Description

Auckland International Airport (AIA) owns and operates the largest airport in New Zealand. I’m recommending it as a long.

The elevator pitch is that AIA is metaphorical beachfront property. Like beachfront property, AIA never looks cheap. But AIA is as good of an infrastructure asset as I’ve come across. If I had to bet on a company to still be around with its moat intact 50 years from now, AIA would be at the top of my list.

Moreover, AIA is embarking on a 10+ year period of elevated capex as it builds a new domestic terminal and eventually adds a second runway. For many companies, elevated capex is a bad thing because it results in reduced FCF, reduced capacity utilization and deteriorating pricing (because of higher capacity). But in AIA’s case, more capex is a good thing. In its regulated Aeronautical segment, AIA will get a guaranteed return on these capital investments, while its unregulated segments will further benefit from the increased passenger volumes that these investments allow. In past periods of elevated capex, AIA’s stock has outperformed.

Company Description

Built in 1966 and privatized in 1998, AIA owns the only airport in Auckland, the largest city in New Zealand (~1/3 of the country lives in Auckland).  The airport is located ~15 miles (25-45 minute drive) from Auckland’s central business district.

As part of the airport, AIA owns 1500 hectares of land. About 80% of this land is needed for current and future airport operations, but AIA has been and is developing commercial property on the other 20%. AIA also owns a 25% stake in Australia’s Queenstown Airport and 50% stakes in a couple of airport hotel JVs, but these minority stakes are probably worth a combined NZD 200 million and don’t move the needle for the overall company.

Pre-COVID, AIA served >20 million passengers, generating ~NZD 750 million (~$500 million USD) in revenue at a ~75% EBITDA margin. New Zealand’s COVID-related travel restrictions were especially severe and weren’t fully removed until the second half of calendar 2022. So AIA has yet to fully recover to pre-COVID volumes (as of June 2023, traffic was still running 12% below 2019 levels), but they should get back to these levels over the next year or two.

AIA has three segments:

• Aeronautical (~45% of EBITDA in a normal year)
  • Consists of regulated fees paid by airlines for use of AIA’s runway and terminals
• Retail (~40% of EBITDA)
  • Rents/royalties from store operators as well as parking revenue
• Property (~15% of EBITDA)
  • Rents from warehouses, shopping centers, and hotels on AIA’s land
  • AIA has ~300 hectares of land in this segment, about half of which has been developed already

For its Aeronautical segment, AIA is subject to “Dual-Till” regulation (as opposed to the alternative of “Single-Till”). Under Single-Till, an airport’s aeronautical and non-aeronautical revenues are combined for the purposes of determining the Aeronautical “tariffs” the airport can charge airlines. Single-Till airports are akin to regulated utilities – they receive a guaranteed, fair return on investment, but no more.

Under Dual-Till regulation, an airport’s Aeronautical tariffs are set without consideration of non-aeronautical revenues, which are unregulated. Dual-Till airports enjoy the monopoly status of utilities while retaining the ability to generate returns on investment in excess of “fair” levels. While Dual-Till airports enjoy higher margins and higher returns on investment than their Single-Till peers, customers arguably benefit too. Under Single-Till frameworks, airports have no incentive to maximize non-aeronautical revenues. In contrast, Dual-Till airports are incentivized to maximize non-aeronautical revenues by doing things like making sure security lines move fast (so passengers spend more time spending money in the terminal), maximizing post-security square footage available for restaurants and shops, providing premium parking options, and developing adjacent lands for hotels, logistics facilities, warehouses, etc. Dual-Till airports are usually more pleasant experiences for passengers than Single-Till airports.

AIA has always been regulated under a Dual-Till framework. Every 5 years, AIA embarks on a “Price Setting Event” process whereby the company consults with airlines to forecast future passenger volumes and the capital expenditures required to serve such volumes. AIA, in concert with New Zealand’s Commerce Commission, then decides on an appropriate return on equity (usually 7-8%), and sets Aeronautical tariffs that will allow it to achieve its targeted return on regulated equity over the next 5 years.

