15 May 2017 by John Stittle
Airport operator’s financing challenges are mounting up
London’s Heathrow airport is a business used by more than 75 million passengers every year, taking off or landing in almost half a million aircraft, with an annual turnover of more than £2.8 billion. This international airport hub now faces a range of concerns about financing the construction of its new third runway and the resulting and potentially large increase in airport charges that may be imposed on passengers.
Earlier this year, the key airport operating company, Heathrow (SP) Ltd issued its 2016 financial statements and disclosed a pre-tax loss of £213 million, compared with a pre-tax profit after tax of £702 million in 2015.
From a balance sheet angle, Heathrow is already highly geared with its existing debt finance exceeding £13 billion and that is before construction of the third runway starts. The construction costs for this project will massively contribute to increasing the airport’s financing burdens and threatens to impose more burdens on servicing its growing debt.
Given the net loss reported by Heathrow in 2016, it is unsurprising the airport favours highlighting the EBITDA measure as one of its key performance indicators. This examines ‘earnings before interest, tax, depreciation and amortisation’.
“Many companies prefer to stress EBITDA because it broadly equates to operating cash flows”
It is often colloquially known as a company’s profit before ‘all the bad stuff’ is deducted – and Heathrow’s news release informing the market of its 2016 results used EBITDA as part of the introductory highlights to its performance.
Many companies prefer to stress EBITDA because it broadly equates to operating cash flows and they often point to a more pleasing EBITDA performance indicator when wishing to distract readers’ attention away from disappointing and lower bottom-line net earnings.
Heathrow ‘adjusts’ its EBITDA by then excluding the impact from losses on marking its financial instruments to fair value. The result is that the airport now produces an ‘adjusted’ EBITDA of a healthy £1.68 billion, almost 5% higher than the previous year. The use of ‘adjusted’ EBITDA is another example of alternative performance measures that are increasingly attracting concern from the FRC.
In its income statement, Heathrow’s losses on financial instruments are revealed in a multi-column presentation. The airport highlights its £267 million pre-tax profit in its introduction summary, but its income statement reveals more useful information.
Heathrow shows these losses on financial instruments as ‘exceptional items and certain remeasurements’ which have a net loss of £480 million – largely arising from these financial instruments being ‘marked to market’. As a result of including this, Heathrow reports an overall pre-tax net loss of £213 million.
This loss arises from Heathrow’s financial instruments concerning interest rate swaps and index-linked swaps, which were reported as being ‘unhedged’. Like many large companies, ‘swaps’ are used to manage, for example, any fluctuations between activity levels and revenue. In Heathrow’s case, it uses swaps to manage its revenue from airlines using the airport and the variation in interest rates on its £13 billion debt burden.
In its preliminary results, Heathrow provides little useful information to explain how it came to have such large uncovered or mismatched hedges leading to these large ‘remeasurement losses’. Nevertheless, under current reporting rules, these hedges adopt fair valve accounting, which then means hitting reported earnings.
Heathrow CEO John Holland-Kaye’s reported explanation did not directly address the cause of this loss, but he made clear his displeasure with fair value adjustments, which he claimed ‘always drive me mad’. However much the losses upset Heathrow’s CEO, the International Accounting Standards Board’s enthusiasm for the use of fair values is not going to disappear.
In terms of income generation, Heathrow cannot determine its own charges for passengers and aircraft using the airport, because its earnings are subject to a complex regulatory pricing method.
The Civil Aviation Authority (CAA) steps in to control the prices UK airports can charge where it can be established that an airport has ‘substantial market power’ and the advantages of regulation are considered to outweigh the disadvantages.
“Heathrow uses what is termed an incentive-based ‘single till pricing mechanism’ to determine airport charges to passengers and airlines”
With the exception of Heathrow and Gatwick, all UK airports fall outside CAA rules, so their charging policies are not regulated. For Heathrow, however, the impact of having a regulated pricing mechanism affects its financial and operational policies.
The regulated pricing model is not simple. In general terms, Heathrow uses what is termed an incentive-based ‘single till pricing mechanism’ to determine airport charges to passengers and airlines. The CAA sets revenue targets for the airport’s non-aeronautical businesses.
