Azul: A third-force Brazilian carrier in the making Jul/Aug 2009

Amid all the doom and gloom this year, the Brazilian aviation market has seen an exciting new development: the rapid build–up of a promising new LCC, Azul Linhas Aereas Brasileiras, which took to the air with JetBlue–style E190/195 operations in December. David Neeleman’s latest airline venture has been well received by Brazil’s travelling public and already has had an impact on the pricing environment. But can it become profitable and co–exist successfully with the TAM/GOL duopoly?

Azul is off to a great start. The airline began operations on December 15th — a month earlier than planned in order to make the most of the Brazilian summer season – with three E195s and two E190s, linking its base at Viracopos Airport (at Campinas, some 90 kilometres from Sao Paulo) with two regional capitals. By mid- June the operation had grown to 11 E190/195s, 13 destinations around the country and 74 daily flights. Belo Horizonte is due to be added as the 14th destination in early August.

By May Azul already had a 4.16% domestic market share, making it the third largest airline in Brazil, ahead of Webjet and OceanAir (which had 3.99% and 2.88% shares, respectively). TAM and GOL’s combined domestic market share in May was 87%, down from 94.5% a year ago.

The newcomer’s load factor trends are also encouraging, although they may partly reflect discounting to increase customer awareness. Azul had an excellent 79.2% load factor in May, up 1.8 points from April and 10.5 points from March. It was much higher than the 57–60% domestic load factors achieved by GOL and TAM in May.

The airline’s founder and chairman David Neeleman predicted at Airfinance Journal’s New York conference in late April that Azul would start earning monthly profits by the end of this year.

Azul has an ambitious growth plan, backed by $1.4bn of firm E195 orders with Embraer, plus another $1.6bn of options and purchase rights. The plan envisages 42 aircraft and 25 cities by 2012. If all the options and purchase rights are taken up, the fleet would be 78 aircraft in four or five years’ time.

This could potentially make Azul a sizeable “third force” carrier in Brazil. But there are many challenges, including airport and ATC constraints, TAM’s and GOL’s solid market positions and financial muscle, and the constant influx of new competition on the domestic scene. Brazil has traditionally been a tough environment for airlines and has seen numerous failures, including those of Transbrasil, VASP, Varig and BRA in recent years.

Solid capital backing

Azul is among the world’s best–funded airline entrants, having raised US$200m of start–up capital from investment funds in the US and Brazil. The initial investment facilitated the $1.4bn Embraer order in March 2008 and gave Azul good reserves to withstand price and market share battles with GOL and TAM.

The venture was able to secure such significant backing from institutions because of Neeleman’s track record in creating successful airlines. He co–founded Morris Air in the 1980s (and sold it to Southwest in 1993), co–founded WestJet in 1996 and went on to create JetBlue in 1998. JetBlue’s current CEO Dave Barger noted last year that Neeleman was “expert at exploring market opportunities in the airline industry and stimulating demand”.

Neeleman was ousted from JetBlue CEO’s position in the spring of 2007, because the board wanted more of a manager than a visionary. He subsequently sold a significant part of his ownership stake but remained chairman until May 2008, when he left the JetBlue board to devote his full attention to Azul.

Neeleman holds a 25% equity stake and 80% voting control in Azul. Being Brazilianborn, with both US and Brazilian nationality, the country’s restrictions on foreign ownership of airlines do not apply to him. The US investors include Peacock Capital and other funds. One of the major Brazilian funds, Gavea Investimentos, had invested in low cost carrier BRA, which ceased operations in November 2007.

Several former JetBlue executives assisted Neeleman in getting Azul off the ground, and some have stayed — notably Trey Urbahn, chief commercial officer, who was chief revenue officer at JetBlue. But Neeleman hired essentially a Brazilian management team. President Pedro Janot came from the retail industry, while COO Miguel Dau was technical/operational EVP at Varig.

Unique market opportunity

Like GOL and other recent new entrants, Azul is attracted by the enormous potential offered by Brazil’s undeveloped and overpriced aviation market. Brazil has a population of about 190m (2007 census) and is Latin America’s largest economy, but it has only 0.2–0.3 enplanements per capita annually, compared with 2.0 in Canada and 2.4 in the US. There are currently only about 50m domestic airline passengers annually, compared with 150m long–distance bus passengers. According to Neeleman, air fares were on average 50% higher than fares in the US on routes of comparable distance, so there was “tremendous opportunity to stimulate airline demand with lower prices”.

