Ratings Upside Could Hinge On Stronger Financials

The ratings on the airports in our portfolio are mostly investment-grade, but still below pre-pandemic levels.   Despite the post-COVID-19 recovery in air traffic, the ratings on European airports remain below pre-pandemic levels, with mostly stable outlooks. Most European airports are struggling to restore their financial metrics. In the first quarter of 2024, European airports' debt exceeded 2019 level by an average of 20%, while all rated airports' total capex increased by about 25%. The ratings benefit from supportive regulatory frameworks, wealthy catchment areas, and strong competitive positions (see table 1). Nevertheless, we expect the future rating trajectory will be more company-specific, implying meaningful deviations from the average. For example, the negative rating outlook on Aeroports de Paris (AdP; A/Negative/--) reflects the unsolicited sovereign rating on France, while the positive rating outlooks on Royal Schiphol Group N.V. (Schiphol; A/Positive/A-1) and Flughafen Zurich AG (A+/Positive/--) reflect their improving financial metrics.

We believe there may be ratings upside for airports whose financial metrics strengthen on a consistent basis.   This could stem from supportive regulations, healthy traffic dynamics, prudent financial policies, lower-than-expected capex, and moderate dividends. The ratings on some airports could inch closer to pre-pandemic levels if increases in funds from operations (FFO) offset any increments in capex or dividends, strengthen ratios, and do not weaken airports' typically solid business risk profiles.

• Schiphol: Higher airport tariffs that compensate for the airport's underperformance during the pandemic, a delay in implementing regulatory traffic caps, and elevated, but still manageable, capex would increase FFO to debt above our 12% rating threshold if regulations and Schiphol's financial policy remain favorable.
• Flughafen Zurich: Operational performance normalized, while capex requirements were well below our previous expectations. This could support very solid credit metrics, subject to financial policy and regulatory steps.

However, this trend is not universal.   For example, for Heathrow, the 20% tariff cut from 2024 onward could delay deleveraging after an increase in indebtedness during the pandemic. We do not rule out potential ratings upside for other companies if their financial risk profiles improve continuously and benefit from solid regulatory and financial policy frameworks.

Table 1

Leisure Up, Business Down

Passenger levels at European airports continued to recover after the unprecedented drop in volumes during the pandemic.   In some cases, passenger volumes have already surpassed pre-pandemic levels (see chart 1). Now that the recovery in passenger levels is over, we believe volume growth will increasingly depend on macroeconomic factors, the attractiveness of catchment areas, and main airlines' capacity deployment, particularly in the case of low-cost carriers, which can choose airports. Tourist destinations, which have attracted higher capacity deployed by low-cost carriers to meet strong demand, posted higher passenger traffic growth in the first quarter of 2024. For example, Aeroporti di Roma SpA (BBB/Stable/A-2) and TAV Airports (BB-/Stable/--) demonstrated a year-on-year growth of 27.3% and 21.8%, respectively. On the other end of the spectrum, Germany and the Nordics continue to lag, given high taxes and aviation fees, as well as geopolitical factors. That said, we think the most relevant factors that will affect airports' passenger volumes include airports' ability to retain and attract airlines, connectivity to urban areas, competition from other airports or alternate modes of transport, and airlines' flight plans.

Chart 1

Business passenger volumes are still 30% lower than before the pandemic and unlikely to recover any time soon.   We think new habits, such as video conferences and hybrid working, left a mark on business travel. People will continue to travel for meetings and conferences but not as frequently. Higher airfares and environmental considerations are among the reasons why companies cut back on business travel, with lasting changes on business travel in Europe.

Supply chain disruptions in the airline sector could have a more severe effect on traffic trends than a sluggish demand recovery.   We currently assume that the two main aircraft manufacturers, Boeing Co. (BBB-/Negative/A-3) and Airbus SE (A/Stable/A-1), can deliver narrow-body aircraft in 2024, with Boeing addressing manufacturing flaws and Airbus working on supply chain efficiencies. However, if supply chain and labor constraints or persistent manufacturing defects delay the delivery of new aircraft to carriers, the launch of new routes and the renewal of existing fleets could be at risk. This could lead to flight cancellations.

