Flughafen Zurich AG: A Scarce And Durable Real Asset In The Heart Of Switzerland – Flughafen Zuerich AG ADR (OTCMKTS:FLGZY)

Source: All data is sourced from Refinitiv, unless stated otherwise.

Company background & description

Since 2000, Flughafen Zürich AG (OTC:FLGZY, OTC:UZAPF) (“FZAG”) has operated Zürich Airport – Switzerland’s largest airport – as a publicly listed company on behalf of the Swiss Confederation. FZAG is the owner and operator of the airport, with a license to operate it until 2051.

In 2018, the airport handled over 31 million passengers and 493k tons of cargo, servicing 206 European and intercontinental destinations in 68 countries. In addition to aviation services, Zurich Airport provides commercial, real estate, and other services closely related to its aviation services. Last, FZAG also manages eight airports in Latin America – mainly in Brazil, Chile, and Colombia. The company has also developed projects in Asia, including India.

In fiscal 2018, FZAG generated total sales of CHF 1’153 million, EBITDA of CHF 571 million, and net income of CHF 238 million.

The chart and graphs below display a breakdown of the company’s sales by segment and activities:

(Source: Annual report 2018)

(Source: S&P Global Rating)

The aviation segment generated sales of CHF 657 million in 2018, or 57% of group total.

This represents the regulated part of FZAG’s business. Pursuant to the Federal Aviation Act (FAA), a concession is required for the operation of any airport open to public aviation in Switzerland. The Federal Office of Civil Aviation (FOCA) provides regulatory oversight and ensures that the income resulting from the aviation charges does not exceed the certified costs plus a reasonable return on invested capital. The FOCA is responsible for the determination and collection of charges via the Ordinance on Airport Charges. The last Ordinance came into force in June 2012, and a process to selectively revise the Ordinance was announced by the FOCA in the summer of 2018. The revision process is still ongoing, and we discuss this in detail later in this report.

The non-aviation segment generated sales of CHF 496 million in 2018, or 43% of group total. Note that approx. 17% of segment sales (7% of total) were derived from international activities.

This is the non-regulated portion of FZAG’s business, which is primarily involved in commercial operations (e.g., retail, food & beverages, tax & duty free, etc. at Zürich Airport), real estate operations (e.g., leasing, car parks, real estate services at Zürich Airport and in the wider Zürich area), and other services, including the construction and management of airports globally.

Industry background, competitive position, and barriers to entry

There are many things to like about FZAG’s assets. First and foremost, they represent real tangible assets that are both scarce and extremely durable. This is due to the fact that these assets essentially enjoy a status of geographical monopoly as a result of both regulation (i.e., the necessity to acquire a concession from the Federal government) and “efficient scale” (i.e., the fact that it would make little economic sense for a competitor to replicate such capital-intensive assets within a certain proximity). As a result, barriers to entry are close to insurmountable.

Regarding its competitive position, FZAG competes with other airports for local and transit passengers. As for the former, the map below shows the passenger catchment percentages by area, which supports the notion of a local monopoly.

(Source: Facts & figures 2018)

Including transit passengers, Zürich Airport ranks as the 15th largest in Europe with over 31 million passengers in 2018. The airport is regularly rated as one of the best in the world, as assessed by a wide range of criteria, including quality of airport services, shopping facilities, restaurants, waiting areas, as well as proximity to the city and transport links. Having said that, there is significant competition for transit passengers from other European airports, some of which are also highly ranked, including Munich, Frankfurt, and Vienna.

Overall, we rate FZAG to be in a strong competitive position and possess very high barriers to entry.

Fundamental profile

Profitability, capital efficiency, and returns on investment:

Let’s take a look at FZAG’s fundamental profile by segment. The aviation business is regulated, which offers both advantages and disadvantages. The main benefit is that the aviation business is not only guaranteed to make a profit for delivering highly competitive services, it is guaranteed to earn a small excess return over its capital costs. The main disadvantage is that it is not permitted to earn large excess returns by law, and the fact that regulatory changes can create some level of transitory uncertainty (as is the case today).

The aviation business is highly profitable but very capital-intensive, and thus earns somewhat satisfactory levels of return on invested capital. Over recent years, EBITDA margins and ROIC have average 45% and over 6% respectively. Being unregulated, the non-aviation business offers more scope for higher levels of profitability and excess returns. In the recent past, EBITDA margins and ROIC have averaged 60% and over 13% respectively.

As shown below, the combination of these regulated and non-regulated assets leads to a consistently high level of profitability and a satisfactory return level given the company’s attributes and risk profile.

(Source: Annual reports for ROIC since the company started publishing it)

Growth:

The vast majority of FZAG’s business is driven by growth in the number of local and transit passengers that travel via Zürich Airport. As shown below, the total number of passengers has grown at a CAGR of 3.4% between 1988 and 2018. It is worth noting that passenger growth is very stable over time and in various economic environments. For example, the number of passengers only declined by about 1% in 2009, and total sales declined less than 5%. The sharper decline that can be noticed in 2002 relates to the bankruptcy and subsequent dissolution of Swissair and Crossair, and creation of Swiss International Air Lines (SWISS) as part of the Lufthansa Group (OTCQX:DLAKF) and the Star Alliance.

