Latam: Overcoming many challenges to stage financial recovery April 2014

Latam Airlines Group, created when Chile’s LAN completed its cross-border acquisition of Brazil’s TAM in June 2012, is staging a promising financial recovery after two very difficult years, despite depreciating local currencies and continued weak demand in key markets such Brazil and cargo. How is the acclaimed LAN management team making it happen?

Airline mergers are typically undertaken for their long-term strategic benefits. In Latam’s case, there was a unique opportunity to create a dominant airline combine for one of the world’s fastest-growing regions.

But such mergers are tough to execute and can wreak financial havoc in the short term, when one-time costs are incurred and revenue and cost synergies have not yet kicked in. In Latam’s case, the merger integration challenges were compounded by adverse developments in the marketplace: rising costs, declining yields and weak demand in certain key markets.

The result was that, first of all, LAN lost the double-digit operating margins and the solid net profits it had been earning since the mid-2000s. In 2012 and 2013 the combine achieved only marginal operating profits (0.7% and 5.1% of revenues) and incurred net losses totalling $804m.

Second, LAN lost its investment-grade international credit ratings, which it had enjoyed since 1997. When the merger closed, Fitch assigned Latam a junk-grade “BB+” rating, citing TAM’s weaker credit profile and heavier debt load.

Third, Latam lost more than half of its stock market value between June 2012 and August 2013. The New York-listed ADRs plummeted from $24-plus in late 2012 to around $12 in August 2013. (Since then the shares have recovered to the $15-16 level.)

All of that was disappointing, given that LAN had been the embodiment of airline efficiency, with a highly diversified and flexible business model and a management team that has been regarded as the very best in the industry (a team that is now steering Latam). The business model had proved recession-resistant, thanks to a sizable cargo component and domestic operations in many different South American countries (now Chile, Peru, Argentina, Colombia, Ecuador, Paraguay and Brazil).

The post-merger cost headwinds have included continued high fuel prices, labour cost pressures (especially at TAM in 2012), the effects of the Brazilian real’s depreciation at TAM, lingering negative effects from LAN’s Aires acquisition in Colombia in 2009, and the start of merger integration expenses.

On the revenue side, Latam saw negative trends in most of its segments. International passenger markets, which account for half of its passenger revenues, have been relatively weak, especially to and from Europe and Brazil.

Brazil, Latin America’s largest air travel market, began to see a dramatic slowing of economic and air traffic growth in 2011-2012, while competition domestically had increased. Brazil is now seeing its fourth consecutive year of modest GDP growth; the IMF is currently projecting only 1.8% growth in 2014 (after 2013’s 2.3%, 2012’s 0.9% and 2011’s 2.7%). It meant domestic losses and sharply reduced total earnings for TAM in 2012 and first-half 2013. Domestic Brazil accounts for about 34% of Latam’s passenger revenues.

Latam has also been hit by a multi-year cargo slump, reflecting weaker southbound demand to Latin America and increased competition in that segment. 2012 was bad and 2013 even worse, even though LAN and TAM were quick to integrate their cargo operations. Cargo was historically one of LAN’s key strengths.

While demand has held up well in most of Latam’s Spanish speaking domestic markets (16% of passenger revenues), yields have been under pressure because of the depreciation of local currencies in all of those markets. Q4 2013 saw a 5.5% RASK decline in the six countries, as Chile’s and Peru’s currencies each weakened by 8%, Colombia’s by 6% and Argentina’s by 25%.

The stock’s decline also reflected analyst and investor scepticism about Latam’s ability to achieve its merger synergy targets. Many analysts had felt that the carrier’s projections were overoptimistic.

However, Latam managed through those challenges effectively. The turnaround was first evident in last year’s third quarter and was consolidated in Q4. In the second half of the year Latam’s operating margin was running at the 7.5%-level, though net earnings were affected by huge foreign exchange losses (mostly recognised by TAM).

