Description

Grupo Aeroportuario del Pacifico (PAC-US) is one of three publicly traded managers of Mexican airports. The PAC symbol ADS shares trade on the NYSE. PAC manages thirteen airports in Mexico and Jamaica anchored by the cities of Guadalajara and Tijuana and also the tourist towns of Puerto Vallarta and Los Cabos in Mexico as well as Kingston and Montego Bay in Jamaica. PAC provides exposure to a gradual return of jet travel via an airport with material exposure to leisure travel, a segment which may return faster than business travel. About 30% of passenger traffic through PAC airports is in the tourist destinations mentioned above. An investment in PAC is likely less risky than playing a recovery in jet travel via an airline as the rate PAC charges terminal passengers is set and does not change due to competition which is the case with an airline ticket. Also, unlike jet fuel, the price of which changes constantly, costs for an airport are more stable and predictable.

Using an EV/EBITDA multiple of 13 and my 2023 estimates which assume terminal passengers return to 97% of 2019 levels, I get a fair value of USD$95 for the U.S. traded shares, or about 25% upside from a recent price of $75. The EV/EBITDA multiple over recent years has ranged from 11 to 16.  However, I think my conservative model does not fully account for a faster return to air travel and/or a strengthening of the peso, both of which would add material upside.

I believe both of these potential upside events, more travel sooner and a stronger peso, have roughly even odds of occurring. I own the equity in part due to the belief that the downside is in and that these factors may enhanced upside. For instance, my model and fair value works off 22:1 MXN/USD. Even at 21:1 MXN/USD fair value moves from $95 to $100. The peso closed today at 21.66 and the peso chart is beginning to look like it might break through resistance and strengthen further. We’ll see.

I have not modeled how a faster improvement in travel trends changes fair value, but I believe the potential exists for the desire and, more importantly, the willingness to travel to shift materially out the current fear mode. This could happen rapidly when it occurs sometime over the next 12 months and might start in the next six months. I don’t believe the entire world is going to carry on like this for much longer.

I am working off the assumption that after a northern U.S. cold weather covid wave happens, but turns out to be less spectacular and with fewer deaths than assumed, that a large chunk of the world is going to move on with life. I am assuming a near return to 2019 travel trends in 2023, but that could quickly become a 2022 if covid is perceived to be behind us. This perception might happen in late 2002 and early 2021 and the market would then only be looking to one out year, to 2022 to make this valuation. I admit this could be wrong and if it is wrong, then at least I have not modeled for it. My model does not assume a return to 2019 travel levels until 2024 (it gets close in 2023).

PAC’s management of the 13 Mexican airports is regulated by the government through a 50-year concession expiring in 2048. The agreements require the airport manager spend certain amounts on capex as specified in a 5-year Master Development Plan approved by the government. The most recent plan was approved in late 2019. Similar agreements exist for Jamaica. Between the long runway remaining for the overall concession (to 2048) and the recently approved capex plan, much of the near-term regulatory risk is lessoned or eliminated. Arguably, regulatory risk is now to the upside in the near term as the master plan allows for operators to request a reduction in capex or rise in tariffs if Mexican GDP drops more than 5% in a twelve-month period. Mexican GDP is on track to drop closer to 10% this year and thus there may be some relief forthcoming. The reduction in capex could be significant. However, this is not central to the thesis and it is not in my model at this time.

PAC generates revenues from two sources. Aeronautical revenues are the per passenger amounts paid by the airlines for usage of the airport. Commercial revenues are rents and fees paid by stores, restaurants and service vendors that are located within the airport and on airport grounds. The agreement under which PAC operates is what is known as a ‘dual-till’ arrangement in which regulators only use Aeronautical revenues as an input when setting tariffs. Under this framework, the airport operator is free to manage and maximize commercial (non-aeronautical) revenues to increase company profits. This works out better for PAC shareholders compared the “single-till” alternative in which commercial revenues are factored into rates set by the government. Additionally, tariffs are inflation protected and are adjusted by the government annually to reflect year to year inflation.

VIC member Par03 wrote up the Mexican shares of PAC in August of 2019 (my write up covers the U.S. ADS shares). I refer you to his writeup for a good description of the business, the growth opportunities open to the company prior to pandemic, which should return, and also some of the relevant regulatory matters.

Among those growth opportunities include the addition of a runway at the Guadalajara airport such that it can become a hub for connecting flights and in the process take pressure off the overloaded Mexico City airport. These opportunities will be important in the out-years, but are not the driver at the moment. The driver now is a return return of air travelers within and to Mexico such that the business begins to break even and then begins to claw back towards the previous terminal passenger high water mark set in 2019. In this write up I will spend some extended discussion of pandemic in Mexico and speculate how it may play out through 2020 and how that is likely to impact PAC.

