Heathrow Results for 2023

Bumper results, despite the management spin

Apologies that I haven’t posted for a while. I’ve been vacationing in New Zealand for most of February. That is also the reason for today’s blog post image being one of my “holiday snaps”, rather than yet another picture of Heathrow airport. It’s a photo I took in Whakatāne, which happens to be the name of the meeting room I used on an almost daily basis when I worked at BA’s Waterside head office at Heathrow. A feeble link I know, but hopefully you like the picture.

Heathrow has just released its financial results for 2023. The company pitched the results as showing that they had (just barely) returned to profit for the first time since COVID. That was based on their preferred metric of “adjusted profit before tax”, on which metric they recorded a profit of £38m.

However, we also need to look at the actual reported results, before “management adjustments”. On that basis, pre-tax profitability was already restored last year and the 2023 result was a profit of £701m. In the following chart, I’ve shown both the unadjusted and the adjusted figures for the last five years. In blue, I’ve shown the figures before financing costs (operating profit) and in red after financing costs (pre-tax profit).

I wrote about the 2022 results a year ago, and at that time I predicted a "bumper 2023", on the basis of an expected rebound in passenger volumes and the incredibly generous interim charges settlement for 2023 set by the CAA. Heathrow's regulator largely fell for the airport company's doom-laden passenger forecast when setting the interim charges and with so much of the airport's cost base fixed, a low-balled passenger assumption translated into an inflated set of allowed charges.

I went as far as to make a prediction for Heathrow’s operating profit for 2023 of "over £1.5 billion", a figure which I noted was more than 25% higher than the airport made pre-crisis.

A year later, and now with the benefit of hindsight, how well did I do with my prediction?

2023 operating profit compared to my expectations

When it comes to revenue, I got the total figure about right, although there were differences in the detail. The revenues are of course heavily driven by the passenger numbers and last year I said I expected passenger numbers to be "at least 77m". I did my forecast on the basis of 77m, so it would be no surprise if the figures came in a little higher. The actual outturn was 79.2m, 2.5% higher. I'd say I was pretty close. Certainly much closer than Heathrow's own public forecast at the time of 67 million.

Revenue from aeronautical charges is pretty much a given once you know the passenger numbers, since the rate per passenger is set by the CAA. The outturn of £2.5 billion was therefore also slightly higher than my forecast of £2.4 billion.

I assumed retail revenue would go up by 5% per passenger, driven by the inflationary environment, whereas in fact it fell by 4%. I think that was due to the government’s decision to end VAT free shopping for overseas visitors from the start of 2023 (another “Brexit dividend”). That was decided back in 2020, so I should have taken it into account, but I didn’t. However, the shortfall in retail revenue was compensated by growth in other revenues, which came in 10% stronger compared to the 5% that I assumed.

Overall, Heathrow's revenue was 1% above my forecast. On the cost front, I assumed a 5% increase on 2022 and Heathrow managed to spend 10% more, with employee costs up 15%. You would have thought that revenues being 1% higher and operating costs being 5% higher would result in profits substantially lower than I predicted. But Heathrow's margins at an operating level are so high (40% in 2023), that a given % change in revenue is worth a lot more than the same % change in costs. Overall operating profits of £1.5 billion were only £50m or 3% lower than I predicted.

I didn't try to predict fair value gains or losses on investment properties. Those come from the company writing up or down the value of their investment property assets. For 2023, Heathrow booked a profit of £200m for those, so the actual operating profit was £1.7 billion. That's a cool 30% higher than the figure they reported back in 2019 and was I think an all-time record performance.

I reckon that qualifies as "bumper" by any standard.

What about pre-tax profits?

