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Morningstar | Auckland Airport's Retail Investments Paying Off, and Margin Uplift Around the Corner; Raising FVE

Wide-moat Auckland Airport's fiscal 2018 results highlighted the positive impact of the group's ongoing investments. While total passenger growth slowed versus the prior year, as discussed in our note dated July 23, 2018, and lower passenger fees crimped aeronautical revenue growth--both in line with our expectations--retail revenue shot up an impressive 17%, as the airport began to open new commercial space in the international terminal. This timing was slightly earlier than we had expected, and underlying NPAT of NZD 263 million outperformed management guidance for NZD 250 million to NZD 257 million, and our NZD 256 million forecast. Nonetheless, the company's outlook for fiscal 2019 NPAT in a range of NZD 265 million to NZD 275 million matches our forecast for NZD 275 million (which we've increased from NZD 269 million due to slightly lower interest expense), keeping the firm on track to meet our expectations. We increase our fair value estimate to NZD 7.40 from NZD 7.20 due to the time value of money, although our Australian valuation falls to AUD 6.70 from AUD 6.80 on the back of a weaker New Zealand dollar. Shares currently screen as slightly undervalued.

We expect Auckland Airport to enjoy continued high-single-digit revenue growth over the medium term, stemming from low-single-digit passenger traffic gains, positive mix shift toward international traffic, which carry higher landing fees, and continued strong gains in nonaeronautical revenue such as retail and property income. Auckland met these expectations in fiscal 2018, growing consolidated revenue nearly 9% on the back of roughly 6% passenger growth. Beyond the solid retail revenue gains, the firm enjoyed 8% growth in car park revenue and 15% gains in property rental income. We expect further new parking capacity additions and property development in fiscal 2019, leading to 6% and 19% respective top line gains for these segments.

Operating leverage and margin expansion will take longer to materialise, however. Expenses continued to rise faster than revenue in the year, climbing nearly 14%, reflecting continued investments in staff, operations, and IT systems, as well as costs associated with operating recently expanded infrastructure. As such, despite the rise in retail revenue--typically a higher-margin opportunity for the airport--EBITDA margins fell to 74% in the fiscal year from 75% the year prior, continuing the trend seen in the interim result in February 2018.

Nonetheless, we attribute this movement primarily to timing, rather than a sign of limited long-run margin upside. The company had flagged upfront costs as part of its five-year planning process about a year ago, and management estimates operating expenses will climb in fiscal 2019 at less than half the rate seen in fiscal 2018. We remain comfortable with our forecast for EBITDA margins to rise to about 77% by fiscal 2023, as fixed costs are spread over a larger revenue base.

Auckland continues to embark upon a sizable capital investment program, supporting future passenger growth through expansion of facility capacity, transportation upgrades, and security, as well as new retail and commercial space. Capital expenditures for fiscal 2018 were NZD 387 million, and management expects to spend another NZD 450 million to NZD 550 million in fiscal 2019, tracking our NZD 50 million forecast. We expect further increases over the coming years, with annual capital expenditure climbing to more than NZD 500 million by fiscal 2021. While these endeavours will crimp available free cash flow, we note the airport should recoup these investments through the mechanism of higher per-passenger landing fees upon the commencement of its next five-year plan, scheduled to begin in fiscal 2023. As a result, we expect return on invested capital to climb to above our estimated 7.0% weighted average cost of capital by the end of our 10-year explicit forecast period.

The firm's balance sheet remains supportive of these investments. Following the sale of North Queensland Airports in fiscal 2018, net debt/adjusted EBITDA fell to about 3.9 times from 4.3 times in fiscal 2017. We anticipate this metric climbing back to north of 4 times as the capital spending program continues, considering Auckland pays out 100% of its underlying net earnings, but believe risk is low given EBITDA/interest cover of nearly 7 times. These metrics compare favourably to Sydney Airport, which is more heavily geared at 6.7 times net debt/EBITDA and about 3.0 EBITDA/interest cover.