Given that the VIC community seemed to appreciate the Radio Centro idea I wanted to submit another attractive US-listed Mexican company with the following characteristics: (i) near monopoly, (ii) very cheap – and 10.2x ’04 EV / FCF with a debt-free, cash rich balance sheet, (iii) very profitable – EBITDA margins in excess of 50%, (iv) doesn’t misallocate capital and returns most of it to shareholders in the form of regular and special dividends, (iv) has uncommonly shareholder friendly corporate governance for a Mexican company (v) sizeable - $70+ million in EBITDA and $120 million in revenues, and (vi) offers excellent long-term return characteristics along with catalysts to unlock value. There are several unknowns overhanging ASUR right now, providing for an excellent buying opportunity, since everything will be resolved by yearend
So with that out of the way, let me get to the point. ASUR has a 50-year concession (1998 – 2048) to operate the airport of Cancun along with 8 other airports in Southeastern Mexico with the most prominent ones being Merida and Cozumel. The Company went pubic in late 2000 at $15.13 per share and was the first of 4 Mexican airport groups to do so (the other 3 are awaiting better market conditions). Privatization of airport concessions has become popular over the last 15 years, with the majority of publicly traded airports being domiciled in Europe, such as British Airport Authority (Ticker: BAA), Copenhagen Airport (Ticker: KLUF), Frankfurt Airport (Ticker: FRA) and Zurich Airport (Ticker: UZAN). Additionally, Auckland and Beijing airports are also publicly traded. The business model is fairly similar and most airports derive revenues from three sources.
- Aeronautical revenues. These are comprised of passenger fees which airlines pass on to their customers and landing / gate fees which are paid for by airlines – in 2003 this should represent 76% of ASUR’s revenues;
- Commercial Revenues. These are comprised of royalties (% of sales with sizeable minimums) from vendors operating things such as the food court, duty free shopping, foreign exchange and billboard advertising – in 2003 this should represent about 17% of ASUR’s revenues; and
- Ancillary Revenues. This originates mainly from operating parking and ground transportation facilities.
If one had to summarize (albeit in an oversimplified fashion), the main characteristics of the airport business are as follows:
- Heavily regulated with capped ROE due to absence of direct competition and impenetrable barriers to entry.
- Very high fixed costs (as much as 85% of total costs), such that small improvements in passenger traffic result in substantially better profitability
- Fortunes are usually tied to those of the dominant local airline, such as BA for Heathrow, Swiss for Zurich, etc.
- Very high EBITDA margins (in excess of 50% for ASUR) and steady free cash generation
- Significant capital outlays which occur in a step function fashion
- Employment of meaningful financial leverage by operators
Aside from the obvious attractions of a bulletproof competitive position along with steady cash generation, the business model is attractive since it benefits from secular long-term growth in travel while being relatively insulated from corresponding pricing pressures. For instance, the onus to fill hotel rooms in Cancun and plane seats on flights to Cancun is on the lodging/resort operators and airlines – they need to discount when demand slackens and in order to manage their capacity. However, the benefits of such discounting accrue to airport operators and their shareholders and allow them to maintain steady / growing cash generation.
So how does ASUR stack up against other airports relative to the simplified template that I laid out above? I believe that it is superior! Let’s go step by step. Within the regulatory framework lies ASUR’s first unique advantage. Most airports operate under a “single-till” regulatory structure which essentially caps their ROE, akin to a utility, such that any improvements, be it through improved traffic flow or higher concession revenues per passenger, go towards aeronautical fee reductions. However, some airports, ASUR being one of them, operate under a “dual-till” structure, under which non-aeronautical revenues are not regulated and as a result higher commercial revenues accrue to the shareholders and improve ROE and ROIC. In the case of ASUR this is very significant, since its commercial revenues which have virtually no direct costs associated with them are still in their infancy and are growing very nicely.
