If you like businesses with significant economic moats and effectively unscalable barriers to entry, Grupo Aeroportuario del Pacifico (PAC) or "GAP" as it is commonly known, could be up your alley. GAP holds 50-year concessions to operate, maintain, and develop 12 airports in the Pacific and Central regions of Mexico, including Guadalajara, Los Cabos, Puerto Vallarta, and Tijuana. With traffic on the way up and the company exploring more ways to increase revenue from parking, duty-free operators, and other merchandise/service providers, the revenue outlook is pretty solid.
There are clouds in the sky, though. First, the company's traffic and costs haven't always been the best, and the company has lagged other Mexican airport operators in terms of returns on capital. There is also a serious ongoing squabble among its shareholder base, with the loser potentially looking to sell a large amount of shares. I do see some value in these shares, but a lot of growth and margin improvement already seems to be factored in by the market.
A Ride-Along On Air Traffic Growth In Mexico
Mexico's airports are largely run by publicly-traded companies operating under long-term concessions from the government. Grupo Aeroportuario del Sureste (ASR) operates nine airports in the Southeast (including Cancun, Oaxaca, and Veracruz), Grupo Aeroportuario del Centre Norte (OMAB) runs 13 airports in cities like Monterrey, Acapulco, and Durango, and GAP operates in the aforementioned cities in the Pacific and Central regions. As an aside, the Mexico City International Airport (Benito Juarez International Airport) is run by a separate operator.
These operators generate revenue by charging fees to airlines and passengers for access and use of the airport, as well as rents, fees, and other charges for services like parking and concessions like in-airport restaurants and shops. More than 80% of GAP's revenue comes from passenger charges (charges that added on to the price of air fare), but the Mexican ministry of Communications and Transportation does review and approve maximum tariffs every five years, with decisions being based in part on the company's cost base and capital investment needs.
At a simple level, though, GAP is a play on increasing travel (business, tourism, and personal) to Mexico. The more flights that land or depart from GAP airports, the more fees the company takes in, and likewise with ancillary services like parking, restaurants, and shops - the more traffic through GAP's airports, the more the company can charge in rents and so forth. While GAP's traffic has lagged its peers ASR and OMAB for most of the last few years, traffic has recently improved. Third quarter results saw traffic up more than 11% from the prior year, and the company has continued to report double-digit traffic since then.
More Flights, More Revenue, But Mind The Costs
Guadalajara is the second-largest city in Mexico and generates a little more than one-third of the company's revenue and traffic. Los Cabos is second in importance, accounting for about 20% of revenue and roughly 15% of traffic. By carrier, Volaris and Aeromexio account for more than half of the company's traffic.
Volaris is a fast-growing carrier in Mexico, and Volaris, Interjet, and VivaAerobus (which together represent about 50% of GAP's traffic) are looking to more than double their fleets in the coming years - from just over 100 aircraft to more than 250. Not all of that traffic will necessarily go to GAP's airports, but I think its reasonable to assume that they will get their share. In point of fact, they may get more than their share as capacity restrictions in Mexico City could divert traffic to GAP airports as alternate hubs (particularly Guadalajara).
GAP is also making a concerted effort to drive better non-aeronautical revenue. This category is about one-quarter of the company's revenue base and management has arguably been slow to really maximize its opportunities in areas like parking and business development. At the same time, though, business expenses are a significant factor. GAP saw margin erosion in its latest quarter due to higher legal and business development fees. I'm cautiously optimistic that these expenses are of the "it takes money to make money" variety, but I think it smart to keep an eye on them in the coming quarters.
A Bitter Battle Among The Biggest Owners
One of the more challenging aspects to the GAP story today is arguably outside of management's control. GAP's largest shareholder, Grupo Mexico, is pushing hard to end a contract with an entity called Aeropuertos Mexicanos del Pacifico (AMP) that provides various administrative and technical services. Two of the three owners of AMP are experienced infrastructure operators (including AENA Internacional, one of the largest airport operators in the world), and AMP owns about 17% of the shares of GAP.
I have my suspicions that Grupo Mexico's desire to end this contract is more about a power play for control of the company. Perhaps AMP hasn't been the best service provider for GAP (the company has lagged ASR and OMAB in traffic, profits, and market returns over the past five years), but their services are basically income-neutral as Mexican regulators factor in the cost of the contract (5% of company EBITDA) as part of the tariffs GAP can charge. In other words, if the contract goes away, the tariffs will be revised accordingly.
In any case, Grupo Mexico pushed for a special shareholder meeting to vote to end the contract (51% of shareholders have to support the move), and with 30% of the vote I can see why Grupo Mexico would like its chances. AMP argued that this move was too sudden to allow a proper evaluation of the situation, and GAP agreed, and a court ruling was obtained to suspend the meeting.
Grupo Mexico has expressed its desire in the past to own all of GAP, but its current holding of nearly 30% of GAP is technically in violation of bylaws that limit ownership stakes to 10%. If Grupo Mexico prevails with this contract dispute, I would think the parties owning AMP would have little reason to continue owning the shares, give Grupo Mexico the chance to build its stake to over 50% (assuming they're allowed to maintain a larger than 10% stake). On the flip side, if Grupo Mexico is rebuffed and/or forced to sell down to 10%, 20% of GAP's shares could be on the market more or less all at once.
The Bottom Line
Given the number of aircraft on order from some of its largest airline customers, not to mention the overall growth of Mexico's economy and Latin American air traffic, I like GAP's chances to grow in the coming years. I am looking for long-term free cash flow growth of around 9%, as I believe the company can couple growing traffic-related revenue with more profitable ancillary lines of business and more operating leverage.
The catch is that 9% growth only points to a fair value of about $55 even with a lower-than-normal discount rate. That fair value still suggests that these shares are undervalued, and I do believe the security of multidecade concessions at major Mexican airports merits a lower discount rate. Even so, the valuation here doesn't look like a bargain compared to ASR or OMAB, and the squabbling between the major shareholders could lead to additional litigation and turmoil in the shares. While I like the basic model and long-term prospects for GAP, I'm a little more ambivalent about the shares right now.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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