Sydney Airport (SYD) has been placed in a quandary after the Commonwealth government set out the terms for development of the second Sydney airport at Badgery’s Creek in its notice of intention (NOI). The main change to expectations is that there is no federal funding involved in the NOI, placing the investment decision squarely on SYD, which has first right of refusal.
The company is now mulling the investment criteria for the project, such as rate of return, cash flow, growth potential and the impact on its Kingsford Smith Airport. Macquarie calculates that funding a $3.5-4.0bn project without any subsidy over the near term will clearly come at the expense of incremental growth in cash flow, which will be largely capped until 2025.
While an alternative scenario, in which a third party operates the second airport, will ensure short-term cash flow growth expectations remain intact, there are obvious competition concerns which would emerge beyond 2025. Thus, the risk profile for SYD increases over the next 4-9 months that the company has to respond to the NOI. Still, the broker finds it hard to envisage a third party could make the economics work better than SYD.
Aside from this issue, Macquarie notes international passenger growth at Kingsford Smith continues to grow at pace, up 7.5% in November. The main driver has been the increased capacity at the airport and this bodes well for 2017. Load factor trends continue to support further passenger growth.
Current Deal Means Funding Pressure
Morgans is most concerned about the lack of funding and downgrades the stock to Hold from Add. The NOI puts all the risk and funding obligations onto Sydney Airport. The broker had assumed the Commonwealth would offer funding, noting that Infrastructure Australia had indicated a first stage costs of $5bn to develop the airport, although there is no clarity on what cost components were bundled into this estimate.
The government has calculated there would be 1m passengers per annum from opening in 2026, growing to around 10m over the longer term. The timetable contemplates earth moving commencing in late 2018.
Sydney Airport has indicated that the NOI makes the second airport a challenging investment proposition. Morgans agrees, noting there are many instances of failed greenfield, patronage-based infrastructure projects, and cost over-runs and ambitious revenue projections combined with excessive debt funding have been the key factors in such disasters.
The broker also speculates that the government is testing private sector appetite for the project to avoid committing its own capital and in order to cling to its AAA rating. For investors, the risk is one where Sydney Airport proceeds, not on the basis of a value accretive project, but in order to keep a competitor out of its catchment.
Traffic forecasts within the Environmental Impact Statement (EIS) indicated the initial pay mix would be dominated by domestic traffic. This is critical to the early phase economics, Morgans asserts, given domestic passengers are typically low value compared with international. Moreover, airport connectivity will likely be low, as there is no rail link.
The broker also flags the strong passenger growth at Kingsford Smith, with seat capacity growth indications for the first half at 5-6%, suggesting above-trend growth may continue. Morgans does not incorporate a second airport into forecasts but upgrades estimates for 2016-17 to reflect strong passenger growth rates.
Current Proposition Is Simply Unattractive
Deutsche Bank is of the view the company is unlikely to exercise its rights to develop and operate the second airport under the terms of this NOI. The broker has previously calculated that the airport needs $1bn in subsidies or support over the first 10 years to make it commercially viable and de-risk the project.
Changes in the company’s language also suggest the investment would now be challenging. At this point, the broker believes value must come in other ways if Sydney Airport is to salvage the project. The most obvious way would be to remove the 80 aircraft per hour cap at Kingsford Smith and also remove regional dedicated slots during peak times.
Unanswered questions for Deutsche Bank include whether another Australian infrastructure investor – the project requires 51% Australian ownership – could invest in such a long-dated project. The broker doubts the government can afford to build the airport itself, given the budgetary pressures. As the deal is long-dated and demand uncertain, with no government support and potential dilution for Sydney Airport’s existing distributions, the broker finds it unattractive.
FNArena’s database has two Buy ratings, four Hold and one Sell (Credit Suisse, yet to report on the NOI). The consensus target is $6.78, suggesting 9.8% upside to the last share price. Targets range from $6.00 (Credit Suisse) to $7.45 (Macquarie). The dividend yield on 2016 and 2017 estimates is 5.0% and 5.4% respectively.
Disclosure: The writer has shares in Sydney Airport.