Prior to the IPO the Company was not managed with a view of maximizing profit, so the commercial revenue stream was grossly underdeveloped and amounted to less than $0.89 per passenger versus a range of $2.00 to $9.00 per passenger at airports elsewhere in the world (with the average being close to $4.00). One might argue that Mexico is a poor country and as such spending at its airports should be a fraction of what is observed in developed countries. I would disagree, since about 55% of the Company’s traffic originates from the US, Canada and Europe and brings with it high disposable income. Given that the Cancun economy is largely dollarized in terms of pricing and that Cancun represents 70% of ASUR’s total revenues and an even higher portion of commercial revenues, it wouldn’t be difficult to imagine that Cancun could resemble the Miami airport, which produces $6.00 per passenger. I am not suggesting that ASUR will deliver that any time soon, but management targets commercial revenues per passenger of $2.50 in 2004 with about $1.85 in 2003. I believe that this is very achievable given the concessions that have been awarded over the last couple of years. Additionally, the attractive aspect of commercial revenues is that they are largely USD denominated, which takes away the peso risk (more on than later). Overall, the continued above average growth in commercial revenues over the next several years with virtually no associated costs is one of the most attractive value-creating dynamics playing out at ASUR ($1.00 in commercial revenues per passenger would represent $12.0 million of additional annual EBITDA and net income – I will explain the tax situation later – or $0.40 per share).
With respect to dependence on the dominant airline, ASUR has a much better risk profile. For instance, the airport of Zurich flirted with bankruptcy due to high levels of financial leverage coupled with the bankruptcy/painful bailout of Swissair which eventually led to a substantial capacity and traffic reduction. ASUR doesn’t have this issue as 3 Mexican airlines account only for 27% of total traffic, with the rest being evenly spread between US, European and Latin American airlines.
With respect to capital expenditures, ASUR is fairly attractive since the majority of heavy CapEx is behind it – no need for a new runway until 2012 and terminal expansion until 2008 – and going forward, CapEx should be no more than $10-13 million per annum (more conservative than management expectations – they believe 10% of EBITDA or $7-8 million). To support the above assertion it is worth noting that the busiest single runway airport in the world, Gatwick in the UK, handles 48 peak-hour ATMs (“air traffic movements”) during its most active period while Cancun only handles 30. Also, the flip-side to CapEx (if it were to be higher than expected) is that given the aeronautical tariff setting mechanism any additional dollar of CapEx will require a return down the road.
On the capital structure front, ASUR is also less risky than most airports since it is the only airport operator of the ones that I looked at that has no debt and an excess cash balance - roughly $52.7 million or $1.76 per share.
Aside from the structural points above, there are other dynamics that drive the attractiveness of an airport franchise. Ultimately, the most important value driver of an airport is its ability to attract passenger traffic and grow (ceteris paribus). Every additional passenger is unbelievably profitable. For that reason, it pays to invest in airports of cities that are thriving as tourist/business destinations. I believe that Cancun definitely qualifies. Over the last 13 years (since 1990) Cancun’s passenger traffic grew at an average rate of 5.8% with international traffic growing at an even greater 7.9%. In fact, this January, a USA Today poll showed that Cancun has become the number one tourist destination for Americans, ahead of Paris and London. Plaja del Carmen, another resort served by one of ASUR’s airports, was also in the top ten. I definitely appreciate that some of this ascension to the top has been driven by people’s reluctance to travel far, but that could be the new reality that Americans have to live with. Aside from Cancun the whole Mayan Riviera region has been attracting more and more tourists and ASUR benefits from that as well. At the end of the day there’s no good way to get there aside from taking a flight! To underscore the attractiveness of the Cancun area it is worth noting that it is the only travel destination that has already returned to pre 9/11 travel volumes and moreover has posted passenger growth during March 2003 – the month of SARS and the Iraq war. So what’s going to happen going forward? What will traffic do in the future? The only thing that I know is that lodging capacity in Cancun and the Mayan Riviera will likely grow at 4-5% per annum (it is projected to double over the next 15-20 years). Right now there are approximately 46,990 rooms in the region and 8,332 are under construction. This will be the long-term driver of traffic growth.
