Geoff Gannon November 25, 2019

Sydney Airport: A Safe, Growing and Inflation Protected Asset That’s Leveraged to the Hilt

Today’s initial interest post really stretches the definition of “overlooked stock”. I’m going to be talking about Sydney Airport. This is one of the 20 to 25 biggest public companies in Australia. It has a market cap – in U.S. dollar terms (the stock trades in Australian Dollars) – of about $13 billion. It also has a lot of debt – including publicly traded bonds. So, not what you’d normally consider “overlooked”. On the other hand, Andrew and I have a couple standard criteria we use (low beta and low share turnover) to judge whether a stock might be overlooked. And Sydney Airport happened to score just barely well enough on these two measures of “overlooked-ness” that it wasn’t automatically eliminated by our screens. For this reason, I left the stock on a watchlist that went out on our email list. While a lot of people mentioned the stock definitely wasn’t overlooked – a lot of other people also mentioned they’d like to hear my thoughts on the stock. So, here they are.

Sydney Airport was suggested to me by my former newsletter co-writer Quan Hoang. He’s from Vietnam originally. And he’s now spent time in Australia. He was looking at stocks and sent me over some financial data of Sydney Airport. A few things jump out about this company immediately. One: it pays out basically everything it can afford to in dividends. Two: it uses a high amount of debt (close to 7 times Net Debt/EBITDA – at one time that number was closer to 11 times Net Debt/EBITDA). However, this isn’t a distressed company in any way. The debt is spaced out – about half of it matures within the next 5 years and the other half after the next 5 years. The bonds are rated by Moody’s and S&P. Sydney Airport intends to maintain an investment grade rating. That’s usually not easy when you have well over 6 times Net Debt / EBITDA. But, this is an airport.

The problem with the debt here is not solvency risk. It’s that the stock price with the debt added – so, the enterprise value relative to various earnings power measures – creates a pretty high future growth hurdle that needs to be cleared. On a dividend yield basis, the stock looks cheap. It yields 4.3%. However, you need to be careful with that number. Consider, for example, Vertu Motors in the U.K. It also yields 4.2%. But, instead of having more than 6 times Net Debt / EBITDA – it has basically no net debt. It also pays out only about 1/3rd of its earnings as dividends. I’m not saying Vertu Motors is a better stock than Sydney Airport – though, at this point, I do own Vertu and don’t own Sydney Airport – but, I am saying that it’s a lot easier for Vertu to cover its dividend and grow it over time than it is for Sydney Airport. Basically, if Sydney Airport doesn’t want to increase its Net Debt / EBITDA ratio above 7, it can only grow its dividend at the same rate as it grows its cash flows per share. It also has the risk of failing to grow the dividend as fast as shareholders might like if the interest rate Sydney Airport has to pay on its debt rises, if the taxes Sydney Airport has to pay increases (which it will in a couple years), etc. So, Sydney Airport might be cheap enough to buy. But, you can’t tell that by looking at the dividend yield only. If Sydney Airport was already a full tax payer (it doesn’t yet pay cash taxes) and had no net debt at all – it’d be very easy to predict high growth in the dividend for a long time to come.

One way I like to talk about stocks is by working backward from how much they are paying you today and figure out how much they’d need to grow to beat the market. A lot of people reading this are going to want 10% or better returns from a stock. Certainly, if you’re buying something where the debt is rated as pretty low investment grade and there is more than 6 times Debt / EBITDA – you want to be compensated for the financial risks you’re taking. It seems logical that – given how leveraged the common stock is – you’d expect double-digit type returns. What would it take for Sydney Airport to deliver that?

If the dividend yield is 4.3%, then just taking 10% minus 4.3% equals 5.7% a year growth in the dividend is a pretty good guess. If Sydney Airport can pay you a 4.3% dividend yield while growing that dividend by about 6% a year, the stock price should also be able to grow by about 6% a year. The result would be a better than 10% return for a shareholder buying today and holding for the long-term. How realistic is a 6% or better growth rate in cash flow available for dividend payout per share?

