Sydney Airport Outlook Revised To Positive On Low Probability Of Developing Second #BBB# Ratings Aff

"The outlook revision reflects our view that Sydney Airport is unlikely to participate in the development of Western Sydney Airport, enabling it to continue generating strong financial metrics," said S&P Global Ratings credit analyst Thomas Jacquot.

The Australian government is seeking to develop a second airport in the western part of Sydney to service the neighboring population, as well as address the likely capacity constraints that Sydney's existing airport may face in 20 to 30 years. The Western Sydney Airport project would cater to long-term demands from Sydney's population growth and address operational constraints at the existing airport, such as movement caps.

Nevertheless, the project will be a very challenging investment for any private-sector entity. We believe it would require an investment in excess of A$5 billion for a relatively small airport, compared with peers, when it opens by 2026. We expect the airport may serve no more than 3 million or 4 million passengers annually in the early years. As a result, the return on investment would be extremely low in the early years.

Given those challenges, Sydney Airport had been expecting that the Australian government would provide financial support as well as other forms of protection. In its notice of intention, however, the government indicated that it expects the private sector to bear all the risks and fully fund the project. In these circumstances, we believe Sydney Airport is unlikely to undertake the investment, given its very clear position that it will not put at risk the existing airport in developing the project.

Nevertheless, we were of the view that the group, either at the SCACH or consolidated group level, could have increased its debt in order to finance part of the investment. Even if the company adds new debt outside the protection that benefits SCACH's senior secured debtholders, only SCACH's cash flows would be available to support such leverage during Western Sydney Airport's development phase. We believe this additional leverage would have affected SCACH's credit quality. This risk, in our view, has significantly decreased given the terms offered by the government.

Aside from this constraint, Sydney Airport's performance is likely to remain strong over the coming years. Passenger traffic to Nov. 30, 2016, has materially outperformed our forecasts, with domestic and international traffic growing at about 4% and 9% respectively. This could boost the group's earnings for 2016 by A$30 million-A$50 million above our expectations. Combined with our expectation of a lower debt balance, we forecast that SCACH's key ratio of funds from operations (FFO) to debt will be in the 8%-8.5% range at mid-February 2017, compared with our prior expectation of 7.5%-8%.

Given the airport's strong passenger growth over the past 12 months, we have revised our growth assumption for the coming years, lifting international traffic to 6% and 5% respectively for 2017 and 2018 (compared with about 3% previously). We have also revised our domestic traffic assumption to 3%, in line with our GDP growth forecast for Australia.

While the above revisions will result in stronger earnings, we believe that SCACH will need to accelerate some capacity expansion projects at the airport. In that context, we believe that SCACH's previous investment plan of A$900 million for the next four years (based on the company's guidance in early 2016 of A$1.3 billion over five years, including A$400 million in 2016) will be either front-ended or even potentially upsized. As a result, we are now assuming an increase in near-term capital expenditure, with 2017's likely to be broadly in line with 2016's at about A$400 million--this directly affects our financial metrics, since SCACH typically funds its capital investment with debt.

Despite our expectation of higher debt levels, we believe the stronger earnings will more than compensate this trend. We now expect SCACH's FFO-to-debt ratio to remain at or above 8.5% over the coming years, a level commensurate with a higher rating.

Our rating on SCACH continues to reflect our view that Sydney Airport's passenger numbers are likely to remain resilient under a number of different economic growth scenarios. It also reflects our view of the supportive regulatory regime and the company's financial policies regarding capital-expenditure funding and dividends.

The positive outlook reflects our view that SCACH's financial performance over the next two to three years could support a higher rating if SCACH elects not to exercise its Right of First Refusal in relation to the Western Sydney Airport project. Based on the notice of intention issued by the Australian government in late 2016, it would appear that the conditions attached to that notice would make the investment very challenging for the group. We therefore believe that that the company has limited incentive to proceed with the project.

At the same time, an upgrade could occur if SCACH's key ratio of FFO to debt would remain above 8% as per our current forecast. A key consideration for the upgrade will be our belief that SCACH's parent would not seek to pursue an alternative strategy in view of the potential lost opportunity that Western Sydney Airport would have offered and would not seek to implement capital management measures leading to a higher-than-expected leverage.

We would revise the outlook to stable if SCACH elects to respond positively to the notice of intention and exercise its Right of First Refusal in relation to Western Sydney Airport. Alternatively, a revision to a stable outlook would also occur if SCACH's parent were to pursue an aggressive growth strategy, increasing its leverage or risks for the group.