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How rising interest rates affect sydney airport

No variable is more important to Sydney Airport shareholders than interest rates, but predicting them is a fool's game.

In 1906, crowds gathered for a country fair in England. Among them was statistician Francis Galton and he was drawn to a competition where 800 people tried to guess the weight of an ox carcass.

Galton noticed something strange when analysing the results: the median guess was within 1% of the ox’s true weight. The median, he later concluded, was the most balanced guess: ‘Every other estimate is condemned by a majority of voters as being either too high or too low, the middlemost alone escaping this condemnation.’

This phenomenon is known as the wisdom of crowds. Individuals have biases, but when you take a group’s collective opinion those biases tend to even out. The group opinion, then, tends to be more accurate than any individual’s.

This article is about how interest rates affect Sydney Airport. Naturally, then, the million dollar question is whether rates will rise or fall, but no individual – not even the Reserve Bank governors – can tell you what they will do over the long term. There are just too many variables.

What you do have at your disposal, however, is the collective opinion: the 10-year government bond yield, which sits at 2.8% at the time of writing. The Reserve Bank’s cash rate is currently 1.5%, so, for what it’s worth, interest rates are expected to rise over the next 10 years.

The reason all this matters for Sydney Airport shareholders is that small changes in long-term interest rate expectations have a big impact on its operations, cash flow, and share price. Since mid-December, the stock has fallen around 8% and the main driver has been the rise in the 10-year government bond yield from 2.5% to 2.8%.


Debt up, leverage down

As Warren Buffett likes to say, interest rates are to asset prices what gravity is to apples. All asset valuations fall as interest rates rise because the cash flows they produce are relatively less attractive compared to the ‘risk free’ return you get from simply owning government bonds.  

Sydney Airport's share price tends to be more sensitive to changes in interest rate expectations than other stocks because its stable earnings encourage people to think of it as a substitute for bonds and deposits. Not that it is.

Furthermore, Sydney Airport is highly leveraged, carrying $7.9bn of net debt compared to $856m of equity. The company funds all its capital expenditure needs with debt, so its debt pile is marching upwards.

The interest bill approaches $400m a year, for an average interest rate of 4.9%. With interest expense consuming a third of operating cash flows, small changes in interest rates will have a large effect on dividends: a one percentage point increase in the interest rate on Sydney Airport’s debt could be expected to shave around 10% from free cash flow, which was around $750m in 2017.

For most businesses, that situation would give us the heebie-jeebies, but Sydney Airport is in better shape than it looks.

Counterintuitively, while debt is growing, the airport is actually deleveraging at the same time. The airport’s costs and capital expenditure requirements are largely fixed, so as passenger numbers increase – and revenue with it – operating earnings are able to grow faster than expenses. In the first half of 2017, revenue increased 8% but costs only rose 1%. Free cash flow was up 15%. 

As you can see in Chart 1, Sydney Airport’s debt and interest measures have never been better and they should keep improving as the airport grows. A cash flow coverage ratio (CFCR, the amount by which cash flow covers the interest bill) of 2.9 would normally suggest an unhealthy amount of debt, but given the stability of Sydney Airport’s revenue and its monopoly position, it’s able to handle more debt than most companies. We won’t go so far as to say that the current level of debt is conservative, but it is comfortable given the quality of this asset.


Short-term prudence

Sydney Airport has taken steps to reduce its sensitivity to interest rates in the short term. The company has mostly long-dated debt and the weighted average maturity is around six years. However, the airport has spread its loans across many years, some of which only fall due in 2030. Around $1.3bn needs to be refinanced in 2020 – the most due in any one year – but even that is less than a seventh of the total. This spread of maturities reduces refinancing risk and protects against operational interruptions.

What’s more, some 86% of Sydney Airport’s debt is fixed interest or hedged against spot interest rate movements. Around 60% of the company's total interest rate exposure is hedged for the next five years and management intends to increase this to 70% in 2018. Foreign currency debt is 100% hedged against currency movements.

All this is to say that for a good five years or more, changes in interest rates will have little effect on Sydney Airport’s operations or ability to service its current debt. Having said that, if rates rise, the company will need to progressively refinance at higher cost and that could act as an anchor to dividends in the long term. All things being equal, if rates revert to something more ‘normal’ over the next decade, it’s reasonable to assume a couple of percentage points or so will be knocked off the dividend growth rate.

Case closed, right? Alas, interest rates tend to reflect economic conditions. As the economy strengthens, the Reserve Bank raises interest rates, and when things fall apart, interest rates are lowered. As such, if interest rates do rise, it’s probably because the economy is picking up speed – and that would be reflected in more domestic and international travel. This would have a moderating effect on Sydney Airport’s interest rate sensitivity, as higher interest expenses would be offset by higher aeronautical revenue. Should interest rates rise over the next few years, it’s conceivable that Sydney Airport would actually report significant growth in profits due to the operating leverage mentioned above – so long as those rate rises happen alongside a booming economy.

Given so many unknowns when it comes to interest rates, the best we can do is value Sydney Airport using its probable long-term earnings under the current interest rate environment, and then build in a margin of safety to account for the inevitable errors in forecasting.

The stock offers a dividend yield of 5.0%, though it’s likely that management will increase the dividend at next month’s annual result given the ongoing vigour of international passenger growth. With a 5.0% yield growing in the high-single digits, Sydney Airport is hovering a bit above our recommended buy price of $6.50. We’re likely to upgrade the stock if it settles below that level but, for now, we’re sticking with HOLD.


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