Based on Sydney Airport’s past record, it’s achievable. It’s also achievable based on the targets set in the company’s bonus program. Executives receive some additional compensation once Sydney Airport increases cash flow per share by 8% a year. The bonus – for this part of the program that’s tied to cash flows – maxes out at a 12% annual growth rate in cash flow per share. The measurement period is over 3 years. Sydney Airport admits these are aggressive goals in fitting with the company’s “high performance culture”. So, I wouldn’t take those numbers as some sort of easily achievable guidance. But, it’s entirely possible that the price of Sydney Airport stock will grow by about the same rate as the cash flow per share will grow by. So, if they do hit 8-12% cash flow per share growth while you own the stock – you might make 12% to 16% a year in total return, because you get stock price appreciation of around 8-12% plus a dividend of more than 4%. Remember, because Sydney Airport targets what is basically a 100% payout ratio of truly free cash flow – you’re going to see the dividend yield rise along with the stock price to the extent the stock price doesn’t grow faster than the underlying cash flows per share.

We can also look at the company’s past. Over the last 30 years, passenger numbers grew by more than 3% a year. Sydney Airport has a 20-year plan in place to help guide its long-term capital spending needs. That plan envisions 2% a year growth in passenger numbers over the next 20 years. Inflation in Australia has often been around 2% a year recently. If you assume that Sydney Airport’s revenues tied directly and indirectly to passenger traffic pretty much automatically escalate with inflation – the company strongly suggests this at several points in its annual report – then, we’ve already hit a 4% expected growth rate in revenues for the next 20 years. Actually, the plan suggests better than 4% revenue growth. This is due to a shift in passenger mix. Sydney Airport currently gets a lot of domestic passengers. The airport serves more domestic passengers than international passengers. However, the international passengers produce more revenue (and more profit) per person. So, Sydney Airport already gets about half its revenue, earnings, etc. from things tied to international passengers despite the company mainly serving domestic passengers. Over the next 20 years, the company expects that international passenger growth will be higher than domestic passenger growth. By the end of the 20 years, the airport will be serving at least as many international passengers as domestic passengers. If the relative contribution from each additional domestic passenger and each international passenger stays the same over these 20 years – REAL revenue would actually grow faster than the growth rate in passengers. For example, it’d be possible for Sydney Airport to grow passengers by 2% a year, have 2% inflation and yet actually have 5% or greater nominal revenue growth because more and more of the passengers moving through the airport were international passengers.

Why do international passengers contribute more to Sydney Airport’s earnings than domestic passengers? There are a few possible reasons. One is retail. The company’s international terminal has a lot of high end shopping. The “dwell time” for international passengers is significant at 2 hours and 13 minutes. International passengers have a lot of time to kill and can do so by shopping, buying gifts, eating, etc. They may also be more likely to use the company’s hotels. Sydney Airport only has a little over 300 hotel rooms. However, occupancy is very high (recently 88%). And the average stay is very short (0.8 days). The airport wants to more than double its available rooms. These are “non-aeronautical” reasons why international passengers would be more profitable. It’s also possible that Sydney Airport directly makes more money off international passengers than it does domestic passengers. The company has contracts with airlines that usually provide for a payment per passenger using the terminal, airport infrastructure, etc. Some contracts instead require payment based on the maximum weight of an aircraft using the airport. This brings me to a side point. It’s clear that at least in the most recent year, Sydney Airport handled more passengers without handling more planes. My best estimate was that the number of passengers per plane actually increased about 3%. Again, it’s possible that the number of passengers per plane on an international route could be higher than the number of passengers per plane on a domestic route. If true, this would mean revenue per plane would be higher on international than domestic. It’s also likely that the profit per plane discrepancy might be even greater too. Calculating marginal “profit” versus marginal “revenue” for Sydney Airport is tough. A lot of times – I think marginal revenue basically falls to the bottom line. Expenses are often fixed. Cap-ex is the big cash expense. The company actually employs very few people. My estimate was that between 98% and 99% of the people working at Sydney Airport are employees of others – airlines, government, retailers, restaurant operators, outside contractors, etc. – rather than Sydney Airport’s own employees. The company makes about half of its money fairly directly from “aeronautical” sources. These are more direct fees paid by airlines. The other half is “non-aeronautical.” However, I still think non-aeronautical sources of profit are basically driven by passenger volumes – just a bit less directly. At several points, the company makes it clear that things like hotel revenue, parking, etc. are ultimately driven by passenger numbers. There are things you can do to tweak the dining, shopping, advertising, etc. sources of revenue to extract a bit more profit per passenger (perhaps especially by optimizing for international passengers). However, all of these things are ultimately tied to traffic figures too. Advertisers want a certain number of eyeballs. Restaurants, retailers, etc. want a certain amount of foot traffic. This is what drives rents. So, even where – as is often the case – Sydney Airport gets minimum guarantees from tenants that ensures the airport will collect a certain amount of rent even if the sales of the tenant are disappointing, I still think long-term minimum guarantee levels will tend to track passenger traffic trends. Tenants will accept higher minimum guarantees when they feel they know they can count on a minimum level of traffic passing right by their stores, restaurants, etc.

