Monopoly Business Taking Off Amid Secular Growth Tailwinds

My Objectives for an Investment in PAC Stock

I’ve conducted a deep dive into Grupo Aeroportuario del Pacifico’s (PAC) business as part of my buildout of The Prime Portfolio. Grupo Aeroportuario del Pacifico is Spanish for “Airport Group of the Pacific,” which I’ll refer to as GAP. GAP is the most recent addition to my focused portfolio strategy. As background, I’ve committed to building a transparent portfolio from the ground up and in public view. The objective is to build a collection of my highest conviction holdings in a concentrated portfolio of 8 to 12 stocks.

To build out the portfolio, I’m interested in high quality companies trading at reasonable prices with respect to the strength of their business franchise and future return potential. Since I subscribe to Warren Buffett’s adage that “time is the friend of the wonderful business,” I’ll be targeting long investment holding periods with portfolio turnover of 10% to 20% or less. Consistent with these objectives, my goal is to identify businesses which possess enduring competitive advantages and reinvestment opportunities that will be sufficient to compound their intrinsic value over a long time horizon.

How I Think About GAP

Before making an addition to The Prime Portfolio, I ask four questions, which are inspired by Warren Buffett, but which I expect to apply according to my own unique investing style:

  1.  Is the business simple and understandable?
  2.  Is the business a franchise?
  3.  What are the business’ prospects 10 to 20 years into the future?
  4.  Are its profits regulated?

Although they can sometimes provide important clues about the future trajectory of a business, I’m less focused on quarterly earnings reports and temporary periods of undervaluation and overvaluation, and more interested in strategic developments that could strengthen or weaken the position of the business based on these four metrics. With that in mind, let’s begin the analysis.

Is GAP’s Business Simple and Understandable?

For anyone who’s traveled by air, GAP’s business should be very easy to conceptualize. In its simplest form GAP is essentially a toll collector that generates fees from the numerous activities conducted within its airport facilities. In this sense, GAP is similar to my other Prime Portfolio selection Visa (V), which is a toll collector on world commerce. GAP, by contrast, is a toll collector on Mexican travel and the related economic activity within its properties.

Under this toll collector business model, GAP derives revenue from two key sources: (1) Aeronautical Services and (2) Non-Aeronautical Services. Aeronautical services are made up primarily of fees collected for the number of departing passengers, which are charged by airlines and remitted to GAP's airport. Passenger charges alone make up approximately 85% to 87% of aeronautical services revenue.

Other aeronautical services include aircraft landing charges, aircraft parking, airport security, passenger walkways, leasing of space to airlines, and other complementary services. These additional revenues are from charges to airlines for use of the airport’s resources.

Non-aeronautical services make up approximately 22-24% of total revenue and are derived from leasing of space to service providers, retail stores, restaurants and bars, car rentals, financial services (such as currency exchange), parking facilities, advertising, and others. Some of these services are operated directly by the airport, while others are part of leasing revenue. In this part of the business, GAP is collecting its share of all economic activity conducted within its airports that isn’t directly related to flights.

Out of the company’s cash flows, GAP maintains a generous dividend policy which is a base annual payment plus any retained amount in excess of the company’s minimum cash balance required to cover necessary expenses and investments. This means that it regularly pays special dividends and, by my calculations, its yield has ranged from 2.6% to 7.2% (median of 4.0%) in the last five years as measured against its year-end stock price. This gross dividend yield is subject to a 10% withholding tax.

Now that we know GAP’s basic business model, what characteristics does it possess that could lead it to consistently improving performance over the long term?

Is GAP’s Business a Franchise?

A franchise business is one that is needed or desired and that has no close substitute. The unique aspect of the airport industry is that each individual airport serves as a natural monopoly with respect to the geographic area it serves. GAP serves both business (need-based) and travel (desire-based) passengers. Although there is some competition for method of travel, air travel is a necessity for some and a more practical option for others.

