Description

ENAV has a perpetual concession to operate air traffic control services in Italy - whenever a plane flies over Italian air space, takes off at an Italian airport, or lands at an Italian airport, ENAV earns a fee. The average Italian utility trades at a 9.7x multiple of EBITDA. The average airport concession operator in Europe trades at a 10.2x multiple. ENAV trades at 5.5x multiple pro-forma for cash owed to it by airlines due to declines in traffic from Covid.

The opportunity exists primarily due to complicated accounting that makes cash flow and reported IFRS income very different numbers.  It doesn’t help that ENAV is majority owned by the Italian government, but as we’ve seen with Leonardo a 1% holder can nominate a shareholder slate and have a big impact on the board / capital allocation.

We believe cash flow is at an inflection point and that we are buying ENAV at a 15% FCF yield on 2025 numbers. This is an exceptional business at a value price. We believe ENAV possesses minimal downside due to the contractual nature of their cash flows and upside of ~60% to ~110% if it trades closer to its historical multiple or peers, respectively. 

High Level Thesis / Summary:

ENAV’s business is relatively simple, but the way they are paid and report revenues is not.  Most of our writeup will focus on explaining how ENAV is paid and the convoluted accounting that obscures the true economics of the business. Although understanding the dynamic is somewhat complicated, the mechanism is relatively simple and foolproof once you grasp it. Please be patient and feel free to follow up with any questions.

ENAV is Italian’s air navigation service provider (ANSP) and the 5th largest in Europe. The company has a perpetual concession with the Italian government to be the sole provider of air navigation services in Italy. Fees paid to Europe’s ANSPs, including ENAV, are governed by Eurocontrol, which itself is regulated by the EU Commission.  Eurocontrol collects fees on behalf of the ANSPs and reverts payments to the ANSPs based on their share of the traffic.  If an airline were to refuse or delay payments, Eurocontrol has the right to ground their planes. For this reason, even in times of distress for airlines, ENAV has gotten paid.

Eurocontrol sets the rates that all airlines have to pay ANSPs.  This is done every 5 years and is set out at the beginning of each five-year period – we are currently on RP3, which runs from 2019 to 2024.  The rate charged in each year is based in part on a 5yr “service unit forecast” for each ANSP that is set out at the beginning of each block.  Each 5yr period makes different assumptions on variables that may impact costs and revenues – the two biggest factors that need to be predicted are inflation (for costs) and traffic.

Because of the extreme decline in traffic due to covid, and higher than expected costs due to inflation, we believe ENAV has materially under-earned on a cash basis since covid.  Shortfalls in traffic relative to the RP3 budget and higher than expected inflation relative to plan are eventually reimbursed to ENAV via higher rates, but the effect of these higher rates only happen 2yrs after the shortfall occurs.  In the case of the traffic decline during covid, the shortfall was so large that the rate increases associated with these declines were postponed until 2023.  Cashflow increased materially in 2023 and is likely to increase further in 2025 as the full impact of the inflation escalators are felt.   We believe as people appreciate the divergence between cash flow and IFRS earnings, the shares will re-rate. While we wait, we own a regulated monopoly at an unusually cheap price that dividends out most of its cash flow to shareholders.

The Details: Traffic Sharing Mechanism:

ENAV's revenues are calculated as price (revenue per service unit) times service units.  ENAV gets paid based on the number of “service units” in their airspace – service units are an amalgam of the size of the airplane, distance flown in Italian airspace, and the popularity of the departing and / or arriving terminal airport. There exists a “traffic sharing mechanism” whereby the ANSPs service units are unlikely to vary much from the budgeted traffic numbers that are used to calculate pricing.   As mentioned previously, the “planned traffic” refers to the traffic forecast set out in the 5yr plan (in this period, RP3). This mechanism is illustrated below: 

Any traffic divergence vs. the forecast above or below 2% is absorbed 100% by ENAV.  The next 8% up or down is absorbed 70% by the airlines and 30% by ENAV.  Anything below or above 10% is fully reimbursed either by the airlines or ENAV (if traffic exceeds 10% of forecast).  Stated another way, ENAV’s service units are guaranteed not to exceed or 4.4% greater than forecasted or, in a downside case, decline more than 4.4%. 

COVID Traffic Risk Sharing:

Throughout COVID (2020 / 2021) there was obviously lower than expected service units due to the lack of air traffic.  But because of the traffic sharing mechanism and how it is accounted for in the income statement, ENAV’s reported financial results felt minimal impact from these shortfalls:

ENAV recognized €383mm and €294mm of traffic balance adjustments as revenue in 2020 and 2021 related to covid but did not receive any cash associated with this adjustment.  ENAV recognizes income on its income statement from the traffic sharing mechanism in the year of the shortfall but does not typically receive cash until 2 years later, which it receives via adjustments to pricing.  Due to the uniqueness of the situation and the magnitude of the implied traffic risk sharing balances payable, ANSPs agreed to take a ~15% - 20% haircut on the balance amount they were owed and have it be paid over 2023 – 2029.

From Q4 '23 onwards ENAV is owed ~€585mm of COVID balances with €510mm of that being paid over the next 5 years and the remaining €75mm being paid over 7 years. The company will not have to pay taxes on the cash flow since they paid those when the balance was initially created during COVID and flowed through the income statement. This translates to ~€140mm of annual incremental cash flow through '27E. Applying a discount rate of 5% yields an NPV of $530mm.

We have created an Appendix at the end of this write-up that goes into more detail on how the traffic sharing mechanism flows through the income statement and balance sheet.

