Description

Summary

Grupo Mexico Transportes (“GMXT”) is a high quality, monopolistic infrastructure asset with an attractive customer mix and a long history of steady performance through economic cycles. Unlike US peers, GMXT has no exposure to the declining coal industry. It does have exposure to areas of high growth, most notably intermodal, which should benefit as rail takes share from trucking, and energy, a category that should show strong growth as the deregulation of the Mexican energy industry continues. Further, GMXT under-earns its US peers both in terms of pricing (where a gap will likely remain) and margin (where there is potential to narrow the gap over time). These features should drive faster growth than North American peers, yet GMXT’s valuation remains low on both a relative and an absolute basis.

With undemanding operating assumptions and a multiple near peers, GMXT offers a roughly 40% return and a favorable risk/reward. Several inefficiencies exist. Most obviously, this is a recent IPO where liquidity remains limited: it has only been trading $3-6mm per day. Along with this, there is an overhang from Grupo Mexico and Carlos Slim. Presumably both parties will sell down over time with Slim the more likely near-term seller, alleviating this valuation drag. In addition, disclosure and public communication since the IPO have been disappointing but should improve. More qualitatively, this is an “orphan asset” with no direct comps. The US rails have coal exposure, generally weaker volume growth prospects, and less margin upside. The only other publicly-traded LatAm railroad is Rumo, where the outlook is dictated by regulatory questions, and where ~80% of volume is agriculture.

Thesis Detail

1. GMXT and Mexican Rail Industry Background
2. Performance History
3. Customer Exposure and Growth Outlook
4. Margin Upside Opportunity
5. Comparison to Other Rail Assets
6. Risks
7. Operating Assumptions & Return

1) GMXT and Mexican Rail Industry Background

The rail industry in Mexico is highly consolidated with two dominant operators, GMXT and KCSM (a subsidiary of Kansas City Southern, ticker KSU), and several small, short-rail operators. GMXT and KCSM have limited overlap and therefore operate effectively as monopoly providers of rail freight in their respective regions. GMXT’s primary competition is with trucks, which have significantly higher market share in Mexico than in the US. This can be explained in part by shorter average rail freight haul length (US avg is ~1,000 miles vs. ~620 in Mexico), which improves trucking’s relative economics, but there does appear to be a market share gain opportunity for rail (more on this in the growth outlook).

GMXT’s primary asset is two large rail networks in Mexico, which they operate through 50 year concessions with the Mexican government, 35 years of which are exclusive on the key contract. The most important agreements were struck in 1997 and 1998, leaving ~30 years remaining on the concessions, ~15 of which are exclusive. In privatizatizing the national freight rails, the Mexican government divided the country into four regions. GMXT was awarded Ferromex, a rail network covering ~70% of Mexico, in 1997. Union Pacific (UNP) owns 26% of Ferromex and, as part of their agreement with GMXT, despite a minority ownership position, UNP benefits from extraordinary voting and governance rights, which is a favorable dynamic for minorities. GMXT later purchased Ferrosur in 2005, a smaller network that was the product of a previous consolidation of two southern concessions. Today, GMXT controls three of the four original concessions, while KCSM, KSU’s Mexican subsidiary, controls the remaining northeast concession. GMXT also owns an extension line into Texas, and it acquired a short line in Florida, Florida East Coast Railways, last year. The Florida purchase, which represents ~17.5% of PF EBITDA, appears to be primarily a standalone financial investment, but there may be synergies in using barges to move freight directly from Florida to Mexico, cutting out a Class 1 line in the US. Below is an asset map:

Below is a table from the S-1 that summarizes GMXT’s concessions:

2) Performance History

GMXT’s long-term results speak to the stability of the business. Since the 2005 acquisition of Ferrosur, volumes have grown at a ~3.5% CAGR while revenues have grown consistently at ~9-10%. Revenue has not declined Y/Y since 2001, and during both the GFC and the ‘15/‘16 energy downturn, GMXT saw continued growth. US peers, in contrast, saw ~15% revenue declines in the GFC and HSD revenue declines in ‘15/‘16.

3) Customer Exposure and Growth Outlook

Attractive and well-diversified exposure has driven GMXT’s stable growth over time. Unlike US peers, where coal still represents ~12.6% of total volumes, GMXT is not exposed to any categories that face obvious secular decline risk. GMXT also benefits from ~10% exposure to both Energy and Intermodal, which should grow faster than the broader economy. Taken together, it appears likely that GMXT’s volumes will outgrow the Mexican economy with limited volatility.