For instance, while Mexican travelers using bus transportation greatly exceed those using air travel, air travel has made steady gains, is far more time efficient, and has now become less expensive than bus transportation along many key routes in Mexico. We’ll explore this dynamic later, but for now just note that air travel is an entrenched industry with natural competitive advantages for airport operators. And while the relative preference for one tourist destination over another may vary from time to time, Mexico is in high demand among tourists and GAP’s diverse collection of airports in heavily-trafficked destinations insulates it against declining popularity of any single one of its airports.

For example, GAP’s owns 13 airports, all of which are located in Mexico except the recently-acquired Montego Bay airport in Jamaica. GAP’s airports serve a blend of business, leisure, and tourist travelers, with 49% of traffic in metropolitan areas, 15% midsized cities, and 36% tourist destinations. The airport’s traffic is 57% domestic and 43% international.

The company owns 5 of the country’s top 10 airports by passenger traffic, including Guadalajara, Tijuana, and popular tourist destinations of Los Cabos and Puerto Vallarta. The full list of top Mexican airports is shown in the image below, with GAP’s airports highlighted.

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In total, GAP serves approximately one-fourth of all Mexican air travel, and approximately three-fourths of Jamaica’s. The quality of GAP’s business model is evident in results of the company’s operations. The operating margin has ranged from 45% to 50% in the past 4 years. As much as 40% of revenue drops to the bottom line. And the company also boasts an EBITDA margin ranging from 59% to 66% over the past four years, and it converts 50% to 60% of revenue into operating cash flow.

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The monopolistic business model, strong margins, and improving returns make GAP’s business a solid franchise, in my opinion, and one with the potential to strengthen over time on the back of long-term growth tailwinds that could develop over the next 10-to-20-year timeframe.

What are GAP’s Prospects 10 to 20 Years Into the Future?

GAP is positioned well for emerging trends. Mexican air travel is expected to be a secular growth industry for the foreseeable future. In the 20 years from 2015 to 2035, Mexican air traffic is expected to achieve a 4.6% cumulative annual growth (CAGR) rate according to an Airbus forecast. This is following a similar CAGR of 4.5% from 1999 to 2017.

There are several factors driving this growth. Among them are a growing manufacturing base, a shift from bus to air transportation, and new U.S.-Mexico aviation guidelines. With respect to GAP in particular, it expects to benefit from these external trends as well as internal factors of Tijuana’s new cross-border exchange bridge and terminal expansions. All of these factors can contribute to a successful expansion of GAP’s business for years into the future. Let’s examine each one in sequence:

Growing Manufacturing Base

The Motley Fool describes the Mexican economy as one that's growing as a result of its strong manufacturing sector, and explains that Aguascalientes, Guanajuato, and Guadalajara are becoming important economic hubs.  In a Seeking Alpha article, Ian Bezek discusses how Hermosillo, which is another GAP airport location, is a booming industrial center and is even trying to pull foreign investment from China. This is possible because Mexico’s labor costs have declined to be 20% lower than China’s as of 2015, in stark contrast to the turn of the century when they were 58% higher.

Mexico Aviation & Aerospace Review explains that Mexico’s free trade agreements, quality workforce, and its proximity to the U.S. have led Mexico’s rise as a world industrial force, and the country has grown its GDP to be the 16th largest in the world.  It also writes that, “A vast majority of foreign companies are expecting to export to the U.S. by using Mexico as a logistics platform.” Mexico’s short distance from the U.S. also allows for lower transportation costs and gives Mexico access to the world’s largest consumer economy.

Shift from Bus to Air Travel

A second aspect affecting the long-term prospects of GAP is the secular shift from bus to air transportation. The air travel industry in Mexico is far from mature. The U.S. market features 8 times more passenger traffic per capita than Mexico, and the Brazilian and Chilean markets reach 2 times great air travel per capita. Contributing to the disparity is the large volume of bus travelers who have not yet shifted to air transportation. Morningstar notes that air travel is expected to gain prominence as rising incomes will allow travelers to elect for the convenience and time saving attributes of airlines relative to buses.

