Description

Grupo Aeroportuario del Centro Norte (which I shall henceforth refer to as OMA) is one of three publicly-traded airport operators in Mexico (the other two I’ll refer to as GAP and ASUR).  Airports in Mexico are good businesses.  They are high-growth, inflation-protected monopolies.

The “inflation-protected monopolies” part I’ll elaborate a bit more on in the section entitled “Background on the Airport Industry in Mexico.”  As for the high-growth part, it’s not complicated.  Air travel in general is a growth business, because as uncomfortable as flying may be, people still like to travel more so long as they can afford it.  Since 1970, worldwide air passenger volumes have grown at a 6% CAGR (CAGR is the same for the last 10 years).

Air travel growth in Mexico should be even higher than it is for the world as a whole.  Mexico has all the ingredients needed to be a high-growth market for air travel.  It’s not a compact country – it’s a nearly 50 hour drive from Cancun to Tijuana.  Over the last decade it’s developed a robust low-cost carrier presence, with airlines like Volaris pricing not only to steal share from legacy carriers but also to get bus passengers to switch to air.  And air travel is still relatively underpenetrated among Mexicans – Mexicans take an average of 0.3 air trips per person per year, as compared to 0.5 in Brazil and 2.4 in the U.S.

Over the last five years, the three publicly-traded airports in Mexico have seen their aggregate passenger volumes (for Mexican airports only) grow at a 10% CAGR.  Year-to-date through the first quarter, volumes are up 9%.

With an investor-friendly dual-till regulatory framework in place (see “Background on Airport Industry in Mexico” for more detail), Mexico’s airports have been able to convert high volume growth into excellent EBITDA and FCF growth:

Data from company filings.  Mexican CPI used for computing real growth figures. EBITDA figures above exclude EBITDA from OMA’s hotels and industrial park, ASUR’s Puerto Rican and Columbian airports, and GAP’s Jamaican airport (I excluded EBITDA from these sources to present apples-to-apples organic data).

Data from company filings.  FCF can by lumpy from year-to-year depending on timing of expansion capex.

The investment thesis isn’t complex – I don’t have any particularly clever observations.  I just think the Mexican airports are especially good businesses that are likely to compound earnings at at least mid-to-high single digit real rates for many years, and OMA in particular trades at a reasonable valuation:

Data from company filings.  Based on closing prices as of 4/12/18 and LTM financials as of 12/31/17 (with exception of CAAP, for which I only have financials through 9/30/17).

Why is OMA trading at low multiples relative to both other airports and its own trading history?  One factor surely is Trump’s election and concern about NAFTA’s future.  The Mexican airports all saw their multiples drop quickly in the aftermath of Trump’s victory.  OMA in particular is more exposed to NAFTA disruptions than the other Mexican airports.  Manufacturing is key to the region OMA serves, and OMA’s most important airport is Monterrey, which accounts for about half of the company’s passenger volumes and revenues.  These parts of Mexico would likely be impacted more severely than others in the event of trade restrictions.  And unlike ASUR (which operates the Cancun airport among others) and GAP (which operates the airports in Los Cabos and Puerto Vallarta among others), OMA doesn’t have much tourist traffic to soften the blow of domestic weakness (international passengers make up less than 15% of OMA traffic versus a third at GAP and more than half at ASUR).

Another factor likely contributing to OMA’s low multiples is a slowdown in passenger volumes, as traffic at OMA’s airports only grew 1.5% in the second half of 2017.  In the summer of 2017, the capacity-constrained government-operated Mexico City airport introduced some slot restrictions that compelled airlines to cancel some flights to smaller airports.  In addition, Aeromexico decided to swap out its smaller Embraer 145s with Embraer 190s (which don’t operate at smaller airports).  As OMA is disproportionately exposed to smaller airports, these two factors hit OMA much harder than GAP and ASUR.  These headwinds should stop blowing in 2Q18 and 3Q18 as OMA begins facing easier comps.  For what it’s worth, OMA’s traffic growth has rebounded a bit and is up 8% YTD through 1Q18 (note that Easter, which occurred in April of last year but March of this year, flatters the 1Q18 figure).

A third issue is the weak financial health of Mexican low-cost carrier Interjet, which represents about 20% of OMA’s traffic.  Should Interjet go out of business, that will clearly impact OMA in the near-term, although eventually the supply provided by Interjet should be replaced by other airlines, just as it was when Mexicana, which represented a third of the Mexican airline market before its demise, went out of business in 2010. 

Lastly, there is concern about the upcoming Mexican presidential election.  The favorite right now is Andres Manual Lopez Obrador (AMLO).  AMLO is leftist, which by itself tends to scare investors.  Moreover, AMLO has threatened to shut down construction of the new Mexico City airport.  As the existing Mexico City airport is already capacity constrained, a failure to open the new hub in the next few years is likely to depress overall Mexican air travel volumes (although OMA might get some more volumes in Monterrey as a substitute hub for Mexico City).  The existing regulatory framework for the publicly-traded Mexican airports has worked well – from what I gather these airports have better efficiency and lower tariffs than the government-operated airports – so I doubt there are major changes to the regulatory framework, regardless of who wins the election.