Barring a significant negative macro event in Mexico, GMXT’s steady revenue growth should continue. Industry contacts estimate that GMXT should comfortably grow volumes 2-3%/year and increase prices 1-2% ahead of inflation. GMXT management expects volume growth of 4-5%. Supporting the revenue outlook are two idiosyncratic factors: energy reform and intermodal.

Although hard to quantify with precision, the potential benefits of energy reform are significant. Not only should energy reform drive direct category volume growth at the rails, but energy reform also should provide a significant tailwind to the broader industrial economy in Mexico. Based on conversations with management, there is a significant opportunity for GMXT to grow their refined products business as Pemex’s monopoly on transport is broken. Moreover, should natural gas prices decline with improved infrastructure, the Mexican petro-chemical sector should become increasingly competitive, which would accelerate volume growth for GMXT in other categories. Mexican freight trends over the last few years demonstrate that energy is growing, but most of the growth still appears to be a few years out.

Mexico’s intermodal rail market is immature relative to the US, and GMXT’s mgmt has described intermodal as “in the 2nd inning.” Intermodal represents 46% of volumes for US Class 1 rails but only 10% for GMXT. And Mexican rails have less than half the share of their national freight market than US rails:

4) Margin Upside Opportunity

GMXT’s EBIT margins today are at the low end of North American Class 1 rails, which have seen significant expansion in recent years due to the adoption of Precision Railroading. From 2010 – 2016, the average US rail EBIT margin increased from 28% to 36%, with CP and CNI (Harrison’s former companies) leading the industry at 41% and 44% EBIT margins today. Starting from a base of 32%, it seems reasonable to assume a margin trajectory similar to that of US rails over the last few years, with ~125bps of EBIT expansion per year. Scuttlebutt has generally suggested that 100bps of EBIT margin expansion per year to be a conservative assumption. Management is more bullish: they anticipate EBIT margin expansion of ~200bps per year over the next four years.

GMXT management appears focused on the efficiency gap to Class 1 rails. In the S-1, GMXT highlights a number of precision railroading KPIs, suggesting that they intend to emulate Harrison’s approach.

In benchmarking vs. US peers, there are some puts and takes in the margin comparison: a notable positive is that GMXT has a lower cost of labor, while to the negative, GMXT has higher security expenses and operates in mountainous regions, increasing opex intensity and slowing train speeds. On balance, it seems likely that margins should gravitate towards US levels over time.

5) Comparison to other Rail Assets

Broadly speaking, GMXT is a similar business to US Class 1’s, though in an earlier inning of development and efficiency. There are a few notable points of differentiation worth highlighting, most of which are favorable to GMXT.

Cons for GMXT:

• Mexico country risks: political change could result in less business-friendly environment
• Drags to operating efficiency
  • Theft and other criminal interference is a constant reality for GMXT and could weigh on opex in the long-term, preventing GMXT from reaching US levels of efficiency, but this dynamic is already in the numbers so it shouldn’t weigh on the multiple.
  • GMXT operates in an unusually mountainous region that may also keep margins structurally lower or capex structurally higher.
• Shorter freight lengths in Mexico improve relative economics of trucks

Pros for GMXT:

• Better growth prospects given exposure to faster growing industrial end markets (has been growing at ~2x the pace of US peers over the past decade)
• No coal exposure, which is a significant risk for many US rails and a drag on growth
• More margin upside given the lower starting point and earlier stage of lifecycle for the assets
• US rails have exhibited significantly more cyclicality than GMXT over the last 20 years, which as of late has been masked by operating efficiencies (shown below)
  

Weighing the pros and cons, GMXT does not appear to warrant a discount to class 1 rails. Note also that GMXT has a slightly cleaner balance sheet than most US peers.

6) Risks

Cycle

• The railroad industry is cyclical, and given the operating leverage in the model, downswings can be painful. As a mitigant, GMXT’s exposures are attractive, with notable secular growth drivers in energy and intermodal, and the business has been steady over time.

Mexico Country Risk

• Political / General Mexico
  • NAFTA reform/repeal disrupts US/Mexico trade and depresses Mexican economy
  • Left-leaning government comes to power and attempts to regulate rail more aggressively
  • Organized crime is a legitimate political problem
• Regulatory
  • Given the monopolistic nature of GMXT’s business, there is risk that the regulator could attempt to control pricing; however, it appears that the regulatory environment is favorable. A key mitigant to regulatory risk is the value of a well-functioning rail network to the Mexican economy. Legislators should seek to incentivize railroad companies to invest large sums in maintaining and growing rail networks, which requires that the rails be profitable.
  • GMXT also benefits from a fuel tax credit that may be at risk