And with the rise of low cost carriers like Volaris (VLRS) in the Mexican airline industry, the cost of flights has become even more competitive than the inferior method of bus travel. A recent Wall Street Journal study found that discount airlines were not only less costly than large airlines, but also a better value than traveling by bus. This was true for popular city-to-city routes in Latin American countries including Mexico. As an example, the trip from Mexico City to Reynosa: $78.50 and 12 hours by bus versus $45 and 1 ½ hours with a discount airline.

Upon learning this, it’s easy to see the major value proposition that low-cost carriers have over bus companies. And while this may be difficult to relate to given the prevailing methods of travel in America, these findings are no small matter. According to Volaris’ Chief Commercial Officer Holger Blankenstein, as quoted in a 2016 article: “the bus market is 100 times bigger than the air market.” As of 2006, Mexico’s domestic air market was 22 million passengers compared to 2.8 billion bus passengers annually. Even after approximately doubling the number of air passengers since then, with 96 bus passengers for every air traveler, there’s still plenty of opportunity to convert more travelers to air. As more and more travelers learn of the convenience, reduced time, and lower costs provided by air travel, this continuing shift stands to move air traffic meaningfully higher in Mexico in future years.

New U.S.-Mexico Aviation Agreement

A recent loosening in regulations of cross-border air traffic between the U.S. and Mexico is another possible driver of future growth. A Moody’s forecast predicts expansion of Mexican airports as a result. Robert Mann, president of RW Mann & Co., explained the development this way:

“What’s happened in Mexico, just as of last month, there is an open skies agreement between the two countries so there are no longer any restrictions in terms of number of markets or frequencies (of flights) that can be served.  It’s causing quite a bit of new service in the market.”

Volaris, the highest-traffic airline at GAP’s airports, has begun offering more cross-border flights from larger cities (like New York) and smaller ones (like Cleveland) as a result. The new aviation agreement is one more tailwind that could benefit GAP’s business.

Tijuana-San Diego Cross-Border Exchange Bridge

Another factor working in favor of the company is the newly-opened Tijuana-San Diego cross-border bridge. Per an excellent article by Ian Bezek on Seeking Alpha, the cross-border bridge makes possible the following:

“Ticketed passengers can now land in Tijuana, walk within contained airport facilities to the U.S., and exit customs there.”

Bezek emphasizes the significance of this by explaining that the feature allows travelers to bypass San Diego’s capacity constraints. San Diego is one of the busiest single-runway airports in the world.

A GAP investor presentation reiterates this view:

“A Third of Tijuana’s growth is due to CBX.  It offers passengers a new, safe, and efficient option to cross the most transited border in the world, Tijuana, Mexico to San Diego, U.S.A.  It reduces crossing time from 2-3 hours to just 15 minutes.  CBX benefits travelers from several regions, as this airport has domestic connections to several Mexican cities not covered by San Diego or Los Angeles airports.”

The cross-border bridge should continue to increase demand at Tijuana’s airport where traffic grew 30% in 2016 and 16% through June 2017.

Terminal Expansions

Morningstar notes that a terminal expansions can increase capacity by several million passengers. GAP has undertaken recent expansions to increase Guadalajara’s square footage by 25% and boarding gates by 40%, and to grow Tijuana’s square footage by 57% and capacity by 9 million passengers. The Tijuana reconfiguration is the largest in the airport’s history, and includes new master contracts for retail, food, and beverage vendors. The effects of these expansions should impact operations in 2018, and should aid management in reaching its goal of deriving a larger portion of revenue from commercial activities (vs. aeronautical revenue) which is in line with the results obtained by other leading private airports.

Are GAP’s Profits Regulated?

Although an ideal investment won’t be affected significantly by government regulation or intervention, GAP can’t quite check off this box. The company’s relationship with the Mexican government is both symbiotic and potentially detrimental.