Airports' international expansion plans add growth opportunities but could elevate country and regulatory risks.   Since the potential for further traffic growth in Europe is limited, some airports aim to expand internationally as part of their growth strategy. For example, AdP's long-term growth expectation for its core market in Paris is only 1.0%-1.5%. We therefore expect AdP's future earnings growth will mainly result from international assets, including the airport's 46.1% stake in TAV Airports, which contributed more than 20% to AdP's reported EBITDA in 2023. We estimate TAV Airports could account for slightly more than 30% of AdP's operating profit over the coming years, absent any mergers or acquisitions. Flughafen Zurich could increase its presence in emerging markets over the next years through ongoing investments in India and Latin America. But while international assets can improve growth prospects and increase profits, they may come at the expense of higher country risks and less predictable or less tested regulatory frameworks that are typical of emerging markets. Over time, this could weigh on airports' business strength, as reflected in AdP's latest business risk profile (see "Aeroports de Paris 'A' Ratings Affirmed On Solid Credit Metrics; Outlook Negative," published on March 19, 2024, on RatingsDirect), which we revised to strong, compared with excellent for key European hub peers.

Aeronautical revenues, which represent the main source of income for most airports, benefit from regulatory stability (see chart 2).   We believe airports exposed to a stable and independent regulatory framework that supports the recovery of operating, capital, and financing costs will be better positioned to receive aeronautical tariffs that are commensurate with their investment commitments over the next years. A few European airports benefit from a traffic risk sharing mechanism that increases certainty on investment returns over the long term. In our rated portfolio, Schiphol's future tariff adjustments will exceed inflation to compensate for depressed passenger numbers in the past years. Aeroporti di Roma has also benefited from some compensations from a traffic risk sharing mechanism during the pandemic. Heathrow has implemented a similar feature since the beginning of its H7 price control period, which lasts from Jan. 1, 2022, to Dec. 31, 2026. A lack of clarity on the regulation, however, could impair the airport's ability to recover its costs in full.

Chart 2

Commercial revenues rebounded after the uptick in passenger numbers.   Commercial revenues are typically traffic-driven and fundamentally more volatile than regulated aeronautical revenues. Despite the recent cost-of-living crisis, European airports have gradually improved their commercial revenues (see chart 3). Major exceptions are Heathrow, which is more exposed to international passengers that do not benefit from tax-free shopping after Brexit, and Avinor AS (A/Stable/A-1), where passengers are now subject to quotas on certain product purchases, such as tobacco and alcohol. We expect commercial revenues will continue to increase as inflation and interest rates ease and pressure on disposable income reduces. Especially airports with dual-till regulatory frameworks will benefit from this, given that they can profit fully from any upside in commercial activities. For single-till airports, additional commercial revenues above the regulatory target will be deducted from their revenues over the next regulatory period.

Chart 3

Higher Investments Could Slow Deleveraging

We expect most rated airports' margins will stabilize below pre-pandemic levels as cost pressures prevent further profitability improvements.   We forecast that European airports will be able to pass on inflation to tariffs and apply above-inflation adjustments, provided regulations support a recovery in passenger numbers. However, cost pressures, for example due to salary increases and energy costs, take a toll and prevent margins from a return to 2019 levels for most of our rated portfolio (see charts 4 and 5). Additionally, airports that were more exposed to business travel may have to offer incentives to attract low-cost carriers, which could also depress margins, despite a recovery in traffic. We therefore expect that rated European airports' average EBITDA margins will be about 45% over 2025-2026, versus 48% in 2019.

Chart 4

Chart 5

Airports increase their investment plans.   After years of capex deferral to preserve cash, operations have normalized again, meaning airports must catch up on their investment plans. We expect an overall increase in capex of up to £5.0 billion annually in our rated portfolio, compared with an annual average of less than £3.0 billion over 2020-2023 and £4.0 billion in 2019. We believe investments will focus on the maintenance of terminals and runways, while expansion plans will only play a minor role, given moderate traffic growth prospects. European airports' expansion opportunities are limited, not least because European governments aim to reduce carbon emissions in their countries by 45% until 2030 and reach net zero by 2050, in line with the Paris agreement. Some governments, including Germany and Spain, aim to reduce carbon emissions by shifting from short-haul flights to rail transportation and because of potentially adverse social effect of expansion works that could materialize in the form of land expropriations.

Many airports will need to issue new debt to fund their investment needs, against a backdrop of high interest rates and shareholders demanding dividends.   Rated European airports' cash flow generation is insufficient to fully cover their capex, meaning they will need to issue debt (see charts 6 and 7). Although central banks are discussing interest rate cuts throughout 2024, we expect the cost of debt will remain higher than it was in the past 10 years. This puts pressure on airports' credit metrics (see charts 8 and 9). Additionally, airports did not upstream dividends to their shareholders in the past few years due to depressed cash flows and, in some cases, covenant restrictions. Now that passenger numbers are up again, shareholders will expect dividends. We will monitor airports' financial policy management, including their commitment to the ratings. On average, credit metrics will remain lower than before pandemic.