Analysts attribute Latam’s recovery to successful efforts to streamline costs, manage PRASK, execute the merger and repair the balance sheet. The turnaround had four key components:

• First, against all odds, Latam has delivered a strong turnaround on TAM’s domestic operations in Brazil.
• Second, there has been a significant restructuring of international passenger operations. Latam has reduced long-haul capacity, contracted sharply at Rio de Janeiro, begun to develop a hub at Sao Paulo’s Guarulhos Airport and implemented major fleet changes.
• Third, against expectations, Latam has met or exceeded all of its original interim merger synergy targets.
• Fourth, Latam implemented some very successful cost-cutting in 2013, especially in Brazil and in the labour, maintenance and commissions categories (though many cost categories have also benefited from the weakening of the local currencies, because Latam reports its results in US dollars).
• Finally, Latam made progress in three other important areas that will help its future results. At the end of 2013 it raised almost US$1bn through a primary share offering, which brought liquidity to much more comfortable levels and should help Latam regain an investment-grade credit rating in the next couple of years.

In late 2013 Latam also accelerated its fleet restructuring — a strategy that will pay dividends over the next three years.

And, significantly, after two years of hard work, Latam has almost eliminated the exposure to the Brazilian real in TAM’s balance sheet.

TAM reduced its domestic ASKs by 8.4% in 2013. As demand remained flat, the domestic load factor surged by six points to 79.4%. That and the better yield management have resulted in double-digit growth in unit revenues since mid-2013, reversing the previous declining trend. TAM’s RASK surged by 19% in Q3 2013 and by 11.3% in Q4, as measured in reals. TAM has maintained its domestic market share at about 40% and claims to have maintained its leadership in corporate passengers.

TAM will not be adding capacity in Brazil in 2014 and expects double-digit RASK growth to continue. So, even though economic growth will be anaemic, TAM seems positioned for a reasonably good year (as is Gol). BofA Merrill Lynch recently described the Brazilian market as “still highly competitive” but “in a better shape than in previous years”.

Long-haul restructuring

TAM plans to develop Sao Paulo’s Guarulhos as its main hub for regional and long-haul traffic in South America. It essentially means improving itineraries to make them more attractive to connecting passengers. Having recently received approval from the Brazilian authorities to better allocate slots at Guarulhos, TAM hopes to implement the changes in the second half of 2014, when more capacity becomes available at the airport. The management regards it as a “big opportunity for Latam”, though the exact impact cannot be estimated until the airport’s total capacity is known.

The restructuring has involved fleet changes. TAM’s 10 oldest A330s have been grounded and replaced with LAN’s 767s, which are freed as more 787s arrive. The 767s offer lower CASK and a better product, with full lie-flat business class seats.

New codeshare agreements between TAM and American, implemented in August 2013, have improved TAM’s network, connectivity and RPK generation.

On the cargo front, because of the addition of TAM’s bellyhold capacity and weaker demand, Latam has been reducing freighter capacity (a trend seen at many global airlines). Latam’s freighter/bellyhold ATK split is now about 50/50 and cargo accounts for 14% of total revenues, down from LAN’s pre-merger 24%.

Merger integration

That is all very impressive, considering the potential pitfalls in combining airlines from different cultures and making the complex multi-country ownership and management structures work.

Roberto Alvo, Latam’s Chief Corporate Officer who spoke at a Wings Club lunch in New York in mid-April, noted that it was impossible to plan for such a “very complex endeavour”. He also suggested that Latam is the only true cross-border airline merger so far and a precedent for what may come in the future.

Even though their economic interests are consolidated under Latam, LAN, TAM and their affiliates continue to operate under their own brands and identities. Alvo said that the decision on whether to adopt a single brand has not yet been made; it is a “very complicated question” because both brands are so strong.

Last year’s global alliance decision was evidently a very tough one. It meant TAM switching from Star to oneworld, which took place in March. Analysts have praised it as the correct decision, because Latam will avoid direct competition with American, which is the largest carrier on US-Latin America routes and has over 30% of the Brazil-US market.