AIA is currently in Price Setting Event 4 (PSE 4). PSE 4 covers the period beginning 7/1/2022 and ending 6/30/2027. Normally, AIA would have instituted new tariffs at the beginning of PSE 4, but due to COVID related uncertainty over passenger forecasts, AIA delayed the determination and setting of new tariffs for 12 months, so the new tariffs didn’t go into effect until 7/1/2023. The new tariff schedule will remain in effect until PSE 5 commences on 7/1/2027. I’ll discuss the details of AIA’s capex plans and tariffs for PSE 4 and PSE 5 later in this writeup.

Why AIA is Metaphorical Beachfront Property:

Airports in general tend to be good businesses. They are usually local monopolies (new airports are extremely difficult to build and usually require eminent domain), and they benefit from a secular tailwind of increased air travel. AIA is especially attractive, however, for a number of reasons:

1. Freehold status
   1. Unlike some airports that operate limited-life concessions, AIA owns the airport and the surrounding land indefinitely
2. Regulated via a transparent, dual-till framework in a stable, western-style democracy
3. Faces little competition from other airports or high-speed rail – it is the proverbial toll bridge through which most New Zealand travel must pass
   1. AIA is the only airport in by far the largest city in New Zealand
   2. Island geography = no competitive threat from high-speed rail
   3. 75% of visitors to New Zealand travel through Auckland (this percentage has grown over time)
   4. 67% of domestic flights in New Zealand originate or end in Auckland
   5. AIA is one of only two airports in New Zealand (Christchurch on South Island being the other) capable of handling Boeing 747s or Airbus A380s
   6. Airlines prefer flying into Auckland instead of Christchurch because airlines have hub operations in Auckland and because, from most international destinations, the flight distance to Auckland is meaningfully shorter than it is to Christchurch
4. Capacity to serve growing passenger volumes for decades to come
   1. Unlike some airports that have no land on which to expand, AIA has plenty of room to build a second runway  (which will double its capacity from ~25 million passengers annually to ~50 million).
5. High mix of lucrative international passengers coming to an appealing tourist destination
   1. International passengers, spend more time in the airport, spend more at duty-free stores, and are subject to higher Aeronautical tariffs (regulators are less concerned about higher per-passenger fees borne by tourists than they are by higher per-passenger fees borne by local constituents)

Pre-COVID, AIA grew passenger counts at ~5% on average, revenue and EBITDA at ~7% on average, and EPS at ~10% on average, while paying out nearly 90% of earnings as dividends:

AIA’s Upcoming Capex Cycle – And Why It’s a Good Thing

Over the next ten years encompassing PSE4 (FY2023 – FY2027) and PSE5 (FY2028-FY2032), AIA has announced plans to spend NZD 5.6 billion in regulated Aeronautical capex. This includes spending for, among other things, a new ground transport hub and a new domestic terminal that will be connected to the international terminal.

This ~NZD 560 million in annual regulated capex is a major ramp up – in PSE3 (FY2018-FY2022), AIA averaged NZD 153 million in annual regulated capex, and in PSE2 (FY2013-FY2017), AIA averaged NZD 106 million in annual regulated capex.

Put another way, AIA’s regulated asset base (RAB = the base upon which AIA earns its regulated ~7-8% return on investment) grew at a ~3% CAGR in PSE2 and a ~7% CAGR in PSE3. In PSE4, AIA’s RAB is forecasted to grow at a 20% CAGR (and at a 10% CAGR in PSE5). AIA’s profits from its regulated Aeronautical segment should grow in line with its rapidly increasing RAB.

