Description

INVESTMENT THESIS

• Aeromexico is Mexico’s only full-service carrier. Low cost per average seat per km compared to other full-service airlines. CASK stage adjusted of 5.5USD vs 6.1 LUV, 6.2 COPA, 6.7 JBLU, 8.4 DAL, 9.8 UAL.

• AICM (Mexico City Airport) slot constraints are a temporary barrier to excessive competition. The new airport to be opened in 2020 will serve as a hub for Mexico and Central America.

• Delta 49% (announced early 2016 and just approved by all regulatory agencies in the US and Mexico) investment in Aeromexico a game changer. Clear cost and revenue synergies. Delta completed the purchase of it's stake in Aeromexico at a $49/sh price, almost 60% above current prices.

• Connectivity is key part of Aeromexico's business strategy. i.e. flying people from Peru to Japan via Mexico.

• Mexico’s favorable demographics and growing middle class a strong tailwind.

• Flights per capita for middle and upper-class population in Mexico still very poor at 0.6 flights vs 0.8 in Brazil, 1.4 in Europe and 2.4 in the US.

• Fleet homogenization a big positive. By early 2018 there will only three types of aircraft in Aeromexico's fleet: 787-800/900, 737-800/NG and E-170/190

NEAR TERM CATALYSTS

• Ancillary revenues are speeding up.

• Cost savings and revenue enhancements due to Delta JV.

• Young aircraft fleet. 8.3 years average ltm.

• Price war in Mexico (50pct revenues) stabilizing.

• Revenue increases 2018/19 and margin expansion. Double EBITDAR margins by 2020 seem realistic to us.

• Interjet, the most important domestic competitor in Mexico is at a precarious financial condition. Debt/EBITDAR at 9x.  If Interjet ceases operations big plus to profitability in domestic market. Some airports in Mexico recently announced they’ve decided to stop supplying fuel on credit to Interjet.

• Aeromexico has a strong balance sheet, access to favorable financing terms, more so after DAL investment.

BUSINESS STRATEGY

The most important thing Aeromexico offers is its network, The carrier’s domestic network is the most important one in the country. Given Mexico’s geographical location, Aeromexico is becoming a more global airline, connecting south and central America with North America, the plan is to make the new Mexico City’s international airport a global hub. Why not Cancun? Because the average fare there is too low and they’d be competing with the charter carriers, even though geographically it would be ideal. The goal is to create a hub south of Texas, since Delta doesn’t have a hub in Texas and passengers who use Texas as a Hub do it through American or United.

Mexico is a sub penetrated market that has grown very fast. Today, the average is .7 flights per capita, a few years back it used to be .5. In 2010 40mm Mexican’s flew, this year the number will be close to 80mm. We expect 100mm Mexican flying by 2020.

THE DELTA JV

Aeromexico is taking over some flights and is opening a flight to Portland, Seattle, Bajio-Atlanta, and Merida-Atlanta. Delta already had flights to Seattle and Portland through Delta Connections, Aeromexico is taking over due to a more convenient cost structure of the E-190.

The company has guided to $200 million dollars in synergies by 2021, of which 160 million are in revenue side and 40 million are in costs. Delta has the highest Revenue per passenger and Aeromexico has the lowest cost per passenger among full service carriers, this creates a lot of opportunities for synergies.

Premium in Delta’s Revenue: Delta has been able to identify the qualities that the clients appreciate and are willing to pay for. On the other hand, it is ranked as the best customer service in the US in terms of punctuality. In terms of service the quality is very high and consistent, Delta’s clients trust the service will be excellent. A very important point is that they have been able to segment their clients through their Brand Fares (different fare classes, ex. the back of the plane has the lowest fare). Aeromexico wants to implement this fare system, American already copied it and United is in the process of copying it.

Currently there is a new revenue service being implemented. Before, they couldn’t due the complete fare segmentation and sell all the ancillary revenues that they wanted since the booking system wasn’t adequately designed for it. This system was introduced in April and it is working very well. Besides introducing Branded Fares, Aeromexico is looking to penetrate the corporate segment, the big companies use US airline. Aeromexico can expand its corporate network with a Delta-Aeromexico product. They are investing towards achieving a high Net Promoter Score (NPS), since there is a high correlation between NPS and revenue per passenger.

Additionally, in terms of revenue, the main income will come from the connectivity between the two networks, and the additional flow of passengers that will be created. There is also the matter of the Skyteam alliance, Delta has an alliance with KLM, Air France, among others. The idea is to bring Aeromexico closer to this alliance so that, for example, our flight Mexico-Paris doesn’t compete with the one of Air France or Delta, this way offering an integrated product with a coordinated network.

In terms of costs, there are already combined purchases of fuel with Delta in the US, Japan, and Central America. Every station creates a saving of $50-70 thousand USD.

FINANCING/FLEET MODERNIZATION

JOLCO (787-9 y MAX): great opportunity in which there were a lot of large leasers who didn’t had the 787-9 plane, and there was a lot of appetite for this asset. They did a Sale and Leaseback deal of 25 planes that will be delivered between 2018 and 2020 with excellent lease rate factor conditions. In 2021 and 2022 is when they will rely more on their financing.

