Airport operator ready for take-off

Corporacion America Airports SA (NYSE: CAAP) is the largest private operator of airports (by number of airports), having a concentration of concessions in Argentina and Latin America. The airport operator has a resilient, utility-like business model with limited competition and high returns through the cycle. The icing is a capable, long-term-oriented controlling shareholder (>80% stake) who is among the wealthiest people in Argentina with a great track record in building value. Airport businesses are rarely for sale, but this one is because of two temporary demand shocks that can’t happen simultaneously at a better time – macroeconomic weakness in Argentina and travel depression related to Covid-19. CAAP generates $280m unlevered FCF relative to $1.4Bn EV. Even using very conservative estimates (5% declined in FCF over 2 years and zero growth in perpetuity), the stock has 80% upside (Target price: $6.70. Current price: $3.70).

CAAP operates 52 airports in 7 countries through government-granted concessions that lasts at least 10 years. CAAP pays “leases” for airports to governments in exchange for the right to collect fees from airlines, passengers, and businesses for their use of airport facilities. Airlines are charged for every take-off, landing, and parking. Passengers are charged fees, which are typically bundled in the cost of air tickets, for the use of airports. Businesses pay for cargo storage, warehouses services, and leases to operate retail stores in airports. By geography, airports based in Latin American accounted for ~90% revenues, in which 60% was from Argentina. By business line, aeronautical revenues contributed 50%, commercial 35%, and construction services 15% of revenues.

Airport operators are recession-resistant businesses that maintain high returns even during economic slowdowns. Argentina has been mired in recession since 2018 (GDP declined by 9% in 2018), yet growth in operating statistics remain strong. Passengers, cargo volume, and aircraft movement showed growth in 2018 (6/5/3% growth respectively). However, it is easy to miss the strong resiliency because revenues showed 15% decline in 2018. The real decline is actually only 0.8%, which supports the resilient picture shown by operating statistics.

Out of the $176m decline in revenue in 2018, $112m was related to the application of IAS 29, an accounting principle required for hyperinflationary economies like Argentina. IAS 29 applies most to companies that receives revenues in Argentinean pesos but reports in other currencies (CAAP reports in USD). Hyperinflation depresses the value of pesos, hence revenues must adjust for the depreciation. However, CAAP receives ~80% revenues in US dollars, so its adjustment for peso depreciation should be much lower than what IAS 29 requires. This means that the nature of the $112m decline was accounting-related, not economic related. Another portion of the decline concerned a $55m decline in construction service revenue, which was really capital expenditures rather than revenue (more on this later). Excluding the two declines, the real decline was $9m (<1% decline), not $176m (15% decline).

The resilient fundamentals were accompanied by ~14-16% returns-on-capital, which were maintained even during recessionary periods. Returns are defined as after-tax adjusted EBITDA minus capex, and capital as the sum of debt and equity. CAAP applies IFRIC 12 like many infrastructure companies, which makes the calculation of ROC more complex. The key point to note in IFRIC 12 is that all investments required by the concession agreement are recognized as revenue, and the actual cost of these investments are recognized as cost. Companies typically do not recognize investments as revenues because investments do no immediately result in revenue. Yet those who apply IFRIC 12 are typically toll-like businesses that can quickly gain revenues from investments. For example, a busy airport may invest in a parking structure that can realize revenue quickly upon completion.

To adjust EBITDA, I treat “construction services cost” as capex (on top of what CAAP already reports as capex) because this is the actual cost of investments, and discount “construction services revenue” to a present value. Going back to the previous example, the airport building the parking structure should only recognize additional revenue from parking fees after the structure is completed, but not before. We can discount future revenues to present by using a factor of 0.5, which roughly corresponds to revenues coming 9 years later and an 8% discount rate (discount factor=1/(1.08)^9=0.5), both of which are conservative estimates considering the low-risk nature of the project. Based on the table below, 2018 adjusted EBITDA should be ~$350m (=445.9-196.3+0.5*198.4) before tax/working capital/reported capex, and not the stated $445.9m. These adjustments, plus tax and working capital changes, result in ROC ranging 14-16% between 2016-18. To achieve 16% ROC in 2018 when the key country reported 9.5% decline in GDP in the same year is formidable, demonstrating a recession-resistant business model.

 $ m2015201620172018
Reported adj EBITDA277427462446
Reported capex-8-10-12-15
Additional capex (Construction services costs)-177-164-249-196
Discounted future revenue (Construction services revenue)898312599
  Discount factor applied0.500.500.500.50
Tax expense-45-56-47-14
Change in working capital (receivables and inventory only)-60-96-79-43
Unlevered FCF76183200277
Interest expense-69-118-115-96
Levered FCF66585181
Total capital1,3231,3091,6871,569
ROC (unlevered FCF/total capital)14%15%16%
ROE (levered FCF/total capital)14%19%39%

(As a side note, ROE was even higher than ROC because of declining tax expenses caused by over-payment. The focus here is on ROC because of significant debt and interest expenses.)

