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Azul: Brazil's rapidly growing LCC reignites the IPO process December 2014 Download PDF

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Azul started December with a bang: launching A330 services to the US and filing for an IPO in New York and São Paulo. These major moves came within days of the carrier announcing $6.5bn of orders and lease deals for the A320neo family aircraft.

The A320neo represents a yet another new aircraft type for Azul, which until this autumn operated only E190s/E195s and ATR72s in regional markets in Brazil. It signals Azul’s ambition to expand into domestic long-haul and high-density markets and eventually become the largest airline in Brazil.

The November 28 A320neo transactions comprised of 35 firm orders from Airbus, valued at $3.6bn, and leasing deals for another 28 aircraft. Deliveries will take place in 2016-2023.

The launch of the US services (Fort Lauderdale on December 2 and Orlando on December 8, both from Azul’s hub at Campinas near São Paulo) marked Azul’s debut on the international arena and in widebody operations. Azul has announced plans to lease 12 widebody aircraft, including seven A330-200s (of which five were due by year-end) and five A350-900s (from March 2017).

The filing of the preliminary IPO prospectuses on December 1 represented the third time in 18 months that Azul initiated the IPO process. The delays have been entirely due to market conditions.

Azul originally filed in May 2013 to raise up to R$1.1bn ($405m) in offerings in the US and Brazil, but those plans had to be shelved due to weak economic and market conditions. Brazil was seeing faltering GDP growth, rising inflation, currency volatility and a wave of anti-government protests.

Azul briefly tried to revive the IPO plans in February, but it soon became apparent that 2014 would be another difficult year in Brazil. The airline formally withdrew its IPO registration in July.

World Cup hassles, anaemic GDP growth (0.19% projected for 2014), 6.4% inflation, depreciating currency and political uncertainty associated with October’s presidential election made market conditions so dismal that only one company has managed to go public in Brazil so far in 2014 (Ouro Fino, a small veterinary products firm).

Brazil is stuck in economic doldrums. The government recently reduced its 2015 GDP growth forecast from 2% to 0.8%. But political uncertainty has dissipated; in particular, the appointment of a market-friendly finance minister in November helped improve market sentiment. Brazil has now a pipeline of IPOs and secondary offerings that some have estimated at $10-12bn.

The substantial fall in oil prices, which has lifted airline share prices worldwide, may make this an opportune time for airline IPOs. One potentially helpful trend for Azul is that Brazil’s domestic air traffic has continued to grow this year, even as the economy was technically in recession. The first nine months of 2014 saw 5.4% domestic RPK growth, up from 1.4% in the same period in 2013. It was leisure traffic (as business travel has remained extremely weak), but not all of it was the lowest-yield World Cup traffic.

Azul is hoping that investors will focus on the long-term growth potential offered by the Brazilian market, and on how well it is positioned to take advantage of that growth.

Domestic passengers in Brazil have grown from 29m in 2000 to 90m in 2013, thanks to the rapid rise of Brazil’s new middle class and the stimulation of low fares offered by LCCs (mainly Gol, but also Azul since its launch in December 2008). Air travel per capita still remains relatively low. Long-distance travel alternatives are limited, and there is much further potential to get people to switch from bus to air. According to Azul’s filings, Brazil’s domestic passenger numbers are expected to reach 122.4m in 2017, an increase of 32.4m on the 90m in 2013.

Third time lucky?

Azul has registered to sell a yet-to-be-specified number of preferred shares in simultaneous international and Brazilian offerings. The preferred shares receive dividends (0.1% of annual net income). The company plans to list the ADSs on the NYSE and the regular preferred shares on the São Paolo Stock Exchange.

Because of the aircraft leasing deals, Azul’s leadership has stated that the airline has no urgent need to raise funds. Rather, the main purpose of the IPO is to provide an exit to investors, some of whom have already waited for six years.