Fleet Reduction from 5 planes to 3: next year the company will see several cost reductions we haven’t seen yet, such as maintenance (777 and E-145 are very expensive to maintain), pilot training is going to be much simpler, before it used to be highly and efficient and required of a lot of training. Currently Delta doesn’t operate 190’s or 787’s, they are studying whether to purchase Airbus or Max (MAX is more convenient given synergies).

Synergy curve: During 2017, the amount of synergies is important but there is also the matter of significant amount created by the open skies. In 2018 and 2019 is when you will really be able to see a significant amount, since these initiatives take time to implement. Others won’t be seen until 2021 since this is when contracts expire. They know what is the potential synergies, but to implement them it is necessary for contracts to expire.

LABOR RELATIONS- UNIONS

On the labor side, there is a contract renewal with pilots in 2018. They expect to introduce changes to improve the productivity of the pilots. A payment plan in which if a pilot flies 60 hours a month, he is payed a certain amount, if he/she flies between 60-70 hours they are paid a larger amount for each additional hour and an even larger amount for hours exceeding 70 hours. This is cheaper than hiring an additional pilot. Currently they fly around 72 hours (in line with the international average). The law established a maximum of 90 hours and it was increased to 100 hours. Flight attendants are beginning to accept the 100 hours. At the end of the year more than half of pilots will be hired under contract B, which will reduce costs.

LEVERAGE/FINANCIAL OUTLOOK

They are looking to reduce their leverage to 3x-3.5x EBITDAR: it comes through both sides, an increase in EBITDAR, and leverage decreasing once the fleet program stabilizes.  

There are three pillars in the financial strategy:

1. Maintaining a very conservative risk management strategy. Conservative management of capacity and a lot of flexibility of fuel coverage. They count with a natural FX hedge.

2. Achieve a double digit operating margin through cost and revenue initiatives. Aeromexico has one of the lowest CASKS in the industry, however, it has half the operating margin of United, this is because the unit revenue per passenger is one of the lowest among full service airlines. When you look at TRASK they are below the average of full service airlines. The US carriers have better revenues per passenger as they have benefited from the industry's consolidation, revenue per passenger is Aeromexico’s biggest potential.

3. Discipline in investing resources, which management has historically demonstrated.

NEW MEXICO CITY AIRPORT

New Mexico City Airport: Aeromexico has a strong relationship with the government and with the airport. The objective is efficiency, reducing connection times and that a connecting international-international flight doesn’t have to go through the entire connection process. The international-domestic flights have not been resolved yet since many small airports don’t have customs. The new airport is planned to open in 2020, however we believe it will take more time. A two-year delay is convenient for Aeromexico.

OTHER POINTS

Financial Performance: The first quarter was very complicated with the arrival of President Trump and the exchange rate at $22 MXN/USD, the border market plummeted. In the second quarter, there was a recovery and the third one was doing fine until the hurricanes and the earthquakes. The third quarter is expected to perform worse than last year, a two-point decrease in occupation rates is expected.

There has been a large capacity increase in Europe and Asia. Wide body planes have been very successful in Europe and Japan. They introduced a flight to Seoul, Increased Shanghai to five times a week, and daily flights to London and Amsterdam.

HSBC report published a report called “A world without Interjet”: Interjet has a leverage of 9x (Latin America average is 5.2x). In a world without Interjet the main beneficiary would be Aeromexico. Interjet requires capitalization or selling equipment in order to survive.  Interjet has canceled flight to 6 destinations and is growing at 20%. The cause of this is unknown, but they believe it’s a matter of adjusting their operation, or because with the new slot rules they are using more slots than which they have.

The E145 are in preservation service, but they are unlikely to be flown again. If a good sale arises they would sell them, but currently the market is too weak to sell them. They are almost completely depreciated so there is no accounting impact. There are 12 of them remaining, 4 of which have burn out engines. Zero value for those four.

Energetic Reform: Before they used to pay an 8% premium above international cost because transportation was so expensive. Today they are paying a 10% premium, since there is no domestic production of fuel and it all has to be transported through pipelines which are very inefficient. There are initiatives to reduce these inefficiencies, however since ASA controls fuel supply in Mexico it’s a long-dated opportunity.

VALUATION

We believe Aeromexico’s valuation is very compelling for the factors just discussed and we do not take into account the whole of the synergies that the company expects from the DAL JV.

We account for 100% of the cost synergies and only for 30% of the revenue synergies.

In our model we maintain the company’s current load factor of 80% for the next couple of years and increase ASK’s as new aircraft deliveries are scheduled. We are now able to buy the company at a 2017 EV/EBITDAR multiple of 4.6x and assume an exit 2019 multiple of 3.6x. The latter suggests Aeromexico should be worth around $51 pesos per share today (58% upside to the current share price) at a 10% free cash flow yield and a potential $71 price target two years out at an 8.4% free cash flow exit multiple which equates to around 3.5x EV/EBITDAR multiple.

Current price per share $32.7MXN

Shares outstanding 703.2

Market Cap $22,979 MXN

EV (capitalizing aircraft leases) $67,908 MXN

Target year end 2019 FCF yield 8.4%

Target year end 2019 EV/EBITDAR 3.5x

Estimated net debt/EBITDAR 2019 3.6x

Fair value year end 2019 $71.4 MXN

Potential return in 24 months 118%

Catalyst

Mexican competition being more orderly as the second largest carrier (Interjet) is in apparent financial duress, cost and revenue synergies from DAL JV materializing