Azul also believed that the highly concentrated market share between GOL and TAM — the result of GOL purchasing Varig in 2007 and fully integrating it last year — created an opportunity to establish a “significant, third Brazilian airline which can co–exist with GOL and TAM”. When announcing Azul in March 2008, Neeleman suggested that “there is sufficient untapped potential to support all of us”. Analysts have noted that the Brazilian market traditionally supported up to five domestic airlines, though typically not profitably. But most of those airlines failed because they were poorly–run companies, with old–style managements, antiquated fleets and unimaginative strategies.

The Brazilian market is certainly dynamic. Even with fares relatively high by US standards, the domestic market registered double- digit RPK growth in 2004–2007 and a 7.4% increase last year. This reflected continued strong GDP growth, rising incomes, GOL’s and TAM’s efforts to stimulate leisure travel and growth of new entrants such as Webjet, OceanAir and TRIP.

As the “low–cost, low–fare” pioneer in Brazil, GOL has played a key role since 2001 in making air travel affordable to a larger segment of the Brazilian population. In addition to entering most markets with 20–30% lower fares, GOL was the first to identify the opportunity to pull passengers from the long–distance buses by offering night flights at bus rates. GOL captured a 22% domestic market share in just three years.

But Azul identified another factor that it believed had suppressed demand in Brazil: lack of air service between cities, even large ones. Neeleman noted in April that both GOL and TAM operate essentially hub–and spoke networks and that their domestic networks are basically identical, with hubs centred in Sao Paulo, Rio de Janeiro and Brasilia. So people travelling to or from other cities usually have to make a connection.

GOL’s domestic strategy (which was covered in the September 2004 issue of Aviation Strategy) focuses on two types of markets. First, there are the high–density competitive markets, such as Sao Paulo–Rio de Janeiro, where the airline operates direct point–to–point service. Second, there are the thinner leisure–oriented markets where it operates multiple- stop service (a linear–type network that has all but disappeared in most mature aviation markets). Since the first or last segment is typically a major route such as Sao Paulo–Brasilia, the strategy enables GOL to offer more destinations and frequencies and achieve higher load factors. So even though GOL has played a Southwest–type role in Brazil, it has not provided the point–to–point coverage that LCCs typically do elsewhere.

Another factor that distinguishes Brazil from the US and other relatively mature aviation markets is that its regional airline sector is not well developed. According to Neeleman, regional jets account for only 5% of air service in Brazil.

The Azul model

So Azul has stepped in to try to fill those gaps. Its strategy is to create a point–to point network, providing nonstop air service in markets where such service did not previously exist. The smaller size of the E190/195, compared to the 150–seat or larger aircraft operated by TAM and GOL, enables Azul to focus on smaller markets and/or provide high–frequency service in key city pairs. The strategy obviously supports the objective to successfully co–exist with GOL and TAM. Azul seeks to stimulate demand through both low prices and greater convenience. It is targeting both leisure passengers/ first–time flyers and high–end business travellers. Leisure passengers are targeted with offerings such as advance purchase fares (a fare category that apparently did not exist in Brazil before Azul arrived), which equal the bus fares. The aim is to get many of the 150m annual bus passengers to switch to air travel, as well as attract people who do not travel at all. Brazil has a 97m–strong, rapidly–growing “middle class”. The effort to attract that segment also involves “teaching people how to fly”; among other things, Azul is creating a little booklet that explains how to fly and how to get credit.

Business travellers are wooed with frequent, nonstop flights that bypass hubs and reduce travel time, and by offering a superior in–flight service, including satellite TV from late 2009. “The Azul experience” includes single class, pre–assigned seating; leather seats in two–by–two configuration (no middle seats); extra legroom (31- or 34–inch pitch); individual video screens; a variety of branded snacks; and no overbooking. The 34–inch pitch seats in the first five rows of each aircraft can be purchased for an additional R$30 (US$15).