Then again, Azul’s cash reserves are low (R$348m in September 2014 or 6.6% of 2013 revenues), profitability is spotty, and the carrier has a lot of growth planned. Without the IPO, it would probably have to be urgently looking for new debt or private equity funding. As a public company, raising funds would be easier. Azul would then be able to tap the large US capital markets (debt and equity) for all of its funding needs. The IPO prospectus lists a large number of underwriters — relationship-building for future financing deals.

The IPO proceeds collected by Azul will be used to finance E-Jet and ATR deliveries, fund capital expenditures associated with adding new destinations, repay US62.3m and R$103.2m of short-term debt, and for general corporate purposes.

A large part of the proceeds will be collected by the selling shareholders. Azul currently has 464m common shares and 93m preferred shares. Founder, chairman and CEO David Neeleman holds 67% of the common stock; the remainder is held by the Chieppe and Caprioli families (founders and owners of TRIP, which Azul acquired in 2012).

In addition to Neeleman and the ex-TRIP executives, holders of Azul’s preferred stock include private equity firms Weston Presidio, TPG Growth and JP Morgan’s Gavea Investimentos — all early investors that contributed to Azul’s R$400m start-up capital.

In December 2013 Azul raised R$240m in a private placement from Fidelity (US institutional investor), private equity firm Grupo Bozano and Peterson Partners. Azul issued warrants to those investors that entitle them to receive some of the preferred shares in the IPO. The Class B preferred shares originally issued to those investors will then be abolished, leaving just one class of preferred shares. Some of the IPO shares will be reserved to Azul’s directors, officers, employees and FFP members.

After the IPO, Neeleman will continue to hold the majority of Azul’s stock and voting rights. He will continue to control all shareholder decisions, including the ability to appoint the majority of the board of directors. Neeleman, who was also JetBlue’s visionary founder, has indicated in several interviews over the years that he did not like the way he was ousted from the New York-based carrier by its board of directors after one fateful snowstorm in early 2007.

Key selling points

Azul’s main selling points are its formidable route network in Brazil and its great growth prospects. However, the one thing that may ultimately sway investors is David Neeleman’s track record of founding and running four successful LCCs.

He co-founded Morris Air in the 1980s (and sold it to Southwest in 1993), helped launch WestJet in 1996 and created JetBlue in 1998. At Morris he implemented the industry’s first electronic ticketing system and pioneered a home reservation system that is now the foundation of JetBlue’s call centre. He took the electronic ticketing to Open Skies, which he sold to Hewlett Packard in 1999.

Neeleman is an American born in Brazil, with dual citizenship. In addition to raising an impressive amount of capital for Azul from investment funds in the US and Brazil, he has built a management team that “combines local knowledge with diversified experience in and knowledge of best practices from the United States”.

Azul already has the largest airline network in Brazil in terms of cities served (103) and daily departures (31.6% of the total). The airline covers all of Brazil and offers high frequencies in many markets. But the smaller aircraft have meant that its current market share (RPKs) is only 16.8% (September 2014). Azul operates a hub-and-spoke network, which allows it to consolidate traffic and serve many smaller cities.

Azul’s home base and main hub is at Viracopos Airport in the city of Campinas (1m population), just 50 minutes from downtown São Paulo. The airline operates a secondary hub at Belo Horizonte’s Confins.

The main hub’s strategic location, its brand new $1.5bn terminal and the feed generated by Azul’s huge domestic network make the carrier well positioned to operate the US services, which its customers had been asking for years.

The business model domestically is to stimulate demand by providing frequent and affordable air service to underserved markets. The result is that Azul is the sole carrier in 65% of its existing routes and the frequency leader on another 11% of routes.

Azul has also built a strong brand. Its low fares, nonstop flights, superior offerings (leather seats, more legroom, free LiveTV) and its customer focus and fresh approach have gone down well in the domestic marketplace. Azul has been voted “best low-cost carrier in Latin America” four years in a row by Skytrax.