As noted a strengthening peso could be a material source of upside. Also noted is that MXN/USD now trades just under 22. To be conservative my estimates and fair value incorporate a 22:1 peso/dollar. However, at MXN/USD of 21 fair value on my numbers moves to $100. At MXN/USD of 20, fair value on my numbers moves to $108. At MXN/USD of 19 fair value moves to $114. MXN.USD was 18.5 on Feb 19^th, immediately prior to pandemic gathering a head of steam worldwide. From the chart below you can see that peso weakness peaked in April and has stabilized at slightly lower levels in the 22 range. It looks ready to strengthen further.             

Pesos/Dollar, 2-yr chart

Mexico is an oil producing state and crude receipts are key to the stability of the sovereign budget and thus some component of currency strength/weakness is likely driven by the oil price. Oil may have found a floor, but I am not trying to opine on the commodity’s next move. However, the fact that U.S. production has declined precipitously can only be a positive and as we exit pandemic demand for gasoline and jet fuel is only likely to increase.

Currency is also likely to improve as pandemic recedes and economic activity picks back up. But a decline in covid is perhaps even more central to a return of air passenger traffic.

Regarding pandemic in Mexico, August reported covid cases were 23,000 below the amount reported in July, the first month with a monthly decline since the virus began its spread in earnest in the country.  The country is gradually returning states to lower levels of risk and higher levels of activity. See the below links from Mexico Daily News (English).

Coronavirus cases reach 600,000; August total 23,000 lower than July

https://mexiconewsdaily.com/news/coronavirus/coronavirus-cases-reach-600000/

Most states could turn green by October on virus stoplight map: López-Gatell

https://mexiconewsdaily.com/news/coronavirus/most-states-could-turn-green-by-october/

Per Google covid tracking one can see below that cases hit a peak in late July and early August, have decline slightly, and continue to trend at high levels. Deaths (lower chart) have flat-lined at a the high rate reached back in May. Presumably, if cases continue to decline deaths should eventually follow lower.

Mexico Daily Positive Covid Cases (Google: “Mexico covid tracking”)

Mexico Daily Covid Deaths Covid Cases

While I discuss pandemic within the context of the currency, it also serves as a segue into a discussion of both Mexican domestic business and leisure traveler. Obviously, air travel is not resuming until covid dies down. American and Canadian travelers are not returning for winter vacations until they feel safer. One of the Mexican Daily News articles I link to above says Mexican health officials are looking to October to see a more material decline. I suspect covid trends could indeed play out in that manner. This would be just in time for winter high season at PAC’s tourist destination airports of Puerto Vallarta, Cabo and the two in Jamaica.

I believe covid will (effectively) end in Mexico because the country’s approach to dealing with covid has been to follow what was the original plan in the U.S.; namely, to flatten the curve enough so as not to overwhelm the hospitals, when possible to sequester the at-risk (which is absolutely not always possible in Mexico because not everyone has the means), but to then let the virus spread because there isn’t any way to stop it and there is nothing else they can do.

The government has received plenty of criticism, certainly credible complaints can be lodged, but I’m not sure how anyone else could have done much differently given the lack of resources and the reality most of the populations faces. I would add, to Mexican President Obrador’s credit, he didn’t blow out the budget on hand outs.

I believe herd immunity is coming because the masses in Mexico can’t afford to lock down, they live tight inter-generational quarters, and this all conspires to keep the virus spreading. There is no unemployment insurance much less extra pandemic pay that pays one more than they made if they had worked. Finally, if people don’t work, they don’t eat. Many workers even receive a mid-week advance on their weekly pay so they can eat until payday at the end of the week. The country is going back to normal because it has little choice. Now it will continue to the logical conclusion of herd.

Look again at the graph above of the positive covid cases. It reached a high level and stayed there. The curve is different than the curve in most countries. Using that google link provided one can toggle to other countries and compare to get a feel. Some successfully crushed the virus. Others did crush it but it is coming back. The Mexico chart shows cases spiked and have never come down. This is because there was no true lock down. But it has, at least for now, plateaued.

What is exhibited in the chart jives with what we have been experiencing living in Puerto Vallarta. There has been a lockdown in our state of Jalisco, but only for a while and then only somewhat. For example, we continued going to restaurants the entire time. First, we went only to the few restaurants that remained open and with varying degrees of social distancing. Slowly, but soon enough, more restaurants re-opened.

