Apr 2020: Aena – Toll roads for 50 cents

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Aena – Toll roads for 50 cents

Apr 2020 (€112)

 

“The time to buy a road toll is when there is no one using it”

We feel no need to explain the toll-road business model or its attraction as an investment. Collecting money, as a monopolist with very little daily effort, is as close to a ‘money tree’ as we are ever likely to find. The attraction of this model means that many such companies are almost always highly valued due to their predictable growth and prodigious cash generation…almost always. One of your authors was analysing airports, and their road toll characteristics, a mere 25years ago; We conclude in this piece that in the last two and half decades there has never been a better time to buy shares in an airport operator than in 2020. You can put us down as buyers of them all, but our focus and preferred picks are Spain’s Aena and China’s Beijing Capital International Airport (BCIA).

What did you do yesterday?

Last week we took a break from balance sheet stress testing and daily Government briefings to read the annual report of Aena (monopoly owner of all airports in Spain and the Balearics). After that we poured ourselves a strong coffee and read DORA. For those of you stuck at home with young children this is not a story about an adventurous 7-year-old with a backpack, but the regulatory accounts/regime of Aena for the period 2017-2021. As with all regulated companies this is an area critical to understand. We will not yet claim to be Aena regulatory experts, but we like much of what we found and see the shares as very cheap. In addition, we have been looking again at Beijing Capital International Airport (BCIA) adding to the knowledge we started building in a piece published in May 2018 (re-attached). Those of you that look for super cheap, hard assets will love Beijing Airport.

Aena – Reach for bucket not a thimble

For these that know what they seek, this is, to paraphrase Buffett ‘a time for buckets not thimbles’. It is also a time to focus on the analysis needed to assess a company rather than the long-hand write ups. As such we have studied a number of documents related to Aena airports. These we have marked up, highlighting the most relevant areas we think investors should be focused on (see attached). We highlight below the impressive combination of factors that we are pleased to have found in Aena. We then expand a little on regulation.

In Summary, Aena:

• owns all the airports in Spain and on the Balearic islands, so it and its regulator can have a sensible joined up way to think about future planning for capital and expansion on a national scale
• carries c.275m passengers annually
• makes high EBITDA Margins (c.65%)
• has high Free Cash generation
• has low leverage (2.3 x EBITDA) vs. airport peers – many of which have 5x leverage
• has the lowest landing fees in Europe (by a wide margin)
• and the lowest operating costs per passenger (also by a wide margin)
• unlike many other airports in Europe, Aena is not overly reliant on one airline group such as say Swiss or Lufthansa
  • It also has a high exposure to those airlines that are likely to emerge intact and will be strong growers post the Covid-19 crisis (Ryanair, IAG and EasyJet)
  • 158m of its passengers are from low cost carriers (LCC’s)
• is also well positioned in two regards:
  • Spain is a country that attracts the second highest number of visitors globally
  • Spain is also positioned in a geographically advantageous location – i.e. it is a natural westerly transit point for travellers to either North or South America.
• has a sensible and favourable regulatory framework under which it operates
• …and in 2018/9 had an 80% dividend pay-out ratio (current dividend yield = 6.8%)

Prior to Covid-19, Aena shares (when changing hands for €170) traded on an undemanding 11x EV/EBITDA and a PE of 17x. Today at €112 these multiples are 8x and 11x respectively.

Traffic and economic growth

In addition to this note is a variety of documents that will aide readers understanding of this company and the airport industry.

Separately from these there is significant data on this industry (i.e. airlines and airport travel) made available by IATA. If we chose to super-simplify the main findings of almost all IATA studies for the last 30 years, the consistent conclusions would be:

1. That any major set-back that has ever occurred which has significantly reduced global air travel (recessions, 9/11 attacks, Icelandic ash cloud) have all been recovered from and in most cases quite quickly.
   1. See appendix chart showing US Airline travel pre and post September 11^th attacks and 1990 gulf war
   2. Also reference our argument in our recent Perfect Storm research piece – today’s crisis is importantly not about the safeness of flying per se.

Fig.1: GDP vs. Traffic

  Source: DORA

2. That including these periods of severe disruption global airline travel has increased at a rate close to 2x GBP on average globally pa. This correlation is higher in developing countries and lower in developed ones, as the chart above shows. That said the overall correlation with a GDP Plus growth rate is very very well established over multiple decades that includes severe shocks to short term travel

Normalisation or traffic – In reality

In each of our (normal) daily lives we are able to see the truth of this data with us travelling more as our disposable incomes have risen and the cost of air transport has fallen. We can all accept that the world will experience an occasional crisis. But just as inevitable are the seasons that the world continues to enjoy and each of our own (and our children and grandchildren’s) desires to travel to sunnier climes or to enjoy better weather and wider experiences.

