Description

Summary of ENAV Thesis

ENAV is the only publicly traded air traffic control service provider in the world and we believe ENAV is an interesting way to gain exposure to a travel recovery, notably leisure, without having to take a lot of traffic volume risk. We think that as we move further away from the depths of COVID and closer to regulatory finalization in mid-to-late 2021, it will become more and more apparent that the earnings power of the business is very much intact. This clarity will coincide with the timing of vaccines released to the general public and coincident travel volume recovery, providing two catalysts to drive down the cost of capital imbedded in ENAV’s current stock price back towards its pre-COVID level. We think €5/sh or 20x 2023 FCF is very achievable in the next year (30% upside) and a 3-year IRR in the low-to-mid teens (%) range with dividends – an attractive return for an infrastructure asset with volume protection. Simply put, we anticipate ENAV will go back to being a boring, stable cash flowing machine that continues to provide mission critical services and that COVID will be treated as a once in a lifetime event.

There are two dynamics that have driven ENAV’s stock to where it is. One is obviously COVID and its impact to air travel. The second is a delay in finalizing regulations for the next tariff period (2020-2024) due to the historic volatility in air travel and the fact that the regulators want to have more clarity on the trajectory of the volume recovery before finalizing anything. This regulatory discount, in our view, is overblown based on both what the regulators have said and based on our discussions with industry participants. If anything, based on our dialogue with industry participants, there’s a view that the profitability of air traffic controllers could be stronger post COVID than before due to operators taking a much more aggressive look at efficiencies than before. Once we get to mid-2021 (May) when the regulatory picture will largely be etched in stone, it will become more apparent that 2022 will start looking more normal and the FCF generating power of the prior several years leading up to COVID of €130m or so will likely reoccur around 2023 and on.

While we are not giving ENAV credit for this in our valuation over the next couple years, we think that there is a lot of cost takeout opportunity (consolidating air traffic controllers from four to two, utilizing technology to keep reducing overhead, etc) and opportunity to deploy excess free cash flow into related non-regulated activities at very attractive multiples of earnings versus where the company has historically traded.

Given the nuanced nature of the business, we will spend a disproportionate amount of space simply describing what ENAV is, how they make money and how they are regulated.

ENAV Overview

ENAV is the 5th largest Air Navigation Service Provider (ANSP) in Europe and has been the top performer among European peers for performance quality since its IPO in 2016. ENAV is the sole provider of air traffic control and navigation services in Italy entrusted by national law without time limit. This is unlike most other European infrastructure companies that have finite lives on their concessions. ENAV is in a solid position to capitalize on travel to and from Italy and over Italy (ie Middle East and the Mediterranean region) when travel resumes.

ENAV has two regulated revenue streams that comprise the vast majority of the business – en route (75% of total) and terminal (25% of total). En route services involve the handling of air traffic crossing Italian airspace managed from 4 Area Control Centers located in Brindisi, Milan, Padua and Rome. The company has a diverse customer base and 80% of ENAV’s en-route traffic is international or over-flight (aircraft fly over airspace without landing), limiting exposure to potential softness in the Italian economy. Terminal services involve assistance during the phases of approach, takeoff and landing from 45 Control Towers located throughout Italy and is divided into 3 charging zones.

Regulated revenue is a function of charging the users of its airspace a tariff on the volume of airspace used. Traffic volume is expressed in service units (SUs), which are a function of distance travelled x weight of aircraft for en route services and just aircraft weight for terminal services.

Eurocontrol, the Eurozone’s airspace network manager, collects this “regulated revenue” on behalf of ENAV and other air navigation service providers on a monthly basis. Eurocontrol is able effectively to ground airline operations for delinquent payment which has historically resulted in even distressed airlines prioritizing amounts due to Eurocontrol above all else. Without payments to Eurocontrol (and ENAV), an airline has no operation.

It’s a solid business model that is experiencing a delay in regulatory approval for the next 5 year period due to travel volume volatility. This temporary hold-up / element of regulatory uncertainty is creating an attractive 3 year IRR opportunity for a longer-term stable infrastructure asset.

Deeper Look at Regulated Revenue Generation

The majority of regulated revenue is protected on a largely cost-plus model so the cash flows of the business should be relatively consistent again once the new regulation is finalized and tariffs are matched to the new volume trajectory. ENAV’s revenues are based off of determined costs (opex + D&A + cost of capital) and traffic revenue volatility is largely hedged through mechanisms discussed below that provide for revenue capture in future years if traffic volumes fall below plan.  ENAV has been building up a lot of this recoverable “balance” in 2020 and it will result in a big jump in cash flow in the 2023-2027 period when 85% of the balance is recovered. ENAV will produce record FCF during this period. We expect that approximately 80% of ENAV’s current market cap will be generated in discretionary FCF over the next decade as a result of this balance recovery + strong underlying FCF.