Chart 6

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Chart 8

Chart 9

Net-Zero Targets Put Pressure On Future Traffic, Not Capex

Investments to reduce carbon emissions represent only 10%-15% of European airports' total capex plans.   As part of their goal to achieve net zero by 2050--some airports aim to reach that target by 2030--airports invest in electric utility vehicles, the replacement of heating and cooling systems, and the efficient use of electricity, among others. These investments aim to reduce scope 1 and 2 emissions, which are under the airports' direct control.

Most carbon emissions in the industry come from airlines, not airports.   Airports' scope 1 and 2 emissions represent less than 1% of the airline industry's total carbon emissions, which amount to 900 million-1,000 million metric tons of CO2. Airborne aircraft account for the bulk of emissions.

The industry focuses on reducing aircraft's carbon emissions to achieve net zero by 2050.   The International Air Transport Association (IATA) approved a resolution in October 2021 that requires airlines to achieve net zero by 2050. We think the sector will only achieve this goal by combining several approaches. In the short term, carbon offsetting mechanisms--such as the U.N.-sponsored International Civil Aviation Organization's Carbon Offsetting and Reduction Scheme for International Aviation and the EU's Emissions Trading System--will be the main tools (see chart 10). Once the commercial production of sustainable aviation fuel (SAF) has reached scale, it will be key to reduce emissions.

Chart 10

European governments' restrictions on short-haul flights have a limited effect on rated airports at this stage.   Europe pioneers global decarbonization efforts, with mobility transition representing a top priority for European governments to achieve net zero by 2050. Many European governments encourage investments in railway networks as an environmentally friendly alternative, with some having introduced special taxes or even direct bans on short-haul flights. Still, impairments on rated airports' traffic have been very modest so far:

• In 2020, Austria banned short-haul flights if they can be replaced by train journeys of less than three hours. In reality, this only affected the route from Vienna to Salzburg. To further stimulate the mobility transition, the government also introduced a €30 tax on all flights that depart from Austrian airports and cover less than 350 kilometers.
• Although Germany has not implemented a legal ban on any route, it increased taxes on domestic and European flights to €12 from €7.50 in 2020, to reduce short-haul air travel. In a continuous effort to disincentivize flights, the government approved another 19% hike on taxes on May 1, 2024, that applies to domestic and international passengers. Additionally, the exemption of jet fuel for commercial air transport from the energy tax is currently under discussion. If the exemption no longer applies, costs could increase, which could disincentivize passengers from taking specifically short-haul flights, which are easier to replace with trains or cars.
• In December 2022, the French government banned short-haul flights if the alternative train journey takes less than 2.5 hours. This currently applies to only three routes from Paris Orly airport (Nantes, Lyon, and Bordeaux), all of which account for less than 3% of passengers.
• The Spanish government also proposed to ban short-haul domestic flights if alternative train journeys of less than 2.5 hours exist.

The U.K. government's net-zero policy in aviation focuses on SAF but supply is limited.   Unlike other European countries, the U.K. relies heavily on air travel due to its geographic location. A ban on short-haul flights is therefore not in sight. Instead, the government announced in September 2023 that it would provide £165 million in funding to help companies build at least five plants to produce SAF by 2025. According to the government's plan, SAF will account for 10% of jet fuel by 2030. Yet the production of SAF in the U.K. is in its early stages, with only one plant producing SAF at a rate of 50 million liters per year, according to the International Civil Aviation Organization.

SAF production is not viable yet.   According to IATA's forecast, SAF production should reach about 1.9 billion liters by the end of 2024, representing a mere 0.53% of jet fuel needs. SAF production is still about 6 billion liters short of IATA's goal to achieve 7.9 billion liters by 2025 (see chart 11). We think it is highly unlikely that SAF production rates will increase in line with IATA's goal over the next 18-24 months.

Chart 11

European airports could come under pressure if the mobility transition and socially motivated regulations impair airport traffic and are not offset by favorable regulations.   If governments further tighten traffic restrictions because airlines do not decarbonize quickly enough, airports could suffer meaningfully from indirect repercussions that are largely beyond their control. Slow progress in airlines' decarbonization efforts could also reduce passenger numbers. Beyond that, residents of airport-adjacent areas can be sensitive to noise pollution, which could lead to regulatory restrictions. Schiphol faced traffic caps, even though their implementation has been delayed, while other airports are subject to night flight restrictions. It remains to be seen if the development of existing regulatory frameworks will enable the recovery of additional costs and traffic restrictions. On the other hand, expansion limitations could provide barriers to entry and help protect the margins of existing airports.

Related Research

• Industry Credit Outlook 2024: Transportation Infrastructure, Jan. 9, 2024
• European Air Travel Defies Economic Pressures On Robust Demand, June 7, 2023
• Europe's Airlines To Bear Highest Carbon Costs, April 3, 2023