We also noticed that traffic on the streets during the day was consistently trending back towards our unscientific, eye-ball and memory estimation of normal levels. In fact, traffic has long been back to normal. Parking availability on the street is back to normal low-season availability. We were at a sushi restaurant (for locals, not in the tourist area) this weekend and every table was full and there was a line out the door. On the ride home we saw many restaurants filled to capacity. As activity continues to rise, the case count continues to flat line at a high level.

Indeed, covid has spread in our locality, Puerto Vallarta. About two months ago we learned of multiple Mexican nationals having testing positive for covid. These Mexicans confirmed they knew of many others with positive tests. We know of two Mexican nationals who died. One was a very nice man who assisted us with obtaining our Mexican residency cards. He had children. It was really tragic because he was young, though he was quite overweight. About a month ago covid began to hit ex-pats we know. Two of them died, one an acquaintance. He was a very friendly man who was involved in local charity and well known and liked by many ex-pats, we among them. No death from covid is a good thing, but at least this man was over 80. Then, beginning about a month ago, no new news about covid deaths or cases among those we know. Nothing.

More recently – and this is an important anecdote -- we’ve heard that the local hospital where most of the covid treatments occur has also seen a drop off in cases. Through the middle of the summer the reports on the ex-pat Facebook group were of how crazy it was trying to deal with the onslaught of cases. There is an American nurse who is central to this and she was constantly seeking contributions of food and beverages to provide medical workers during and after their shifts. Then, all of sudden we got first reports of the case load dropping and the first hints that the worst has passed.

By December, I argue, Mexico may be well past peak and demonstrably so. I further argue the U.S. may be seeing the North American fall cold weather outbreak beginning to peak and likely with lower death rates similar to that experience during the U.S. summer outbreak in the southern states. We may have vaccine news. Net: there will be reasons to be less scared and probably a desire to take steps to return to normal coupled with a realization that it is time to move on because we need to move on.

A great place to start moving on might be a Mexican (or a Jamaican) vacation, much to PAC’s benefit.

Doesn’t a Mexican vacation in a warm weather paradise is sound particularly inviting after, by this winter, almost a year of lock down by government edict. In places like PV, Cabo and Jamaica one can hang outside by the pool or beach all day, gaze at the ocean in open-air safety. Almost all dining is covid-safer open air. Even most (not all) hotel lobbies are open air. Even many hotel hallways are open air (not all). Seems like a lower risk vacation given the state of the world. Hotel costs (generally in USD) will be lower. Dining and other ancillaries in Mexico cost less than any developed world vacation destination.  Actually, it sounds so good that I may even take myself up on this idea. Oh, wait! I live in Puerto Vallarta full time!  I enjoy this every day! Sweeeeet! I think plenty of vacationers are ready to get back and enjoy it again, too.

Recently, when Delta cut flights in the U.S. for the fall they actually added flights to destinations in Mexico and the Caribbean. This suggest that they are getting some booking uptake or at least believe it is a good bet on where demand may return earlier. I read this week that American added flights as well. This directly benefits PAC if travelers utilize the opportunity.

A return of tourist travel offers a solid foundation for PAC’s passenger trends. Business travel is important, too, and may be slower to return. While I absolutely believe more meetings that involved travel will be conducted via video, I’m still taking the “over” on an eventual return of business travel.

First, I think world-wide there will be a realization that a sale, particularly for large dollar items, is best secured by making an in-person visit and building a relationship via a face-to-face connection.

I believe those who think they can just zoom in from their home office in jacket, tie and underpants while be scooped by competition that will make the effort to get on a plane and get in front of the client. Granted, this will require clients to decide they will accept visits, but this will come. I argue that clients will also want to vet the people they are hiring. There is risk to one’s own job to purchase a product or service without conducting in-person vetting. I argue that once that threshold is crossed, there will be a wave of businesspeople rushing to get on a plane and show their lack of complacency in general and making an effort to best the competition. We’re not there yet, but I believe we will get there.

In addition, while I believe business travel world-wide will begin to crawl back I believe in Mexico it may come even sooner. I confirmed with a lawyer friend of mine in Guadalajara that they are using Zoom for certain meetings. However, he thinks this is less suited to the Mexican culture than in the U.S. People do business face to face. He has already been flying for business trips, but so far less so than in the past. He also told the younger lawyers in his shop to stop working at home and get back in the office. Even though there was less work, he said he didn’t want them home watching Neflix all day. He wanted them in the office doing something, anything useful.

PAC passenger trends have been improving since travel essentially hit full stop in late March and April. The July report of down 62.3%, a number that showed two (technically three) months of improvement got the stock moving.  They report August traffic in the next few days.