En-route services (75%% of regulated revenue)

ENAV is the sole provider of air traffic control and navigation services to all air traffic passing through Italian airspace. En-route services are defined as any traffic flying crossing Italian air space, with or without a stopover at an Italian airport. En-route traffic volume is expressed in terms of service units (SUs), which are a function of the distance travelled x weight of the aircraft. En-route traffic is made up of the following three categories:

International commercial traffic (41% of 2019 SUs) – flights with a point of departure or arrival at an airport within the Italian territory.

Commercial overflight traffic (41% of 2019 SUs) – flights over Italian air space without a stopover at an Italian airport.

National Commercial traffic (18% of 2019 SUs) – flights whose point of departure and arrival is within the Italian territory.

Terminal Services (25% of regulated revenue)

Terminal Services assist during the phases of approach, takeoff and landing within a radius of 20km of the runway and ENAV carries out this service from 45 airports across Italy. Traffic volumes (SUs) are only a function of aircraft weight at terminal services vs weight x distance at en route. Terminal services are ~2/3 international travel and ~1/3 national travel.

There are three charging zones, segmented by the amount of traffic they handle. Each zone subject to a different set of regulations but they largely emulate those of en-route:

Terminal Zone 1 (5% of 2019 regulated revenues) – airports with more than 225,000 movements annually. Rome Fiumicino is the only airport in ENAV’s network in Zone 1.

Terminal Zone 2 (7% of 2019 regulated revenues) – airports between 70,000 and 225,000 aircraft movements annually. Milan Malpensa, Milan Linate, Venice and Bergamo airports are in Zone 2.

Terminal Zone 3 (13% of 2019 regulated revenues) – airports with less than 70,000 aircraft movements annually. There are 40 airports and 4 Italian air force bases in Zone 3. Zone 3 is different in that it’s subject to the national regulatory framework from ENAC and provides for full cost recovery.

Tariff Build-Up – Cost Plus with Traffic Volatility Protection

To establish the applicable tariff to be charged for each area of operation (en route, Terminal Zone 1, Terminal Zone 2 and Terminal Zone 3), ENAV submits a detailed breakdown of the planned costs (determined costs) associated with each service for the regulatory period based on the regulators view of traffic evolution over the period. Costs include personnel, other operating costs, D&A as well as a European Commission agreed to cost of capital (around 9%-10%). There are also costs not directly associated with ENAV (non-ENAV determined costs) related to regulatory agencies (ITAF and ENAC) that are also submitted, but are basically passthrough. The final cost component is a revenue stabilization mechanism called the balance reversal. It partially offsets variance between planned vs actual traffic, planned vs actual inflation, and bonus/malus component in order to incentivize quality and capacity targets. The formula is basically ENAV Determined costs (Labor + Other Opex + Eurocontrol costs) + D & A + Cost of capital (9-10% WACC) + Non-ENAV Determined costs (ITAF + ENAC) = Total Determined Costs + Balance Adjustment (if necessary) = Chargeable Costs. The ultimate tariff charged for each operational area is Chargeable Cost / Planned Service Units for that operational area. This has historically and was expected to continue (pre COVID) to result in a high-teens EBIT margin.

The determined unit cost (determined costs / planned service units) profile is established at the beginning of each regulatory period and remains fixed throughout (the reason regulators want to have a better understanding of the traffic trajectory coming out of 2021 before finalizing), while the applicable tariff is adjusted in November of each year. The balance (traffic, inflation and bonus/malus) accrues in the reference year but the cash element is only collected in year N+2 through the applicable tariff adjustment. Given the magnitude of the balance build in 2020/2021, this recovery will spread over the 2023-2027 period and ANSPs have agreed to a 15% haircut as a token kindness gesture.

This “balance” framework limits both upside and downside risk associated with traffic, inflation and operating expense variance vs. projections over the course of the regulatory period. With respect to en-route services and Terminal Zones 1 and 2  (~50% of terminal revenue), ENAV bears full traffic risk within a band of +/- 2% of forecast. If variance extends beyond 2% to 10%, ENAV bears 30% of the risk. Anything above 10% and there’s no risk to ENAV. As a result, risk is capped at +/- 4.4% vs projected en-route traffic. For Terminal Zone 3 (other ~50% of terminal revenue), ENAV bears no risk associated with any variance from planned traffic. With respect to operating expenses, ENAV bears risk for all variance at airports that see 70,000 movements or more.

Regulatory Overview

European airspace is organized into functional blocks, according to traffic flows, rather than to national borders and the European Commission launched the Single European Sky (SES) in 1999 as the regulatory framework to provide for a common set of rules and procedures governing European airspace. SES’ aim is to meet future traffic growth and safety needs as well as encourage air traffic management (ATM) efficiency and improving performance.

Eurocontrol assists the EU with the implementation of the SES program. Eurocontrol was established in 1960 and has 41 member states including all of the EU states. It helps the European Commission draft the SES regulatory framework and provides support on rule-making as well as safety and environmental legislation. Eurocontrol was nominated by the European Commission in 2011 as the Network Manager for the European ATM network. Eurocontrol assists in helping maintain overall health of the European ATM system and helping to implement the performance scheme.