All of that, combined with a leading network position and a good yield management system, have enabled Azul to achieve significantly higher unit revenues than the other carriers. The PRASK premium, consistently high load factors, high efficiency and a competitive cost structure offset the poorer economics of smaller aircraft.

Azul will obviously achieve significant CASK improvements from the deployment of the widebody aircraft and the A320neos. The latter will be operated on domestic high-demand long-haul routes, including those to the Northeast of Brazil, from 2016.

Also, Azul can be expected to benefit from economies of scale as it rolls out its growth strategy. This is because it created a “robust and scalable operating platform” before launching its operations, featuring advanced technology such as ticketless reservations, an Oracle financial system and electronic check-in kiosks at its main destination airports.

Azul is expected to be the main beneficiary of the Brazilian government’s planned regional aviation stimulus programme, under which hefty ticket price subsidies will be paid to encourage airlines to develop regional services. The programme got delayed in November, but there is still hope that Congress could approve it early in 2015.

Azul was the main beneficiary of another government programme — the redistribution of slots at Congonhas — that took place in October.  The carrier received 26 slots at São Paulo’s centrally-located airport, which enabled it to start 13 daily flights to some of its most profitable destinations.

Azul’s plan is to continue expanding its domestic network while “simultaneously leveraging the strong connectivity we have created in Brazil to benefit from the addition of select international destinations in the US”. The next destination will be New York (JFK) by mid-2015. Two-thirds of the 24% capacity growth Azul is projecting for 2015 will come from the US services.

Growth opportunities are important, because Azul has not yet attained sustained profitability and because there is evidence of potential economies of scale. After losses or marginal operating profits in in 2009-2012, Azul’s operating margin jumped to 8.9% in 2013. Also, that year Azul earned its first annual net profit of R$96m. The reason was the TRIP acquisition, which almost doubled the carrier’s revenues in 2013. But Azul’s earnings have again declined this year, and there was a net loss in January-September. Perhaps the international services will get Azul back on track to profitability.

By Heini Nuutinen

Brazilian Airlines' Domestic Market Shares
% of total domestic RPKs
June 2014 June 2013
TAM 37.5% 39.7%
Gol 35.1% 36.0%
Azul 12.8%
TRIP 3.9%
Azul+TRIP 17.7% 16.7%
Avianca Brazil 9.0% 6.9%
Others 0.7% 0.7%
TOTAL 100% 100%
Source: ANAC
Azul Fleet Plan
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
E175/E190/E195 26 38 69 78 81 88 86 86 86 86
ATR 47/72 1 11 49 55 52 55 55 54 54 54
A320neo 6 14 21 28
A330/A350 5 7 7 11 12 12
Total operating fleet 27 49 118 133 138 150 154 165 173 180
Brazil's Domestic Passengers
Brazil's Domestic Passengers Produced by GNUPLOT 4.6 patchlevel 3 0 20 40 60 80 100 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 0% 5% 10% 15% 20% 25% Pax (m) Year-on-year percent change gnuplot_plot_1 gnuplot_plot_2 Pax pct change

Source: ANAC

Azul: Financial Results
Azul: Financial Results Produced by GNUPLOT 4.6 patchlevel 3 -200 -100 0 100 200 300 400 500 2009 2010 2011 2012 2013 0 1,000 2,000 3,000 4,000 5,000 R$m R$m gnuplot_plot_1 gnuplot_plot_2 gnuplot_plot_3 Operating income Net Income Revenues
Azul: Passenger traffic and capacity
Azul: Passenger traffic and capacity Produced by GNUPLOT 4.6 patchlevel 3 0 5,000 10,000 15,000 20,000 2009 2010 2011 2012 2013 65% 70% 75% 80% 85% 90% gnuplot_plot_1 gnuplot_plot_2 gnuplot_plot_3 RPK ASK Load Factor

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