Description

Fairfax India has been written up twice on VIC: Once in 2015 just after its IPO, when at $10/share it traded at a slight premium to NAV, and again in 2017 when at $13/share it traded at a 25% premium to NAV. Both authors were bullish on the infrastructure growth of India and on Prem Watsa’s ability to shepherd Western capital in a notoriously difficult market.

Today at $7.50/share Fairfax India trades at a 50% discount to NAV and is worth a revisit. Buyer beware: this idea involves airports, India, and opaque valuations of private assets.

VIC members will be familiar with Prem Watsa, the founder and chairman of Fairfax Financial. Watsa launched Fairfax India in 2015, ultimately raising $1.5bn to create a dedicated subsidiary that invests in public and private operating businesses in India, with a bias towards infrastructure and financial services. Fairfax Financial owns 34% of the total equity and controls the vote (via a non-traded supervoting class), while Canadian pension fund OMERS owns ~14% of the equity. Watsa’s ability to tap Canadian institutional capital is an important consideration here, as OMERS may be propping up the NAV via a questionable related-party transaction. Again, buyer beware…

There’s plenty not to like. Holders since the IPO are -25% while Watsa has extracted $114m in performance fees (admittedly taken in shares, not cash). The internal NAV calculation is quite possibly inflated, which raises all sorts of governance and transparency questions. India is currently leading the world in COVID-19 infections, with daily incidence rates 2x the US, 3x Brazil and >8x every other country. Oh and the rupee has shown no signs of mean reversion for 20 years...

But despite the above, at $7.50/share there appears to be hidden value. Fairfax India owns listed equities worth 79% of the market cap, plus a portfolio of profitable operating businesses, and its stake in Bangalore Airport - the second fastest growing airport in the world - is worth something: looking out 3-4 years and assuming just $10/pax in revenue on stable normalized margins, the airport stake might be worth $1.5bn to Fairfax (vs. today’s NAV mark of $1.3bn). This implies you are purchasing the airport for a 25% discount and getting everything else for free.

Portfolio & NAV

Fairfax India has 13 disclosed investments, the largest of which is a 54% stake in the Bangalore International Airport (BIAL). If you believe the NAV, shares today are trading at a 52% discount, with ~30% of the value in listed holdings and ~70% in private investments. This current discount is the largest it has ever been, due to (a) general investor concerns over India and (b) specific concerns over Fairfax’s internal valuation of BIAL.

The Bangalore Airport Concession accounts for 46% of the GAV, while the second largest holding accounts for 11% (Sanmar Chemicals, a private PVC manufacturer). Below is a summary of all holdings, reflecting NAV values as of 2Q20 for private holdings and current values for public holdings. All figures are in USD:

At first glance, it’s easy to get excited about this NAV discount. Buying a share today gives you the BIAL asset at a 16% discount to management’s current valuation and everything else for free (assuming moderate leverage). Not only that, but the BIAL valuation was “validated” by a minority sale Fairfax announced in December of 2019 to a “third party” (the deal is expected to close this month…) and management have announced an IPO of this asset by the end of 2021, targeting a 20% premium to the current mark. 

The obvious issue here, which the market is clearly reflecting, is that management’s valuation of BIAL is highly questionable. More on that below…

But even if we dismiss Fairfax’s valuation of BIAL, there still appears to be a large discount to intrinsic value. Consider the following rough math: Fairfax India has a diluted equity value of $1.1bn, plus $500m net debt for an EV of $1.6bn. Its listed holdings are worth $865m and appear reasonably valued on a multi-year view (10x-15x earnings with high growth). Then the private holdings ex-BIAL are all dominant operating businesses in their respective markets, which Fairfax values collectively at $614m. Let’s haircut this by 50%, which is likely excessive. The remaining stub valuation for BIAL is $461m to the enterprise, versus management’s $1.35bn mark:

In other words, the market valuation of Fairfax India is valuing 100% of the Bangalore Airport concession equity at $813mm, which is 8x FY18 earnings. Add $1.4bn of debt for an implied EV of $2.2bn and the valuation is $67 EV/pax on FY19 passenger figures and $44 EV/pax on a plausible FY24 passenger figure. By comparison, both Mexican airport operator OMAB and Fraport trade at $75 EV/pax (all 2019 passenger figures…). Maybe you think this is the right valuation. I'm inclined to think India's rapid growth and underpenetration in civil aero make the above estimate moderately cheap.