It is a bit harder to disentangle what is going on with Heathrow's profitability when it comes to the figures after financing costs. As I explained in an earlier article (Heathrow: the hedge fund with an airport attached), Heathrow uses massive amounts of leverage and a complex array of financial derivatives to "juice-up" its returns for its equity investors. Things are not helped by the accountants - many of the derivative transactions done by the company do not qualify for so-called "hedge-accounting", which would try to match the timing of value movements in Heathrow's derivatives to the cash-flows they are trying to hedge. So there are huge quarter to quarter swings in profit driven by "mark-to-market" adjustments. The company presents an "adjusted" set of profit figures, which excludes those non-cash mark-to-market profits and losses. It also excludes exceptional gains and losses and the periodic revaluations they make to property values. On that adjusted basis, pre-tax profit came in at a measly £38m, considerably down on the £375m they made on the same measure back in 2019.

So, in a year where the company made record operating profits, was the company really barely profitable after financing costs? During 2023, in its adjusted profit figures the company recorded interest costs for its bonds and loans of £832m, up 40% on the 2019 figures. Some of that was driven by higher debt levels following the losses of COVID. But borrowings were up only 13%, so most of this increase was somehow driven by rate increases. Perhaps that is understandable, given the big rise in interest rates. But much of Heathrow's debt is at fixed rates. So I think a lot of the "rate increase" probably relates to payments made as a result of indexation of Heathrow's inflation-linked debt as inflation spiked.

Not included in Heathrow's adjusted profit figures were £452m of profits from interest rate and inflation swaps. Also excluded are the £200m of "fair-value adjustments" in Heathrow's investment properties. In a high inflation environment, property values will tend to appreciate, all other things being equal. Given Heathrow's vested interest in pleading poverty to its regulator, it does strike me as a bit suspicious that these £652m of profits are excluded from Heathrow's preferred headline profit figure, whilst all the costs of rising interest rates and inflation seem to have been included.

We certainly know that high inflation is extremely positive overall for Heathrow's finances. On the investor call, their CFO called inflation "our friend" and highlighted that with all of their revenues being linked to inflation and only half their debt being so linked, high inflation was very positive on a long-term value basis. But he also commented that the short-term results didn’t show that as there was a mismatch in duration - the bad news on debt crystallised over five years whilst the good news on revenues was spread over twenty years.

I think a good way to get a feel for Heathrow's underlying economics based on their 2023 results would be to take their operating profit number of £1.5 billion, before gains from writing up their property values, and deduct a "reasonable" cost for their debt. With £17 billion of net debt at a cost of say 5% (£850m), that would give you a pre-tax profit of £650m. In my opinion, even that is conservative as there should be property gains over time and I think Heathrow does better than 5% really.

In any event, the official unadjusted profit before tax for the year was £701m, 28% above 2019 and representing a pre-tax profit margin 19%. Much as the company likes to focus on its adjusted numbers and claim that they were barely profitable, for once I think the accountants official view is much closer to the truth than the management’s adjusted numbers.

How good was Heathrow's operating profit performance in 2023?

In their investor presentation, Heathrow made a couple of points about how their revenue and operating costs compared to 2019. Passenger numbers were very close between the two periods (2023 was 2% below 2019), so a direct comparison of the figures is a reasonable thing to do.

For revenue, which was up 20%, Heathrow made the point that this was 7% below 2019 levels after adjusting for inflation. The company's charges are regulated using an RPI inflation metric, so it is understandable that RPI was the measure used to adjust for inflation. Over that period, RPI went up by 29%, so their -7% calculation is correct (1.20/1.29 - 1). Revenue from charges levied on airlines has gone up faster than inflation. It is the weakness of retail revenues that is driving the overall reduction, with government changes to VAT for foreign visitors top of the list of culprits.

On the cost front, Heathrow did the same inflation adjustment calculation and came up with a figure of a 2% reduction in costs. Is that a good performance, as it was pitched by the management? A 2% reduction matches the decline in passengers and for me holding cost per passenger flat in real terms isn't particularly impressive in a high inflation environment. I'd also point out is that the use of RPI as the inflation measure flatters performance. If CPI had been used, which is the inflation measure almost everyone else uses these days, costs went up by 6.4%, against a decline in passenger numbers of 2%.

