The case for investing in airports December 2004

The case for investing in airports still remains a strong one. They promise long term volume growth and typically have low cash flow and low earnings volatility.

At the recent Global Airport Development conference held in Prague, the state of the sector and investment cases were discussed.

Airports are regulated monopolies with robust EBITDA margins, which have in most cases withstood external pressures like September 11, SARS and even the demise of flag carriers (for example Sabena at Brussels). At successful airports, non–aeronautical revenues typically grow at twice the rate of the regulated aeronautical revenues.

Within the sector it is clear that there is a difference of emphasis between the investment models of the key investors — airports and financial buyers.

Airport operator investment model

The major airport operators (BAA, Fraport, Vienna International, Copenhagen Airports and TBI) have had their appetites for investments somewhat reduced post September 11. It has been a period where the airports have had to concentrate on cost cutting and deal with increased security requirements.

Also, shareholders have shown a lukewarm reaction to investments made by airport operators where they have been unable to secure a controlling stake and have historically underestimated the political risk involved (for example, Fraport’s investment in Manila, where contractual disputes culminated in a multi–million dollar loss for Fraport).

Copenhagen Airports is still receiving criticism for its 49% investment in Newcastle Airport, which cost Copenhagen £95m in May of 2001, at the time that was a hefty 18.5 times EBITDA.

BAA makes as much money from the Heathrow Express (an express rail link serving the airport and central London) as it does from its total airport investments in Melbourne, Perth and Naples.

These airport investments account for only 2% of BAA’s group pre–tax profits. Few airports also have major free cash flow to invest; for example, BAA’s gearing will rise to around 50% at the peak of its investment in Heathrow’s Terminal 5. Rather than just bricks and mortar, BAA is happy to expand its international activities through retail contracts, where there has been no equity investment but an upside potential through profit sharing.

However, activity in the airport sector is resuming again, reflecting the general upturn in aviation. Recently, Abertis, the Spanish toll road group and AENA, the Spanish airports authority, have acquired 29.9% of TBI and have binding offers for another 19.5% of the shares. Last month, Macquarie Airports acquired a 70% equity interest of Brussels Zaventem airport for €735m ($953m) from the Belgian state–run BIAC and a number of other shareholders .

Macquarie Airports: the financial investment model

Macquarie Airports, a listed globally diversified airport fund, looks to invest in developed assets. They focus on dominant airports within a strong catchment area, airports with above average traffic growth and strong EBITDA margins. Also crucial for the investment case is a strong commercial upside, light–handed regulation at the airport and preferably no large future capex programme.

Macquarie has expertise in financial restructuring rather than managing, they prefer to apply their aviation knowledge as a shareholder not a manager and so unlike an airport operator there are no management fees.

Their skill lies in managing the airport’s capital base and using sophisticated financial instruments to fund new acquisitions or to refinance existing debt (which Macquarie is preparing to do at Bristol Airport).

Macquarie prefers to apply their aviation expertise as a shareholder rather than as a manager, this tactic seems to be paying off. The Macquarie Airports fund is now trading at 14 times EBITDA, while the average EV/EBITDA of the quoted European airport sector is currently at around 8.

The future

The sellers, which are usually governments, are becoming increasingly sophisticated in how they sell their airport assets and competitive auctions are producing high prices. In Europe, Budapest Ferihegy Airport has issued a tender publication for a privatisation adviser and Aeroports de Paris are in the initial stages of restructuring ahead of a planned privatisation (the French government however are set to retain a majority stake).

Determining who will be the winners and losers is becoming harder in this more complicated investment environment. In Europe, it is clear that three super–hubs (Heathrow, Charles de Gaulle and Frankfurt) have true pricing power and our set to dominate.

It is less clear whether any of the minihubs will make good investments.

Take for example, the case of both Prague and Budapest airports, both slated for future privatisation and both are keen to challenge Vienna as the hub for eastern Europe. But, Prague and Budapest have much less pricing power and often need to discount to attract passengers, a situation that is comparable to the contrast between Frankfurt and Frankfurt- Hahn airports.

Schiphol Airport is also facing some uncertainty regarding the dual–hub strategy that has been implemented following the Air France/KLM merger. Schiphol’s future is secure, at least for the next five years according to the merger terms, however investors will tread warily over the future of the weaker hub.

Other challenges facing airport investors are the instability of traffic flows, in the US hubs are collapsing and in Europe flag carriers, such as Swissair and Sabena, have failed. Also, historic travel patterns are being challenged by the LCCs. At regional airports, LCC growth is now typically growing ten times faster than the legacy carriers.

In Germany, hubs such as Frankfurt and Munich recorded high growth rates for 2003 and the early months of 2004, however the most dramatic growth rates came from regional hubs boosted by the LCCs such as Berlin Schonefeld, Frankfurt–Hahn, Nurenburg and Stuttgart.

At the same time, investors will have to take a view on the survival of core carriers. Prague Airport is served by 14 LCCs momentarily, the figure was 15 before the recent collapse of Volare. However, there have been 20 LCC failures in the last two years.

Added to this volatility, future travel patterns are likely to be distorted by the arrival of new aircraft types. The A380 will be good for super–hubs but Boeing’s 7E7 will suit smaller hubs and larger regional airports.