Total revenues typically grow a little faster than growth in the number of passengers. Between 2002 and 2018, total revenues grew at a CAGR of 4.5%. Revenues from the aviation segment grew at of 4.4%, while non-aviation revenues grew at 4.7%. Operating income and net profits typically outgrow total sales by a small amount over the long term.

(Source: FZAG Facts & figures, Annual reports)

Cash flows:

Another attractive feature of FZAG’s business is its cash flow profile. While very capital-intensive in terms of fixed assets, FZAG requires little working capital to operate. The company generates a ton of cash from operations, as it is very profitable, and because of large depreciation and amortization expenses on the P&L (averaging 23% of sales).

However, large investments are required to maintain, improve, and expand the airport’s infrastructure, with a capex-to-sales ratio of 22% on average. Still, over the past decade, FZAG has generated free cash flows averaging 26% of sales and over 140% of net income. Despite being very capital-intensive, we rate FZAG’s cash flow profile as very attractive.

Financial position

As of today, FZAG is in a very strong financial position, as exemplified by the AA- / Stable rating by Standard & Poor’s.

While total debt has remained more or less stable over the past decade, shareholders’ equity has steadily increased as a result of retained earnings. Cash balances have also increased. As a result, FZAG’s leverage ratios have gradually declined to a net debt-to-equity of 28% and net debt-to-EBITDA of 123% in 2018.

With a cost of debt of literally close to 0% in Switzerland for a company such as FZAG, it is difficult to argue that the company’s balance sheet isn’t being managed in an overly conservative way, although this does offer flexibility and option value.

Management team and track record of capital allocation decisions

Mr. Stefan Widrig (48) has been CEO of FZAG since January 2015. He joined the company under its former legal structure in 1999 and worked within the real estate operations. Between 2005 and 2008, he was the CFO of Bangalore International Airport in India (FZAG held a 17% participation in the new airport when construction started in 2005, and was subsequently selected to operate it until 2015). Mr. Widrig returned to the company in 2008 as a member of the Management Board.

Historically, capital allocation decisions have been sensible and in the best interest of shareholders. By far the largest use of cash from operations has been capital expenditures, which have amounted to over CHF 2 billion over the past 10 years. Most of that has been spent maintaining and expanding airport infrastructure and related assets. The second-largest use of cash has been for dividend payments (more on that in the next section), and finally, for working capital requirements.

Last, our basic checks on corporate governance and executive compensation yields no red flags.

Dividend

Since 2005, a few years after becoming a listed company on the Swiss Stock Exchange, FZAG started paying an annual dividend to shareholders (in April of every year). Over time, the dividend grew at a rapid pace as the payout ratio steadily increased to the company’s current dividend policy of distributing 35-45% of profit excluding one-off effects. Between 2005 and 2018, the dividend increased at a CAGR of over 25%. Over the past decade, it has increased at a CAGR of over 15%. It is also worth noting that FZAG did not cut its dividend during the last financial crisis, keeping it steady yoy and even paying out a small special dividend in 2009.

Additionally, in 2015, the company decided to pay out a special dividend out of capital contribution reserves of approx. CHF 100 million p.a., or CHF 3.2 per share, “over the coming years,” which is estimated to be the 2015-2019 period.

So, for fiscal 2019 (dividend paid out in April 2020), we estimate a regular dividend of CHF 4.2 per share and a special dividend of CHF 3.2 per share, for a total of CHF 7.4 per share. At today’s price, this represents a total dividend yield of 4.9%. However, unless FZAG decides to extend its payment of special dividends, next year’s dividend will only amount to an estimated CHF 4.5 per share, at the very high end of the company’s payout range. At today’s price, this represents a dividend yield of 3.0%.

More details on the dividend policy for future years are expected when the company next reports on March 10th, 2020.

Note: EPS payout ratio refers to the regular dividend only.

Current affairs and forward-looking assumptions

Now that we’ve completed a brief fundamental review of the company, let us turn to current affairs and the various factors that impact our thinking on forward-looking assumptions and thus valuation.

By far the most significant development over recent years has been the proposed revision of the Ordinance on Airport Charges. As previously mentioned, in November 2018, the FOCA announced a process to selectively revise the Ordinance and proposed a much higher level of transfer payments (i.e., “cross-subsidization” between regulated and non-regulated activities).

According to estimates by the company,

If these proposed provisions were to be imposed in conjunction with a lower return on capital, aviation revenues […] would drop by around 25% in the next charging period.

However, in June 2019, the Swiss Federal Council announced that it had rejected the FOCA proposal, and that neither the level of transfer payments nor WACC calculation formula would be adjusted. The new Ordinance came into force on August 1st, 2019. The next step is for the negotiations of actual tariffs between the airport and airlines, a process which is expected to be completed by mid-2020.

(Source: 1H19 presentation)

In its half-year 2019 report, FZAG mentions that as a result of the anticipated changes in tariffs,

We are expecting a substantial decrease in aviation revenues over the next charging period.

We assume that aviation revenues will decrease by 15% in 2021, with an even larger drop in segment operating profits.

