Grupo Aeroportuario Centro Norte (OMA) is an extremely inexpensive infrastructure asset. Its regulatory structure is mis-understood by the market and sell-side analysts. The total TEV trades at a significant discount to the value of the utility-like regulated business, and there is significant value in the unregulated side. OMA is the smallest of the three major airport groups in Mexico (GAP and ASUR are the other two). They operate (via 50-yr concessions that expire in 2048) 13 airports in North Central Mexico. The most valuable airport is Monterrey, the industrial center and fastest-growing city of Mexico. Tourist airports include Acapulco and Mazatlan and regional city airports include Culiacan and Chihuahua. Like all Mexican airports except Mexico City, the OMA airports are not hubs and only serve their catchment areas, where no competitors exist. Although ASUR has been written up on VIC previously, that write-up fails to explain the regulatory structure, which is all-important in understanding this infrastructure asset. While management is not terribly forthcoming with details, I have visited numerous times with management (on-site in Mexico and in the U.S) of all three operators to determine the details of the regulation.

The key issue that seems to be missed is that maximum tariffs are re-set every five years (2006, 2011, etc.) to adjust for unexpected traffic growth and changing discount rates. Thus, while analysts and the stock price react to monthly traffic reports and oil prices, the effect of traffic variation on the value of the regulated business is minimal. The maximum rates are adjusted every five years to correct for any over-growth or under-growth. It is a low-volatility infrastructure asset that is being priced as a highly cyclical stock.

While the pre-tax real discount rate was set to 12.35% in 2006, it will fall in time (along with Mexican risk premium) and the real pre-tax discount factor will be about 10% over the remaining life of the concession. After taxes, this translates to a nominal return of 8% plus inflation. At the current stock price (S=$9.0;$/Ps=12.33), TEV = Ps.3.8bn while the reference value = Ps.9.0bn and LTM EBITDA for unregulated services was Ps. 315mm. Thus, we can buy both the unregulated business and the regulated business at a significant discount to the RefVal of the regulated business. The unregulated business has great ROI and lots of growth ahead. It is worth at least 12x EBITDA, and probably significantly more. The fair value for OMA is about RefVal + 12xNon-Reg EBITDA = Ps.12.8bn. Thus, we can expect the TEV to more than triple. And note that if TEV rises to fair value, we would still expect a very reasonable 8% + inflation return going forward. I believe this is conservative and that the regulated business is worth a premium to the RefVal.

- No Debt -- I should note that they have indicated they may incur some debt to fund capex related to Monterrey airport expansion.

- Regulation limits valuation volatility of regulated businesses

- Regulation formulas set by concession contract, not law

- Maximum tariffs have annual inflation step-up (less efficiency factor)

- Aeronautical services regulated to produce a return on the Reference Value

- Unregulated services have 85-90% EBITDA margins, 25+% ROI, and lots of growth ahead

- Unassailable moat for both regulated and unregulated services

- Analysts are bearish due to oil prices, worseing economy, and falling traffic

- Revenue, expenses, regulation all set in Ps. so simple to hedge country risk

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Valuation

MktCap = 397mm shrs * $9.00 / 8 (shrs/ADS) * 12.3 (Ps./$) = Ps. 5,493mm

Cash: Ps. 400mm

Non-regulated assets under construction/unused land: Ps.1,300mm

Note that OMA made these investments in H1 2008. Most relate to land surrounding the Monterrey airport that will be developed into offices and retail. In my valuation, I have assumed these assets are worth what was paid for them. I would have much rather management used the cash to buy back shares, and I have told management that on several occasions. I have seen the proposed projects, and my sense is that they are not throwing the money away, but in this economic climate, they should be buying back stock instead. I will let you decide how to value these recent capital expenditures related to the Monterrey airport. Even if you decide they are throwing away the mony, the stock is still very cheap. Do note that these assets are contributing nothing to LTM numbers.

