Wednesday 8 February 2017

Beijing Capital International Airport: Ready for take-off

Over the past few months, I have accumulated a 70bp position in Beijing Capital International Airport (694 HK) at an average price of HK$7.50, and continue to nibble at the position on weakness. Given the right opportunities to add, I can see this growing into a core portfolio holding in time. I believe the stock to be attractive, trading at a FCF yield of 8-9% and a forward FY17E PE multiple (on conservative assumptions) of 15x. Here is why.

BCIA operates the world’s second busiest airport, with annual passenger throughput of some 90m people. Airports are generally great tollgate-type businesses that have delivered outstanding risk-adjusted returns for long-term shareholders. One need look no further than the long term share price charts of the likes of Sydney Airport, Auckland International Airport, or Airports of Thailand or Malaysia for evidence of that. Multiples of 30-40x are not uncommon, as investors have come to appreciate the high value of these assets.

It is not difficult to understand why. While airlines have historically slogged it out and cut each others throats with aggressive price competition, and roundly failed to capture any value for shareholders from the multi-decade secular trend towards rising air travel, airports have kept on clipping the ticket and producing reliable, growing cash flows. Indeed, airports have been passive beneficiaries of deflating ticket prices triggered by the emergence of low-cost carriers and more fuel-efficient planes. Customers can shop around online for cheap air tickets, but they seldom shop around for a better airport deal. Airport stocks infrequently look optically cheap, but the robust operating leverage built into their business models, which can convert low single digit passenger growth into much more rapid bottom-line earnings and FCF growth (as interest costs, D&A, and operating costs prove relatively fixed), have often made them rewarding long term investments.

Airports (and infrastructure assets more generally) are potentially less good businesses in China, however, because the Chinese government likes to build infrastructure. It’s good, after all, for GDP growth. And so sometimes more infrastructure ends up getting build than is realistically needed (or at least is built out far ahead of present day requirements). That’s less than ideal if you’re an infrastructure owner, and some of those fears may be being reflected in BCIA’s valuation, which is low on a comparative EV-per-passenger, P/BV, EV/EBITDA, or P/E basis vs. international peers (or any other way one wishes to slice and dice it).

More pointedly, a second Beijing airport is currently under construction (which is not being built by BCIA), which is slated for commissioning in 2019. It is also a large airport with targeted capacity of 70m people – not too far from BCIA’s 90m. Fears this will harm BCIA’s growth and profitability are weighing on the stock. In addition, the airport is capacity constrained at present (contradicting the generalization that infrastructure in China is always and everywhere overbuilt), and in the eyes of many, lacks and ability to deliver meaningful earnings growth from here. And lastly, the investment community (including myself) is far from bullish on the medium term outlook for the Chinese economy (and yuan), and a lot of Chinese/HK listed stocks are therefore inexpensive at present.

I think these fears are overdone. Firstly, there is something of an inconsistency between worrying about capacity constraints and the impact of a competing airport. The existence of capacity constraints means that BCIA is not in a position to fully capture future demand growth anyway. When the new airport opens, carriers representing approximately 30% of BCIA’s current revenues will transfer to the new airport, but this is targeted to be phased-in over four years, rather than absorbed in a single hit. Meanwhile, the remaining carriers representing 70% of BCIA's current volume will have additional 'runway' to expand.

In addition, BCIA derives much more value from international flights than domestic flights, and an ability to divert a portion of lower-value domestic flights to an alternative airport should allow it to improve its aircraft movement mix. International flights are typically larger planes that carry more passengers per aircraft (the choke point for BCIA is allowable landing/takeoff time slots), and international passengers also have longer 'dwell times' at airports, and hence deliver much higher per-passenger non-aeronautical revenue (F&B, retail concession, etc). BCIA also has an ability to continue to incrementally add capacity over time via small add on investments, including an upcoming forth runway. 

Low single digit passenger volume growth should therefore be sustainable for quite some time, which combined with an improved aircraft movement mix, ought to result in trend revenue growth approaching the mid-single-digits. That will be more than enough to support robust earnings growth off an operationally-leveraged fixed cost base. The exception will be during 2019-23 when Beijing's new airport ramps up, but my expectation is that earnings will trend relatively flat during during this period, rather than fall. I also believe earnings should grow some 20% between then and now. Lastly, while an economic downturn remains a risk to this base case, in the long term it is highly likely that a growing middle class will underpin a continuation of solid passenger throughput growth. 

Crucially, there is a very important silver lining to BCIA from development of the competing airport – namely a significant decline in capex requirements. High ongoing expansionary capex – often well ahead of present-day demand requirements – is something that has kept a lid on the valuations of a number Chinese airport companies (see for e.g. 600004 CH), but that is fast becoming a non-issue for BCIA. Indeed, in its recent debenture prospectus, BCIA disclosed that its aggregate 2016-20 capex budget is RMB 4.4bn, which translates into an average of RMB 0.9bn per year. By comparison, D&A is running at about RMB 1.6bn pa at present. Consequently, FCF to equity holders over the next five years should average RMB 0.7bn higher than NPAT. Furthermore, a lot of itemized capex projects are actually incrementally expansionary in nature, rather than purely maintenance, and therefore should support incrementally higher revenues and earnings over time.

With NPAT expected to come in at about RMB 1.8bn in fiscal 2016, that equates to free cash flow to equity holders of RMB 2.5bn. In 2017, I anticipate earnings and FCF growing further to RMB 2.0bn and RMB 2.7bn respectively. By comparison, BCIA’s market capitalization is currently only RMB 30bn (HKD 33bn), which implies that the stock is trading on a 8.3% FY16E and 9.0% FY17E equity FCF yield. For a relatively low risk cash flow stream that is also likely to grow over time, and in a world with low interest rates, that appears very attractive.

In the intermediate term, a lot of that FCF will likely be dedicated to paying down debt (which is about 2x EBITDA). However, after a period of deleveraging, BCIA will have the capacity and probable willingness to raise its dividend payout ratio from its current relatively-low 40%. This could well act as an eventual catalyst for the stock to re-rate to closer to 20x earnings.

BCIA is by no means the cheapest stock I have ever seen, but is a solid proposition in my view.