Factoring this all in, I think OMA is a good investment.  At current prices, OMA (which you can own either via the Mexican-listed shares or via the US-listed ADR) is my favorite of the three, with GAP a close second.  ASUR is my least favorite of the bunch, largely because it has diversified into Puerto Rican and Columbian airport assets that I view as inferior to their core Mexican airport assets.

Background on the Airport Industry in Mexico:

Prior to 1998, Mexico’s airports were government-owned.  Faced with the need to modernize and improve the nation’s airports, the government decided to privatize most of the industry.  The country’s airports were divided into 5 groups: GAP (12 airports on/near Pacific Coast), OMA (13 airports in North Central Mexico), ASUR (9 airports in Southeast Mexico), the Mexico City airport, and a 5^th group of small airports deemed too unprofitable to privatize.

The government granted 50-year concessions (expiring in 2048) to each group, and then auctioned off portions of GAP, OMA, and ASUR to private operators (Mexico City was initially supposed to be privatized but the transaction was never consummated – fast forward to 2018, and the Mexico City airport is considering an IPO).  In the year 2000, the government disposed of most of the rest of its stake in ASUR in that company’s IPO.  IPOs of GAP and OMA followed in 2006. 

In conjunction with the privatization of GAP, OMA, and ASUR, Mexico introduced a relatively investor-friendly regulatory scheme.  Before I get into the details, I’ll go through “Airport Regulation 101” for those not already familiar with the industry.

There are two basic revenue sources for airports: Aeronautical and Commercial.  Aeronautical revenues represent the “tariffs” that airlines pay the airport for usage of the airport (in Mexico, these fees typically range from 150-300 pesos, or ~$8-$15 in USD, per passenger).  Commercial revenues represent rents that stores/restaurants pay to operate in the terminals, as well as fees from parking, etc.  Given the captive audience in airports, commercial rents are usually steep; a typical rental contract requires a store or restaurant operators to pay either a guaranteed minimum rental amount, or a royalty (typically 20-40% of the operator’s sales), whichever is higher. 

In most airports worldwide, tariffs (the fees airlines pay the airport) are regulated by the government under utility-like frameworks that aim to ensure the airports achieve “fair” returns based on capital deployed.  But there are significant differences among the regulatory frameworks used by different countries.  Under “single-till” regulatory schemes, regulators consider revenues from both Aeronautical and Commercial sources when setting tariffs.  In practice, that means that any extra money that an airport makes on the Commercial side just serves to reduce the tariffs that the airport can charge the airline.  It also means that airport margins are effectively capped under single-till regulation.

Under “dual-till” regulatory schemes, regulators only consider revenue from Aeronautical sources when setting tariffs.  The revenues (and high incremental profits) from Commercial sources are additive.  Airports operating under “dual-till” regulation typically grow margins over time. 

Given that I already described Mexico’s airports as benefitting from “investor-friendly” regulation, you can probably guess that Mexican airports operate under a dual-till framework.  That is the case, but that is not the only reason to like the Mexican airport regulatory scheme from an investor perspective.

Each Mexican airport operator operates under a 5-year regulatory cycle (these cycles are staggered – ASUR’s next regulatory cycle starts in 2019, GAP’s starts in 2020, and OMA’s starts in 2021).  Every 5 years, an airport operator submits a Master Development Plan (MDP) outlining expected volumes and proposed capex for the next 5 years, and the government sets tariffs for the next 5 years largely based on the MDP inputs.   Importantly however, the allowable tariffs can and do change over the course of each 5-year regulatory cycle.  Tariffs can be adjusted upwards if Mexican GDP falls more than 5% in a 6-month period and/or in the event of natural disasters.  Even more importantly, the allowable tariffs set by the government are adjusted for inflation annually.  Adjusted for inflation, tariffs at OMA’s airports have grown at a 2% CAGR over the last 15 years (0% CAGR for GAP, -1% CAGR for ASUR).  On a nominal basis, this translated to a 7% CAGR for OMA’s airports (5% for GAP, 4% for ASUR). 

This is why I describe Mexican airports as inflation-protected monopolies.  Aeronautical revenues are adjusted annually for inflation, and Commercial revenues naturally adjust for inflation because many commercial rental agreements in airports are structured as a % of the tenant’s sales.  (As for the monopoly part, airports are effective local monopolies since it’s very difficult and rare for a new airport to be built in an existing airport’s catchment area).

One fly in the ointment is that, as I mentioned earlier, the concessions for Mexico’s airports expire in 2048.  I’m not sure what will happen then, but for the sake of conservatism, you should probably assume that the government takes back the concessions in 2048 and then re-auctions them off.  If you put on your academic hat, then that means the publicly-traded Mexican airports should be valued as annuities ending in 2048 (rather than perpetuities like most businesses).  In the discounted cash flow analyses I’ve done, using such an annuity calculation instead of a perpetuity calculation slices about 25% off the per-share values of the Mexican airport stocks.

Catalyst

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