BAA in play Feb/Mar 2006

Shareholders in BAA have enjoyed a 30% increase in stock value since Ferrovial, the Spanish infrastructure company, announced a possible bid for the airport group in February. Although Ferrovial has not yet assembled its bidding consortium, and reports of a rival consortium centred on Macquarie Bank remain unconfirmed, the fact that BAA is being seriously considered as a takeover target is remarkable.

Since its privatisation in 1987 BAA has been a heavily regulated entity, with the regulator, the Civil Aviation Authority (CAA), controlling the aeronautical charges that can be levied and the rates of return that the BAA can generate. According to a detailed analysis of BAA by Dresdner Kleinwort Wasserstein (DrKW) the Regulated Asset Base (RAB) accounts for about at least 76% or £11.12bn of BAA’s enterprise value.

Essentially the CAA reviews on a five–yearly, or quinquennial, basis the BAA’s planned capital expenditure at the three London airports, its operating expenditure and its forecast income from commercial activities (this is the single till approach whereby income from concessionaires in effect subsidises aeronautical charges, unlike the dual till approach at most major European airport which excludes commercial revenue from pricing regulation). Based partly on the capex planned the CAA agrees weighted average cost of capital (WACC) that the BAA can apply — currently it is 7.75% pre–tax in real terms — and the resultant net income is then used as a basis for setting the maximum aeronautical fees that BAA can charge.

For the current quinquennium, 2003–08, BAA set charges per passenger at Heathrow at £6.48 with annual increases equivalent to inflation (RPI) plus 6.5% permitted. At Gatwick the regulated charges were £4.32 per passenger with increases limited to RPI, and at Stansted £4.89 also limited to RPI.

It is difficult to see how a new owner could escape in any significant way the constraints of the regulatory regime, and the CAA has issued a statement emphasising the importance of its role as the regulator (see box on page two). In the next quinquennium (2009–2014), following the completion of Terminal 5 at Heathrow, there are two major projects planned: the first phase of capacity expansion at Stansted, including a new runway, costing an estimated £3.5bn and the redevelopment of Terminals 1 and 2 at Heathrow, creating a new terminal with a similar design to Terminal 5, costing £1.5–2.0bn. These projects are probably non–negotiable.

Normally an airport purchaser would attempt to extract value from the investment by trimming operating costs or enhancing retail activity. But under the BAA regime, the regulator would be likely to channel the benefits from such activities into capping aeronautical charges. A takeover of BAA would inevitably leave the group with a much more highly leveraged financial structure. But the CAA does not take gearing levels into account when calculating WACC. So this probably closes off another avenue for a new owner to extract value.There is the possibility of refinancing or selling the other assets in the BAA group, which include four UK airports (Glasgow, Edinburgh, Aberdeen and Southampton), 75% of Budapest Airport, bought last year, plus smaller stakes in Italian, US and Australian airports.

These are valued by DrKW in total at £4.3bn or 24% of the group’s enterprise value, using multiples from recent transactions (see table below) in the case of the UK regional airports and purchase price in the case of Budapest. But even with these airports there is a form of regulation, albeit with a lighter touch — for example, the CAA reviews and approves the fees charged at the UK airports.

Regardless of whether a firm bid materialises, the interest shown in BAA and Heathrow in particular has possible political repercussions. DrKW observes that 20 years of UK utility regulation have turned Heathrow into one of the cheapest major airports in Europe, leaving it undervalued in normal economic terms, and there is now an opportunity to correct that anomaly by a one–time rebasing of the aeronautical charges. The airlines will not be happy, but DrKW argues that this would have the effect of better rationing finite capacity, reducing congestion, planning and environmental pressures as well as the capex requirement.

And it would also have the effect of rendering BAA virtually bid–proof.