PAC Passengers

Month                Change YOY       Internal Management Comments (I translate to English for convenience)

JAN                     +13.1%                “Awsome!”

FEB                      + 17.0%               “We’re brilliant. No one has managed an airport better than us ever… E V E R”

MAR                    -30%                    “Ruh-roh”

APRIL                   -91.5%                “Shit.”

MAY                    -90.7%                “At least we still have our families.”

JUNE                    -76.8%                “Improving. Down only 77%. Actually, not even 77%.”

JULY                     -62.3%                “Ok, maybe we make it through.”

https://www.aeropuertosgap.com.mx/en/traffic-report.html

The strong Jan and Feb trends were enhanced by the addition of the Kingston, Jamaica airport in 2019 Q4. However, in Jan and Feb passengers in only the 13 Mexican airports were up 9.2% and 11.2%. Still strong.

In the near-term I believe the upside driver to the stock is continued improvement in year-over-year terminal passenger trends. During the early fall months I believe there is risk the current improvement stalls until we get to closer to winter high season in the tourist destinations and a few more months pass and Mexico shows more improvement in covid tracking trends which should then begin to benefit business travel.

Compared to 2019, I am assuming combined aeronautical services and non-aeronautical services (which is to say revenues from travelers) is down 39% in 2020 (thus, 2020 over 2019), down 20% in 2021 (thus 2021 over 2019), down ~10% in 2022 (thus 2022 over 2019) and down 7% in 2023 (thus, 2023 compared to 2019).  2021, 2022 and 2023 will grow revenues year over year, but not year over 2019.

I assume EBITDA falls from 9.8B pesos in 2019, to 4.6B in 2020, then 8.2, 8.8 and 9.5 in 2021, 2022 and 2023. Debt continues at the current level of pesos 24.6B. Cash is currently at pesos 15.7b. Cash flow is negative in 2020, slightly negative in 2021, breakeven in 2022 and +4B pesos in 2023.

Holding back cash flow is elevated capex in 2020, 2021 and 2022 before dropping materially in 2023 and 2024 per the mandated master plans. However, I expect the company to negotiate for material reductions in mandated capex as their agreement with the Mexican government allows for should GDP drop more than 5% in any trailing 12-mo period. I suspect there will be significant savings and it is likely that 2021 will ultimately be cash flow positive based on changes to the mandated capex. I do not model for this. I also do not model for the potential for higher tariffs that might come out of any renegotiated agreement.

They have raised cash via debt to cover the capex requirements.the company has peso 24.6b in debt and cash of peso 15.7b.

Below I provide management’s liquidity discussion from the Q2 conference call:

“Our balance sheet has remained strong during the pandemic. We have raised MXN 4.2 billion in the Mexican debt market to better position us to meet the capital expenses commitment for this year and part of the 2021. Combined with funds received through 2 credit lines of MXN 1 billion each, we ended June quarter with a cash balance of MXN 15.7 billion, 55 -- 57% in Mexican pesos and 43% in U.S. dollars.

This amount was higher than expected due to the recovery of some accounts receivable that were not previously forecast. Even with nonimprovements in our cash burn rate and reserving the MXN 4.2 billion for CapEx, this equates to 23 months of liquidity to cover operational expenses, taking in account the refinancing of the short-term debt maturities. This is more than enough to address operating expenses and committed impairment. However, if we need it, we also have the option to raise additional debt.

We closed the quarter with total debt of MXN 24.6 billion, of which 23% of total debt is U.S. dollar-denominated. Coming due next year, we have some maturity payments of $181 million, divided in 2 tranches during January and February, and MXN 2.5 billion due in July. We will analyze the cash position at the end of this year in order to define if we're -- we'll refinance both loans or only the U.S. dollar-denominated debt.

With respect to ratios, the net-debt-to-EBITDA ratio stood at 1.13x at the close of the second quarter. As I have mentioned before, to preserve liquidity during this crisis, we postponed the majority of nonmandatory capital investments. Thus, we will continue only with the projects that began in the first quarter of the year and also those that imply cost savings or boost commercial revenues, specifically ongoing construction works in VIP lounges, parking lots and solar panels over the carports.”

RISKS

Pandemic re-engages with force this fall in Mexico, the U.S., and Canada causing travelers to continue to forgo travel. The economy, which is improving sequentially from the bottom in Q2, rolls back over and experiences a double dip. Mexican currency, which has stabilized, re-weakens and either trends back towards the 24 to the USD it traded at worst earlier this year, or perhaps worse.

Catalyst

A slow and steady return of air travel in PAC’s key markets. Potentially upside from a spike up in travel post covid and also from an improvement in the peso.