Outlook for 2024

There are four big moving parts we need to consider when trying to forecast Heathrow's performance in 2024. Namely passenger numbers, the CAA settlement, cost performance and net financing costs.

Heathrow is predicting a growth in passengers from 79.2 million in 2023 to 81.4 million in 2024, a 2.8% growth. The first 0.3% of that will come from the extra day in 2024 (it's a leap year), so that's 2.5% underlying growth. Published schedules suggest that carriers will grow seat capacity at LHR by 5.1%. Of course, there is usually some "shrinkage" as the day of operation draws closer. There is also some evidence of over-scheduling in the published data. If everything published were to be operated, there would be 484,000 movements. LHR is capped by regulation at a maximum of 480,000. My own estimate for seat growth is based on cutting back the published figures to comply with the cap and trimming another 1% for "shrinkage". That would result in seat capacity growing by 3.2%, or just a little shy of 3% excluding the impact of the leap year. I think there is also some scope for improved load factors. 2023 load factors at LHR were 79.6%, a little below the 80.0% recorded in 2019. The mix of traffic at Heathrow has also shifted a bit towards leisure passengers, which should give a load factor benefit (leisure passengers book further in advance). 2023 was still a recovery year for the airlines and as long as there isn't a lot of disruption, they should be able to better optimise in 2024. I'm going to plump for a 1 point improvement in load factors, which will give me a 4.4% growth in passengers, or a prediction of 82.7 million.

We know that the regulated aeronautical charges will fall by 20% in real terms in 2024 based on the final CAA decision. After allowing for inflation and other "devil in the detail" adjustments by the CAA, that is £26.77 per passenger, 14.3% lower than 2023. If passenger numbers grow by 4.4% as I predict, revenue from aeronautical charges will fall by about 10.5%, or £260m.

Heathrow's other revenues totalled £1.2 billion and its cash operating costs added up to £1.5 billion. The revenues are mostly volume related whilst the costs should be more fixed in nature. So I think if I was Heathrow's CFO I would be disappointed if the £300m deficit from those two parts of the P&L widened next year and I'd actually be looking to try to offset some of the £260m lost aeronautical revenues. But we've already seen that I am useless at forecasting Heathrow's operating costs. From the outside it looks to me like there is plenty of scope for improvement and I'd have thought this should be a priority for the new CEO. But who knows?

There were also depreciation charges of another £700m, but with only £700m of capital expenditure having been spent in 2023 and another £1 billion to be spent in 2024, that doesn't seem like a cost line which is likely to see much of an increase.

So overall, I think that a reasonable starting point for Heathrow's 2024 operating profit outlook would be for something like a £200-300m drop compared to 2023. So about £1.2-1.3 billion, before allowing for any fair value adjustments on investment properties.

Forecasting financing costs for the opaque hedge fund that is today's Heathrow is not a task I'm prepared to take on. But using my earlier £850m placeholder for underlying financing costs, that would give me a "go forward" figure of £350-450m of pre-tax profits, before fair-value adjustments to properties.

I suspect Heathrow's management will find a way to do better than that, as they must be very motivated (and indeed financially incentivised) to resume paying dividends to their shareholders. They certainly suggested during the investor call that it was their objective to resume dividends in 2024.

A pause in the great regulatory game?

With the “H7” regulatory settlement now concluded, normally a period of relative calm might be expected, with the airport management more able to focus on improving performance and working with, rather than against, its airline customers. The company would also normally feel more free to talk positively about the profitability and prospects of the company and to give less obviously biased public forecasts.

But the H7 process took so long to finalise that charges are only set until the end of 2026. It won’t be long before the process for setting the charges for 2027 onwards will kick off again. There is probably only a short window of opportunity before the regulatory game recommences.

For those of us watching from the outside, I suspect it won’t be long before we need to lay in a fresh supply of pop-corn.