For AIA to achieve the targeted return on this rapidly growing RAB, it will be able to charge much higher aeronautical tariffs. In June of 2023, AIA announced the tariff schedule that went into effect on 7/1/2023:

Aeronautical charges for international passengers are increasing 40% in FY24 and are scheduled to increase at a 12% CAGR over the three subsequent years. Charges for domestic passengers are increasing 52% in FY24 and are scheduled to increase at a 15% CAGR over three subsequent years.

This is just through PSE4, however. Keep in mind that capex will continue to be elevated in PSE5, so the above-trend RAB growth (and therefore above-trend Aeronautical revenue and EBITDA growth) will continue then. And by the time PSE5 is wrapping up in FY2032, AIA will likely have to build a second runway. This era of elevated capex is therefore likely to continue for the next 15 years.

You might ask – is it really that attractive to invest so much capex at a mere 7-8% regulated return? But keep in mind that the Aeronautical investments AIA makes benefit the company’s unregulated Retail and Property segments as well. The incremental passengers resulting from investments in new terminals and runways will spend money parking at the airport, buying food and merchandise in the terminals, etc. And increased activity at the airport will drive greater demand for the property AIA develops and leases adjacent to the airport.

Despite long being subject to a regulated return framework for the Aeronautical segment, AIA as a whole has generated mid-teens ROIC historically (ROIC in recent years skewed by COVID):

*Note that, because AIA carries PP&E and Investment Property at fair value, not cost (and the difference between cost and fair value for these assets is significant), any ROIC calculation for AIA you see on Bloomberg/FactSet etc. is probably wrong. To calculate ROIC for AIA, I had to rely on some estimates to calculate an “Invested Capital” denominator for AIA. I started with an estimate of the amortized cost of AIA’s assets as of 6/30/2002, and then added each year’s capex and D&A to get estimates of the amortized cost of AIA’s assets in each subsequent year.

Because AIA gets such attractive returns on the investments it makes, elevated capex is a good thing for AIA. If we look at AIA’s past regulatory periods, the stock has done especially well in periods of elevated capex:

AIA ramped up capex in the FY2003-2007 and FY2013-2017 periods, and the stock posted strong returns then. Conversely, in the FY2008-2012 regulatory period, capex levels were lower, and the stock was a more modest outperformer. The correlation breaks down with the FY2018-2022 time period – capex was high in this period, but the stock was an underperformer. I would attribute that to COVID’s impact on the business. FWIW, the stock was outperforming during this regulatory period until COVID happened, and then it underperformed in the COVID-impacted years (2020-2022).

Valuation

Before we get into the details on AIA’s valuation, we have to discuss the fair value accounting treatment that AIA uses.

Most companies carry assets at amortized cost. AIA, on the other hand, carries PP&E and Investment Property at fair value. To do this, AIA uses third-party real estate appraisers (firms like CBRE, Jones Long Lasalle, etc.) to value its infrastructure and real estate assets every six months based on cap rates, DCFs, and comps. Changes in the fair value of AIA’s assets (either positive or negative) in some cases flow through the income statement and in some case through Accumulated Other Comprehensive Income. AIA’s “underlying” EBITDA and EPS figures exclude these fair value changes.

Thus, book value per share is a good valuation metric for AIA, since it approximates NAV. Also, for earnings based valuations, one should focus on “underlying” EBITDA and EPS figures.

Those explanations out of the way…AIA currently trades at 1.5x book – it has traded at higher than this in the past:

Of course, with book value approximating NAV, why should the stock be worth more than book value? If IAIA was a static piece of infrastructure with no room to expand, then it probably shouldn’t trade much more than book value. But this is not the case - the value of AIA is more than just its existing assets – there is also the ability to reinvest capital in the business at attractive rates for many years in the future.

In terms of earnings multiples, based on my estimates for FY2024, AIA trades at 20x EV/EBITDA and 42x P/E.

As I acknowledged earlier, AIA, like most beachfront property, never looks cheap. With the degree of RAB growth forthcoming, AIA’s EBITDA and EPS are set to grow at double digit CAGRs over the next decade, so the company has the ability to grow into these multiples.

