- The blockbuster hit Airplane! was released over thirty-seven years ago. Thankfully for our investors, as we navigate through turbulent markets we are not like Ted Striker, a rogue pilot with a drinking problem.
- In keeping with our approach of exploring value wherever we may find it, we have found a pocket of value within Mexican airport operators. If you’re thinking to yourself that you’ve never heard of a publicly traded airport, well they’re large buildings where people go to fly on planes, but that’s not important right now.
- Unlike the ill-fated Trans American flight from Los Angeles to Chicago, Mexican airport operators have been on a steady ascent with minimal amounts of turbulence, resulting in healthy long-term returns for investors.
- For these high quality and relatively higher-valued stocks, we believe that price is what you pay and value is what you get. These airport operators continue to warrant higher valuations, given the long runway of growth prospects that will provide a tailwind for future growth.
Mexican Airports – Overview
The internet and media alike have a knack for reporting stories about customer’s experiences that can seem outlandish. However, on the rare occasions when they are true, they tend to create a marketing nightmare for the company. When this occurs, it’s almost guaranteed that someone in your office will say something along the lines, “well, any publicity is good publicity, am I right?!”, followed by a slight chuckle from his or her co-workers.
This certainly isn’t the case for the airline industry. The best-case scenario, especially for passengers on a flight, is no news. When we do hear stories about plane mishaps, each story tends to be more ridiculous than the previous. Whether
it is a scorpion biting a passenger midflight, to Snakes on a Plane, to the way United Airlines treats their passengers, the news always appears to be a nightmare for CEOs, making it a bad week for them to quit sniffing glue.
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Setting aside United’s recent PR nightmare, U.S. airlines have recently received good publicity as Warren Buffett, a long-time airline bear, invested over $10B in airline providers over the last six months. Previously, Buffett argued that the capital requirements for airlines are vast with low returns on spending as they lacked a long-term durable competitive advantage. In 2013, Buffett went as far as dubbing the industry a “deathtrap for investors”. However, Buffett had a change of heart (or maybe, perish the thought, he talked them down to get a better deal), as he invested in four airline companies, of almost equal amounts, reflective of a bet on the entire industry.
Buffett’s investment thesis states that the landscape of the airline industry has changed greatly over the past two years, as airlines have reported record profits, buoyed by post-financial crisis capacity discipline, depressed labor costs, and cheap oil. We agree with Buffett as we invested in Hawaiian Airlines ( ticker: HA), in our Opus Small Cap Value strategy, before Buffett announced his investment in HA’s larger brethren.
However, in keeping with our approach of exploring value wherever we may find it, we have also invested in a much less efficiently priced area within air travel that the market has overlooked, airport operators. These stocks have consistently outperformed major airlines by a significant spread in most trailing periods over the last ten years.
If you’re thinking to yourself that you’ve never heard of a publicly traded airport, well they’re large buildings where people go to fly on planes, but that’s not important right now. Mexican airports have not always been publicly traded as it wasn’t until 1998 when Mexico’s state-owned airport operator Aeropuertos y Servicios Auxiliares (“ASA”) identified thirty-five of the country’s fifty-eight principal airports as being suitable for privatized investment. The thirty-five airports were separated to be run by four different operators: del Pacifico (“PAC”), del Centro Norte (“OMAB”), del Sureste (“ASURB”) and de la Cuidad de Mexico (“AICM”). Three (3) of the four (4) operators are publicly traded, with AICM being the outlier. In September 2016, Mexico announced that they would privatize the remaining airports into a fifth operator, which has yet to be announced. The planned privatization is aimed at bringing in additional funds to the federal government at a time when the country’s public finances are under pressure from low oil prices.
Very much like airlines, these airports earn revenues from seat traffic, but the difference between the two is that airport operators also earn revenue from non-aeronautical sales. First, aeronautical revenues are driven by seat volumes and gate fees, while non -aeronautical sales are derived from a plethora of items such as leasing of commercial space to retail tenants all the way to ground transportation and parking. With much of the costs incorporated in running an airport being fixed, it is necessary for an airport to increase the variable portion of their revenues, leveraging their operating income. This can be done through adding new routes or even increasing gate capacity. With the forecasted strength in this industry, Mexican airports are expected to expand terminal space by over 20% by 2020 and have been continually adding flights around the world.
These airports have had consistently strong balance sheets, i.e., low debt, and have been outstanding generators of cash flow. Mexican airports have attractive operating leverage as many of their costs are fixed while their revenues depend on traffic volumes. In periods of increasing traffic, airports see their margins expand quickly, increasing net income and cash flow from operations. The operators can reinvest in the airport through terminal expansion, which drives traffic growth, and remodeling in commercial retail space, which yields a higher leasing price. With the growth in air traffic, airports have seen increasing revenues in many different selling verticals, especially retail sales, which yield higher margins, as terminals act as captive malls. Through growing revenues and margins, even after investing back into the company, airports can provide a healthy return to shareholders through share buybacks and double-digit dividend growth.