So what might BIAL be worth? First let’s address a potential red flag. In December of 2019 Fairfax sold a 5% minority stake in BIAL to an unnamed buyer at a $2.5bn valuation (valuing Fairfax’s stake at $1.35bn). Although I cannot confirm this, it is highly likely that this 3rd party is OMERS, the Canadian pension fund and #2 shareholder in Fairfax India. If true, that would obviously be concerning. OMERS 2019 annual report doesn’t disclose individual investments, but its direct investments in India increased from $877m in 2018 to $1,741m in 2019. Notably OMERS spent $121m in February 2019 to acquire a 22% stake in a toll road portfolio in India. The OMERS press release for that deal included language about their intention to expand infrastructure investing in India. Fairfax India management have not replied to my requests for a meeting or clarification on this point. It may be possible to confirm this via government filings in India but I haven’t figured it out.

Fairfax structured this minority sale by creating a new subsidiary, Anchorage, into which it transferred most of its stake of BIAL. Anchorage now owns 43.6% of BIAL while Fairfax retained 10.4% (which it may eventually shift into Anchorage). The strategic intention is to turn Anchorage into a diversified Indian infrastructure holding company, with BIAL serving as its anchor holding. Fairfax simultaneously announced its intention to IPO Anchorage by YE21, with a targeted valuation of $1.3bn (implying a $3bn valuation for 100% of BIAL).

Incredibly, Fairfax also agreed to a ‘‘ratchet’’ mechanism with the unnamed minority investor whereby if the IPO is completed at a valuation below $1.3 billion, the investor will receive incremental shares of Anchorage from Fairfax to compensate for the difference. This smells of desperation. Note that the 5% sale hasn’t closed yet but at the 2Q20 results Fairfax said it expects the sale to close by the end of September (this month). 5% of $3bn is $150m so the dollar risk here isn’t hugely material to Fairfax. But it’s still a big red flag (and an awesome free option for the buyer).

OK if I haven’t scared you off yet, let’s look at a reasonable valuation for BIAL:

Some facts:

1. The Indian civil aviation market has grown at a 15% CAGR since 2015. By 2035 India is expected to be a market of 442m pax/yr
2. BIAL is the #3 airport in India and the second fastest growing airport in the world (2019). Its revenue has grown at a 16% CAGR 2009-2019. 
3. BIAL served 33m passengers in 2019; the population of Bangalore is 8 million people.
4. The airport opened in 2008 and BIAL was granted a 30-year concession with a 30-yr extension option; it also has a 25 year exclusivity right for a 150km radius 
5. The concession operates under a standard regulatory framework: BIAL generates revenue from (1) a regulated ROI on its infrastructure, (2) retail, and (3) greenfield real estate development
6. A second runway was commissioned in 2018 and will be fully operational by 2021, expanding functional capacity from 30m pax/yr to 50m/yr
7. BIAL owns 460 acres of undeveloped land around the airport that it plans to monetize; there is currently just 1 hotel.

BIAL is the first PPP greenfield airport in India. It is owned 54% by Fairfax, 20% by Siemens, 13% by the local state government and 13% by the federal government. The original private investors were Siemens, Larsen & Toubro and Zurich Airport. In 2008 GVK bought a 43% stake from all 3 founding investors. Fairfax built its stake across 2016-2018, taking out Zurich and GVK. In total Fairfax paid $650m for its 54% stake.

In 2019 BIAL generated $211m in revenue, $54m in PAT and $132m of FCF after maintenance capex. It handled 29m domestic passengers and 4m international, 10% more than its stated capacity. Notably 2019 saw aero revenue decline 29% because BIAL’s largest carrier, Jet Airways, filed for bankruptcy. In 2018 sales were $234m and PBT was $99m. Before the pandemic management expected a quick recovery to prior levels.

The regulated ROE for aero operations is calculated every 5 years and currently has a 16% cap. BIAL over-earned during the last period and so is required to under-earn during the current period, which ends 3/2021. Despite this, BIAL management still expects a total ROE of 19.6% during the current period (thanks to non-regulated revenues), which would lead to an ROE since inception of 19.1%.

Fairfax values its 54% stake in BIAL at $1.35bn using a DCF with 3.5% terminal growth and 12.6%-15.2% discount rates. This translates to a 100% equity value of $2.5bn, which is 25x FY18 earnings for a business Fairfax thinks will grow passenger volumes >10% for over a decade. Global comps trade at 15x-25x earnings with much slower growth, but also fewer risks. On Fairfax's NAV estimate, BIAL has an EV of $3.9bn due to $1.4bn of expansion debt (2nd runway and terminal). Once the Phase 2 expansion is complete BIAL will have capacity to serve 50m passengers/yr, a figure that could be realized within 4 years. 50m passengers on Fairfax’s current valuation implies an EV per passenger of $78. Fraport has an EV/passenger of $75 and is active in 11 countries serving >130m passengers, including several emerging markets. Grupo Aeroportuario del Centro Norte (OMAB) in Mexico trades at $74 EV/pax, 18-20x earnings and in 2019 earned $19 in revenue per passenger with a similar domestic vs. international split as BIAL. Yes India is a lower GDP and per capita civil aviation market, but the growth is faster and the long-term trajectory seems clear:

The above is a way to back into Fairfax’s NAV valuation for BIAL. It’s plausible, but aggressive. Ultimately I prefer the following guestimate for BIAL’s potential value:

1. BIAL has invested $490m into regulated infrastructure, from which it can generate a 16% ROE (so far it’s exceeded this return and been capped by the regulator)
2. Once the Phase 1 expansion is completed the total aero-related invested capital will be ~$1.3bn, implying a regulated return of $208m
3. 50m pax/year earning $10/pax of revenue = $500m revenue, and $208m net income is a 41% margin vs. the 4 year average of 39%
4. Arbitrarily haircut these guesstimates to $400m revenue and $150m PAT - on these figures a 20x earnings multiple is required to hit Fairfax’s $3bn valuation target
5. A more plausible 10x earnings implies $1.5bn equity value - half of Fairfax's estimate but still good enough to make the SOTP attractive
6. Global airport comps have historically traded at 10x-15x EBITDA. BIAL doesn’t disclose EBITDA but is earning >50% margins. On the above assumptions, $240m of EBITDA at 12x is $2.9bn. There is currently $1.4bn of expansion debt (2nd runway and terminal), implying $1.5bn equity value if we assume no de-levering. That’s the same 10x earnings figure and implies $810m of equity value to Fairfax.

As per the below, BIAL screens well vs. global airport operator peers:

Chart credit: Broyhill Asset Management

Bottom line: it’s possible to underwrite Fairfax’s $3bn valuation for BIAL based on global comps, but it’s also possible to underwrite half that valuation. Even at a $1.5bn valuation of BIAL the SOTP for Fairfax India suggests value.

#2 investment Sanmar Chemicals

Brief comments on Sanmar Chemicals, which is 11% of the GAV. Fairfax paid $199m in 2016 for a 42% stake that it holds today at $326m. Sanmar is a PVC manufacturer with two production sites in India and one in Egypt. Parent company Sanmar Industries discloses $1bn in sales, of which ~72% are from the Chemical division that Fairfax has a stake in. Fairfax’s current NAV valuation implies an equity value of $758m for 100% of Sanmar Chemicals, or 1x sales. Fairfax’s equity injection was used to double capacity in the Egyptian plant, which is now struggling. The business was EBITDA breakeven in 2019. Management seem to expect a turnaround but who knows.

Corporate structure and management fees

Fairfax India utilizes a complex but fairly standard corporate entity matrix to allow FDI into India. The Canadian-listed company has several Mauritian subsidiaries to allow for both public and private asset ownership in India. 

Fairfax Financial, the parent company, charges management fees across these entities that total 1.5% of NAV and 0.5% of undeployed capital. This totaled $27.5m in 2019.

There is also a 20% performance fee that is calculated against the NAV and includes a hurdle and high watermark. It is calculated and accrued quarterly, and paid-out every 3 years in either cash or common stock at Fairfax’s discretion. There have been 2 of these calculation periods since IPO: the 2015-2017 period crystalzied $114m that was paid in stock ($14.88/share), which set the high watermark. The 2018-2020 period ended with no performance fee and the NAV $240m underwater.

Fairfax India has a $550m 1+1 year term loan at LIBOR +450 that has been renewed annually. With no dividend there is ample liquidity from cash and bond holdings. Additionally the public holdings are viewed as sources of capital as/when new investment opportunities are identified.

Management have deployed effectively all capital and are now focused on closing the discount to NAV in order to realize a performance fee for the 2019-2022 period. In addition to an IPO for BIAL, management have been repurchasing shares - $20m worth so far this year (1.7% of outstanding).

Risks

1. All the usual external shock risks exist for BIAL: pandemics, terrorism, accidents
2. Aggressive behavior by the government (26% shareholder in BIAL) to promote growth of civil aviation at expense of concession shareholders. This seems unlikely.
3. Continued rupee devaluation vs. the dollar
4. Bad behavior by Fairfax management - self dealing, NAV inflation, etc.

Catalyst

1. Closing of 5% sale in BIAL by end of September and further clarity/transparency on this transaction

2. Progress towards an IPO of Anchorage by YE21

3. Continued share repurchases, funded by cash flow from operating businesses and sales of listed holdings