So, it all comes down to passenger levels primarily. Secondarily, there’s the mix of domestic versus international – with international being preferable. But, then there’s the big question of operating leverage (and financial leverage too). If Sydney Airport’s costs are relatively fixed whether passenger traffic grows 1% a year, 2% a year, or 3% a year – then, hitting 3% instead of 1% would make a very big difference to the company’s cash flow per share growth. Except to the extent the company’s bond ratings change or interest rates rise or fall – we know debt service will be fixed. So, as a common shareholder who is only entitled to the payment of dividends after the bondholders get their interest – it matters a great deal whether passenger traffic grows 1%, 2%, or 3%.

Basically, Sydney Airport looks like a very highly leveraged – both operationally and financially – bet on international passenger growth in Sydney. This might be a good bet. But, we have to rely on expectations formed based on what the company is telling us. The company is using an 8-12% cash flow per share growth rate for its incentive compensation targets. The 20-year plan is for 2% annual growth in passengers with more new passengers being international than domestic. I can easily imagine that – after inflation, benefits of passenger mix, etc. – Sydney Airport experiences 5% or better annual revenue growth for the next two decades. Expenses – other than financial expenses like additional interest payments and taxes – won’t grow as fast as 5% a year. So, cash flow per share should compound at a greater rate than any revenue growth expectations I have.

If I assume the company can maintain its multiple (of 23 times dividends) and its debt load (of almost 7 times Debt/EBITDA), I’m already projecting numbers here that will give shareholders 10% or better returns over the next 20 years. That sounds like a great stock to buy.


I do have concerns. I don’t think I can easily predict what interest costs will be for the next 20 years. I don’t think I can easily predict what cash taxes will be for the next 20 years. And I do think there’s a real risk both can be higher than they are now. I also think that under tighter credit conditions globally, there’d be more pushback by ratings agencies and bond investors against something even as stable as an airport carrying nearly 7 times EBITDA in debt. So, I’m not sure Sydney Airport bonds won’t be junk rated at some points in the next couple decades. They might be.

So, let’s talk about the price here on an unleveraged basis. I’m going to do something strange here and use U.S. dollars, because it’s a lot easier for most readers of this article to think in USD than in AUD. At the moment, one Australian Dollar is equivalent to about 68 American cents. Sydney Airport has about $6.5 billion (USD equivalent) in debt. It has around $13.5 billion (again, USD equivalent) in market cap. That’s an enterprise value of a little over $20 billion (USD). What are passenger numbers today? What are passenger numbers expected to be in 20 years?

Sydney Airport currently has passenger traffic of about 44.4 million a year. It expects to have 65.6 million passengers in 2039. This is a 2% annual CAGR in passenger volumes. But, what I want to look at here is the price you’re paying – on an UNLEVERAGED BASIS – for an annuity on passenger traffic at Sydney Airport.