To better understand ASUR I believe it is worthwhile to discuss the shareholder structure of the Company. There are two classes of stock – class BB which comprises 15% of the company and is owned by ITA – a consortium headed by Copenhagen Airport and several Mexican Companies – and Class B which comprises 85% of the company and that trades publicly in the US and in Mexico (99% of trading volume is in the US). Note that the Mexican government owns 3.3 million Class B shares (11%) – always good to have them on your side! Additional point to note is that ITA paid an equivalent of about $26.70 per ADR (75% premium to today’s prices) in the initial privatization in 1998. All of the above aside though, the many important factor to consider here is that unlike most corporate structures in Latin America which have robbed minority shareholders, this is a clean and transparent structure with class BB shareholders not enjoying many extraordinary privileges that are typical of dual class structure situations (IR magazine awarded the Company the Best Corporate Governance Award for Latin America in May 2002). Namely, Class B and Class BB shares have equal voting right -1 vote per share, Class B shareholders (us) appoint 5 out of 7 directors. In fact the only special rights that ITA shareholders have is to veto major corporate actions such as capital raising, etc., which in my opinion is not too bad!
One of the benefits of ITA is that Copenhagen Airport, which indirectly owns 6-7% of the Company and is widely considered to be one of the best operators in the world, watches ASUR’s management like a hawk. In fact, they designed the entire commercial revenue program for ASUR – developed the terminal layout, designed royalty programs, etc. Copenhagen is a truly amazing airport in that contrary to intuition it generates way above average commercial revenue per passenger – higher than Sydney, Amsterdam, Munich, Los Angeles, etc, which speaks to the operating skills of its management.
This point is extremely important – all too often shareholders of great cash generative businesses never see a dime as the resources get reinvested into “strategic acquisitions.” Since going public in 2000, ASR has paid one special dividend and two regular annual dividends totaling over $2.00 per share. The Company “gets it.” They repeatedly say that the money on the balance sheet is “not our money, but your money and we’re going to return it to you.” They understand that acquisition values for airport franchises are off the charts and are orders of magnitude greater than what ASUR is trading at. So their guidance for the future is a progressive dividend policy (a nice feature of Mexico is that it doesn’t charge a withholding on dividends). Unfortunately, they’re stuck on the concept of liquidity and refuse to buy back shares. Despite that, I believe that the likelihood of the Company doing something stupid with our money is low, especially due to the involvement of Copenhagen.
Financial Projections & Valuation
Shares: 30 million
Price : $16.50
Equity Value: $495.0 million
Less Cash: $52.7 million (at peso exchange of 11.11 peso to USD, although about 30% of cash is kept in dollars)
Enterprise Value = $442.3 million
In 2003-2005 we expect (i) passenger traffic to increase 6.5% in 2003 (despite the fact that through September it grew 9.8% yoy) and 1-1.5% per year thereafter, which I believe is conservative, (ii) commercial revenues to reach $2.50 per passenger in 2005, a full year later than management’s goal, (iii) the peso to stay at 11.25 for the next 3 years, and (iv) the aeronautical rates to drop 2% in 2004 and 1% thereafter. This will result in revenue growth of about 3-4% per year. Costs will grow relatively modestly, aside from the technical assistance fee to Copenhagen, which is tied to EBITDA, and a concession fee to the government which is 5% of revenues. As a result we believe EBITDA will increase from $66 million in 2002 to $79 million in 2005. With respect to free cash: (i) CapEx will be fairly heavy in 2003 - $34 million but will drop as I addressed earlier, (ii) Cash taxes will be $13.0 million declining at about 10% per annum (I will explain why in a moment), and (iii) net working capital will remain fairly static. This will produce Free Cash flow of $27 million in ’03, $52 million in ’04 and $57.5 million in ’05 (before dividends and associated taxes on dividends – see discussion below for more clarity).
