A stocktake on the financial health of Heathrow
How is the airport coping with lower fees following the recent pricing review?
I last gave an update on Heathrow’s financial position back in February, after they published their full year results for 2023. The company positioned the results like this:
"We delivered much improved service for our customers, and managed to turn a small profit after three consecutive years of losses".
The small profit they were referring to was £38m of “adjusted” profit before tax. The actual pre-tax profit was quite a bit higher at £701m. Not only a substantial chunk of change, but also 28% above the profits they reported before the pandemic.
Heathrow's results are always tricky to interpret, because of the highly leveraged balance sheet and the heavy use of derivatives. I will refer you to my earlier articles if you want to understand my analysis of this, but the TL;DR for the 2023 results was that the £701m reported profit was a much better indicator of the actual underlying profitability, and represented a very healthy level of profits by any standards.
Why would Heathrow want to downplay its financial performance? As a regulated utility, they have an interest in positioning themselves as impoverished and struggling to afford the investment necessary to keep the lights on, in order to try and get softer pricing reviews.
Back in mid 2022, the CAA (their regulator) issued proposals for charges for the next few years and Heathrow has been bleating that if the proposal wasn't changed, financial carnage would ensure, with the company being unable to finance its capital investment or attract equity investors. The CAA didn’t back down and the new lower charges came into effect in 2024.
We are now half way through 2024 and the airport has reported its results for the first quarter. If the airport wasn't crying wolf (spoiler alert: they were), we should be seeing evidence of financial distress by now, right? Let's look at what we've seen in reality, starting with current profitability.
Profitability in 2024
In my analysis of the 2023 results, I had a go at forecasting Heathrow's profitability for 2024. That has to start with a forecast for passenger numbers. The airport's own forecast is always low-balled, for the same reason that they downplay their profitability. When they announced their 2023 results, they forecast 2024 passengers of 81.4m, a 2.7% growth on 2023. I said that, as usual, this looked too low. For my own forecast I went with 82.7m (up 4.4%). When announcing their Q1 2024 results, Heathrow increased their forecast to 82.4m. Q1 passengers were up 9.5%, but despite that, they’ve left their forecast for the rest of the year unchanged, with growth slowing to 2.7%. Capacity for Q2-Q4 should be up by 4.0% and April passengers grew by 4.8%, so once again this looks a low-balled number. I'd now say that even my higher forecast looks too conservative and 83.5m looks a more reasonable forecast.
They also gave a forecast for EBITDA in 2024 of £1,938m, a curiously precise figure. That compares with the 2023 adjusted figure of £2,228m, and so represents a decline for the year of about £290m. The CAA pricing decision means that 2024 charges will fall by 20% in real terms, which I thought would be worth some £260m after adjusting for inflation and passenger growth. So a £290m decline would be understandable. However, I also thought they'd be able to offset some of that and passenger growth looks to be coming in stronger than I expected, so this suggests the EBITDA guidance is too low.
I reach the same conclusion looking at the evidence from the reported figures for Q1. Aeronautical charges declined by only £30m compared to last year, in part helped by the stronger passenger volumes. Adjusted EBITDA fell by only £43m, much less than the £72.5m you'd expect per quarter based on Heathrow's guidance for the full year.
Despite the decline at the EBITDA level, pre-tax profits for Q1 were up by a lot. That's true however you measure it. On a reported basis they were up by £249m and on an adjusted basis they were up by £222m. This was due to finance costs dropping by a cool £256m in the quarter. Strangely, Heathrow's management didn't see fit to mention this in their headline summary of the quarter, with the only mentions of profit being the decline at an EBITDA level and the fact that they "Continue to make an adjusted profit before tax".
The price of Heathrow's traded bonds
Given the company's dire warnings about the impact of the CAA's proposals on its ability to raise finance, you might think that the price of Heathrow’s bonds would have been hit by the CAA’s proposals. But there is scant evidence of that. The chart below shows the return on Heathrow’s 4.125% senior secured bond, maturing in 2029. As a comparison, I’ve shown the performance of a UK corporate bond fund with a similar overall maturity. Although the price of Heathrow’s bonds has varied over the period since the CAA announced its decision, the movement is closely correlated to overall UK corporate bonds, driven by overall market movements linked to the interest rate environoment. There doesn’t seem to be any underperformance for Heathrow’s bonds.
Did the pricing settlement spook the shareholders?
Maybe the financial damage from the CAA's price settlement has all been felt by Heathrow’s shareholders? Some of them did indeed decide to sell up following the verdict, with an announcement back in November 2023 that Ferrovial were selling their 25% stake to a combination of private equity company Ardian and the Sovereign Wealth fund of Saudi Arabia. Other shareholders have since exercised their “tag along” rights, so a full 60% of the shares in the company are now likely to change hands. Could this be evidence of an overly harsh pricing review causing equity investors to flee?
