Auckland International Airport's fantastic share price performance has been a major NZX story this year.
At yesterday's close the airport had a market value of $11.9 billion. This was just behind Meridian Energy, the NZX's most valuable company with a market capitalisation of $12.2b.
a2 Milk was in third position with a market value of $10.8b, followed by Fisher & Paykel Healthcare on $8.9b and Spark $7.3b.
Fletcher Building, which was once the NZX's most valuable company, languished in tenth position with a $4.1b market capitalisation after another dreadful week.
Auckland Airport has had a total sharemarket return of 38.7 per cent for the first six months of 2018 compared with the NZX 50 Gross Index's 19.2 per cent appreciation. The other top five companies had the following six month returns; Meridian Energy plus 41.9 per cent, a2 Milk plus 31.6 per cent, Fisher & Paykel Healthcare plus 20.0 per cent and Spark minus 0.6 per cent.
Auckland Airport's stellar performance has been due to several factors including the company's infrastructure status and its economic moat.
Infrastructure companies have been performed extremely well on most global markets, particularly those with strong moats.
Economic moats, which are a favourite Warren Buffett concept, are the ability of a businesses to protect themselves from competitors and grow their long-term profitability. These commercial motes are derived from medieval moats around castles, filled with water, that protected the inhabitants against marauding invaders.
Airports have strong economic moats because few new airports are being built, particularly in major urban areas. Airports are also trying to build stronger moats through their retail operations and car parking.
These moats have enabled airports to generate huge profit margins, as illustrated in the accompanying table. The three major New Zealand airports - Auckland, Wellington and Christchurch - have operating profit margins of between 44.2 per cent and 74.0 per cent, while the three major East Coast Australian airports - Brisbane, Sydney and Melbourne – have margins between 72.6 per cent and 80.9 per cent.
Meanwhile, Air New Zealand and Qantas had operating profit margins of only 23.6 per cent and 18.1 per cent respectively last year even though it was a strong period for airline companies.
Airline operators have little ability to create economic moats because there are few barriers of entry to the sector and they have much lower profit margins than airports. Consequently, airline companies and airports have tense negotiations over aeronautical charges and many low-fare operators, particularly Ryanair, fly to smaller European airports that are often a long way from city centres
NZX listed Infratil purchased several small airports in the UK and Germany to take advantage of this low-fare trend but its strategy failed. This endorsed the view that most large airports have built successful moats to fend off small airports.
Airports have two main sources of revenue, aeronautical charges that are levied on airlines and passengers and commercial revenue, mainly retail and car parking.
The Airports Council International estimates that aeronautical revenue represents 55.8 per cent of global airport revenue but it is lower than that in Australasia. For example, aeronautical revenue represents 44.2 per cent of Auckland's total revenue and between 39.6 per cent and 45.5 per cent for the three major East Coast Australian airports.
Non-commercial revenue is growing faster than aeronautical revenue and retailing is becoming more important, particularly for airports with large international passenger numbers.
Airports force us to walk through brightly lit duty-free shops when we transit from security to the departure gate.
How many readers have been through an international airport that hasn't had at least one large Toblerone stand to navigate?
Retail now represents 28.0 per cent of Auckland Airport's revenue, 22.5 per cent of Sydney Airport's income and 18.5 per cent at Melbourne Airport, which also includes Launceston Airport in Tasmania.
Auckland Airport wrote in its latest annual report; "Shopping is now an integral part of the air travel experience. Our customers continue to tell us they want best-in-class retail experiences and in the past 12 months, we have focused on delivering major improvements as part of the international departures' expansion project. These enhancements significantly expand outboard passenger processing as well as dwell and retail areas – and we are now in the early stages of retail planning for the future domestic terminal".
Duty Free World Council reports that global duty free and travel retail sales have almost doubled in the past decade, from US$37.7b to $68.5b. Airports account for 55.8 per cent of these sales, other shops 37.2 per cent, airlines 3.9 per cent and ferries 3.1 per cent.
The largest categories are fragrances & cosmetics, with a 35.8 per cent market share, wines & spirits 16.7 per cent, fashion 14.1 per cent, tobacco 10.9 per cent, watches & jewellery 8.3 per cent and confectionery & fine foods 10.9 per cent.
A major objective of every international airport is to extract money from passengers, mainly by encouraging them to buy something that you don't need. Airports, particularly in Europe, use several cunning tricks to encourage this spending, including;
• Encouraging passengers to check in early and automating this process to give them more time to shop
• Delaying posting gate numbers to give longer shopping time
• Having curved walkways through duty free has encouraged passengers to spend up to 60 per cent more according to one study. Most curves are to the left because this encourages right-handed people to look to the right whereas they look ahead when walking on a straight passageway
• Toblerone stands encourage visitors to buy this product and a large percentage buy something else once they have made this decision
• Many duty-free shops scan boarding cards where there is no requirement to do so. This gives them additional traveller information and allows these retailers to collect unclaimed VAT rebates in some European countries
• Carpets encourage passengers to linger while tiles encourage them to move more quickly
• Airports can charge for wi-fi to encourage travellers to stop using their phones and browse instead
• Must buy items are placed just beyond security so passengers can relax after these are acquired and then walk slowly through the non-essential luxury item areas.
Auckland Airport uses some, but not all, of these techniques, particularly the curved walkways.
But Auckland's main advantage is its dominant position in the international passenger market because these travellers spend far more than domestic travellers.
According to Statistics NZ, Auckland Airport had 74.5 per cent of total NZ international passenger movements last year compared with Christchurch Airport's 13.0 per cent, Wellington's 6.7 per cent and Queenstown's 4.5 per cent. The latter is 25 per cent owned by Auckland Airport.
Car parking is also important having grown from $29.3 million, or 8.3 per cent of Auckland Airport's revenue a decade ago, to $61.0m, or 8.9 per cent in the latest year.
Auckland International Airport has always been a bottom drawer, long-term hold stock. This is consistent with Buffett's argument; "the most important thing [is] trying to find a business with a wide and long-lasting moat around it … protecting a terrific economic castle with an honest lord in charge of the castle".
But how much should we pay for these moats?
Auckland Airport now has a price/earnings ratio of 44 based on the company's underlying net profit guidance of between $265m to $275m for the June 2019 year.
Investors looking at Auckland International Airport must weigh up the trade-offs between price and the advantages of a strong economic moat.
This isn't a simple equation.
• Disclosure of interests: Brian Gaynor is a director of Milford Asset Management.