Description

*Note the price listed above is for the Mexican listed shares (GAPB.MX) in pesos. Market cap, net debt, and TEV figures are in USD assuming a 19.60 exchange rate. The stock also has an ADR (PAC) that represents 10 shares and is traded in dollars. The ADR was at $94.19 at the time I submitted this write-up.

Back in April of 2018, I recommended a Mexican airport operator (Grupo Aeroportuario del Centro Norte, aka OMA) as a long.  I still own and like OMA, but today I’m recommending another Mexican airport operator that I own: Grupo Aeroportuario del Pacifico, aka GAP.

Airports in Mexico are good businesses.  They are high-growth, inflation-protected monopolies.  Of the three publicly-traded Mexican airport operators, GAP has arguably the best assets.  Unlike peer ASUR (which operates the Cancun airport), GAP isn’t overly dependent on a single airport.  GAP gets about 32% of its passengers from the Guadalajara airport and 18% from Tijuana, with the remaining 50% from 10 other Mexican airports and the Montego Bay airport in Jamaica.  Compared to peer OMA, GAP has a higher share of international travelers and therefore a higher mix of unregulated commercial revenues.

I think now is a particularly good time to own GAP for a couple of reasons.  The first is that the market is pricing in a discount due to regulatory risk.  As explained more fully later on in this write-up, every 5 years, Mexican airport operators must submit 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.  GAP is submitting its MDP this year, and the outcome of this tariff negotiation will be finalized in December.

GAP has already submitted its MDP to the regulator, and they are proposing to spend 20 billion pesos in capex over the next 5 years (20-25% of Mexican airport revenue), up from about 8 billion pesos (~18% of Mexican airport revenue) over the existing 5 year MDP.  The step-up in capex is needed to further expand GAP’s airports to handle increased passenger volumes. In particular, GAP’s Guadalajara hub is getting a second runway, which could help the airport handle additional connecting volumes if/when airlines move connecting flights from increasingly constrained Mexico City to secondary hubs like Guadalajara.  In exchange for deploying this expansion capex, GAP is requesting a 3-5% real increase in tariffs as compared to the existing MDP.

However, given that GAP trades near the bottom of its historical EV/EBITDA range, I believe the market is pricing in a much less favorable tariff outcome than GAP is proposing:

Since Andres Manuel Lopez Obrador (AMLO) took office in Mexico last year, the market has worried that his administration will be harsher on Mexican airport operators in the next round of tariff negotiations.  These fears were exacerbated when AMLO canceled construction on a new Mexico City airport last year. The existing Mexico City airport (which, unlike most other airports in Mexico, is operated by the government) is running at max capacity, and a new one was under construction and about a third completed.  AMLO held a non-binding referendum in October 2018 on whether or not to complete the new Mexico City airport, and, based on the results of the referendum, decided to cancel the new airport. Instead, he plans to refurbish the existing airport, refurbish a smaller satellite airport near Mexico City, and repurpose a military base near Mexico City to address the city’s airport capacity constraints.  The referendum was viewed by the market as a sham, as only 1000 polling places were set up across the country (vs. 156,000 for the presidential election), and turnout was very light (only 1 million votes cast, vs. 60 million for the presidential election). This episode cemented perceptions that AMLO would be hostile not just to business in general, but to the air travel sector in particular.

So why do I think the upcoming tariff negotiation will be resolved satisfactorily from GAP’s perspective?  There are a number of reasons:

• Pressuring airport fees is not an obvious populist strategy:  Airport tariffs are not paid directly by consumers (they are paid by airlines), and ultimately these fees are borne by foreign travelers and the relatively wealthy segment of the Mexican population that flies.

• The technical staff of the Mexican regulatory agency in charge of applying the long-standing regulatory framework used to set airport tariffs is unchanged since AMLO took office.

• GAP’s “sales pitch” to the Mexican government is compelling: With its MDP proposal, GAP is proposing to significantly expand Mexico’s airport infrastructure and help alleviate the capacity constraints at the government-operated Mexico City airport without a single peso of government funds being used.

Should GAP’s MDP be approved largely as proposed in December, I expect GAP’s stock (as well as the other Mexican airport stocks) to do very well.