These revenue streams come from commercial activities such as concession fees from retail outlets, car parks and advertising, which are offset against the airport’s operating costs in setting passenger and aircraft charges. As a consequence, the airport has every incentive to outperform the CAA’s commercial revenue targets, because the ‘excess revenues’ (above the CAA’s target levels) are not then offset against the airport’s operating costs. The result is that these ‘excess’ revenues can then further increase the bottom-line earnings of the airport’s owners.
However, in addition to the airport’s net operating costs, the CAA then applies a return on the value of the airport’s regulated assets based on Heathrow’s weighted average cost of capital – which is used as a proxy measure for profit. It then adds a depreciation charge – to determine finally the airport’s aeronautical revenue. This revenue is the amount that is largely recovered from passengers using the airport and from aircraft landing fees.
Most of Heathrow’s balance sheet is dominated by the high level of its debt finance. In 2006, BAA plc, the privatised company that owned most of the UK’s major airports, was bought by an investor consortium led by Ferrovial, the Spanish infrastructure and construction group, and delisted from the London Stock Exchange.
Subsequently, competition concerns led to a further sell-off of other airports in the BAA group – but Heathrow remained. However, the BAA sale came at the price of a heavily leveraged buyout for Heathrow and, as a result, the airport was saddled with substantial debt that now exceeds £13 billion – supported by a relatively small equity investment base.
“So far, Heathrow has remained silent about how its new runway will be financed”
The income statement is now burdened with gross interest payments that are approaching £1 billion each year. But these interest charges could soon start to surge further with the need to finance major construction work on the third runway. So far, Heathrow has remained silent about how its new runway will be financed, but this silence cannot last much longer.
The Airports Commission, under the chairmanship of Sir Howard Davies, estimated the cost of building the third runway at Heathrow to be around
£17.6 billion – giving considerably higher finance servicing costs. Other industry analysts say the final all-inclusive cost might even exceed £20 billion.
IAG, owner of British Airways, has already expressed concern that the high cost of financing the runway will ultimately mean increasing charges for passengers. It has warned it will not pay ‘excessive charges’, which may well be self-defeating, encouraging passengers and airlines to switch to lower-cost airports.
IAG contends that there were considerably cheaper cost options at Heathrow in building additional capacity. In particular, it sought a cheaper financing model and supported just an extension to the existing northern runway instead of constructing a complete new runway.
Even the Airports Commission suggests that passenger charges could increase by 50%. Willie Walsh, CEO of IAG, claims the third runway will be a ‘rip off’ and predicts some passenger airport charges could double in order to finance the construction.
Heathrow Airport is part of a complex group structure which is ultimately owned by FGP Top Co Ltd. The current shareholders of this company are largely based overseas and include Ferrovial and investors from Qatar, China, Singapore and Canada. The only significant UK investor is the universities pension scheme. On a positive note, this investor consortium has already indicated it is prepared to finance the expansion.
Given the cost of Heathrow’s expansion programme, a substantial amount of finance needs to be raised. Currently,
the airport group has total shareholders’ equity of around £1 billion, with most financing being based on debt. Some analysts suggest there will need to be a mixture of debt and equity to finance Heathrow’s construction programme.
“A combination of debt and equity will provide a more balanced and flexible financing model”
Although Heathrow currently has a respectable level of debt creditworthiness, the level of debt and its servicing will quickly escalate before the cash flows from the new runway start to emerge.
Certainly, a combination of debt and equity will provide a more balanced and flexible financing model, rather than Heathrow simply increasing its capital gearing ratio even higher.
In fact, a number of aviation analysts already believe it is only a matter of time before Heathrow seeks a stock market listing in order to raise more equity financing. Some of the more pessimistic analysts suggest that if construction costs exceed forecasts, or if debt markets become difficult, the airport group may even need to seek direct or indirect government financial support.
Despite Heathrow reporting a bottom line net loss in its 2016 financial statements, the airport still generating a solid operational net cash flow of £1.6 billion. The airport now faces a major challenge of formulating a financing policy for the new runway.
In addition, this financing needs to be set in the context of the CAA’s strict regulatory pricing mechanism, which provides further risks to future cash flows from the new runway.
These financing concerns, combined with further unforeseen environmental, legal, political and transport access issues, will inevitably add to the new runway’s costs.
Whatever the outcome of these financing challenges, the airport needs to ensure its charges to passengers do not soar. Otherwise, constructing a second runway at Gatwick, for less than half that of Heathrow, might have been a more attractive option.