TEV = Ps.5493mm - 400mm - 1300mm = Ps.3,793mm

Non-Regulated Revenue LTM: Ps.362mm

Non-Regulated EBITDA LTM: Ps.315mm

Regulated Revenue LTM: Ps.1633mm

Regulated EBITDA LTM: Ps.790mm

Total D&A: Ps.370mm

Total EBITDA: Ps.1105mm (3.4x)

Total EBIT: Ps.735mm (5.2x)

Total NOPLAT (28% tax rate): Ps.529mm (7.2x)

A quick note about working capital. Normalized working capital is Ps.175mm. We can expect working capital to require Ps.10mm for growth. Working capital mainly consists of receivables from airlines, and working capital has blown up in 2008 due to issues with discount airlines. OMA may lose some of these receivables due to defaults, but this is temporary and should not recur.

                            Shr Price                               TEV                           Nominal RefVal(2008)                     Non-Reg EBITDA

OMA                     $9.0                                 Ps.3.8bn                                 Ps.9.0bn                                     Ps.315mm

GAP                      $20.0                                Ps.12.2bn                                Ps.13.1bn                                   Ps.575mm

ASR                      $40.5                                Ps.12.8bn                                Ps.11.2bn                                   Ps.780mm

Regulation

OMA is regulated according to a strict dual-till system. OMA has a concession on each of its thirteen airports through 2048. At that time, OMA can be given a new fifty year concession. However, the rate-setting formulas assume that the concession ends in 2048. And in my valuation, I assume that the business is worthless in 2048. The reality will probably be somewhat better as the government will let OMA renew its concessions for a price. The regulator is La Secretaría de Comunicaciones y Transportes (SCT), our equivalent of the Secretary of Transportation. Only aeronautical services are regulated, and the law explicitly forbids regulators from taking into account capex, profits, etc. related to commercial services in determining regulated rates.

The aeronautical services are regulated in a very strict manner. Real maximum tariffs are set every five years for each airport according to a fairly strict formula. The maximum tariff sets the maximum allowable revenue per passenger (or 100kg of freight). The airport has the discretion of setting rates for individual services so long as the revenue per unit is less than the maximum tariff. Between the five-year intervals, the maximum tariff increases by inflation (Mexican PPI not including oil) less an efficiency factor (set by regulators every five years).

The details of the regulatory structure are set out in the Concession Agreement attached to the F-1. In this Concession Agreement, the contract explicitly specifies the RefVal for each airport from 2000 through 2006. These RefVals are real values set to December 1998 pesos. At the end of 2005, the regulators took the 2006 RefVals, updated traffic estimates, updated regulated capex, and updated the discount factor to determine maximum tariffs for 2006-2010 and reference values for 2007-2011. In a few years, these 2011 reference values will then be used to set 2011-2015 maximum tariffs. Thus, the whole process is anchored by these formulaic reference values. While OMA has not released reference values past 2006, it is quite simple to accurately update the reference values year by year by using the formula:

RV(t+1) = (1+discount rate) * RV(t) - [Expected Regulated EBITDA in t -Expected Regulated CapEx in t].

Note that these are all real numbers set to December 31, 1998 pesos. While we do not know the exact expectations the regulators used for the 2006 reset, after much prodding, management has given me the approximate traffic forecasts and EBITDA margins. And the company gives us Expected Regulated CapEx and the real discount factor (12.35%) exactly. Thus, we know the constant peso RefVal with a high degree of accuracy for 2007-2011. And applying inflation, we know the nominal RefVal as well.

A few notes about each element of the formula:

Capex

- OMA must make all the investments in the Master Development Program (MDP) each five-year period or else it will be penalized. This is fairly simple though.

- OMA is not compensated for capex overspend. However, the capital requirements of these airports is known with a high degree of accuracy every five years.

Regulated EBITDA

- While the Mexican airport operators do not explicitly break out EBITDA between regulated and unregulated, I have consistently been told my all three management groups that unregulated margins are much higher and hover near 90%.

Efficiency Factor

- Each year, the maximum tariff is raised by inflation less an efficiency factor.

- This efficiency factor was 1% for 2001-2005 and 0.75% for 2006-2010. The efficiency factor was consistent across all three airport groups for their regulatory periods. Note that regulatory periods are staggered by a year.

