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Stock Strategist

Airport Operator Soars Above Competition

GAP's focus on organic growth takes advantage of its wide moat.

 Grupo Aeroportuario del Pacifico (PAC) owns the rights to operate a geographic monopoly of airports in Mexico, allowing it to extract high economic profits from its customers. Our wide Morningstar Economic Moat Rating is based on intangibles (rights given by the Mexican government) and efficient scale (opening nearby airports would probably decrease profits for all parties involved). Within Mexico, 35 airports handle more than 95% of the total traffic. GAP has rights to operate 12 of these airports, which collectively generate around 27% of Mexico's total air passenger traffic. Airlines and their passengers have no other choice but to use GAP's airports for certain destinations such as Guadalajara, Los Cabos, Puerto Vallarta, and Tijuana. These factors allow GAP to earn strong returns on invested capital, excluding the value of the airport concessions that it received "free" from the government. We would not have excluded this item had the company been required to pay the designated amount to receive the concession.

GAP turns more than 50% of revenue into operating cash flow, easily covering the required annual capital expenditures that represent 15%-20% of revenue. The power of its wide moat is evident in the resilience of its margins: During the plunge in travelers from 2007 to 2009, GAP's EBITDA margin narrowed just 200 basis points, to 65% from 67%. The company posted a 68% EBITDA margin for 2013, and we believe that could serve as a ceiling as GAP invests for top-line growth.

The earliest expiration of the current concessions is in 2048. With more than 95% of Mexico's air passenger traffic handled by 35 airports, we believe the granting of new concessions would have minimal impact on GAP's financials. Excluding Mexico City International, the other 34 airports are currently operated by just three companies: GAP, Grupo Aeroportuario del Sureste (ASR), or ASUR, and Grupo Aeroportuario del Centro Norte (OMAB), or OMA.

A piece of legislation was recently introduced in Mexico's lower house of Congress that would add certain conditions to the original concession agreement for railroad operators (a duopoly between Ferromex and Kansas City Southern de Mexico). Our understanding is that Mexico wants to open the rail infrastructure for more users, as it believes the current form limits competition. According to The Economist, the legislation has the backing of President Enrique Pena Nieto and was initiated by the National Steel Chamber. The three additional conditions are tariff regulations as necessary, smooth interchange between the networks, and opening the infrastructure to new competitors. Still, the upper house of Congress may water down the legislation, as Mexico does not want to scare foreign investors by altering a concession partway through.

Could the government alter the concessions it has given to the airports? We believe the likelihood is low because ample competition already exists--Mexico already allows smaller airports to take commercial flights, and airports compete with each other by offering incentives to airlines. Importantly, the process for approving tariffs is completely transparent and part of the five-year master development plan. Recently, ASUR's five-year MDP for 2014-18 was approved with maximum tariffs that will decline around 2%-3%. Furthermore, the Ministry of Communications and Transportation receives an annual fee equal to 5% of EBITDA from the concessioned airports, and these fees would be lower if profitability were to decline. Finally, all three private airport groups have Mexican citizens as part owners, and the political ties should help lower the probability of concession changes.

We See Mid-Single-Digit Passenger Traffic Growth in Mexico
Passenger traffic across Mexico remained nearly stagnant from 2001 to 2009 following rapid increases from low-cost carriers in the middle of the past decade. Following the worldwide recession, traffic rebounded to reach a new high of more than 93 million passengers in 2013. We utilize various methods to forecast passenger traffic growth in Mexico over the coming years. We initially look at the relationship between air trips and GDP per person. Next, we determine fleet growth at the large Mexican airlines. Finally, we look at available seats.

We do not believe there will be great market share shifts among the airport operators over the next five years (from 2009 to 2013, Mexico City International handled around 32% of total traffic, GAP 25%, ASUR 22%, and OMA 15%). However, upside to our projections for the three privatized airport operators exists as Mexico City International Airport's capacity nears saturation, which could lead travelers to look for other airports. Furthermore, international traffic has hovered around the 36% of the total, plus or minus 2%. Therefore, we make Mexico-wide traffic estimates and apply the result to individual operators. Combining the three described methods, we project that mid-single-digit traffic growth is achievable over the next five years.

Passenger Traffic and Year-Over-Year Growth in Mexico

Source: Direccion General de Aeronautica Civil, company reports, Morningstar estimates

Annual Trips and GDP per Capita Should Continue to Rise
Mexico's gross domestic product per capita has grown to more than $8,800 in 2013 from $3,000 in 1995, according to USDA Economic Research Service estimates. GDP per capita should eclipse $10,000 by 2020. Historical experience across many countries shows that annual air trips per capita increases exponentially with higher GDP. Clearly, infrastructure assets are needed to attain these results, and there are many other factors that affect travel, such as population density, country size, air travel rights between countries, and world GDP.

We believe Mexico's annual trips per capita has increased from 0.16 in 1995 to around 0.32 in 2013 and will continue to increase. Still, annual trips per capita were flat during 2000 and 2005 even as GDP per person increased to nearly $8,000 from $5,600. We estimate that Mexico's travelers will experience more than 0.50 trips per year by 2025 when GDP per capita is around $12,800.

Airline Fleet Expected to Increase
Mexico's aircraft fleet actually declined over the past 10 years, as the low-cost carrier entry and subsequent rapid increase in fuel costs led to bankruptcies at many players. The robust rebound of the overall airline industry is remarkable, as passenger traffic has hit new highs even with a smaller fleet, as seats per aircraft have increased somewhat. We use orders and estimated aircraft deliveries to arrive at a forecast for fleet totals in the years to come. Based on our estimates, we believe that the overall fleet will exceed the 2010 total for the first time in 2014. We project fleet growth of 6.7% per year, on average, over the next five years. This is higher than, but consistent with, the mid-single-digit growth in passenger traffic from the estimate of annual trips by GDP per capita.

