Sydney Airport: Valuation support in a lower-for-longer world
About the author:
- Author name:
- By Nathan Lead
- Job title:
- Senior Analyst
- Date posted:
- 22 July 2019, 4:54 PM
- Sectors Covered:
- Infrastructure, Utilities
- We revise down key modelling assumptions to reflect the lower-for-longer scenario implied in government bond yields.
- Short-term forecasts decline only 0-2% but the compounding impacts are longterm. DPS growth declines to ~2% pa CAGR across FY20-23F.
- We upgrade to ADD, with 14% total shareholder return (TSR) potential.
- Next key events are the 1H19 result (15 August), monthly pax releases, and release of the final report by the Productivity Commission (by October).
Cost of equity declines with falling risk free rate
Government bond yields have continued their long-term downward trend. These yields are used as a proxy for the risk free rate (RFR) in our DCF cost of equity (COE).
We have decreased the COE from ~8% pa to 6.8%, as we reduce the assumed RFR from 3.75% to 2.5% pa (equity risk premium unchanged).
Such a RFR remains >1% pa above the current 10yr CGB yield of ~1.4% pa, and thus implies upward normalisation of bond yields over time.
This change lifted our valuation. If we were to instead fully factor in the current bond yield our valuation would increase (Morgans clients can view here).
Aero pricing has interest rate linkage
Aeronautical pricing (aero contributes ~50% of revenue) has staggered resets, with the next being the international agreement in 2020 and Jetstar (domestic) agreement this year.
While commercially agreed, we understand these prices are negotiated in the context of a shadow regulatory framework. Cost of capital, capex plans, and pax outlook are key variables.
On the base charge, we assume an initial 1% decline in international pricing then flat until 2025 (and flat for domestic), and have now decreased the assumed return on new investment (Morgans clients can view here).
Headwinds for CPI-linked revenues
The RFR decline is being partly driven by lower inflation expectations.
SYD’s earnings have direct and indirect, and immediate and lagged, CPI-linkage, albeit it has downside protections via contracted minimum price escalations.
We factor in lower assumed CPI as per the current CPI swap curve (~1.5% pa CPI across next 5 years), which reduces our valuation (Morgans clients can view here).
Benefits from lower interest rates on new and unhedged debt
Debt service absorbs more than a quarter of SYD’s EBITDA.
SYD’s treasury practices insulate it against immediate interest rate and refinancing risk. However, falling market interest rates benefit the cost of new debt and unhedged debt.
Updating our forecast assumptions for the current interest rate swap curve adds (Morgans clients can view here) to our valuation.
Slowing pax growth in a lower growth world
While pax growth is driven by a number of structural forces, weaker economic conditions implied in declining bond yields are likely to have an impact.
We note though that SYD’s pax has historically recovered to long-term trend growth after negative growth events (GFC, weather, terrorism, strikes, etc).
We have nudged down our pax forecast, with a scenario of a benign FY19 before recovering to a lower trend growth rate than previously assumed (and no alteration to capex); this tipped our valuation.
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