Another important item to mention is that in 2015, FZAG (51%) teamed up with Swiss Life AG (49%), a large direct life insurance carrier, to build a CHF 1.2 billion, 180’000 m2 retail complex next to the airport, called “The Circle”. This complex will offer a mix of various services, including two Hyatt Group hotels, a convention center, international businesses and firms, a medical center, practical office space, and a wide range of art, cultural, gastronomy, entertainment, education and retail facilities.

For more information on The Circle, we recommend reading the insightful articles of fellow SA Contributor Joseph Harry here and here.

The Circle is set to open in mid-2020, and as of 1H19, the pre-letting rate stood at approx. 2/3rd. Tenants include Microsoft, SAP, Raiffeisen, Hyatt, Globus, Jelmoli, Edelweiss, Horvarth & Partners, and many more.

We estimate that the launching of this new retail complex will help support growth in non-aviation revenues of approx. 5% p.a. in the long run.

Valuation

A conservative DCF-based valuation yields a fair value estimate of CHF 185 per share, marginally higher than the current share price.

The main assumptions for the 10-year forecasting period are outlined below:

  • Aviation, non-aviation, and total revenues to grow at a CAGR of 0.5%, 5.0%, and 2.7% respectively
  • Average operating margins of 29%, with operating income to grow at a CAGR of 2.2%
  • Average FCF conversion rate of 110%
  • Tax rate of 22%
  • WACC of 7.0%
  • Terminal growth rate of 2%

As far as valuation multiples are concerned, FZAG currently trades at a 12-month forward P/E of 15.4x vs. a 10-year average of 18.4x (see Appendix for more detail).

Overall, we see FZAG as slightly undervalued as of today, as the price decline of the past 3 years (close to -40%) adequately reflects the anticipated reduction in aviation revenues and brings valuation levels back towards long-term averages.

Ownership

Very briefly, a few words about the ownership structure of FZAG. The Canton of Zürich owns 33.3% of the share capital, which is the minimum it can own according to the current Federal law. The city of Zürich owns another 5.1% of the share capital. The remaining shares are freely floated on the Swiss Stock Exchange, with a sizable level of institutional ownership.

We view the partial ownership of government entities as a positive, as it reinforces the notion that Zürich Airport is an asset of national importance. As a result, all stakeholders share a common interest in the successful maintenance and further development of the airport infrastructure over the long term.

Risks and red flags

The following chart provides a SWOT analysis of FZAG, and highlights key risks to an investment in the company.

One risk in particular to highlight is the potential impact of epidemics on air travel and the number of passengers going through Zürich Airport. It seems reasonable that investors potentially interested in FZAG would want to wait and see how the spread of the Coronavirus develops over coming weeks and months, as there is a large amount of uncertainty as of today about the impact it may have.

Another key risk to highlight is regulatory risk, although we would stress that the overall long-term regulatory backdrop remains constructive. Yes, aviation revenues and profits will decline in the next charging period, but this is of little relevance for long-term investors provided they acquire the company at a fair price.

Last, FZAG is highly dependent on a fairly concentrated number of airline companies. SWISS, which is wholly owned by Lufthansa, represents 53% of total passengers in 2018, and the top 5 airlines represented 69%.

Initial conclusions

Flughafen Zürich AG is a set of regulated and non-regulated assets that are attractive in many ways. They represent real tangible assets that are both scarce and extremely durable. The company essentially enjoys a local monopoly status, and barriers to entry are close to insurmountable.

FZAG can be expected to grow at a low to moderate pace, be highly profitable, and generate adequate levels of return on investment. Its free cash flow profile is attractive, and will become even more so as the peak in capex related to The Circle is passed this year. Unlike similar “hard asset” companies, FZAG’s balance sheet is very strong, offering plenty of flexibility and option value. Last, the company’s capital allocation decisions have been shareholder-friendly, although the combination of regular and special dividends can perplex some investors as to the company’s dividend policy.

One final item we’d like to highlight is that this company and its underlying assets is not just denominated in Swiss Francs (CHF), but it earns over 90% of revenues and profits in CHF (whereas many Swiss companies are export businesses that mainly earn foreign currencies). This is a clear positive for both Swiss and non-Swiss investors, as we expect the CHF to be one of the strongest currencies (after gold) in the mid- to long term, for a variety of reasons. We will not detail these reasons here, but suffice is to say that the Swiss National Bank (SNB) has spent the better part of the past 5 years ensuring that the CHF doesn’t appreciate too much, mainly relative to the EUR. In order to do so, the SNB has taken interest rates down to -0.75% and expanded its balance sheet to over 100% of GDP, buying foreign assets with CHF and essentially becoming a very large global institutional investor.

In conclusion, FZAG is a set of high-quality and durable assets based in Switzerland that are worth considering owning at the right price. Today’s price is not a bad price at all for long-term investors, although new investors may want to wait and continue to assess the impact of the Coronavirus before buying a participation in the company.

Appendix

Disclosure: I am/we are long FZAG ON THE SWISS STOCK EXCHANGE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed to or by the author. This article reflects Oyat’s views and does not constitute investment advice.

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