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Morningstar | Sydney Airport’s Retail Revenue and Profitability Expansion Set to Take Off; Raising FVE Slightly

Narrow-moat Sydney Airport’s first-half results reflect continued solid international passenger growth, retail sales gains, and slight operating leverage, largely in line with our expectations. While we expect passenger growth to slow as the year progresses, we remain confident that the airport will continue to enjoy gains well above population growth, alongside further retail spending benefits and expanding EBITDA margins over the long run. To this end, we’ve lifted our near-term profit outlook to account for slightly higher retail spending gains and a lower tax impact, incorporating management’s reiterated outlook for full-year distributions of AUD 37.5 cents per security, slightly ahead of our prior AUD 36.5 cent forecast. But we’ve maintained our long-term assumptions, and our fair value estimate increases slightly to AUD 7.30 per security from AUD 7.20.

First-half passenger traffic at Sydney Airport tracked our expectations, as discussed in our note dated July 23, 2018. Year-to-date, domestic movements increased 2.1% versus the prior comparable period, or PCP, tracking our full-year forecast, while international traffic has risen 5.2%, ahead of our 4% projection.

Sydney’s revenue climbed about 8%, similarly outpacing our full-year 6.5% expectations. Retail revenue was a standout, growing 9% over the PCP, as spending per international passenger grew 3.6%. This was ahead of our full-year 2.7% forecast, driven by better-than-expected retail lease renewals and solid duty-free spend rates. We’ve lifted our assumption to 3.7% gains for this year and to 4% for the next two years (from 3%), reflecting this trend continuing, and the likelihood that Sydney will be able to renew the Terminal 3 retail space--currently on lease until mid-2019--at a similarly higher rate. However, we expect this metric will slow to slightly above inflationary levels long-term, and we maintain our assumption of 3% past 2020.

Offsetting this higher revenue growth, Sydney Airport’s EBITDA margins trailed our projections in the half. Profitability ticked up on slightly, to 80.9% from 80.8% in the PCP, but were lower than our full-year forecast of 81.1%, as higher employee and utilities expenses offset lower maintenance costs. In sum, the airport’s expenses increased 7.4% versus the PCP. Nonetheless, management noted that costs rose a more modest 2.5% after normalising for noncontrollable security costs (which are passed through to airlines) and investments for new hotel property. As such, we remain confident that the firm’s EBITDA margins will expand to nearly 83% over the next five years with higher aeronautical prices, a positive mix shift toward international passengers, and continued operating leverage of the group’s fixed costs. The announced plan to source up to 75% of electricity needs from third-party renewable sources also supports our view.

Sydney Airport’s Master Plan 2039 supports our long-term outlook for passenger growth to slow. Management forecasts 65.6 million passenger movements in 2039, with 31.5 million of those international. This implies a CAGR of just under 2% for total passengers, and about 3% for overseas traffic, tracking our long-run projections. While we don’t forecast out 22 years, our 10-year explicit forecast period envisages a higher 2.6% CAGR for total traffic, and 3.7% for international. But this is front-end loaded; we see total traffic slowing to about 2% by 2027, and international movements similarly at 3% in that year.

However, a risk to this outlook is the planned Western Sydney Airport, scheduled to open in 2026. We believe we’ve accounted for the impact from this competitive asset, which will be focused on domestic traffic, in our slowing long-run growth forecast and narrow moat rating for Sydney. Still, if the Western Sydney Airport opens on time in 2026, and takes more domestic traffic than we anticipate, Sydney Airport could face operating deleveraging from overcapacity, which could dilute returns for several years until it can again reprice its passenger fees with airlines.

Another key risk remains Sydney Airport’s balance sheet. Capital spending is elevated to expand automated check-in, refurbish runways, and modernise facilities. Management reiterated its planned AUD 1.3 billion-AUD 1.5 billion spend over the next four years, in line with our AUD 1.45 billion forecast. We’re encouraged that net debt/adjusted EBITDA ticked down to 6.7 times in the first half, in line with the end of calendar 2017, and the next major unfunded maturity is not until 2020. But because Sydney opts to pay out 100% of its net operating receipts (net income plus depreciation and amortisation, and other noncash items), taking on debt to support both its payout and capital spending programs, the firm will likely remain at the mercy of debt market conditions.