JetBlue replica

The 106–seat E190 and the 118–seat E195 obviously have higher unit costs than competitors’ 150–seat or larger aircraft, but their trip costs are much lower, and by eliminating connecting hubs and other costs Azul can even obtain competitive unit costs. But Azul is not necessarily going to offer lower fares for all segments. It needs to attract business traffic, which it should be able to do. (Some 70% of all domestic trips in Brazil have traditionally been for business purposes, compared with 30% in the US.) All of this is a close replica of JetBlue’s E190 strategy (see Aviation Strategy, July/August 2003), which has worked well for the New York–based LCC in conjunction with its primary strategy of operating A320s. The key factor is the aircraft type, which offers not just attractive economics but has the look and feel of a small jet, rather than a regional jet. The E190 has met JetBlue’s very exacting standards, which included a requirement to offer the same comforts as the A320s.

Neeleman has called the E195 “the perfect aircraft for the Brazilian market”.Azul has worked very closely with the Brazilian Development Bank (BNDES), which was set up to help Embraer exports but is now providing assistance also to Brazilian airlines. BNDES is believed to have offered attractive lease financings to Azul for some of the E195s. Although Azul has also sought commercial financings, the BNDES relationship is very valuable at a time like this.

Growth plans

Azul is very customer–driven and has a fresh approach, which many believe will carry it far in Brazil. Neeleman started on the right note by holding an online contest for the Brazilian public to name the airline. There were more than 150,000 entries from 108,000 people. While “Samba” actually received more votes, the team preferred “Azul” (Portuguese for “blue”). The airline gave free tickets to people who entered both names and lifetime passes for free travel to the first to cast their votes. The contest was described as “part of an ongoing dialogue with customers”. Since starting operations from its Campinas (Sao Paulo) base to Salvador in Brazil’s northeast and Porto Allegre in the south in December, Azul has expanded its network to include three more cities in the northeast (Recife, Fortaleza and Maceio), three more in the south (Curitiba, Navegantes and Maringa), Manaus in the northwest, Campo Grande in the centre west region and Rio de Janeiro and Vitoria on the southeast coast.

Most of the operations are to and from Campinas, but Azul is expected to soon start “connecting the dots”.

Significantly, Azul gained access to Rio de Janeiro’s centrally–located Santos Dumont airport in April, when the government lifted restrictions on flights to/from that airport (previously only 50- seat turboprops were allowed for any destinations other than Sao Paulo’s Congonhas). Azul had originally wanted Santos Dumont as its main base. With the restrictions in place, it had added service from Campinas to Rio’s more distant Galeao airport in February. Azul is now expected to develop Santos Dumont as one of its key hubs, eventually flying to 22 destinations from there.

The only problem with Santos Dumont is that it has seen a massive influx of new flights by TAM and GOL, as well as Webjet, OceanAir and TRIP, since the restrictions were lifted – some 95 new services within the first month. TAM has added flights to at least seven destinations from Santos Dumont. There has been significant fare–cutting in response to Azul, with reductions as large as 30–40% on some routes. So Rio de Janeiro has provided an early venue for a competitive clash between Azul and the incumbents.

Azul is currently much less of a threat to the incumbents in the Sao Paulo market, because Viracopos airport lacks easy access to Brazil’s business capital (Campinas itself, with a population of 5m, provides a good local market for Azul). However, Azul continues to seek access to Sao Paulo’s two centrally- located, slot–restricted airports, Congonhas and Guarulhos.

In addition to the planned addition of Belo Horizonte in early August, key future destinations include Brasilia (the federal capital), Goiania in the south and Cuiaba in the centre–west region. According to AvNews, Azul is in negotiations with nine state governments in the northeast to provide close to 30 new nonstop routes in the region.

The pace of the expansion will be dictated by the aircraft delivery schedule, which is roughly one E195 monthly until the fleet of 78 (including two ex–JetBlue E190s) is reached in 2013. Azul expects to carry 4m passengers in 2010 and end next year with 21 aircraft and 18 destinations.

Azul’s plans envisage it ultimately serving most major markets throughout Brazil and perhaps “other South America” at some point. The E195, with its range of 2,200 nautical miles (4,077 kilometres), will be able to fly nonstop routes between any two major Brazilian cities. The E190, with a slightly better range, would reach any point in South America from Brasilia.