Whilst individual airlines and travel companies may fail there will (and has always been) others that take their place. The secular growth of air travel that the IATA data lays out over multiple decades does not occur because of one or two airlines or travel companies promote this growth. It occurs because the global population is growing and is becoming a little wealthier each year and has a little more disposal income. As such this is an industry where there is a constant and secular growth in demand for air travel. The airline suppliers of which may come and go according to the fortunes their operationally geared business models bring. But the airports, i.e. the toll roads these travellers pass through as this secular growth unfolds, remain the same. The only change is that the airports get busier, thus need to invest more in capacity. Also, this greater number of people spend more money whilst passing through these airports. Geographically well-located airports are thus beneficiaries of the secular growth in populations and the secular growth in consumer spending power.

The importance of ‘Dual Till’ regulation

Fully understanding the regulatory regime is crucial to investing in any regulated utility. Each utilities regulation varies slightly, and airports are no different. Simply put airports have aeronautical revenues (landing fees etc.) and retail revenues (Duty Free, bars and parking etc).

Airport Regulation can be ‘single till’ or ‘dual till.’ The former means that the profits the airport makes in its retail operations can be considered as a cross subsidy of the regulated activities of the company. The latter, ‘dual till’, means the two areas of income are looked at separately.

Fig.2: AENA is subject to a ‘Dual Till’ regulatory regime

Source: DORA

The above quote from Aena regulatory regime makes it very clear that Aena’s regulated revenues are designed to compensate the company for providing only its regulated activities. This is an important distinction as Aena earns profitable retail revenues that are thus kept by shareholders.

Our annotated copy of the DORA document is attached. In short, we would highlight:

• Aena has regulatory asset base of c.€10.5bn
• During the 2017-2022 period it is allowed to make a ROCE of 7% (pre-tax) on that RAB
• This equates to €700m-€770m pa expected regulatory profits in the 2017-2022 period

However, two key point we would highlight further:

1. This return is allowed after a deduction of c.€600m of depreciation/amortisation (non-cash)
2. The group is required to spend c.€450m pa in capex over this period
3. The regulatory outlook in 2017 used RAB/costs of capital growth and other projections to throw out the reduction in revenue per passenger Aena had to pass on during this 5-year period. In 2017-22 this was a reduction of 2.22% pa

Regulation summary

The simple way to look at the regulation of this group is that they are being allowed to make a 7% return on a €10.5bn capital base, i.e. €700-€750m. The pre-tax cash they would generate from this is: €730m + €600m – €450m = €880m (i.e. adding back depreciation and taking off capex).

There are adjustments due to future actual passenger growth which can mean the group exceeds such earnings, but for now we will leave our regulatory outline there.

The most important thing about Aena regulation is that it: a) gives the group complete certainty in the returns it will make on these regulated activates and b) under the ‘dual till’ method it leaves the balance of the business profits that are derived from its retail activities untouched. When the non-regulated part of your business generates €1.3bn of revenue and an 85% EBITDA margins that is quite an important assurance.

The blend

The result of these two activities assessed together produces the following:

• Aena group EBITDA margin of 65%
• Aena ROE in 2015-2019 of 22-23%

What is actually occurring here is the blend of two of Buffett’s favourite business models:

• The Compounder: i.e. the utility part of the business that will in time spend more than depreciation, hence growing it RAB, but in doing so will receive a guaranteed return on that capital:
  • Whilst that return is only a 7% pre-tax level it should be remembered that this is at the capital employed level
  • The regulator does not stipulate the leverage that the company can chose to take or sustain, (currently it is 2.3x EBITDA and way below peer levels). Hence any ROE would result in a higher return than that reported at the ROCE/RAB line.
• The Dream: The retail/duty free business is a growing asset-light business that is using the assets of the airport to operate. But the high demand for its services, whether conducted in house or outsourced, ensure that they are very profitable. Particularly in Aena’s case when a captive/spend hungry 275m people pass by their services on a 24/7 basis. We will not try to calculate a RoE for such a segment, but with low assets and EBITDA margins of 85% we feel pretty comfortable stating that it is likely =/>100%

But one could not exist without the other, hence as investors we are presented with the offer to invest in the blended business. Most simply put today you are being offered that blend of two businesses with secular growth and a guaranteed regulatory return earned from world class well-invested assets. But one with a dream, high growth high return business attached. The RoE that Aena reports at a group level is thus instructive of what is on offer (5-year average of 23%).

That investors in December were happy to pay 11x EBITDA and a PE of 17x for such a business we do not find surprising. But todays investors if they are prepared to buy the same business while it has almost no one passing through the toll road get it for a mere 11x PE.

