SINGAPORE (June 25): Much has been made of Asia’s rising middle class. According to estimates by the Organisation for Economic Co-operation and Development, the global middle-class population will be 3.2 billion by 2020 and 4.9 billion by 2030. The bulk of this growth will come from Asia, with the region accounting for 66% of the global middle-class population and 59% of middle-class consumption.

There are many proxies for Asia’s rising middle class — smartphones, banks, tech companies and travel. The growing middle class in developing countries, changing demographics and liberalisation of the airline and aviation industry all point towards the growth of airports as new-economy millennials value experiences over material goods.

Airports, similar to the aviation and airline industry, possess strong moats, or structural economic competitive advantages. Unlike the players in the airline industry, which rely significantly on air traffic demand, cost of fuel and the efficiency of the competition to determine their margins, airports in most cases exist as a monopoly within their own geographic spheres. Operating an airport requires a licence from the state or federal government, and the metric for granting licences usually includes considerations such as environmental constraints, scarcity of land and potential overcrowding of flight pathways. As a result, most major airport operators usually operate solely within a city, are state-owned and have longterm concessions, which guarantee high margins of capital safety and an economic moat.

In Asia, the rise in employment and household wealth is leading to an increase in demand for leisure travel. In turn, leisure travel demand growth should positively affect the airport industry, particularly those airports that use lowcost airlines for air travel. Improving consumer sentiment and increasing income would also better the outlook of airports located in strategic tourist nations and locations. Domestic air travel within large economies such as China is set to rise further. International air travel (outbound travel) depends on the structure and type of travellers and customers (airlines) of the airport industry. Beijing Capital International Airport Co, Shanghai International Airport Co, Japan Airport Terminal and Malaysia Airports Holdings may see more outbound traffic on upbeat consumer sentiment. Sydney Airport Holdings could depend more on a holistic offering, including services for visitor arrivals and airport shopping. Airports of Thailand is likely to continue experiencing steady growth. For FY2017, it reported a 6% y-o-y rise in air traffic movement, a 7.73% y-o-y rise in passenger traffic and an 11.9% y-o-y expansion in freight.

The International Air Transport Association forecasts that 1% of the world GDP, or US$871 billion ($1.17 trillion) will be spent on air transport in 2018. In addition, the total number of air travellers is expected to double from four billion in 2017 to 7.8 billion in 2036, using conservative estimates. This is mainly due to the current and expected growth in emerging markets, particularly in Latin America and Asia-Pacific. The latter is expected to be the biggest driver of demand for air travel over the next two decades, with China expected to overtake the US as the world’s largest aviation market (in terms of air traffic) around 2022.

What makes airports special and distinguishable from the airline industry is their revenue structure, which is made up of aeronautical and non-aeronautical services. Aeronautical revenue involves any airfield- and aircraft-related services such as passenger service charges, aircraft landing and parking charges, air traffic control charges and other airport fees. This segment of the airport revenue structure strongly correlates with and depends on the demand for air travel and traffic, similar to the airline industry. However, airports also receive a significant contribution of their revenue from the non-aeronautical segment, which usually includes retail and commercial services such as concessions from shops, real estate, rental and car parks. This part of the revenue structure is what makes the airport industry lucrative and stable — it is able to derive stable revenue regardless of economic conditions.

Growing Chinese demand for air travel, particularly for international flights within the Asean region and Europe, will boost the airport industry’s growth and outlook. The weaker Asean currencies and euro make it cheaper for the Chinese to travel. In addition, Asean and European airports have granted China traffic rights expansion. The increased availability of direct international flights should open up new markets, bringing more Chinese travellers to destinations worldwide.