I would not go as far as saying that Mexican airport operators have a monopoly, but they have sole authorized control over key infrastructure gateways to geographic locations, plus significant barriers to entry, making it difficult for competition to enter the space. As we have seen, Mexico is looking to add a new operator for the first time in nineteen years. Furthermore, there are several regulatory and investment restrictions on developing new airports in any given Mexican region, so we have not seen increased competition from the private sector entering this profitable space.
The industry has seen very strong traffic growth over the past year, and it may not all be from the assumed catalyst, the appreciation of the U.S. Dollar. While a strengthening dollar has bolstered travel into Mexico from the United States, material growth has also come from homegrown traffic demand. The Mexican economy is highly tied to the success of the U.S., and with increasing U.S. consumer sentiment and an eight-year bull market, Mexico has become a very integrated and more stable emerging market.
Operators have seen the majority of growth come from increased domestic travel, which grew by 11.4% during 2016. Increased demand from Mexico’s middle-class and, most importantly, a structural shift from road to air travel has boosted traffic volumes. An influx of lower-cost carriers infiltrating the market has helped reduce prices for travelers. With this shift, the annual estimated growth in domestic air travel from 2016-2035 in Mexico is expected to average +4.6%.
Though boat travel is not plausible for domestic trips, there continues to be a titanic opportunity as we have just seen the tip of the iceberg for air travel, which has a long runway to continue outsized growth. Currently, bus travel is the main means of transportation for Mexicans, accounting for 95.7% of travel, while air travel is only utilized 2.2% of the time. With the recent influx of low -cost carriers into Mexico, we will see more domestic travelers choose air travel as a means for transportation.
As you can see, this industry has significant tailwinds behind it, not only in the short-term, but longer-term as the Mexican economy continues to expand.
From 2017 to 2018, all three publicly traded operators are expected to generate double-digit EPS growth. Even though the dynamics of these operators are the same, the differentiating factor between them is geographical location and the type of travel that they see within their regions. For example, ASURB owns airports in locations that have higher tourist traffic, i.e., Cancun. On the other hand, OMAB, tends to own airports that have a focus on trade. Their crown jewel airport in Monterrey, an industrial focused city, generates 50.9% of their revenues. When you look at the valuations between these two operators, OMAB has yielded a lower valuation partially due to investors assuming significant trade barriers arise between the U.S. and Mexico, while ASURB has been granted a higher valuation with tourist travel expected to increase as the dollar appreciates.
These airports do have a synthetic currency hedge built within their business model as they derive a significant amount of their sales in dollar-denominated revenues from seat travel from the U.S.
When compared to other airport operators around the world, Mexican airports are expected to see higher growth into 2018 and tend to have a higher dividend yield. The only other operator to see anything close to this growth is the Beijing Capital International Airport Company ( ticker: 694-HK), which does not have a yield. When compared to airport operators in developed nations, New Zealand and Austria, the Mexican operators trade at a discount.
At the time of purchase, these airport operators were trading towards the higher end of our valuation limit, but were below the market’s average valuation. Though the absolute valuation levels were high relative to our other holdings, we continue to believe that these operators should be warranted higher valuations given the growth prospects.
Mexican airport operators are positioned to grow above GDP in Mexico as they see benefits not only from an increase in U.S. travel, but also from increasing domestic traffic. This structural shift in domestic travel will provide a tailwind for earnings growth over the next decade, while they can continue to leverage growth in the current environment. We are happy to see that Warren Buffett is borrowing a page from us, agreeing that the entire airline industry, not just airport operators, are ripe for growth and can reach new altitudes after a prolonged period of stagnant capacity growth.
Opus’ strategies, both domestic and international, have a common tenet to find lower valued, higher-quality companies that have superior growth prospects. If you find yourself nervous investing in these operators due to current valuations, it’s okay, because I’ve been nervous lots of times! For these high quality and relatively higher- valued stocks, we believe that price is what you pay and value is what you get. When we purchased Mexican airports, valuation multiples were
at much lower levels, but recently the market has begun to recognize this high growth industry. Although we trimmed ASURB, as the performance caused the holding to hit a valuation threshold, our thesis for the stock, as well as OMAB and PAC, remains intact. We continually monitor our investment thesis for all of the stocks in our portfolios, as we don’t expect to put investments on autopilot . We believe in what David Einhorn said, “if you have to change your investment thesis to continue to hold a stock after negative news, then you shouldn’t continue to own it” and if you do, you may have more of an awkward conversation with your clients than little Joey did with Clarence Oveur.
Disclaimer: At the time of publication, Opus Capital does owns Hawaiian Holdings, Inc. ( ticker: HA), Grupo Aeroportuario del Centro Norte ADR ( ticker: OMAB), Grupo Aeroportuario del Pacifico ADR ( ticker: PAC ), and Grupo Aeroportuario del Sureste ADR ( ticker: ASR). Mr. Wagner wrote this article himself and it expresses his own opinions. Mr. Wagner is receiving no compensation and has no business relationship with any company whose stock is mentioned in this article. This security is identified and described to illustrate our investment process, and does not represent a recommendation to buy or sell the security mentioned above.
Article by David W. Wagner III, Opus Capital Management