In judging the validity of these projections one has to have an understanding of the following issues: (i) how do aeronautical tariffs get set? and (ii) what is the tax situation? I’ll go in order. Aeronautical tariffs get set every five years and the negotiations for the 2004-2008 period are ongoing right now (resolution by 1/1/04). In conjunction with the discussion on tariffs the levels of required capital spending get set as well. The framework is as follows – ASUR and the government look at a 15 year time frame and take into account passenger traffic projections and capital spending and set the “maximum allowable tariff” which will deliver a required return on capital. The ROI is based on a Mexican risk free rate plus a premium (which will be set in accordance with internationally accepted principles). The last time tariffs were set was in 1998 and they implied a certain level of Cap Ex and 1% annual “real” reductions (i.e. growth in tariffs at a rate of inflation less 1%) in tariffs. What happened since 1998? Mexican risk free rates dropped about 300 bps; passenger traffic has been less than expected and costs have been higher than expected, both due to 9/11. My belief, and ASUR echoes this, is that it is likely that the current tariff regime, i.e. 1% real reductions in tariffs per annum, will be maintained, for 2004-2008. This renegotiation is currently the biggest issue overhanging the Company. What’s the worst case scenario? I believe that the government has a fairly narrow band of ROIs to work with and the worst case, in my opinion, is that tariffs will be reduced by 3-4% in 2004 and at 1% thereafter (which by the way will also likely reduce the required capital spending down the road). Could the Mexican government “screw everyone” and do something outlandish? (The only reason they would want to do that is to help the Mexican airlines which are in bad shape and in which they are a major shareholder). While theoretically it is not out of the realm of possibility, here is why I don’t think they’ll deviate from what was set out in the privatization documents:
- There are 3 more airport groups awaiting IPOs including Mexico City which is a mess - operating at close 100% capacity and needs major renovations or, more likely, could require several billion dollars in capital for a greenfield airport. The government doesn’t have the money to spend and, moreover, wants to receive top dollar for the assets. As such, I don’t think they will jeopardize this by screwing ASUR and its shareholders.
- Breaching the privatization guidelines that were set up 5 years ago would destroy the credibility of the Fox administration with foreign investors and will impact the flow of foreign capital into Mexico – the last thing they want given the current economic situation.
- Airport fees represent a very small portion of airline costs (less than 3%) and even a 10% reduction would not accomplish anything economically.
- ASUR’s rates are very comparable if not cheaper than other airports around the world – The Transport Research Laboratory study that ranked the top 50 airports in the world determined that Mexican airports ranked 31st out of 50 in terms of aeronautical tariffs (in descending order).
- The government is still a shareholder in ASUR (owns 11%) and receives 5% of revenues annually
So, all in all, I believe the risk to ASUR’s shareholders from the tariff renegotiations is very minimal. Now on to taxes. When the Company went public the value of its concession was capitalized on the balance sheet at close to $1 billion to be amortized over the life of the concession for GAAP purposes and 10 years for tax purposes. As a result, the Company doesn’t have any taxable income for tax purposes. In Mexico, companies in these circumstances pay an asset tax which amounts to 1.8% of book value for tax purposes. For ASUR, this amount is roughly 160 million peso or $14.5 million in 2003. Due to the fact that the concession asset is the vast majority of book value and that it is being depreciated over 10 years, it would be fair to expect the asset tax to decline by 7-10% per year. I believe that this is very attractive – pre-tax income growing and taxes dropping! Another important tax consideration, which for now is a big negative is that due to the fact that ASUR is not a current income tax payer, any dividend distributions that it is making are subject to an effective 50% tax (NOTE: All multiples of FCF cited so far deduct this from FCF). This situation in Mexico is unprecedented and the Company has submitted a request for a ruling from the tax authorities essentially requesting to offset the asset taxes against taxes on dividends. This ruling is expected within the next several months. In our numbers we have assumed that the current situation persists even though there is a good chance that the Company gets a favorable ruling (this would enhance the value of the business by $2-3 per share at least).