We can think of this as paying about $20 billion (USD) divided by 44.4 million passengers equals a purchase price of about $450. Now, about $300 of that price is paid by the shareholder. The other $150 is paid by borrowing. But, still – let’s just look at this as paying $450 today for a perpetual profit annuity on each passenger passing through Sydney Airport forever. You can check my math by seeing that Sydney Airport has a price in AUD of about 9 right now – which is around $6 a share in USD. Shares outstanding are 2.26 BILLION (in a recent Instagram, I misspoke and did some math as if Sydney Airport had 2.2 MILLION shares outstanding – it’s 2.2 billion). So, the number of passengers you get per share you buy is 44.4 million / 2.26 billion = 0.02 passengers. You need to buy 50 shares of Sydney Airport stock to buy just one full passenger. That’s 9 AUD times 50 equals 450 AUD (which equals about $300 USD). But, that’s just the equity portion of the purchase price. The company also has over 9 billion AUD in debt (which is over $6 billion USD in debt). This is about another $150 USD per passenger in borrowed price. So, you are buying a passenger at Sydney Airport by putting up $300 USD of your own money and assuming $150 USD of debt on top of your shares.

Is this worth it? Is it worth paying $450 USD for a single airport passenger? Maybe. It’s possible an airport could make around $15 (USD) per passenger right now. And I really do think that a passenger passing through an airport can be viewed as an annuity that will grow by at least inflation. Then, the actual real volume of passengers is also growing. So, you’re paying $450 for a current passenger that is growing their nominal coupon paid to you at more than 4% a year. I think this is a very well protected number inflation wise too. If inflation goes from 2% to 10% a year by the end of the next 20 years, I think the amount Sydney Airport makes per passenger passing through the airport will be growing at a lot closer to 10% a year than 2% a year.

Still, what I just laid out there is obviously a very, very high price. When you count the debt as part of the purchase price – you’re valuing this perpetual passenger annuity that might be starting around $15 and then rising from there at a very, very high price ($300 of equity plus $150 of debt).

Absent my concerns about higher interest costs and higher taxes in the future – this stock looks fine on a leveraged basis. As long as Sydney Airport doesn’t keep deleveraging, I think the common stock could – even at today’s price – beat other stocks you might buy. I think it can keep doing that even over a 20-year holding period. But…

I think there are risks with things like interest rates that need to be considered. As safe as this asset is, I don’t think that something expected to return 10%+ as a stock for the next 20 years while having nearly 7 times EBITDA in debt for all those years is really the same thing as a stock priced to return 10% a year for the next 20 years while never having any debt.

One way to think about this is simply to consider the level of debt here versus the price of the stock. At the moment, we’re talking about a stock price I consider to be about priced right to deliver adequate returns that will beat the market. We can sort of treat the stock as being very closely to fairly valued. If that’s true, you are buying into this company using 2 parts equity (at the current market value of the equity) and 1 part debt.

I can’t deny Sydney Airport is a super safe asset, business, etc. when compared to other stocks that are priced to deliver 10% or so returns for the next 10-20 years. But…

Think of it this way. What if you put $100,000 into a stock you considered very, very safe using $65,000 of your own money and $35,000 worth of a loan from a broker. Could you – given where interest rates are now – leverage up that position to the point where a safe underlying asset was returning about the same as Sydney Airport stock is priced to now?

I think the answer to that is yes. So, I’m not going to say Sydney Airport is too risky. I’m just going to say it seems as risky to me as buying a very safe stock using $2 of your own capital and $1 borrowed from a broker. There are people who do that successfully long-term. And you may be very successful simply buying Sydney Airport stock now – without adding any margin of your own – and holding it long-term.

I just think the attraction here for people is in large part the amount of debt the company is using on your behalf. It’s true the company is borrowing for an average of 5 years (not a margin loan that can run into collateral problems through daily marks to market) but I just see this as being too similar to buying a safe asset using margin to get a market beating return.

I like the business. And I’m actually okay with this amount of debt – though, as always, I’d rather they were spacing it out further than just 1-10 years mostly – if the common stock behind the debt is very cheap. Here, I think the common stock is neither shockingly cheap nor expensive. And I think there’s a lot of debt ahead of it.

It’s probably a mistake to pass on Sydney Airport stock. If I was managing billions of dollars – maybe I wouldn’t. But, I’d just rather find things that offer similar returns without using so much leverage to do it. This reminds me too much of buying a safe asset on margin to beat somewhat less safe assets bought without leverage (the index).

So, it’s a pass for now.

Geoff’s Initial Interest: 70%

Possible Revisit Price: 4.50 AUD (50% lower)