- The CFO of ASUR, who is negotiating with regulators currently for 2009-2013 period, has told me that he expects an efficiency factor of 0.50%-0.75%. We can expect that OMA will receive the same efficiency factor in two years.

- The Concession Agreement explicitly forbids the use of the efficiency factor to manipulate profits. Instead, it is only intended to capture the cost efficiencies due to technology or scale.

Discount Rate

- The discount factor is the most opaque element of the regulatory system. The Concession Agreement spells out that it should be government bond rates plus a risk premium that takes into account the industry risk and the country risk. In 2006, this was set to 12.35% for OMA. There is no doubt that peso interest rates have fallen and that Mexican country risk has also fallen since then. I expect the discount rate used to set maximum tariffs to fall to 11% in this cycle of regulatory re-setting. And as Mexico develops and the cost of capital falls, I expect it to fall further to 10%. The key is that the discount factor is meant to keep the return on the RefVal to market rates. Thus, if Mexico undegoes turbulence, we can expect the discount factor to adjust accordingly.

- The key here is that the regulators set the discount rate to the actual cost of capital in the Mexican market. That is clearly the spirit of the Concession Agreement and consistent with what I have heard from management and regulators. And note that there are several factors that will force Mexican regulators to honor the spirit of the Agreement:

- Mexico has a pipeline of additional infrastructure projects they want to bring over the next decade.

- Mexican airports, especially in thriving regions such as Monterrey are critical to Mexico's development.

- The Agreement requires a minimum discount factor equal to long-term bonds plus a risk premium.

- While open to interpretation, the Concession Agreement contains a statement that the Maximum Tariff will be set "in the understanding that the Maximum Tariff for both these Periods (2005-2014) is considered at similar levels as the First Period (1999-2004) and, in any event, the Ministry will look to reduce abrupt changes in the Maximum Tariff of the subsequent Periods (2014-2048)." I should also note that in saying Maximum Tariff, the document is referring to the real Maximum Tariff. In other words, if the Maximum Tariff remained constant, it would increase nominally by the rate of inflation.

In all the infrastructure assets I have analyzed (utilities, airports, etc.), this is the strictest I have seen for such a long-dated asset with the possible exception of some roads. This is a much stricter formula than European airports. I should also note that this regulation is stated explicitly in the Concession Agreement contract. Thus, the Mexican legislature or regulators cannot unilaterally alter this setup. The President of the Federal Competition Commission issued an Opinion on October 1, 2007 that criticized the regulation of airports. He makes several suggestions, but the most drastic suggestions only apply to new concessions as he recognizes that the existing concessions cannot be altered for fifty years. I recommend reading this Opinion (translated by ASUR) as it contains an excellent summary of the regulatory system and how it compares to other airport regulatory systems.

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Unregulated Business Opportunity

The unregulated business opportunities provide the home-run story for OMA.

Commercial Activities (all not regulated) include:

- Parking (note: pricing is constrained by antitrust laws)

- Leasing of space for non-essential services such as offices and VIP lounges

- Retail stores, including duty-free stores

- Food and beverage service to passengers

- Car rentals and other ground transportation

- Advertising

- Non-terminal office buildings on the airport grounds

- Hotels (none currently exist in OMA airports, but have been very successful in Europe)

- Other non-terminal businesses such as gas stations

If we look at many privatized European and Australia/NZ airports regulated under a dual-till system, we see that the unregulated revenues and profits have grown at a much faster rate than the regulated services. The reason for the explosion of non-regulated businesses is:

- When under government control, the commercial spaces were old, dingy and poorly run.

- As well, they were limited as government bureaucrats had no reason to invest.

- Passengers have become accustomed to doing normal shopping in airports.

- With the security issues and crowdedness, passengers spend more time in airports before each flight.

We should expect similar behavior in Mexico. And we have an additional factor. Currently, international passengers spend multiples that of domestic passengers on unregulated business (such as car rental, retail, food), but as more Mexican travelers reach middle class, they will shop and eat as well.

