Heathrow: the hedge fund with an airport attached
Third quarter results for Heathrow are out
Heathrow airport reported its results yesterday for the nine months ending September 2022. The company drew the media’s attention to its preferred profit metric, “adjusted profit / loss before tax”. On that measure it reported losses of £442m for the period. The airport claimed that the results showed that the airport continued to lose money, whilst airlines had mostly returned to profits.
The company is still haggling with its regulator, the CAA, over charges for the 2023 to 2027 period. The CAA has proposed a reduction in charges whilst the airport wants to see a big hike to allow it to recover its pandemic losses. So at this stage in the regulatory cycle, Heathrow is inevitably being all doom and gloom about the future and the state of its finances.
Before adjustments, the company’s actual reported profit / loss before tax for the nine months was a profit of £643m on revenues of £2,106m. That’s a pre-tax margin of over 30%, the kind of margin made by famously profitable Apple. I’ve shown the quarterly results on the following chart. You can see that revenue has almost recovered to 2019 levels (it is down less than 2%). What has happened to profits is hugely dependent on what profit measure you use.
What is going on? Is Heathrow making huge losses or huge profits? Let’s start with the real business of actually operating the airport.
Airport operations
At an operating level (i.e. before finance costs), the company made profits of £685m, even excluding the £146m gain it made adjusting up the value of its car parks. That is 22% lower than the £874m it made on the same basis in the first nine months of 2019. Heathrow’s biggest customer, IAG, recently gave guidance on its results for the same nine month period. They were down 52% on 2019. So the airport’s gripe that airlines are doing much better than it is doesn’t really line up with the facts.
Heathrow’s operating profit margin works out at 32.5%. To airlines, which often struggle to make double digit margins, that sounds like rather a lot. But of course, airports are particularly capital intensive businesses. Return on capital is therefore a better measure of profitability, perhaps.
The airport has about £10.8 billion of property, plant and equipment on its balance sheet, plus £2.4 billion of “investment properties”. About half of the value of those investment properties is represented by the airport’s commercial car-parks, the rest is rental properties, lounges and advertising sites. The investment properties are valued on the basis of their “fair value”, which in this case is accountant-speak for the discounted value of expected future cash-flows. As such, it doesn’t have anything to do with what it cost the airport to build or acquire them. Saying that the airport needs to earn a fair return on that value because they have assumed they will is a little circular in my books. In any event, let’s be kind and include them in our estimate of the capital employed in operating the airport. That gives us a capital employed of about £13 billion.
£685m operating profit for nine months represents an annualised return on £13 billion of capital of about 7%. If you exclude the COVID-impacted first quarter, annualised return on capital was a more respectable 9%. Is that good or bad? Airports are utilities, with stable cashflows and extremely tangible assets that can be borrowed against. With 10 year government borrowing rates of around 4%, even after allowing for a risk premium and the requirement for some equity capital with higher return requirements, 9% certainly looks like it should be enough.
Of course, the reality is more complicated. The CAA uses the concept of a “Regulatory Asset Base” or “RAB”. That differs from the accounting number mainly by adjusting historic values for inflation. In the “historic cost” values that appear in the reported accounts, the value of a terminal only ever goes down as the asset ages, unless more money is spent on it. When the CAA calculates the RAB, they also reduce the value of an asset to allow for aging, but in addition they increase it each year to allow for inflation. As such it is closer to the concept of what it would cost to build those assets today, adjusted for their age. The CAA also allowed an extra £300m to be added to the RAB during the crisis to partially compensate the airport for lost revenue (the airport lobbied hard for a much bigger adjustment of course). Airlines would argue that the RAB includes values for terminals that were demolished years ago and that the figure is over-inflated. But for all its faults, it is the figure that the CAA uses as the basis for setting charges. If you used the £17.5 billion RAB at the start of the the year as your measure of capital employed, that would give you an annualised operating return on capital of about 7% on the basis of Q2 and Q3 performance.
However you measure it, I think this demonstrates that the airport’s profits have already recovered sufficiently to provide a decent return on capital at an operating level. Add in the potential for further recovery in passenger numbers and things start to look quite profitable. Which should come as a surprise to nobody, with airport fees 32% higher than they were before the crisis. The regulator obviously agrees, which is why they have proposed a reduction in charges going forward.
But let’s get back to trying to answer the question of whether Heathrow made or lost money in the first nine months of 2022. For that, we need to know whether £685m of operating profits was sufficient to cover interest costs. You’d think that would be an easy question to answer, but you’d be wrong.
Heathrow’s cost of financing
At the simplest level, £685m of operating profits was easily enough to cover interest payments in cash terms. Heathrow paid out £252m of interest on its debt and received £11m on its cash deposits. Another way of looking at interest costs is to use the figures Heathrow provides for its average cost of debt, which it gave as 1.52% at the end of March. That had risen to 1.83% by the end of September as interest rates rose during the year, since some of the debt is at variable rates. Gross debt averaged £18.7 billion during the nine months, so that would suggest interest costs of about £235m, lining up pretty well with the figures from the cashflow statement.
So on the face of it, operating profits are easily sufficient to cover interest costs on the debt. However, one of the reasons Heathrow pays such a low interest rate on its debt is that part of it is RPI-linked. If you include the cost of indexing for inflation, the average cost of debt as at March 2022 was 4.89% and that had risen to 8.46% by the end of September. As we’ve seen, most of that didn’t need to be paid out in cash terms, because the indexation cost relates to payments which will be made over many years. With revenues linked to inflation, cashflows will rise to meet the additional cost. Lumping all those financing costs into a couple of quarters isn’t a very helpful way of looking at things. But neither is banking the lower interest rate from RPI-linked bonds but ignoring the cost of indexation.
