Flying High: An Overview of the Aviation Infrastructure Industry
As the coronavirus outbreak continues to spread beyond China and threatens to escalate into a global epidemic, share prices of global aviation-related companies, such as airlines, airports/airport operators, and travel retailers, have been negatively impacted. Here, we’ll share our thoughts on the aviation infrastructure industry and examine some current holdings in the sector.
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As of January 31, 2020 Diamond Hill owned Fairfax Financial Holdings Ltd. (equity) and Southeast Airport Group (equity).
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This material is for informational purposes and is prepared by Diamond Hill Capital Management. The opinions expressed are as of the date of publication and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Reliance upon this information is at the sole discretion of the listener. Investing involves risk including the possible loss of principal.
Not All Airports Are Alike
Today, the top 20 global airport operators manage approximately 400 airports worldwide, accounting for more than half of total passenger traffic in 2018.1 However, not all airports are alike. Airports are subject to varying rules and regulations depending on location. They have different levels of passenger traffic and capacity needs which cause divergences in growth and economic profitability of airports around the world. As a result, company selection within the industry is critically important.
Attractive Industry Structure
Few cities around the world can justify the construction of multiple airports due to the significant investments necessary to provide adequate airport services. Thus, airport operators are natural monopolies. Barriers to entry in the industry are extremely high, so most operators are not threatened by new entrants in their respective geographies.
As part of privatization, airport operators are often awarded the rights to operate, maintain, and develop aviation infrastructures under exclusive, long-term contracts, which typically range from 15 to 50 years. Given that the majority of airports’ operating costs are fixed (i.e. security and utilities), they can service additional passengers at a very low cost. Long-term contracts combined with high operating leverage translate into stable streams of operating cash flow over time, as long as there is sufficient demand for the airports and the services they provide.
Airports’ aviation-related activities such as aircraft landing and parking are regulated, so operators do not have much discretion over fees charged. However, pricing for unregulated commercial activities such as duty-free sales, food and beverage sales, and car parking, are usually left to the discretion of airport operators and merchants. For example, Chinese airport operator Shanghai International Airport Holdings struck a deal with its vendor in 2018 to collect 42.5% of every dollar spent at the Shanghai airport’s duty-free stores for the next seven years. This arrangement illustrates that airports can capitalize on strong passenger traffic and have greater pricing power over their commercial tenants. Essentially, airports are enclosed malls with captive visitors.
Current Holdings in the Aviation Infrastructure Industry
Southeast Airport Group
Southeast Airport Group’s operations are well-diversified across 16 facilities in Mexico, Puerto Rico, and Colombia, including Latin America’s fourth-busiest airport, Cancun International Airport. Mexico accounts for the majority of the company’s revenue and profitability, demonstrating consistent growth with a 6% compound annual growth rate in passenger traffic over the last 30 years. The company enjoys monopolistic conditions in southeastern Mexico, and their operation agreement with the Mexican government is valid until 2048.
Air travel in Mexico is experiencing secular growth due to a larger working-age population, higher income per capita, and expansion of the middle class. Additionally, low-cost and ultra-low-cost air carriers will continue to lure fliers via cheap fares and unlock additional air travel demand as Mexicans migrate from bus to air travel, especially for greater safety and convenience on long-haul trips. Southeast Airport Group has an attractive revenue mix between regulated and unregulated activities, little financial leverage, strong free cash flow generation, and a diversified airport portfolio. Last but not least, the company has a tenured management team that has been in place for almost a decade.
In late 2018, the newly elected Mexican president canceled the construction of a new $13 billion airport in Mexico City that was already one-third complete. This led to a significant market sell-off in all regulated businesses and shook investor confidence in Mexico. Company shares fell meaningfully to an attractive level, allowing us to initiate a position. In 2019, we added to the position when passenger traffic to Cancun disappointed investors following an infestation of Sargassum seaweed across the Caribbean. These events, which were out of management’s control and did not change our long-term thesis, served as great buying opportunities for patient, long-term investors.
Bangalore International Airport Limited
We have indirect exposure to Bangalore International Airport Limited (BIAL) through our investment in Fairfax India. Fairfax India is an investment holding company, similar to Berkshire Hathaway, investing in diverse businesses across multiple industries in India. Fairfax India’s crown jewel and largest investment is Bangalore International Airport.
India is expected to become the world’s third-largest civil aviation market by 2025, behind only the U.S. and China. BIAL, which is located in India’s third-largest city and tech capital, has experienced massive growth over the last decade and was ranked as the world’s fastest-growing airport in 2018.2 The airport is capacity constrained and undergoing a $2 billion expansion, which is scheduled to be completed by 2021 with a total annual passenger capacity of 65 million. BIAL’s operational agreement with the Indian government lasts until 2034 and is extendable by another 30 years. Additionally, no airports can be constructed within roughly 90 miles of BIAL until 2029.
From 2009 to 2018, BIAL’s revenue from higher-margin, commercial activities grew at a compound annual growth rate of 17%. This substantial growth is expected to continue with increased passenger traffic, additional space due to the airport expansion, and increasing propensity of passengers to spend more money at airports. Additionally, BIAL owns development rights for 450 acres next to the airport that could be utilized for real estate development, such as hotels, retail space, and offices. Meanwhile, Bangalore is rapidly expanding in the direction of the airport, making the potential monetization of the airport expansion and commercial options associated with adjacent properties even more valuable long term.
At Diamond Hill, we continuously look for businesses with sustainable competitive advantages, as they allow companies to earn excess returns over the long term. Short-lived events that do not fundamentally change our long-term thesis provide us an opportunity to initiate and/or add to positions amid market dislocations. Our investments in Southeast Airport Group and Bangalore International Airport illustrate this scenario well. Amid the coronavirus outbreak, we are actively looking for attractive opportunities in the aviation infrastructure sector.
1Source: Airport Council International Insights: Global airport groups: A rising value proposition for the aviation industry.
2Source: ACI World Airport Traffic Database, 2019.
As of January 31, 2020, Diamond Hill owned Fairfax Financial Holdings Ltd. (equity) and Southeast Airport Group (equity).
Originally published on February 27, 2020.
The views expressed are those of the research analyst as of February 2020, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.