OMA has a higher percentage of domestic travellers than either GAP or ASUR. Thus, its commercial revenue per passenger has trailed the other two airport groups. However, several factors bode well for OMA. Monterrey accounts for half the passengers at OMA airports, and Moterrey is the jewel of Mexico currently. Monterrey is an industrialized, rapidly growing city, with athriving middle class. It is not burdened by the abject poverty of Mexico City and Guadalajara. Everywhere I went in Mexico, people asked me if I had been to Monterrey. Several people told me that Monterrey is easily the most "American" city in Mexico. Thus, as the middle class grows in Mexico, Monterrey airport will be able to rapidly grow its commercial revenue.

Currently, going on a flight in Mexico is a big deal to most people. And most passengers have no money for food, etc. However, as Mexico develops, Mexican spending habits will begin to mirror those of Americans and Europeans. And Monterrey will see that effect before any other airport. OMA has a monopoly on the opportunity to tap the captured audience of passengers. Since 2001, commercial revenues in constant dollar terms has more than doubled. The real ROI has been about 20%. Thus, the nominal ROI has exceeded 25%. While certainly cyclical and vulnerable to oil prices and airline troubles, I expect the real growth in commercial revenue to grow at a much faster clip than passengers over the next decade. Most analysts believe passengers will grow at 6% for the forseeable future. Based on historical spend per passenger growth of airport groups worldwide, I expect 10+% real revenue growth. And the EBITDA margin will continue to hover near 90%. This sort of growth at a high ROI with an unassailable moat deserves a high multiple. I use a 12x EBITDA multiple above, but with sustained growth over a deacde or two, the multiple is much higher.

The commercial revenue is subject to the cyclical nature of air travel. However, the cyclical nature has been over-stated by the market and analysts. The dire predictions of air travel seem unfounded. Below is a table with Total Passengers in Mexico.

Mexican Air Traffic vs GDP

           GDP            Total Passengers             Total OMA Passengers

1990   5.1%                      10.3%

1991   4.6%                      17.8%

1992    3.2%                      11.6%

1993    2.0%                         6.1%

1994    4.4%                        14.7%

1995    -6.2%                       -12.7%

1996    5.1%                         5.9%

1997    7.0%                         8.4%

1998    3.9%                         7.3%

1999   3.8%                          7.4%

2000   6.6%                          4.2%

2001   -0.3%                        -2.9%

2002   1.0%                         -2.7% -5.5%

2003   1.3%                          5.4% 3.5%

2004   4.1%                         15.9% 10.0%

2005   3.0%                          1.3% 8.8%

2006   4.4%                           5.7% 11.2%

2007   3.3%                           13.6% 7.8%

Sources: Banco de Mexico; Dirección General de Aeronáutica Civil; OMA

Graph these and you'll see a fairly close correlation where the change in passengers is about double that of real GDP. This is consistent with international data from IATA.

- Although somewhat cyclical, this business should not see huge swings. Total Mexican passenger growth from 1989-2007 was 6.3% CAGR. Several crisis (1991 recession, 1994 Peso Crisis, 1998 Emerging Mkt Crisis, 9/11 and the resulting 2002 recession) hit Mexico in that timeframe, but growth continued except for the Mexican Peso Crisis, which struck in December 1994. Passenger numbers were down 12.7% in 1995.

- If the next twelve months see a decrease in traffic of 10%, we would expect real unregulated EBITDA to drop 15% to Ps.270mm in 2007 pesos. This would be significant, but more than baked in at the current stock price.

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Margin of Safety

The margin of safety is provided by a combination of things:

- Regulatory structure that dampens economic effects and produces a reasonable return on the RefVal.

- Limited cyclicality (+/- 15% top-line) even in the worst crisis in history and limited operating leverage in both regulated and unregulated segments.

- No debt.

- The moat is unassailable

  -- No existing airports in the OMA catchment area

  -- New entrants have NIMBY problem

  -- Incumbent has scale and network effects

  -- Unregulated businesses have monopoly at each airport

- At current price, purchasing at a steep discount to the RefVal

- Protection against Mexican inflation and easy-to-hedge country risk

  -- 9% dividend yield

  -- traffic turnaround if oil continues to fall

  -- Infrastructure fund (e.g., Macquarie Airport group) buying stake or acquiring