I think the easiest way to gauge what the “underlying” profitability after financing costs looks like is to imagine that Heathrow had simply stuck to non-indexed bonds. Its cost of debt would have been something like 5%, which is the rate it typically pays on its non-indexed sterling bonds. On £18.7 billion of debt, that would be £234m a quarter of interest costs. For the nine months, operating profits were not quite enough to cover that, but that was mainly down to the poor first quarter, which was still heavily COVID affected. Profits in Q2 and Q3 averaged £300m a quarter. So I’d say that looking through all the complicated financing and accounting, Heathrow was close to break-even on a pre-tax basis for the nine months and made a small pre-tax profit in both Q2 and Q3.
Gearing
For those of you who have been paying attention, you might be a bit puzzled by how a company with operating assets of about £13 billion can support £18 billion of debt. Part of the answer is that the company also has cash balances of around £1.3 billion, so the net debt is lower. But the bigger reason is that it measures its gearing relative to the RAB, not the accounting values. At the start of the year, the RAB was £17.5 billion, as we’ve already seen. The latest figure is now £18.4 billion, thanks to the power of indexation in a high inflation environment. That enables Heathrow to boast that its gearing levels are now better than before the crisis. Nevertheless, it is true to say that the company is deeply indebted and operates with very little equity cushion. That has been a great formula for supercharging returns for its shareholders through the power of leverage in a world awash with cheap financing.
Of course, that world has been changing over the last year as central banks have started to raise interest rates. We’ve already seen that part of the company’s debt is linked to RPI and as inflation has risen, this has raised the cost of serving its debt. In fact, it is worse than it appears because as well as issuing RPI linked bonds, Heathrow also makes heavy use of swaps to further increase its exposure to inflation. Many of the biggest items in its P&L relate to mark-to-market profits and losses on its swaps contracts. To understand those numbers, we’ll need to head further down the Heathrow financing rabbit-hole.
Heathrow’s swaps
Swap contracts are used to change the risk/return profile of a financial instrument. In Heathrow’s case, they use them for three purposes.
The easiest to understand are the currency swaps. As a UK business with all its costs and revenues in sterling, the company has no business borrowing in foreign currencies. However, it does do that, enabling it to tap into global debt markets rather than be restricted to the sterling market. It uses swaps to turn the foreign currency interest and debt repayment cashflows back into sterling. Most of these swaps are accounted for using what is called hedge accounting. Where a swap is clearly linked to hedging a specific risk, in this case a foreign currency bond, the accountants spread the cost of entering into the swap contract over the life of the bond and don’t require any “mark-to-market” adjustments each quarter. These swaps therefore don’t generate much volatility and don’t confuse the profit and loss account very much.
The second type of swap is an interest rate swap. Heathrow has a policy of having 75% of their interest costs at fixed rates and they use swaps to “decouple” this policy from the actual bonds they issue. Sometimes borrowing at variable rates and swapping the payments into fixed rates is cheaper than borrowing at fixed rates. Or vice versa.
The final type of swap they use is an inflation swap. They have a policy that 50% of their borrowings should be linked to inflation and some of that is done by issuing RPI-linked bonds. But they don’t issue enough to hit their 50% target and they bridge the rest with swaps. They enter into contracts with financial intermediaries where they receive fixed payments and make payments linked to inflation. The logic for this is that much of their revenues are explicitly pegged to an inflation index. In a world of falling inflation, having your debt service costs go down in line with your falling revenues reduces risk. Of course, in a world of rising inflation, this works the other way - giving up a portion of the gain they would have got from rising inflation by needing to make higher debt payments.
Neither the interest rate swaps nor the inflation swaps are obviously hedging anything specific and so the accountants don’t allow the company to spread costs or gains over time, as they mostly do for the currency swaps. Instead, they require the company to “mark-to-market” all these swap contracts every quarter and this contributes to huge swings in reported profits when markets are volatile. They appear in the profit and loss account as “fair value gains and losses on financial instruments” and the company excludes them all when calculating its “adjusted” profit / loss.
As we saw at the start of this article, excluding these gains and losses makes a huge difference to the reported profit number. For the first nine months of 2022, they added up to a profit of £939m. £322m of this was from their interest rate swaps, so I assume the swaps were on balance protecting their interest costs from rising rates. More puzzling is the £510m gain on their inflation swaps. With inflation rising, you would have thought they would have recorded a loss here. The most likely explanation is that they had substantial mark-to-market losses at the start of the year, but since most of these paper losses were far out into the future, when interest rates rose, the discounted value of those losses fell.
Recap
For anyone that has made it this far, I can only apologise for how complicated all of this is, despite my attempts to simplify things as much as possible. As I pointed out in the headline, at this point Heathrow is pretty much one giant hedge fund, with an airport as a side business.
I set out to answer the question of whether Heathrow airport made a huge profit or a huge loss in the first nine months. I think once you set aside the hedge fund gyrations, the answer is “neither”. The airport itself was approximately breakeven after paying a normalised interest cost on its debt. Quite profitable at the operating level, but with a huge debt burden to service.
The fact that 50% of that debt burden is not linked to inflation and at least 75% of it is protected from rising interest rates will I think help the airport to “inflate away” some of those debts over time, at least relative to its operating cash generation supported by inflation-linked airport fees.
The flip-side of those inflation-linked airport fees is rising costs for airlines and their passengers. So far that hasn’t seemed to translate into slowing demand, with IAG commenting recently that forward bookings “remain at expected levels for the time of the year, with no indication of weakness”. Heathrow airport is of course making more pessimistic statements about the risks to volume, as they try to pressurise the CAA into giving them a more generous settlement on fees.
The CAA is expected to finalise its airport fee proposals before the end of the year. The next few months will be interesting.