I mentioned earlier that there were two reasons why I think an investment in GAP is particularly timely.  The second reason is that GAP has recently completed significant expansions to the commercial areas (think food courts, shopping areas, etc.) in its airports and the benefits of these expansions should continue flowing through over the next several quarters.  Over the last two years, the total commercial area in GAP’s Mexican airports has increased nearly 50%, from ~24K square meters to ~35K square meters. Much of this expansion was only completed earlier in 2019. GAP has started seeing increased non-aeronautical revenues (Mexican non-aeronautical revenues per passenger are up 14% in 1H19), but based on the timing of the expansion and the assorted store openings, I think there are several more quarters of high non-aeronautical passenger growth to come.

On GAP’s earnings calls this year, there’s been some criticism that much of the benefit of higher non-aeronautical revenues has been offset by increased operating expenses so far.  That said, I suspect much more of the benefit of higher non-aeronautical revenues will start flowing to the bottom line starting next year. My suspicion is that Mexican airport operators tend to ramp up operating expenses in the year in which they submit MDPs to the government (as GAP is doing this year), as they want service levels in their airports to be as high as possible when negotiating tariffs.

What is the upside if these positive catalysts occur?  GAP should generate about 10 billion pesos in EBITDA in 2019, up 13% in nominal terms (9% in real terms) from a year ago.  When the tariff outcome is determined and uncertainty is removed, suppose GAP trades up to its historical median LTM EV/EBITDA ratio of 13.7x.  That would imply an EV of 137 billion pesos. Subtracting 6 billion for net debt and 3 billion for the fair value of non-controlling interests in GAP’s Montego Bay subsidiary leaves 128 billion in value for GAP shareholders, or about 243 pesos per share (up about 30% from current levels).

At 243 pesos per share, GAP would trade at 13.7x EBITDA, ~17x EBITDA minus maintenance capex, and ~23x EPS.  Given the attractiveness of GAP’s assets and the track record or growth (EBITDA has grown at a ~11% real CAGR over the last decade), I view these as reasonable multiples, particularly in today’s asset pricing environment.

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 5th 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 new regulatory cycle started this year (but was negotiated under prior Mexican presidential administration), 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 GAP’s airports have been flat over the last 15 years (+2% CAGR for OMA, -1% CAGR for ASUR).  On a nominal basis, this translated to a 5% CAGR for GAP’s airports (7% for OMA, 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.

Risks:

• Unfavorable tariff outcome in December

• ~60% of total GAP revenue is from regulated Mexican airport tariffs (another ~20% is from non-aeronautical revenue from its Mexican airports, with remaining ~20% from GAP’s Montego Bay and Kington airport concessions).  GAP currently achieves ~70% EBITDA margins, so the math of Mexican tariffs step-ups/step-downs is that every 100 bps change in tariffs has an 86 bps impact on total GAP EBITDA.

• GAP is requesting a 3-5% real step-up in tariffs over the next regulatory cycle (tariffs immediately step up in year 1).  Ceteris paribus, this would result in a step-up in real EBITDA by ~3-4% in 2020. Conversely, if the regulator is especially harsh on GAP and institutes, say, a 10% step-down in tariffs, then total GAP EBITDA will step-down by ~9%.

• Currency

• GAP’s revenues and expenses are primarily denominated in pesos, but most of us care about returns in dollars.  The fact that GAP’s revenues step up almost automatically with inflation provides some protection over the long term, but the fact remains that on the days when Trump tweets about Mexico and the peso falls, GAP’s stock price is likely to fall in USD terms.

• Natural disasters

• Example: ASUR has been weak recently largely because of large amounts of sargassum (a brown seaweed that smells like rotten eggs when it decomposes on a beach) have been washing up on the shores of Cancun beaches.  Cancun hotels are doing their best to remove the sargassum daily, but it’s a Sisyphean task. Hotel occupancy is down in Cancun as a result, and this appears to be impacting Cancun airport passenger volumes, which were up only 2% in the first half of 2019 vs 7% passenger growth across the rest of Mexico’s airports.

• Capital allocation

• Given their high growth and the regulatory framework under which they operate, I view Mexican airports as particularly attractive airport assets.  So when Mexican airport operators diversify by purchasing airport concessions in other, less favorable geographies, I worry about “diworsification”.

• GAP has expanded to Jamaica by taking over the Montego Bay airport concession in 2015 and will be taking over the Kingston airport concession later this year.  The Montego Bay acquisition has been solid enough so far, and the amount of capital they’ve spent on Montego Bay and Kingston has been manageable, but it’s something to keep an eye on.

Catalyst

• Announcement of tariff outcome in December 2019

• Continued strong passenger and EBITDA growth