’s target is to achieve carbon neutrality at the Paris airports by 2030 and net zero emissions by 2050 for these airports plus Zagreb, Liège, Ankara and İzmir (the difference between the two targets is that carbon neutrality can be reached by, for example, buying carbon credits whereas net zero emissions is a physical commitment at the AdP airports).
Greening ground handling (electrification, natural gas and hydrogen).
Partnering in consortia, alongside Airbus and Air Liquide, which are developing alternative aviation fuels.
AdP’s strategy is naturally tied in with that of Air France, which is facing the challenges of right-sizing its CDG hub, probably permanently cutting back intercontinental operations, switching to a A220 short-haul fleet and rebalancing its traffic mix away from connecting to O&D. AdP is 51% owned by the French state, with the majority stake encapsulated in law, while the Air France Group is 28% owned by the French and Dutch states, but that ownership and control is set to expand as a further tranche of state aid is almost inevitable. The green post-pandemic AdP is probably going be more of a statist institution than a global airport investor and developer.
Financially, the new AdP has a few problems in recovering its pre-Covid profitability — in 2019 the company achieved net profits of €588m equivalent to 12.4% of total revenues but in 2020 it made a loss of €1.17bn. Moving to a low traffic model means than AdP will be unable to contain its unit costs through volume growth. With four runways at CDG it has potentially twice the capacity, 120m passengers a year, of two-runway Heathrow, but that potential will not be realised for a long time. And rigid French labour laws make cost cutting through workforce rationalisation very challenging.
On the revenue side it may be able to push up its aeronautical pricing through the cost of capital/ return on investment formula encapsulated in its regulatory regime, but commercial revenues which do not come under the regulatory regime (AdP’s dual till pricing regulation is based just on aeronautical operations, unlike Heathrow’s which combines both aeronautical and commercial, the single till model). AdP has been an innovator in the commercial field focusing on selling upmarket goods to long-haul passengers, especially the Chinese and Japanese. In 2020 commercial revenues collapsed by 57% against 54% for total revenues, and the easy-spending long-haul traffic segment is expected to be the last to recover post-Covid.
Commercial activity: Compatible post-pandemic?
European airports have come to rely on commercial activities for 40-50% of their total revenues. Is this model compatible with requirements of the post-pandemic world?
Optimising passengers “dwell-time” in airside terminals in close proximity to the attractions of shops, bars and restaurants used to be a key element of airports’ commercial strategies. Around 50 minutes was thought to be optimal — long enough to encourage spending, whether through desire or boredom, but short enough to avoid over-crowding. Post-Covid, encouraging dwelling in terminals is unlikely to prove too popular, and medical checks on top of security are likely to make the airport experience more stressful.
Even before Covid, the airport retail offering was being questioned. Brian McBride, formerly chairman of Asos and CEO of Amazon UK and the online retail guru, was very sceptical about the prospects for duty-free shopping at a GAD conference back in 2017; he simply could not see a future for these strange shops. The pandemic is estimated, by consultancies which specialise in such things, to have advanced online retail by at least ten years while dealing a death blow to the high/main street. The question airports should be contemplating is: what will Amazon do to disrupt airport duty-free shopping?
Collecting online purchases at the departure terminal is fairly well established at some airports. Could airport shopping be virtualised by linking online purchases to electronic records of airline tickets and/or boarding passes, with the goodies being delivered to home addresses?
Car parking is the most important single commercial revenue source for many airports yet this seems more and more like an anomaly in an environmentally conscious world which encourages trains over roads. Emission from cars travelling to/from airports are a major element in airports’ carbon footprints.
Airport retail may prove to be more resilient than suggested here, but these issues are not going to go away. Moreover, airports have a fundamental problem with their contracts with their concessionaires. These contracts normally contain Minimum Revenue Guarantees, fees that are paid regardless of passenger footfall at the airport, in other words concessionaires take a large part of the traffic risk. But in the pandemic crisis these minimum fees have simply not been paid, and all are up for renegotiation. Yet some airports appear not have recognised this reality, continuing to book the minimum contracted commercial revenues in their accounts even though they may well be uncollectable. For instance, AENA, the Spanish airport group, reported traffic down by 72% in 2020, aeronautical revenue down by 67% and, by contrast, commercial revenue down by only 17%.
So many issues — No easy solutions
Taking all these issues into account, there appears to be no rapid recovery path for airports, though clearly some are in better positions than others.
At the same time as aeronautical revenues are being squeezed by the oversupply of airport capacity relative to the weakness of airline demand, commercial revenues are also under threat because of changing travel requirements and technical innovation. With former assumptions of growth now untenable, pressure may increase on unit operating costs.
Unless financiers and investors take the very benign view that traffic will soon resume at normal growth rates and the pandemic was just a one in hundred-year event, the cost of both debt and equity will rise significantly. Which implies a fall in asset values. Airports will no longer be regarded as low risk investments.
But, unlike airlines, airports are rarely shut down. Solutions come from financial restructurings and management change.
This article appeared in Aviation Strategy Issue #259 Jan/Feb 2021.