Inflation Mechanism

Another variable obscuring ENAV’s true run-rate economics is higher than expected inflation. Tariff rates (revenues per service unit) are determined at the beginning of the regulatory period and those figures include assumptions for inflation throughout the period. To the extent inflation is above expectations, ENAV is compensated by airlines via the same balance mechanism as the traffic risk sharing. There is ~€5mm of inflation balance created for every 100bps that actual inflation exceeds what was projected at the beginning of the regulatory period. In addition, this inflation balance stacks / carries over each year throughout the regulatory period (i.e., €35mm of inflation balance created in ’22 is carried over to ’23 and an additional €19mm of inflation balance created in ’23 is added on top so the total inflation balance for ’23 is €54mm). We’ve included more details on how the inflation mechanism flows through the income statement and balance sheet in the appendix.  Although ENAV has had to incur substantially higher costs than expected due to high inflation in 2022 and 2023, it doesn’t recoup pricing via higher inflation until 2 years after inflation occurs.  Based on 2022 and 2023 inflation, we believe ENAV will receive an incremental €35mm of cash income in 2024 and an additional €58mm in 2025.

Putting it all together:

Below we outline our estimate of reported EBITDA and cash flow for ENAV for the period from 2020 to 2025:

We view 2025 as the right run-rate for cashflow due to the full impact of the inflation balance (€58mm) finally being felt in 2025, combined with the removal of the 2024 traffic overage that was booked in 2022 because traffic exceeded plan.

Regulatory Risk:

Because the business is relatively simple, we viewed the main risk to the business as potential regulatory changes. Based on our diligence, we feel confident that the current regime is unlikely to change. 

 Europe has several times the number of air traffic controllers per unit of airspace than the US, because each country has its own dedicated ANSP.  The airlines have argued for a The Single European Sky (SES) initiative, which was first introduced in 1999.  The general objective of SES is to consolidate European air traffic controllers in an effort to be more efficient from a cost and environmental perspective and having air traffic managed by several hubs in a country agnostic way. This effort has seen minimal to no progress over the last 20 years and experts we talked to are highly skeptical this will ever gain traction for two main reasons:

1)       Countries want to maintain control over their airspace, typically for military and sovereignty reasons.

2)      Air traffic control unions are very strong, and a strike by one of the air traffic control unions can effectively shut down air traffic.

While we are aware the risk exists, we view the probability of SES negatively impacting ENAV as slim to none.

Price Targets:

Prior to Covid, ENAV traded at an average multiple of 8.8x 

 The relevant comps trade at the below multiples today

In our base case we estimate '25 EBITDA of ~€295mm at a 9.0x multiple. We incrementally add on the NPV of the COVID balance when calculating equity value. We are not double counting the COVID benefit because, as mentioned above, the balance mechanism is P&L neutral during the cash collection period therefore '25 EBITDA isn't affected by the COVID balance. The preceding implies a €5.20 price per share or ~60% premium to current levels.

Other Risks:

The Italian Ministry of Finance, who owns 53% of shares, appoints a new CEO and chair every 3 years. Alessandra Bruni, chairwoman, and Pasqualino Monti, CEO, were recently appointed and have a term through 2025. Expert call background checks on them were not supportive, and they both lack experience in the aviation industry. However, we believe the business is predominately operated by the CFO and COO who have each been at the company for 10+ years. In addition, we view management quality as less critical given the defensive nature of the business.

Rumors surfaced in late December 2023 of ENAV’s interest in acquiring the management company of a Sicilian airport, Gesap. We view this as a modest negative and account for it in our price target table above which negatively impacts our downside price target by ~10%.

APPENDIX:

If service units fall greater than 2% below Eurocontrol's forecast and ENAV is due money from the airlines, it creates a positive traffic risk sharing receivables balance. The receivables balance is typically collected two years later via higher prices (revenue per service unit). Below is a basic example of how the ENAV’s financial statements are affected from the creation of a positive traffic risk sharing balance.

• Year n

  • Increase in non-current receivables

  • Increase in revenue balance account

• Year n + 1

  • Increased financial income from the increased receivables balance

  • Receivables transition from non-current to current

• Year n + 2

  • Increased financial income

  • P&L neutral (no change to revenue or EBITDA because these cancel each other out)

    • Decrease in revenue balance account

    • Increase in revenue per service unit / tariff collected

  • Increase in cash via higher tariff

  • Decrease in current receivables

The effect of the balance Year n + 2 is P&L neutral. You have a decrease in the revenue balance account, but you also have a counteracting effect of increased revenue per service unit. Overall, revenue is higher in the year of lower-than-expected traffic volumes, but it is non-cash, and then the cash is collected via higher rates two years later.

PIR Technical Selling Pressure:

In 2017 Italy introduced a tax efficient investment scheme called PIR. If you were willing to commit to a 5-year holding period, you would get tax breaks. This tax efficient scheme was predominately available through ~70 different PIR compliant funds. The lockup period for that initial vintage of PIR, which represented the majority of PIR fund flows, has recently ended. Over the last 6 months we’ve seen PIR fund ownership in ENAV as a % of total market cap go from 11% to 7%. This is quite significant given the lack of liquidity in the stock relative to its market cap. According to our analysis, we believe that PIR selling accounts for 36% of the traded volume over the last six months.

Important Disclaimer:

Although, as of the publication date of this report, the author has long positions in ENAV and stands to realize gains in the event the stock price increases. Following publication of the report, the author may transact in securities of ENAV. This report does not constitute advice on whether the recipient should buy or sell ENAV now or in the future. The author’s decision to invest or divest – in whole or in part – of its investment in ENAV are based on numerous considerations not discussed herein, including but not limited to the composition of its entire portfolio and the portfolio’s specific investment objectives and limits. All content in this report represents the opinions of the author who has obtained all information within this report from sources they believe to be accurate and reliable. However, such information is presented “as is,” without warranty of any kind – whether express or implied.

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