Well if that were the case, these share sales would be happening at a knock-down price, right? Let’s take a look at the evidence on that.
Back in 2012, Qatar’s sovereign wealth fund bought a 20% stake in Heathrow for £900m, valuing the company at £4.5 billion. Since then, about £4 billion of dividends have been paid out to shareholders. The recently announced deal for Ferrovial to sell 25% for £2,368m values the equity of Heathrow at £9.5 billion, which means that shareholders have made a total profit of £9 billion since 2012. They've basically tripled their money, despite going through the worst ever crisis in the history of aviation. Not much evidence of distress amongst the equity holders, as far as I can see.
The gap between regulatory values and the real world
To provide a bit more perspective on the gulf between Heathrow’s rhetoric about how tough the CAA’s pricing proposals are and the evidence from the financial markets, let’s look at how the valuation from the latest share sale compares to what is implicitly built into the pricing formula.
Prices are supposed to be set to ensure that the airport can finance itself, delivering returns which are sufficient to cover its cost of capital. That means profits need be high enough to cover the cost of debt finance and provide a reasonable return to equity investors too. It is of course important that necessary investment can be afforded, but if the regulator sets prices too high and investors do substantially better than that “reasonable return”, that’s money that has been needlessly taken from airlines and their customers.
The valuation from the Ferrovial sale makes it crystal clear that the CAA hasn’t got this right. The value that shareholders place on Heathrow, based on its expected future profits and cashflows, is much higher than you would get if the airport was only just covering its cost of capital. If that was the case, a profit/cashflow based valuation would be in line with one based on Heathrow’s assets, less its debt. The chart below shows all the key figures. I’ll walk you through the maths in a minute, but the key take-away is that the Ferrovial sale values the business at almost three times what you would expect based on an asset valuation, with the £6 billion difference giving you a good steer for the size of the excess profits Heathrow’s shareholders expect to make.
I said I’d walk you through the maths. The first figure in the chart (£14 billion) is taken from Heathrow’s reported balance sheet at the end of March 2024. It is the value of the company’s assets, excluding cash and financial assets. That figure is prepared using historic cost accounting, and with long-lived assets it is fair to say that means it is likely to be an underestimate of what those assets are worth today. For that reason, the indexation of asset values for inflation is one of the main reasons why the “Regulatory Asset Base” (RAB) used by the CAA to set prices is £6.1 billion higher at £20.1 billion. I should point out that the airlines would say that the way the RAB is calculated leads to overinflated figures that don’t pass the common sense test - for example I think it still includes a substantial valuation of the now closed T1. Nevertheless, even if we use that figure and deduct Heathrow’s £16.6 billion of net debt, we only get a valuation for the equity of £3.5 billion. That is £6 billion short of the value investors are willing to pay based on expected future profits and cashflows.
Back to the subject of Heathrow’s underlying profitability
As I’ve explained before, Heathrow’s high levels of debt and extensive use of derivates makes its real underlying profitability hard to judge, as the figures jump around from quarter to quarter driven by mark to market adjustments. Heathrow attempts to smooth this out with their adjusted metrics, but simply excluding all the volatile numbers is not a reliable way of getting to a good indication of underlying profitability.
The management would have us believe that the airport made a post-tax profit of only £6m in 2023 and for the next few years will be struggling to cope with an unaffordable price settlement. But one of the things we can use the Ferrovial sale value to tell us is how the airport's investors really see the underlying profitability of the airport going forward, because we can equate equity value to profits using Price/Earnings ratios.
Looking at other regulated, low growth utility companies in the UK, a single digit Price/Earnings multiple would seem appropriate. Centrica trades on a P/E of 4x and National Grid on 10x. Let's play with what a P/E multiple of 5-10 would imply about what Heathrow's investors think about profits going forward. A £9.5 billion valuation would suggest after tax earnings of £1-2 billion. Not a company struggling to break even.
Where next?
About the only thing that the airlines and the airport can seem to agree on these days is that the regulatory system needs reform. Of course, they each have diametrically opposed views on what needs to change. Changing the way Heathrow is regulated would be complex and it is hard to know whether the issue would make it onto the priority list for the new Labour government whoever is in power after the UK election on July 4th.
But with the Thames Water situation dragging the subject of how the country’s national infrastructure is regulated into the main-stream of public debate, perhaps there might be appetite for tackling the question of why the UK is home to the most expensive airport in the world, and for looking at whether changes to the regulatory system could get a better deal for airlines and for the travelling public.