Mexican Fleet Development and Forecast

Source: Direccion General de Aeronautica Civil, company reports, Morningstar estimates

Airlines Are Increasing Seats per Aircraft
Finally, we compare available seats across the industry in Mexico and provide a view for the next five years. When we look at seat availability statistics since 2001, along with the year-over-year changes, we're surprised at the record passenger traffic in the face of limited seat availability. Seats peaked in 2007, at the peak of the low-cost carrier craze, and declined the next four years, in line with fleet development. However, we believe seats may not hit a new high until sometime in 2016, two years after a new high in the fleet, as Mexicana had many larger aircraft that were taken out of service. We do believe that the number of seats per aircraft will continue to increase, but that the bulk of the aircraft in backlog is single-aisle, and it will take time to add seat capacity to the marketplace. We project average seat capacity to grow more than 8% per year over the next five years, a bit faster than both fleet and the per capita forecasts.

Available Seats for Mexico's Domestic Carriers and Forecast

Source: Direccion General de Aeronautica Civil, company reports, Morningstar estimates

We believe that using the average of the three methods provides a good basis for projecting traffic growth in Mexico for the next five years. Essentially, we think the mid-single-digit forecast is on reasonably firm ground.

Add Inflation to Arrive at Aeronautical Sales
An airport charges each departing passenger a tariff for using its facilities. Additionally, the airport charges airlines for landing, parking, walkways, security, baggage screening fees, and leasing of space for ticketing, among other things. The maximum tariffs are set in accordance with the master development plan filed every five years. The MDP outlines investments that the airport operator will commit to, along with assumptions for traffic, to arrive at expected tariffs the Ministry of Communications and Transportation will allow. Two other factors are applied to the tariff: a reduction for efficiency, currently 0.70%, and adjustment for Mexico's producer price inflation, excluding petroleum. Over the 10 years to 2012, the Mexican PPI excluding petroleum was 4.1%; however, it declined 1.5% in 2013. Our GAP forecasts call for 1% for 2014 and 3% thereafter, based on the historical average and management commentary. Combining the mid-single-digit traffic increase with the positive inflation adjustment, and reducing the value for efficiency, we see aeronautical sales increasing around 8% over the next five years.

Nonaeronautical Sales Remain a Focus to Drive Growth
Airport operators around the world make substantial profit margins from nonaeronautical sales, also called commercial or nonregulated sales. Services include parking facilities, leasing of space, retail stores, food and beverage, car rentals, time-share marketing and sales, duty-free stores, advertising, communications, financial services, and ground transportation. The airport owners decide whether these services will be offered directly or by third parties that will share the economics. At year-end 2012, GAP noted approximately 960 contracts with providers of commercial services, down 9.4% from 1,059 in 2011. We believe GAP is becoming more comfortable with direct operations, which should drive higher revenue growth.

Captive Audience Has Helped Increase Sales
The three private Mexican airport operators have each increased the proportion of sales that come from commercial sales over the past 10 years. The basic logic is sound: Travelers are a captive audience in the terminals or nearby facilities and will pay for convenience. Many travelers spend more on goods during periods of leisure, leading to less sensitivity to the prices of the goods. Furthermore, each of the airport operators continues to try new venues and fine-tune existing revenue areas. For example, OMA operates a hotel at Mexico City International Airport and hopes to open a new one in Monterrey. GAP's success at Los Cabos has reinvigorated terminal updates at other airports, and it will be looking into operating a hotel in Guadalajara.

Nonaeronautical Sales as Percentage of Total for Mexican Airport Operators

Source: Company reports, Morningstar estimates

International Passengers Spend More
We find that airports with more international traffic have more commercial sales per passenger. Looking at the 10 busiest airports excluding Mexico City International, Cancun, Los Cabos, and Puerto Vallarta generate more than 65% of traffic from international travelers and deliver the three highest sales per passenger. We calculate that Cancun's commercial sales per passenger were almost MXN 100 in 2013, but this is only a third of the level at Aeroports de Paris. While not suggesting that MXN 300 per passenger is a near-term target, we believe there is significant room for growth.

Capital Spending on Terminals Will Drive Growth
GAP plans on continuing to allocate capital to terminal improvements with the goal of recreating the success at Los Cabos, where terminal improvements led commercial sales per passenger to increase to MXN 99 in 2013 from MXN 69 in 2011. Guadalajara is adding new gates and baggage carousels and more immigration counters. This will leave travelers more time to browse--and spend--at the commercial sites in the terminal. The cross-border facility in Tijuana will drive international traffic higher (it's only 0.5% of the total now) and is set to open operations in mid-2015.

We believe the spread between traffic growth and nonaeronautical sales provides a reasonable check for our growth estimates. From 2007 through 2013, the spread averaged 9.1%, meaning that commercial sales were higher by that level. The smallest spread was in 2010 (essentially none). For the next five years, we forecast that spread to be 5.7% (passenger growth of 6.3% and commercial sales growth of 12%, on average).

GAP's Our Favorite
We prefer GAP to competitors ASUR and OMA. ASUR relies heavily on Cancun for more than three fourths of its sales. It has invested in a 50/50 joint venture that operates Luis Munoz Marin International Airport in Puerto Rico to drive profits. OMA operates the greatest number of airports in Mexico, but many of its airports see little traffic. This higher level of fixed costs with lower revenue damps returns on invested capital.

Neal Dihora does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.