Finally, while we’re on the subject of valuation, all private market transactions in the airport business took place at unbelievable valuations. The latest one was the 100-year Sydney airport concession which went for 15x EBITDA (happened after 9/11). Even if one assumes that EBITDA was very depressed, it is still one heck of a multiple. I never believed in relative value, but nevertheless, I felt the above was worth noting.
Risks / Issues / Negatives
So why is ASUR cheap? Is this too good to be true? Obviously 9/11 impacted the company as it did every travel-related business – their passenger traffic dropped (although cumulatively it dropped only 4%) and their insurance and security costs went up (ASUR had to obtain a $50 million terrorist insurance policy). Aside from that here are the major risks / negatives / issues and how they impact the story. I believe that one can get very comfortable with most of them and a few of them will get resolved in the very near term.
- Renegotiation of aeronautical tariffs – addressed above
- Exposure to the Mexican Peso. What happens in the event of another Tequila Crisis? This is definitely an issue, but it is worth considering that the Company’s tariff structure allows to pass inflation on every 6 months (post a devaluation, inflation would spike). In addition, a lower peso makes Cancun more attractive to locals versus going abroad and to foreigners. In fact during the Tequila Crisis traffic didn’t drop initially and proceeded to grow at above average rates for several years thereafter.
- Disputes with Mexican airlines – Since June of last year Mexican airlines have been unwilling to pay inflation-related step-ups in aeronautical fees to ASUR (now a $1.0 million receivable). Having not been able to come to a resolution, in 2003 the airlines filed a lawsuit against the Company asking for the government to revoke its concession. The airlines have been applying this pressure on all Mexican airport groups. Other airports have reportedly granted 10-15% discounts to airlines on landing fees. ASUR has recently intensified efforts to put the airline dispute behind them. I believe that they will end up giving the airlines the same discounts as the other airports did. However, counter to what one might think, this will not have an impact on ASUR’s “maximum allowable tariff” per passenger (and hence revenues). Here’s why. As I stated earlier aeronautical tariffs are comprised of passenger fees (75%) and landing fees (25%), and a reduction in landing fees will simply be substituted with an increase in the passenger fees. The result will be simply that the airlines will be able to pass more of the total airport fees to the passengers. This dispute should be resolved by yearend and will demonstrate to the investors that there is no major economic risk.
- Disputes with former licensees – This is now resolved. Some of the old duty free operators (pre-privatization) refused to vacate their premises and made the ramp-up of commercial revenues process difficult. This hung like a dark cloud over the Company for 2 years. In June of this year, however, ASUR was able to kick these people out and has already opened additional food court and duty free outlets which will add to the Company commercial revenue stream.
- Squandering cash – addressed above.
- Tax leakage on dividends – we assumed that the resolution of this will be negative.
- ASUR CEO resigned in June (although it is our firm belief that he was let go). Currently a representative of Copenhagen Airport is acting CEO (he moved to Mexico until a permanent replacement is found). We don’t view this as a major risk.
- Opening up of Cuba – this is a very long-term threat. Once Castro dies Cuba might become a competitive threat to Cancun. However, I believe that it’s going to take more than 10-15 years to build Cuba’s infrastructure to be able to attract significant numbers of tourists.
We got comfortable with all of the above issues and believe that once the aeronautical tariffs are renegotiated and the airline disputes are settled, the beauty of ASUR’s growing cash generative business will be fully appreciated. If you talk to the Company’s CFO, Adolfo Castro, you will find that ASUR is very balanced, forthcoming with information and non-promotional.
1. Renegotiation of the aeronautical tariff structure by 12/31/03
2. Resolution of disputes with Mexican airlines by 12/31/03
3. Elimination of punitive double taxation of dividends
4. Increasing the payout in 2004
5. Hiring the new CEO