The growth runway in airport fundamentals generally correlate to macroeconomic growth, so it is necessary for CAAP investors to consider the economic growth of Argentina (60% 2018 revenues). As mentioned, Argentina is mired in recession and hyper-inflationary territory. Its debt has been declared unsustainable by the IMF, which lent a record $44Bn to the country. However, the current administration is the first ever in Argentina making credible moves to restore economic growth. It has demonstrated an ambitious start by setting a two-month timeline to restructure $67Bn debt by March 2020 to keep interest expenses manageable for economic growth, and already announced the hiring of advisors in the first week of March. The timeline keeps the administration accountable, and is far more preferable to the mysterious, hostile tactics during the 15-year odyssey of Argentina’s previous default in 2001. For the first time in its history, the country also agreed to Article IV talks that would allow the IMF to inspect Argentina’s accounts before a new agreement is signed, surprising the market because it has almost always been hostile to IMF scrutiny. Article IV talks would assure bondholders as they head into restructuring talks that Argentina is under IMF supervision.

Perhaps the most promising is the appointment of Martin Guzman as finance minister . Guzman has an impressive resume. He is the protégé of Joseph Stiglitz, a Nobel laureate and influential economist. He is a leading expert on sovereign debt policies, and has testified before the US Congress on Puerto Rico’s debt crisis and at the United Nations about the need for a better international system for resolving sovereign debt crises. Most important, he demonstrated a sound understanding of the importance of coordinated policy action and sustained growth, instead of mere monetary tightening, to combat inflation in this op-ed. There is no doubt that Guzman is the best chance for Argentina to get back on sound economic footing.

CAAP is cheap on an absolute basis (I’m not a fan of relative valuation). Assuming no growth and a 10% discount rate, a 3-year DCF results in $2.8Bn EV (~2x current market value). The same DCF produces 140% upside from current price when growth is assumed at 2% (roughly the growth of global GDP, which is a low estimate). Current valuation implies that CAAP shrinks FCF by 9% annually in perpetuity, which is very unlikely given the mission-critical nature of airports, low risks of disruption and substitution, and strong tailwinds in air travel. To allow for the temporary disruption of Covid-19 and recession in Argentina, I assume a 5% decline in FCF per year for the next two years and zero growth in perpetuity, resulting in an ~80% upside from current price.

The target price does not account for upside related to actions from management, which has proven competent for the past 20 years since the founding of CAAP. Management is aligned with shareholders because the founding and managing family owns 82.1% of CAAP while public shareholders own the balance. CEO Martin Eurnekian is the nephew of founder Eduardo Eurnekian, who had a great track record in building value (net worth: $1.5Bn) from diverse business interests in media, energy, infrastructure, and finance as a shrewd entrepreneur. Management transition had been stable without typical family strife with only one CEO transition in the history of the firm. Eduardo had led the company since its founding in 1998, and passed the CEO position to Martin after the IPO. Martin, now 40, had started his first job at CAAP when he was 18, and spent the past 22 years “doing everything one could imagine” at CAAP.

In 2020, it is irresponsible to discuss a travel-related business without thinking about disruptions from Covid-19. The virus, about 5-10x more contagious than seasonal influenza, has almost reached the proportions of a global pandemic. Experts estimate the mortality rate to be ~1% or lower (the current rate announced by the WHO is 3.4%. This is too high because it is based on backward-looking data). I cannot offer more insights concerning the virus. What I can do is offer some extent of clarity based on current facts:

-Covid-19 is infectious but not deadly to most people. This means that most of us (about 90%) can resist the virus. This also means that Covid-19 does not constitute an end-of-the-world-as-we-know-it event.

-A vaccine is possible. Estimated time to production varies from one to two years. What is important to know is that the human race has her best minds working on this day and night. Betting against the human race (ie shorting the market thinking that the virus would destroy the global economy) is unwise.

-Every government and central bank is ready to unleash significant monetary and fiscal stimulus to combat the impact of the virus. Betting against the Fed, ECB, and their peers is foolish.

-The world seems to be over-reacting with mass quarantines, but over-reaction is better than under-reaction. China under-reacted at first by suppressing information about the virus, then the country over-reacted by placing 50 million citizens in mandatory quarantine. It worked – the growth of new cases stalled. Italy under-reacted at first too, then over-reacted by enforcing quarantines and travel restrictions on the entire country. The US over-reacted in a different way by having the Fed cut rates and the White House floating stimulus measures. Over-reaction is good because it preemptively reduces the impact, biological or otherwise, of the virus. But over-reaction can also be misunderstood as a signal that the virus is an end-of-the-world-as-we-know-it event. Over-reaction stops the virus from becoming worse, but does not indicate a worsening of its impacts.

It is easy to be pessimistic by reading headlines showing the relentless growth of new cases. However, reality is often a lagging indicator of our efforts. You exercise to lose weight, but your body typically does not show weight loss until later. Humankind is racing to contain the virus, which will eventually be conquered. The only question is when. I am optimistic knowing what will happen but not knowing when.

CAAP generates high returns through the cycle, owns valuable airport concessions, and demonstrates incentivized management with a good track record in building value. When the sky clears of temporary demand shocks in the form of macroeconomic weakness in Argentina and reduced travel from Covid-19, the stock will be ready for takeoff.