To begin with, the reason GAP owns its 12 Mexican airports in the first place is only because of the concessions made available by the government when it initially privatized the airports. In one respect, this is a positive as it gives GAP license to operate as a natural monopoly with respect to its geographic areas. The downside is that if the government ever revoked these concessions, it’s possible that GAP could lose the right to operate the business altogether. That’s not an expected outcome, however, and GAP currently has concession rights for 31 more years through 2048.

Although GAP operates the airport as a monopoly, its capital expenditures and pricing are regulated. The company submits a Master Development Plan (MDP) that establishes capital spending for each of GAP’s airports, and in turn the Mexican government works with GAP to determine the maximum fees it can charge on its aeronautical operations. So, while GAP operates as a natural monopoly, government regulation prevents it from charging monopoly-like prices on its main services. This dynamic constrains pricing power should management ever need to raise pricing in the future to a level beyond that permitted by the MDP.

Still, the company benefits from growing traffic as it leverages increasing volume against its high fixed cost base, and it also has more flexibility to adjust pricing in its non-aeronautical commercial activities which it has been growing through terminal expansions and reconfigurations as part of management’s strategy to grow that portion of the business.          

It’s certainly true that some risk lives here. Having said that, it’s also true that all investments feature uncertainties. I’m aware of and comfortable with the risks associated with holding PAC stock. But prospective investors should develop an understanding of these risks and decide if they are comfortable with them before making their own decisions to commit any capital.

Additional Risk Factors and Prime Allocation

A weaker peso means that GAP’s profits are translated into U.S. dollars at a lower rate, but it also has a mitigating effect of stimulating tourism as it becomes cheaper for foreign consumers. Currency fluctuations will have impacts on GAP’s business and investment returns. Dividends paid to U.S. investors will also be translated to U.S. dollars at the exchange rate in effect at the time.

Another concern is the aggressive stance President Donald Trump has at times taken against trade with Mexico. Given the high correlation of the Mexican economy with North American trade and its reliance U.S. consumption, GAP would suffer tremendously if the U.S. took action to curtail free trade with Mexico.

An additional risk is the operating leverage inherent in GAP’s business model. Due to a high level of fixed costs and low marginal costs, each additional passenger contributes disproportionately to GAP’s profit when volumes are increasing. We looked at this earlier when examining the 30-40% profit margins and 59-65% EBITDA margins that GAP has produced. This is an extremely powerful dynamic when times are good, leading to profit growth well in excess of revenue growth, but the reverse is true when times are bad and air traffic declines. Lower passenger volumes will have a disproportionately negative effect on profits if the continued secular growth of Mexican air travel fails to materialize or if a major recession were to impact Mexico or North American consumption on which Mexico’s economy largely relies.

Although I’m concerned with these risks, I expect GAP to be a quality holding in the future. Still, I consider its risk profile to be greater than that of another Prime Portfolio holding Visa. Future pullbacks to a more favorable valuation may be an opportunity to average into PAC stock. But as a result of the higher risk profile, I expect to commit less capital to GAP, instead opting to focus the portfolio’s concentration more in Visa and other future holdings of the Prime Portfolio.

As of today, the GAP allocation in The Prime Portfolio stands at 6.7%, with an additional 84% of cash left to deploy. The full portfolio is displayed below.

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Disclosure: Jason Rowland owns shares of PAC and all stocks in both The Prime Portfolio and The Action Portfolio.

Disclaimer: I am not a registered investment advisor. I receive no compensation from any of the companies of which I own shares and of which I write about. The strategies discussed are designed to suit my own investment objectives, not those of any other individual. They are for illustrative and educational purposes, and they are not guaranteed to be effective. It is possible that not all material information will be discussed about each security highlighted on the site.

All investments involve risks. All information on The Virtuous Cycle website is general analysis and my own interpretations of available information. It is neither financial nor investment advice, nor is it a recommendation to buy or sell any security based on an individual's specific investment goals or financial situation. Individuals must do their own due diligence and determine how each investment fits into their own investment and financial plans prior to making their own investment decisions.