But combining the two powerful FFPs may be impossible to accomplish. TAM’s Multiplus Fidelidade is much larger than LANPASS and has been a listed company in Brazil since 2009. The airlines quickly harmonised the main features of their programmes and have just embarked on phase two of that process, but Latam executives stated in March that at this point there were no plans to integrate the Multiplus and LANPASS businesses.

There are still many processes to integrate. The management has its hands full and, despite rumours, is unlikely to be interested in any further airline investments in the short or medium term.

Balance sheet progress

Last year’s fourth quarter saw good progress on that front. First, Latam completed a $450m ticket securitisation. Subsequently it raised $940.5m through a rights offering, using the funds to repay short-term debt and boost cash position. The result was a significant improvement in financial ratios. Cash as a percentage of annual revenues rose to 19.3% (from 8.5% a year earlier), while adjusted net debt/EBITDAR ratio declined from 7.2x to 4.9x.

Also importantly, TAM’s balance sheet exposure to the Brazilian real was cut in half during 2013, from $4bn to $2bn, and should only amount to $500m by June. This was accomplished by moving aircraft and related debt from TAM’s to Latam’s balance sheet, which has the US dollar as its functional currency, and by reducing TAM’s debt in US dollars. Latam has also reduced its exposure to the real via forward contracts.

Fleet restructuring

So Latam will focus on the A320-family in all of its domestic markets, while its long-haul fleet will consist of 767s, 777s, 787s and A350s (the latter from late 2015). Of the 32 ordered 787s, five had been delivered by year-end 2013, five more will arrive in 2014 and seven in 2015.

Latam’s total fleet will decline by 13 units this year to 326 and will remain unchanged in 2015. But the turnover rate will be high: 19 deliveries and 32 exits in 2014, followed by 28 deliveries and 28 exits in 2015. Fleet capex will be $1.17bn in 2014 and $1.89bn in 2015. All new widebodies will be funded with ECA or Ex-Im guarantees, but Latam recently completed sale-leasebacks for its eight owned 777-300ERs that it wants to retire towards the end of the decade.

Brighter outlook

But Latam is not expected to return to double-digit operating margins this year or in 2015. There are still many headwinds and risks, including a weak cargo market and potential setbacks with merger integration. Latam is keeping its total capacity basically flat in both passenger and cargo operations this year.

In the short-to-medium term, there are three potential growth areas: the largest Spanish speaking domestic markets, the US routes and capturing connecting traffic because of the network and schedule enhancements resulting from merger integration and the Guarulhos hub-building.

Despite yield pressures, demand in the largest Spanish speaking domestic markets has remained strong, reflecting those countries’ more robust GDP growth. The IMF is still expecting Peru’s economy to expand by 5.5%, Colombia’s by 4.5% and Chile’s by 3.6% in 2014. Latam is planning 6-8% ASK growth in those markets this year, while keeping capacity flat in the weaker countries — Venezuela, Argentina and Ecuador. Latam is fortunate in that it has relatively modest exposure to Venezuela — less than 1% of its revenues. As of late April, it had about $140m of cash trapped in Venezuela.

Chile-US routes are expected to see increased demand, among other things, because of the recent waiving of US visa requirements for Chilean nationals.

Contrary to what one might expect, this summer’s World Cup in Brazil is actually going to be a financial negative for airlines. This is because June is typically a strong month for business travel, which will be down sharply during the Cup. The airlines are scrambling to cater for what will essentially be low-yield traffic. Latam executives said that they were “working hard to neutralise the impact”. Of course, as the Latam executives noted, the long-term impact of the World Cup (and the 2016 Olympics) is good because of the increase in airport capacity in Brazil.

Latam’s longer-term prospects remain excellent. The combine should be uniquely well positioned in both the passenger and cargo segments to benefit from robust demand growth in Latin America, boosted by surging disposable incomes and swelling ranks of middle classes.