One of the closest comps to AIA historically has been the Sydney Airport. Sydney Airport is an inferior asset to AIA. Sydney operates via a concession that expires in 2097, and there is a competing airport in Sydney scheduled to open in 2026. Nevertheless, Sydney Airport was taken private in early 2022 at a 23x EV/EBITDA multiple.

Risks

1. Regulation
   1. While the regulatory framework AIA operates under is established and stable, AIA and the regulator will differ from time to time on what AIA’s targeted regulated return should be.
   2. For PSE4, AIA is targeting an 8.7% regulated return, which is higher than they’ve achieved in the past (target was 6.6% in PSE3). AIA has justified the higher return based on higher risk-free rates as well as higher beta when factoring in COVID’s impact on air travel.
   3. New Zealand’s Commerce Commission recently released a draft proposal suggesting a 6.7% target return. AIA believes that the methodology the Commerce Commission is using for the 6.7% figure will apply to PSE5 (not PSE4), and in the meantime they’ll argue for different inputs to achieve a different result for PSE5.
   4. New Zealand’s Commerce Commission will make a final determination on AIA’s PSE4 pricing by 6/30/2024.
   5. So there is a chance that AIA will have to revise down PSE4 pricing sometime next year if the regulator objects to AIA’s 8.7% targeted return calculation. And there is a good chance that the target regulated return for AIA in PSE5 is closer to 6.7% than 8.7%.
   6. I estimate the difference between a 6.7% and 8.7% regulated return amounts to a ~5-10% impact to total company underlying EBITDA and EPS. My best guess is that the targeted regulatory return for both PSE4 and PSE5 ends up somewhere between these 6.7% and 8.7% figures, but that should give you an idea for the scale of the potential impact.
2. Overhang from partial sale of Auckland City Council’s 18% stake in AIA
   1. Auckland’s City Council owns 18% of AIA’s shares. The City Council recently voted to sell a 7% stake to raise money for city debt reduction. It’s likely there will be a secondary offering to handle the share sale sometime in the next few months, which could act as an overhang.
   2. FWIW, AIA has done equity raises twice in the past (in 2010 to fund an acquisition and in 2020 to shore up the balance sheet during peak COVID fears) and in both instances, AIA’s stock outperformed in both the three month and one year periods following the announcements of these offerings.
3. Mismatch between when capex is spent and when it enters AIA’s Regulatory Asset Base may force AIA to do an equity raise in a few years
   1. Over the next ten years, AIA is planning to spend NZD 5.6 billion in regulated Aeronautical capex. Most of this will actually be spent over the next 4 years (in PSE4) – but only NZD 2.5 billion of it will be “commissioned” and enter the RAB in PSE4, with the remainder entering the RAB in PSE5.
   2. The logic here is that the regulator doesn’t want AIA to charge the airlines for infrastructure before it’s completed and ready for use. But until capex is commissioned and enters the RAB, AIA doesn’t get paid on it.
   3. Over the long term, I don’t view this mismatch as a big deal – while the mismatch is unfavorable to AIA is PSE4, it’ll be favorable to them in PSE5 (when the RAB will continue growing despite actual cash capex being low). But given the scale of spending PSE4, it could create some funding issues. AIA targets an A- credit rating from S&P, so to fund the increased capex in PSE4, AIA has flagged that they may have to do an equity raise in the second half of PSE4 (ie FY25-FY27).
4. Interest rates
   1. As a high-quality, long duration asset, AIA should garner a higher valuation when interest rates are low than when they are high. There are some mitigants to this – the level of risk-free rates is an input into AIA’s regulated return target – but AIA shareholders are probably better off if rates go down rather than up.

Catalyst

1. Reinstatement of dividend (likely to happen later this year)
2. Continued rebound in passenger volumes post-COVID
3. Above-trend growth in profits over next decade