The European Commission defines, measures and optimizes operating and economic performance of European Air Navigation Service Providers (ANSPs) via the performance plan.  There are four key areas associated with the Performance Plan, they are safety (identifying network hotspots and proactively enacting plans to avoid risk), capacity (minutes of delay per flight), environment (promote more efficient use of airspace) and cost efficiency (target based on real determined unit cost).

Each EU state is required to prepare and adopt a European Commission-approved performance plan. The performance plan outlines the chargeable cost base and the main aspects of national tariffs over the entire regulatory period defined in the plan. ANSPs of member states are entitled to charge tariffs for both en-route and terminal services as part of the regulatory framework and the methodology for establishing the tariffs is detailed in the performance plan.

Regulatory Period 2 (or RP2) was the framework from 2015-2019 and RP3 is from 2020-2024. The RP3 regulatory period should have been approved and closed February or March 2020, but before closure, COVID arrived. The Commission didn’t approve and close RP3 given the pace at which traffic was declining and therefore, the RP3 discussion before became stale. The Commission simply needed a new RP3 that matched the reality of the new post-COVID traffic trajectory. In July, they came out with proposal for temporary derogation for the business – asking all member states to give a little in order for them to not behave and act like “they were on another planet”. The sacrifices are related to the balance. Compared with previous calculation of balance, ANSPs take a 15% haircut, and what would have previously been recovered after 2 years is not allowed to be recovered all at once. The 2020 balance cannot call be recovered in 2022 and the 2020/2021 balance build will begin to be recovered in 2023 and then spread over a 5 year period (2023-2027). Given Eurocontrol’s traffic forecast released early November, ENAV has a strong sense of what the tariff outlook will be for RP3 but the process takes time and the final efficiency target set by the regulator should come by May and then RP3 should be closed by YE21.

Bottom line is that this is a supportive, pan-European regulatory framework that governs the bulk of ENAV cash flow generation. Given the historic decline in air travel, the fact that ANSPs were simply asked to haircut the balance by 15% and spread it out over a longer period speaks to the solidity of the model.

Capital structure, M&A, and Capital Allocation

ENAV has historically run with a net debt neutral cap structure but was planning to add leverage before COVID hit. We project that net debt / normalized EBITDA will peak at around 1.5x EBITDA and that the company will run with ~1x in the future – although the company’s updated capital allocation strategy will not be known until RP3 is finalized. Historically, the company has distributed 80%+ of annual FCF and had a longer term dividend growth target of 4% per year. We conservatively assume that there is no dividend in 2021 and that it resumes at close to the pre-COVID rate in 2022.

With the added help of balance recovery, we project that ENAV will delever to 1.0x by 2023 and that they will produce €400m in excess FCF beyond dividends over the 2024-2027 period. This cash flow will likely go to expanding its third party services for other ANSPs and other non-regulated activities. ENAV has historically been able acquire earnings streams at attractive multiples of EBITDA in the mid-single digit range, or at least a few turns below where the company has historically traded. This should add €0.40/sh+ of equity value over that time period.

Valuation

We think €5/sh or 20x 2023 FCF is very achievable in the next year (30% upside) and a 3-year IRR in the 12% range with dividends – an attractive return for an infrastructure asset with volume protection. Pre-COVID, ENAV traded tightly around the 20x 2-year forward FCF multiple level.

Two other sanity checks have been run on EV/EBITDA and DCF. ENAV historically traded at 9x EBITDA and this multiple is supported by a simple ROIC growth model build-up. At 9x 2023 EBITDA and present value of the balance receivable, we arrive at EUR 5.70/sh in a few years or a 14% 3-year IRR. And a DCF at a market WACC build-up implies €4.80/sh today and €5/sh in a year.

A group of 15 European infrastructure, utility and mail delivery comps are also trading at 20x forward FCF and 9x EBITDA.

History

ENAV became a Public Body in 1996 and then in 2001, it became a public limited company in the context of the wider process of liberalization and privatization of the air transport market. The objective was to achieve efficiency and operational targets, and improve quality and reliability of services, ensuring a high level of safety and quality, as per international standards. ENAV inherited the job of handling civil air traffic control, which until 1979 was managed by the Italian Air Force and subsequently, from 1982, by AAAVTAG (ENAV’s predecessor). More recently, ENAV has been expanding the non-regulated ANSP services it offers to other countries through partnership and M&A. This will be a growing piece of the company going forward, but one that is inconsequential to the current investment thesis given that it comprises only 2% of revenue.

On July 26, 2016 ENAV was listed on the stock exchange and priced at €3.30/sh. The Ministry of Finance remains the majority owner of ENAV and continues to 53% of shares outstanding. Management incentive comp is based on hitting TSR, EBIT and FCF targets. Italy views ENAV as a “crown jewel”.

Catalyst

• Air travel recovery
• Regulatory (RP3) clarity by May 2021 and finalization by YE21