A word on Covid-19 and ‘Time Arbitrage’

We have spent little of this report trying to quantify the effects of Covid-19. The attraction of assets of this nature during a crisis is their longevity and thus only limited damage will likely be done to the equity value of the business during even a protracted period of shut down.

This stems from two factors. The first is a prudent capital structure meaning that even if sizable losses were to amount these are affordable without any new equity being required. The second is the fact that the asset heavy and high margin nature of the business means that it is quite hard for it to be loss making for long. Aena’s pre-deprecation costs are only 18% of commercial revenues and only 44% of Aeronautical revenue. In addition, we know that c.25% of total costs are staff (many of which currently qualify for the Government furlough type schemes). A second significant cost will be utilities which can to an extent be managed with passenger throughput. Such a business would seem highly unlikely to make losses during a full financial year we suggest, even one as unusual as 2020. As such the capital structure, regulation and assets controlled by the group will be largely unchanged ahead of a 2021 traffic recovery.

If this 2020 vs. 2021 dichotomy represents a ‘Time-Arbitrage’, Aena arguably also has a longer- term time arbitrage opportunity too. Analysts keen to see it maximise its equity value occasionally ask management about the uses of the group’s balance sheet, i.e. can you lever up, as other airports have done to improve your equity return vs. your regulated one? Management’s answer to this is instructive. They realise (and admit) that they are not efficiently structured, but also highlight that due to the Spanish Government’s stake in the company there is no desire to make a re-levering move. The analyst’s response seems to be a shrug and a “move along – nothing to see here”. However, management then speaks to its ability to invest in a country like Brazil using its balance sheet to do so. This is allowed under its regulatory regime and in effect is the company using its under-leverage to grow a further revenue stream. Clearly it is important that this capital is invested wisely but so far; we are comforted by the focused approach they have taken to this expansion.

Beijing Capital Airport (694 HK): Find an even bigger bucket..?

Those wanting to understand our view on Beijing airport and a little background as to what is taking place in the airport capacity of this global city should first read our short piece published in May 2018. It is re-attached.

This airport is partly owned by the Chinese state but has been listed since 1999. Until this year it was the world’s second largest airport by passenger numbers with 100m passing through it each year (only Atlanta is bigger). Its share price has been falling for a number of years due to the 2019 opening of a new airport built in Beijing (Daxing airport) that is taking some of BCIA’s traffic away. This was all known and underway well before Coronavirus hit.

Before stating our view that this could be a significantly undervalued asset, we acknowledge the points of risk:

• That the regulatory framework surrounding this company is much less clear than say for Aena
• That central planning for future required infrastructure will be considered by the Chinese state far more important than BCIA’s shorter term profitability we will take as given

The ‘bull’ case on BCIA

We have done a lot of reading on and around this company but will just give the bare bones of why this might be an outstanding investment. Those that want to know more can discuss it with us:

• Today BCIA has almost no gearing, a very unusual state for a global airport company
• Even without gearing it equity only valuation is super cheap
  • It trades at an EV/BITDA of 4.2x the profits it made in December 2018
  • It trades at an PE of 7.5x the profits it made in December 2018

In December 2018 BCIA had 100m passengers. As 2020 evolves some 30-40% of those passengers are being moved to the new Daxing airport thus reducing BCIA’s profits. However, as we observed in our original note a few interesting more favourable trends will then start to occur:

• BCIA is closer to the city centre than the new airport. It will thus most likely remain the main hub for international and business traffic (and crucially, Air China the flag carrier is remaining and expanding its base at BCIA)
• The capacity of both airports in now such that Beijing’s wider travel market can now grow again as both airports have capacity
  • Indeed, late last year Beijing doubled its it traffic capacity with immediate effect. This was logical and always likely to us, but it came as a relief to some who were worried (illogically we suggest) that the two airports would compete for existing slots
• BCIA will then be in the enviable position of having a capacity of >100m but throughput of maybe only 60m
  • As a result, many years of coming organic growth will come at minimal incremental capital cost
  • With airports having significant deprecation charges this creates a period where the groups cashflow will be way in excess of reported profits
• Additionally, the retail spending opportunity at BCIA is huge:
  • In the past the airport has been underdeveloped in its retail offering
  • But development in recent years have seen it make much greater investment
  • This has resulted in far more favourable contracts (announced in 2018) with Duty Free providers

Strong GDP growth – the perfect hill for an airport snowball

Fig.1 earlier showed IATA traffic growth correlated with country GDP growth. Unsurprisingly this suggests that air transport growth in China will grow at a high rate for many years into the future. Just a ratio of 2x GDP might yield a 10% pa growth rate. At such a prevailing rate an airport that in 2020 carried say 65m passengers would in 4-5 years once again be transporting 100m passengers. However, at the same time as this nominal passenger number growth each of those passengers will have far greater spending power. Unsurprisingly the airport is now aggressively developing its retail offering to take advantage of this coming demand. This comes on top of the starting fact that Chinese travellers are already the biggest global spenders when it comes to travel and duty-free purchasing. All this has not been lost on the Chinese state as it has resulted in them looking at ways to bring more of that spending back to China rather than it occurring elsewhere in the world.

