For professional investors and advisers only August 2013 Schroders What makes airports more attractive than the airlines? By Alicia Low, Senior Credit Analyst, Schroders Aviation is by nature a cyclical industry and vulnerable to exogenous events: the collapse of Ansett in 2001, the September 11 2001 terrorist attack, SARS in 2003, record high fuel prices in 2007 and the Icelandic volcanic eruptions in 2010. Added to this there have been macroeconomic shocks such as the Asian crisis of 1997/98, world slowdown/recession of 2001 and the Global Financial Crisis (GFC) in 2008 and 2009. In spite of these major events, all five Australian capital city airports (Sydney, Melbourne, Brisbane, Perth and Adelaide) have delivered positive growth in passenger movements in nineteen of the past twenty years1 (see Chart 1), propelled by rising real incomes and competitive airfares. Chart 1 In this article, we explain the characteristics that make airports more attractive investments than airlines for our fixed income, credit securities and multi-asset funds. What makes airports more attractive investments than airlines? While Ansett’s collapse in 2001 was the most high-profile bankruptcy of an Australian airline, there have been more than a few lesser known failures: Air Australia (2012), Australian Airlines (2006), Airlink (2008), MacAir (2009), Sky Air World (2009), OzJet (2009) and Compass (1992). In all, twenty-one Australian airlines have ceased operations in the last ten years2. While the fortunes and travails of airports and airlines are closely linked, economic reality has rewarded investors in airports over airlines (see Chart 2). What makes airports more attractive investments than airlines? Competition, commercial agreements and credit structure are three key credit attributes underpinning our investment preference for airports over airlines. 1 Ansett collapse and the September 11 terrorist attacks occurred in September 2001 or financial year ending 2002. 2 Source: www.AirlineUpdate.com Issued by Schroder Investment Management Australia Limited 123 Pitt Street Sydney NSW 2000 ABN 22 000 443 274 Australian Financial Services Licence 226473 For professional investors and advisers only Chart 2 High barriers-to-entry have meant that Australian capital city airports are natural monopolies within their geographic markets3. After all, as travellers we can typically choose between airlines but not where to land and take-off! Intense competition amongst airlines is another reason why airports remain profitable even when airlines struggle. For example, Qantas maintains a strategy to defend its 65% market share in domestic aviation against encroachment by Virgin even if this means adding capacity and flying planes that are not full. Since airports typically generate revenues by charging the airlines an aeronautical fee per passenger, airports are indifferent as to whether a passenger flies with Qantas or Virgin. In this regard, the emergence of low cost carriers such as Jetstar and Tiger Airways has led to an increase in passenger travel. Airports are often the beneficiaries of the intense competitive pressures facing the airlines. Airlines often respond to weak demand by releasing heavily discounted tickets as occurred, for example, after the Bali bombings and the Queensland 2010 floods, buffering airports from large declines in passenger traffic. Another reason we find airports more attractive investments than airlines is due to the regulatory framework. Since 2002, Australian airports have operated under a ‘light-handed’ regulation framework whereby airports and airlines negotiate pricing commercially rather than within a regime of regulator imposed price caps. These commercial agreements allow for airports to fully recover operating costs (assuming an efficient delivery of services) and for airport charges to rise in line with inflation even if ticket prices do not! Another key feature of these commercial agreements positive for credit investors is the pre-funding of airport investments. Pre-funding provides airports with the economic and legal certainty to undertake sizeable long-term upgrades knowing airlines have committed up-front to pay for the investment via higher charges. In summary, these commercial agreements create a stream of operating cash flows for airports that are by design less volatile than airlines that reflects not only an appropriate return on investment but also a return of investment. Another reason why debt investments in airports are more attractive than airlines debt is the credit structure. At present, all the debt issued by Australian airports is senior secured providing bank lenders and bondholders with first priority rights to the underlying assets and operating cash flows of the airports in an event of default. By contrast, the only corporate debt issued by an Australian airline and 3 Gold Coast and Avalon provide some competitive tension for Brisbane and Melbourne (Tullamarine) airports respectively. Schroder Investment Management Australia Limited 2 For professional investors and advisers only available for Australian domestic investors is unsecured debt. With secured debt4 comprising 85% of Qantas’ debt structure, an investment in Qantas as an unsecured bondholder is a far riskier proposition than an investment in the secured debt of an airport. What are the risks with investing in airports? Investments in airports are not without risks. Viability of the pre-funding model; business-transforming capital investments funded predominantly with debt; exposure to economic downturn; and the rise of sovereign-owned airlines are some of the key risks. Perth, Brisbane and Melbourne airports are planning to construct new runways in their current master plans. These are significant projects with price tags ranging from $500 million to over $1 billion. Consequently, the future of the pre-funding model is strenuously tested as airports are locked in protracted negotiations with airlines. Proceeding with a major project without securing a pricing agreement upfront with airlines is a major negative credit event. Materially funding investments with debt is another key credit risk for airports especially if the pre-funding model is watered down. The rise of sovereign-owned Asian and Middle Eastern airlines is tipping the negotiation scale in favour of airlines. Consolidation, alliances and partnerships between airlines have also increased the collective bargaining powers of airlines. Consequently, Australian airports are now in regular competition (e.g. Sydney versus Melbourne) when foreign airlines look to open new routes to Australia. Exposure to economic downturn is an unavoidable risk. Business and leisure travels are susceptible to the strength (or weakness) of the Australian dollar, employment levels and GDP growth. For example, Perth Airport is more vulnerable than the other capital cities airports to a mining downturn. Nonetheless, a key mitigating credit feature for airports is that passenger traffic has historically been resilient even in periods of subdued economic growth and have generally exceeded real GDP growth (see Chart 3). One reason is due to the strong rise of in-bound passenger traffic due to rising net wealth in countries such as China and India. Consequently, prevailing economic conditions in these countries are important drivers (and risk factors) underpinning the profitability of Australian airports and not just domestic Australian conditions. Chart 3 4 Qantas secured debt reflects bank debt, US private placement and capitalised operating lease commitments. Schroder Investment Management Australia Limited 3 For professional investors and advisers only Bottom-up credit stock selection While we generally favour Australian airports as a sector over airlines, this doesn’t mean that we indiscriminately invest in all Australian airports. At Schroders, fundamental analysis of an individual credit is an integral part of our stock selection process. We balance the risks and rewards of each credit to see which issuer to overweight, underweight or avoid with reference to our valuation framework. At this juncture, we view Sydney Airport and Melbourne Airport as offering the best risk-adjusted returns whereas Perth Airport’s exposure to mining and Brisbane Airport’s construction of a new parallel runway over 10 years are our least favoured credits. Disclaimer Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. Schroder Investment Management Australia Limited 4 .