Pacifico Calmly Leads Its Market

Of the three publicly traded Mexican airport operators,

According to its government-granted concession, each airport must adhere to regulated fees charged to customers, and rates are adjusted periodically for inflation. The airport operators must comply with the master development plan, which lays out maximum rates and required minimum construction and maintenance expenditures every five years. The expenditures are required to improve infrastructure and flying conditions for passengers and airlines.

In addition to its operations in Mexico, Pacifico in 2015 acquired a 74.5% stake in Desarrollo de Concesiones Aeroportuarias, the entity that holds the concession to operate Sangster International Airport in Montego Bay, Jamaica, until 2033. The airport accounts for roughly 15% of Pacifico’s revenue and represents the company’s only airport outside Mexico. Similar regulations and conditions apply to the airport as maximum rates and a capital development plan are structured with the Jamaican government. Sangster is Jamaica’s primary airport, essentially all passengers are international, and the U.S. dollar is the functional currency, lessening Pacifico’s dependence on the peso. In 2017, the airport served 4.2 million terminal passengers (compared with 36.5 million passengers served in Mexico) with roughly two thirds of those passengers arriving from the United States.

Strong, Stable Competitive Advantage We assign Pacifico a wide economic moat rating and attribute this to two sources: intangible assets and efficient scale. Approximately 95% of all air traffic within Mexico uses 35 airports privatized by the government. Airport operations are split among three publicly traded companies, and the Mexico City International Airport is operated by a separate private entity. Pacifico operates 12 airports and handles approximately one fourth of domestic passengers traveling by air. The concessions established by the government (an intangible asset) limit the possibility for new entrants, and passengers are encouraged to use airports located near their end destination. While ground transportation offers many choices, traveling by air limits the options customers can employ and strengthens the competitive advantage for airport operators.

We do not envision the government eliminating the concession or changing the arrangement in a material fashion. In fact, the government in 2016 hinted at increasing the privatization of the remaining airports (less than 5% of total passengers within the country) to raise additional funds. While we do not believe privatizing the smaller airports will hinder Pacifico’s operations, it does provide a noteworthy signal that the government views the current concession arrangement favorably. Other industries in Mexico are gravitating toward liberalization, and we believe the likelihood for air transportation to move in an opposite direction is small. The concession arrangement has been profitable for the airport operators, and increased passengers and revenue have generated greater concession fees for the government. In 2017, Pacifico paid approximately MXN 950 million to the government in concession fees, and we believe increasing rates and passengers in the future will expand that total. We consider the relationship between the government and airport operators to be solid, as many of the government officials involved in the talks today were in similar positions when the concession was established in 1998. The government officials understand the business model well, and frequent communication with company management strengthens the relationship and helps establish passenger and rate forecasts utilized in the master development plan. Talks between the two begin approximately 18 months before the five-year MDP is put in place and continue throughout each year to understand the incremental increases in regulated rates, inflation, and other metrics influential on the industry.

Efficient scale provides another moat source for the company. Almost the entire makeup of air travel within Mexico is privatized by the government, and there has been a lack of competition outside the main players since the concession was established in 1998. We believe competitors have little incentive to enter the highly capital-intensive and highly regulated market. Constructing an airport entails significant capital outlays to build terminals, runways, and systems for security and transportation. Across the three Mexican airport operators we cover, capital expenditures run between 10% and 25% of sales. Moreover, there is a high degree of asset specificity in the industry, which means exit barriers are high due to low salvage values. These dynamics deter new players from attempting to enter the market.

Excess capacity at each airport and the commoditized services that airports offer to passengers strengthen the efficient scale source. The airport operators have the capability to greatly expand capacity whenever they deem it appropriate, which further dissuades new entrants. Pacifico currently serves approximately 32 million passengers each year, and one terminal expansion at an airport can increase capacity by several million passengers. For example, the Terminal 1 expansion at the Guadalajara airport will expand capacity to roughly 17 million passengers, compared with 12.8 million total passengers (arriving and departing) in 2017. Guadalajara is Pacifico’s only airport that has more than one functioning runway, and adding or restructuring runways to increase capacity is plausible; thus we do not believe the airports are stretched for capacity or will have difficulty matching demand.

Airports and services offered are fairly commoditized, and potential entrants would be limited to competing on price in an attempt to steal market share. The airport serves as an intermediary to help the passenger arrive at another destination and is not an end destination. Air transportation, whether for business or pleasure, is likely to go through the airport with the nearest proximity to the desired destination, and repeat customers are probable if a trip calls for a similar destination. We expect air travel to gain in popularity compared with ground transportation in Mexico as more affluent citizens appreciate the time saving and convenience of flying.

Economically Sensitive Air traffic movements in the region are typically highly correlated with economic growth. As economic growth increases, disposable income rises and boosts air travel. Domestic passenger growth for Pacifico increased at an average annual rate of 5% over 2008-17, while GDP grew roughly 1% annually over the same period. Since the financial crisis in 2008-09, the strengthening economies in Mexico and the U.S. expanded Pacifico's passenger base. However, negative economic growth may lead to decreasing consumer confidence and less travel. During times of negative growth or uncertainty, airports lack options to spur passenger growth. The discretionary nature of air travel, Pacifico's high operating leverage, and the company's exposure to economic growth and/or political events lead to a high uncertainty rating for our valuation.

The company’s performance remains closely linked with U.S. economic conditions because approximately 90% of international passengers in Pacifico’s Mexican airports arrive or depart on flights connected to the U.S., and roughly two thirds of passengers using the Jamaican airport are on flights connecting to the U.S. The financial crisis saw passenger traffic decrease 2% in 2008 and 13% in 2009; revenue remained flat in 2008 and dropped 6% in 2009. Furthermore, with the majority of costs being fixed at the airports, there are not many levers Pacifico can pull to strengthen profitability during times of decreasing traffic. It relies on healthy economies in both the U.S. and Mexico, as well as consumer confidence.

The 2016 U.S. presidential election increased uncertainty surrounding relations between Mexico and the U.S., and raised concerns that deteriorating trade relations would negatively affect Pacifico’s airports. The Mexican National Institute of Statistics and Geography reports that approximately three fourths of Mexico’s exports go to the U.S., so restrictions on trade between the two could negatively affect the company’s operations.

In our view, the company is in a sound financial position and has flexibility for future operations as we forecast it to generate more than MXN 19 billion of free cash flow over the next five years. Total debt of MXN 13 billion compares with MXN 7.7 billion in cash and equivalents at the close of 2017. The company assumed more than MXN 2.9 billion in debt with the Montego Bay acquisition through short- and long-term loans. The debt related to the acquisition is denominated in U.S. dollars, as is approximately half of the firm’s total debt. Devaluation in the peso may increase the cost of debt and increase losses for Pacifico.

An additional MXN 5.2 billion in debt securities matures in 2020, 2021, and 2025, and we do not envision the company struggling to refinance or repay these maturities. Over the past five years, Pacifico has turned roughly 75% of net income into free cash flow as the large proportion of fixed costs in the business model result in excess cash flow with higher passenger numbers. Although the total amount of debt is a significant increase from the 2014 level of MXN 1.7 billion, we think the company’s 0.7 times net debt/EBITDA indicates plenty of financial flexibility, and we would not be alarmed if Pacifico pursued additional acquisitions.

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