Our work on Aena and other airports is interesting to use as a yardstick. Aena has a blended (i.e. regulated and retail) EBITDA margin of 65%. In the December 2018 figures for Beijing Airport we used above BCIA made an EBITDA margin of c.48%.

Roughly right will do: A 3-5x bagger?

For now, we will make do with a guesstimate as to the future earnings power of this businesses. That guess is for a future when 100m passengers (maybe in the year 2025 or 2026) will once again pass through Beijing Capital Airport. They will generate more revenue (say 30%) than they did in 2018. Also, that such activities will be more profitable producing a margin of say 60% rather than the past 48%.

If so, such an assumption would result in an EBITDA of c.$1,325m. We remind readers that today’s EV of BCIA (all equity) is US$3,512m at a price of HKD5.4 per share.

For those that want to salivate on the sort of upside such a starting point could result in we attach in the appendix a summary valuation sheet showing the multiples that many airports operators globally trade at, both today and pre-Covid-19. Most peers are way above the starting price of 11x we observed for AENA in December 2019.

What to do with all that money?

BCIA controls a huge airport asset that likely has a replacement cost of >3x its current market cap. It is poised for profitable cash generative growth and will need little investment to facilitate that growth. Oh! and it has no debt. So, what to do with that abundance of riches if we are right and the cash starts to pour in. Some will ask for a dividend bonanza. We note that for the last 20 years this company has paid out 40% of its profits in dividends. Those with a more cynical/defeatist bent will assume the Chinese state will just steal it all.

We would bring to the attention of investors an RNS released by the company on June 28^th 2018. It stated that BCIA has a long-term option to purchase Daxing Airport (price unknown). At this point we should point out that Daxing was built and is operated by the parent state-controlled company that owns the 45% stake in BCIA. Also, this parent company has in the past sold assets down to BCIA, some we believe at cost.

Depending on your point of view this is either state control to a point you cannot tolerate or a clever way to use public money and planning to build (in only 5 years) an asset that a country needed. Then ensuring that such an asset is run by the right entity long term. The role model for this is clearly the Three Gorges Dam project that was government planned and built but then bought (at a fair price most seem to agree) by China Yangtze Power. With recovered traffic and profitability BCIA would be in a strong enough position to make a purchase of Daxing a decade from now.

When considering BCIA’s intrinsic value it is worth knowing the news that Daxing airport with a current capacity of c.45m passengers is said to have cost $15-25bn. We repeat the sign off from our 2018 assessment of BCIA (Current EV $3.5bn): “Sam Zell – where are you?”

The future of capital allocation at BCIA might not be clear, but crucially it might not be anything like as bad as today depressed equity valuation discounts.

Rarity values + Toll Roads

The world loves predictable cash flows. As such franchises, utilities and REITs that are seen as secure longer term are priced keenly off of ever lower bond yields. Airports offer much of these predictable traits also. As such they are often priced keenly too, but not all airports, all the time. Maybe this is due to the fact that this is not a well-known subsector in the US, or maybe it is due to the differing approaches to RAB regulation meaning that great local/regulatory knowledge is required to invest.

Whatever the reason, we know a toll bridge when we see one. 11x EV/BITDA and 17x PE is either a fair price to pay for such a stream of regulated but growing cashflows or a cheap one depending on your interest rate outlook and the price you will pay for stable cash flows. What this level of valuation is not is excessive or overly optimistic. This however was the starting value for Aena when priced at €170 a share last Christmas. With scope to grow its long-term airport capacity with guaranteed regulator returns, but then supplement these with 85% EBITDA margin retail activities we think the company had (indeed, has) room to grow such a valuation, especially as it is able to use its balance sheet to do so.

BCIA value is illustrative that occasionally significant anomalies can get thrown up in global markets. That there are greater uncertainties we will not dispute, and we would very much like spend time with the company to better understand a number of these. However even allowing for heighted risk its unlevered $3.5bn valuation is very unusual and very low against a long list of global benchmarks. (NB The Regulatory asset value of just Heathrow is c.$21bn).

“you make most of your money in a bear market- it just does not feel like it at the time!” Warren Buffett

With best wishes

Andrew Hollingworth & Mark Power

The Directors and employees of Holland Advisors may have a beneficial interest in some of the companies mentioned in this report via holdings in a fund that they also act as advisors to.

Appendix

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