Sydney Airport won't build Badgerys Creek

Novice golfers will often try to hit the ball as hard as possible off the tee, while those with more experience tend to be happy to forgo a little oomph in favour of a clean connection and greater accuracy. In business also, one of the keys to success is knowing when to hit hard – and when to make sacrifices.

By any measure, Sydney Airport is in a league of its own. This 907-hectare patch of land is an economic powerhouse and the main gateway that connects Australia to the rest of the world. Its monopoly gives it significant pricing power and protects revenues against inflation, while passenger growth has been relentless even in darker economic times. The company pours out cash, distributing $624m to investors in 2016.

Which is why the mere suggestion that Sydney Airport would forgo its right to build and operate a second Sydney airport seems – at first – so outlandish. The company has turned down the Government's formal offer – December's Notice of Intention – but we think that sends a clear message: management knows how to play golf.

As we explained in Who pays for Sydney's second airport?, the terms of the deal changed radically in the final months. The Government was originally going to provide a cheap loan for most construction work and Sydney Airport would have a right to withdraw from the project if there were major cost overruns. However, the final offer provided no Commonwealth funding or cost protections – all expenses related to building and operating the airport would need to be met by Sydney Airport's shareholders.

With an estimated price tag of $5bn–6bn, this was no minor bit of missing fine print. The new airport will take at least 10 years to build, over which time many variables – such as interest rates, traffic forecasts, and construction costs – could, and probably will, change. The risk of cost overruns and bad projections is substantial, yet Sydney Airport investors wouldn't see a penny of return until at least 2026.

Good buy monopoly

Following Sydney Airport's announcement, Prime Minister Malcolm Turnbull said the Government would proceed alone with the project and will release details of its construction plan in next week's federal budget. He also alluded to the involvement of private investment down the line.

If material terms are changed from those outlined in the Notice of Intention, Sydney Airport is still entitled to a Right of First Refusal. However, once the airport is built – and the worst of the risk swept away – it would be tough for it to participate in the second airport's potential privatisation without the Australian Competition and Consumer Commission frantically waving red flags.

As things stand, Sydney Airport's monopoly will end. Owning both airport sites would have had its perks, but a little extra competition isn't the end of the world. It may even come with some benefits: a Productivity Commission report on airport competition is due next year and, with a new stand-alone airport on the block, the risk of unfavourable regulatory changes is probably lower than before.

What's more, a new airport certainly won't mean a mass exodus of airlines and passengers.

Aeronautical charges are only a minor expense for airlines, typically making up around 3% of total costs. Now imagine that you were running Air Canada and had a 300-seat Boeing 777 to land somewhere – Sydney Airport, or Badgerys Creek, 50km from the CBD. Your profit margin is around 2%.

Even if Badgerys Creek were charging half the landing fees, you wouldn't turn a profit if just 10 of those 300 passengers opted to fly with another airline that landed at the more accessible Sydney Airport. For airlines, the minor cost savings aren't nearly as motivating as the convenience factor – particularly when you consider that the number of flights an airline can make into or out of a country is capped by bilateral air services agreements, forcing the airline to pick favourite airports. We doubt Sydney Airport will lose much pricing power.

Growth to continue

High-margin international traffic, which accounts for 70% of Sydney Airport's passenger-driven revenue, is likely to be unaffected by the new airport. Furthermore, some 70–80% of freight cargo is carried on passenger planes, so it won't be easy for Badgerys Creek to steal that honeypot either.

A second airport is only likely to increase competition for low-margin domestic passengers and ultra-budget airlines, so what little revenue does shift from Sydney Airport to Badgerys Creek will have an even smaller effect on profits. You can see why the investment case for the second airport was challenging to begin with.

Sydney Airport currently uses only 340,000 of its 500,000 allowed flights per year, so there is still more than enough room for growth over several decades. Even then, as the country's main gateway, airlines would probably prefer to allocate higher capacity aircraft to Sydney Airport, rather than introduce new flights to less convenient destinations.

London Heathrow, for example, has been at full flight capacity for a decade, yet passenger numbers and revenue have continued to grow as airlines switch to higher volume planes. The passenger mix has also skewed more towards international travellers, which has improved margins.  

Sydney Airport expects to serve almost twice as many passengers by 2030, which is an annual growth rate of a bit under 5%. Once you factor in higher retail rents, parking and aeronautical fees – which will increase by 3.8% a year under the most recent five-year pricing agreement – it's reasonable to expect revenue to increase in the high single digits. And because a large proportion of Sydney Airport's costs are fixed, profits should increase at an even faster clip.

Management expects 2017 distributions of 33.5 cents per share, an 8% increase on 2016. The stock is up 20% since we upgraded it in Who pays for Sydney's second airport? on 5 Jan 17 (Buy – $5.89) and, with an unfranked dividend yield of 4.8%, we're sticking with HOLD.

Note: The Intelligent Investor Growth and Equity Income portfolios own shares in Sydney Airport. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.

Disclosure: The author owns shares in Sydney Airport.