According to the UN World Tourism Organization, Asia contributed 317 million outbound visitors, who generated almost 40% of the world’s tourism expenditures, in 2016. The Chinese made up a majority of these outbound visitors. China has emerged as both Asia-Pacific’s and the world’s fastest-growing source market. There was double-digit growth in the number of Chinese outbound tourists each year from 2002 to 2013. The UNWTO says in 2016, there were 135 million Chinese outbound travellers, a 6% increase from 2015. In 2012, China became the world’s top spender in international tourism and remains in top spot. Tourism expenditure from China rose from US$24 billion in 2006 (3% of the world’s total) to US$261 billion in 2016 (21%).

In 2017, Spain and France reached agreements to expand bilateral flight quotas with China. These trends could drive revenue at Aeroports de Paris and Aena SME. The increase in flight quotas for France (to increase in stages from April 2017) and Spain (lifted in December 2017) will boost air traffic in these two countries. The enhancement in flight connections could also result in other European airports receiving more Chinese tourists so long as they are within the Schengen area.

Sydney Airport’s traffic growth may moderate after strong additions last year from the 2016 China-Australia open-skies agreement. Elsewhere, China-US traffic growth may slow down as Chinese airlines reach the 180 weekly flights quota. Unless the US sees better airport access in China, it is less likely to expand this quota. Next year, though, when new airport capacity opens in Beijing and Shanghai, China may expand this quota. Flight quotas invariably reduce air travel frequency and growth prospects of airports. Australia is China’s second-largest outbound market after the US, and the open-skies agreement between these two countries should boost the prospects for Australian airports.

A new source of Chinese tourists is likely to be from China’s secondary cities, where incomes are rising and the number of middle-class households is increasing. International airlines have access to airports in these secondary cities. Passenger traffic from Chinese airports grew from eight million in 2011 to 19 million in 2017, and totalled more than 20 million in 2Q2018. Increasingly, then, direct international flights to secondary cities are commercially viable. Eventually, this could negatively impact Hong Kong and Singapore as Chinese airlines launch more direct international routes and bypass these traditional hubs.

Rising interest rates pose headwinds

The airport industry is viewed as an infrastructure offering, as it encompasses constructing, developing and maintaining the airport infrastructure. Hence, the airport sector as well as other infrastructure investments would be negatively affected by rising interest rates. Also, airports that pay high dividends would be affected by their yield spread — that is, the difference between dividend yield and risk-free rates. Indeed, infrastructure stocks have underperformed the MSCI AC Asia Pacific Index since the start of the year. Rising bond yields could lead to investors switching out of some high-dividend-yielding stocks into less-interest-sensitive stocks.

Another negative is that higher US interest rates could eventually lead to the deterioration in valuations of airport stocks, particularly Sydney Airport, as most airports are viewed as cash-flow-generating and some are valued based on a discounted cash flow analysis. Here, their cash flows are discounted back to a net present value based on the prevailing discount rate. Earnings may also be suppressed in 2H2018, owing to increasing operating costs and a slowdown in economic growth, which may limit the construction sector’s expansion plans. Rising operating costs could also affect airports adversely. Margins will be reduced, along with limitations in the frequency and size of infrastructure-related projects undertaken by airports.

Yield appeal and growth

To maintain airports’ valuations, their earnings would need to grow at a faster clip than inflation to compensate for rising discount rates, and their dividends would need to grow faster than the rise in interest rates. Among the airports, Sydney Airport could maintain high dividend growth over the next two years, which should keep its dividends competitive against government bonds. In fact, Sydney Airport’s high dividend payout has been a major valuation driver since 2012. Beijing Airport’s yield appeal could rise as dividends expand with earnings. The dividend yields of Airports of Thailand, Shanghai Airport and Malaysia Airports are less than 2%, but they may continue to deliver healthy profit increases on traffic demand growth, capacity expansion and efficiency gains. The airports that pay high dividends should be able to maintain their valuations against other attractive investment alternatives such as bonds. For airports with low dividend yields, valuations and profits would need to be sustained through higher projected air traffic demand growth, particularly in Asia-Pacific, along with expansion of capacity for some of the airports, such as Beijing Airport and Shanghai Airport.

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