On the topic of political risk, there are some concerning headlines, most notably the debate around NAFTA’s future and the success of leftist Presidential candidate Andres Obrador, who is perceived as being anti-business. The NAFTA topic is a notable risk to the investment as its repeal could depress the Mexican economy and discourage cross-border trade. The likelihood of trade with Mexico being completely redefined seems low, so the impact of US/Mexican trade negotiations is likely to be limited, but this is a risk that is difficult to fully handicap. And while the move to a populist government more prone to regulation could be problematic, rails appear an unlikely candidate to suffer. First, the impact of regulating pricing for rails is one that consumers will not experience directly as they would food subsidies, telecom pricing, or employment programs, so the political benefits of rail regulation are limited. Second, rails should represent strategic infrastructure to the government, and depressing profitability would discourage investment in the industry. Third, in the context of a more nationalist economic agenda, GMXT could benefit from greater state-sponsored investment in domestic industries such as refining, an area Obrador has stated that he would like to develop domestic capabilities that would result in spillover benefits for GMXT.

As it relates to pricing specifically, a recent ruling by the Mexican anti-trust authority (the COFECE) is supportive of the view that both pricing regulation and amendments to the current concessions are unlikely outcomes. In March 2018, the COFECE closed an 18 month investigation into cargo and rail pricing without notable findings. The COFECE’s study evaluated whether or not the current concession and market structure either disincentivized network investments or encouraged abusive pricing by the rails. There was speculation that if the findings were negative, the COFECE could require the rails to provide network access to short line operators, leading to more price competition. The COFECE’s favorable conclusions following thorough investigation are a meaningfully positive data point in support of the status quo and reinforce the sanctity of GMXT’s concessions, which carry significant economic value.

To provide some background on the tax risk, Mexico has excise taxes on diesel, and for select industries, the government offers a rebate on that tax in the form of a tax credit. For the past 20 years, truckers were entitled to that rebate, but rails were not, which provided a competitive advantage to trucks. In the 2016, Mexico expanded the tax credit to railroads in order to put them on equal footing with truckers. The credit is evaluated annually for all eligible industries through Mexico’s budget approval process, and both trucks and rail are expected to continue qualifying. There is some anxiety in the sell-side community that this credit will not be renewed and many analysts model it to phase out in the next few years, without an impact on pricing. However, if the credit is removed for rail, it would likely also be removed for trucks, which should push pricing up for freight in general. Therefore, while the near-term implications losing the credit may be negative, the longer term impact is likely to be neutral, as it would affect both rail and trucks equally and therefore be reflected in pricing.

If still uncomfortable with the risks discussed above, a hedge of the Mexican index, which could protect from potential anti-business policies of a leftist government, or buying puts on KSU, which has almost 50% exposure to Mexico and would protect against rail-specific regulations, could mitigate exposure to the factors discussed.

7) Operating Assumptions & Return

The three critical assumptions here are revenue growth, operating margin, and capital intensity. While there are structural opportunities to reduce operating expense, revenue trends should heavily inform margin outcomes given the operating leverage. Key base case assumptions are summarized below:

• 7% revenue CAGR through 2020 in Mexico, driven by ~2-3% volume growth, 2.5% inflation, and 1-2% real pricing growth
  • This growth is below the LT trend of ~9-10%, which management is confident will continue
• 160 bps of annual EBITDA margin expansion in Mexico & 75bps in Florida, driving ~125bps of annual EBIT improvement for the total company, consistent with trends for the Class 1’s over the last few years
  • Scuttlebutt suggests 100bps of EBIT margin expansion to be a conservative estimate, and management is expecting 200bps/yr of expansion
• High teens percentage capital intensity, consistent with high end of US peers
  • All FCF is assumed to go to debt retirement
• GMXT continues to benefit from a fuel tax credit.

Taken together, these assumptions lead to a 2020 EPS estimate of 2.60 MXN, or an 11.5x P/E multiple relative to the current price, which is too cheap for a business of this quality. Applying the average Class 1 multiple of 17x multiple to GMXT’s 2020 EPS, and then discounting it back to a one-year forward stock price, GMXT would deliver a 40% return over the next year.

Disclaimers:

We and our affiliates are long GMXT. We may buy or sell shares without notification. This is not a recommendation to buy or sell shares.

I do not hold a position with the issuer such as employment, directorship, or consultancy.

I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

• Revenue growth and margin improvement begin to show the path to long-term earnings power, clarifying the discount to US peers
• Increased trading liquidity, potentially from key holders selling down
• Improved disclosure and management communication, particularly relating to longer-term targets