LATAM: Impressive cost cutting and fleet restructuring March 2016

LATAM Airlines Group,  created when Chile’s LAN completed its cross-border acquisition of Brazil’s TAM in June 2012, has weathered the tough economic and airline industry conditions in South America relatively well.

Despite its heavy exposure to the Brazilian domestic market (30% of its ASKs), where demand has fallen sharply due to recession, and the depreciation of all of the local currencies in South America, LATAM managed to improve its operating margin by one percentage point to 5.1% in 2015.

 But the net result was again negative — a loss of US$219m or 2.2% of revenues — as a result of a massive $468m foreign exchange loss mainly related to a 49% depreciation of the Brazilian real last year.

Revenue trends were dismal. Because of the currency devaluations and macroeconomic malaise, LATAM saw its operating revenues plummet by 18.8% in 2015. And its unit revenues and yield fell by 20.5% and 18.1%, respectively, in US dollar terms.

But LATAM’s famously capable ex-LAN management team, which has guided LAN through many recessions in the past, again rose to the challenge, implementing what may be the sharpest cost reductions of recent times among global carriers.

 On top of significant fuel cost savings, LATAM achieved $325m of new non-fuel cost savings in 2015, which far exceeded the target of $200m and helped reduce non-fuel CASK by 11.5%. The airline benefited from having a solid cost-cutting programme already in place when the region’s economic problems worsened last year. In 2014 the group had announced plans to reduce non-fuel costs by $650m by 2018. The programme, which consists of a multitude of small initiatives, is running ahead of schedule.

 Second, LATAM has managed to reduce its 2016-2018 fleet commitments by $2.9bn or almost 40% since January 2015 — an impressive reduction for a global airline that is not in bankruptcy, though for LATAM some of it was still fleet rationalisation related to the merger.

LATAM must also be commended for its robust response to Brazil’s recession. TAM cut its domestic capacity in Brazil by 9.4% in the fourth quarter — the sharpest reduction in the industry — and by 2.5% in 2015.

On the negative side, LATAM has now reported net losses for four consecutive years and has made little progress in repairing its balance sheet.

LAN had been consistently profitable up to an including 2011 and had earned double-digit operating margins and solid net profits since the mid-2000s. But the merger changed all that. The combine immediately lost LAN’s long-held investment-grade credit ratings, essentially because of TAM’s high debt levels. And LATAM went on to incur net losses totalling $1.1bn in 2012-2015.

LATAM’s share price performance has been dismal. After a long and steady decline, the NYSE-listed ADRs were trading at $6-7 in mid-March, down from their $26-plus value in June 2012, though there had been a slight improvement since the shares hit $4.50 in January.

It seems that LATAM is taking rather long to integrate key aspects of LAN and TAM. The airlines even continue to have separate FFPs. Notably, though, 2016 will see the start of a three-year process of moving to a single brand.

But, most importantly, the merger is clearly helping LAN and TAM weather the current tough conditions. One example: LATAM has been able to compensate for some of the Brazil demand decline by developing international connecting traffic through Brazil and shifting the point of sale to stronger markets elsewhere in South America.

Tough environment

It is ironic that the very reason LAN wanted TAM — the huge Brazilian market — has, in the short term at least, turned into one of its biggest problems.

In the fourth quarter of 2015, TAM’s domestic Brazil unit revenues (RASK) fell by a staggering 37.8% in US dollar terms, despite the 9.4% capacity reduction. In Brazilian real terms, RASK declined by 2.3%, reflecting weaker corporate demand. The Brazilian economy contracted by 3.8% in 2015.

While LATAM’s other passenger network segments — “International” and “Domestic Spanish speaking countries” (SSC, which include Chile, Peru, Argentina, Colombia and Ecuador) — also saw RASK declines (22.8% and 13.3%, respectively), both of those segments offered some modest growth opportunities.

In other words, LATAM has been able to redeploy some of the aircraft currently not needed in Brazil (domestic or international) in SSC Domestic or in international service to and from the Spanish speaking countries.

Travel demand in SSC markets remains healthy, especially in Argentina and Peru. But RASK has suffered because of the weakening of local currencies, which has also dampened demand for international travel out of those countries. In Q4, the Colombian, Argentine and Chilean pesos had declined 41%, 19% and 17% against the dollar from the year-earlier period.

Argentina is apparently an exception in that outbound demand from there remains strong. That is because the government abolished a 35% tax on purchases made on credit cards internationally. Argentina’ new President Mauricio Macri has abolished capital controls, meaning airlines can now sell there as in any other country.

In the fourth quarter, LATAM’s total international ASKs rose by 11.6% and SSC Domestic ASKs by 5.5%. Including the Brazil contraction, system ASKs were up by 3.4%.

But LATAM continues to suffer from a multi-year cargo slump. In the fourth quarter, its cargo revenues fell by 26.8%, driven by a 13% decline in FTKs and a 15% fall in cargo yields.

Cargo demand is especially weak in the Brazilian domestic and international markets. Connecting cargo traffic at São Paulo Guarulhos has been affected by an ongoing strike by Customs personnel.

To manage the cargo slump, LATAM currently leases out three of its 11 767-300Fs and one of its four 777-200Fs to operators outside the region.

With the worsening economic outlook for Brazil, LATAM has issued new 2016 capacity guidance that sees a bigger contraction in Brazil and lower overall growth internationally. Domestic Brazil ASKs are now projected to decline by 8-10% this year, while international ASKs will grow by 3-5%. The latter will be driven by a further 25% reduction in Brazil-US capacity in the second half of 2016.

LATAM still expects to growth its Domestic SSC operations by 6-8% in 2016, which would be higher than the 4.8% growth rate last year. Cargo ATKs are expected to decline by up to 2%, similar to last year’s 1.9% contraction.

Overall, LATAM expects its capacity to be flattish in 2016. The current projection for system ASKs is somewhere between a 1% decline and a 2% increase.

LATAM is currently guiding for a 4.5-6.5% operating margin in 2016, which would be similar or slightly higher than last year’s. The forecast assumes the price of oil averaging $52 a barrel and the real/dollar exchange rate averaging 4.25.

On the positive side, it looks like the Brazilian domestic market will see a sizable 7% reduction in industry capacity in 2016, with the two smaller players (Azul and Avianca Brazil) for the first time joining TAM and Gol in cutting capacity.

But there is significant uncertainty about the demand environment. GDP projections for Brazil have come down in recent months; the IMF is currently forecasting a 3.5% contraction in 2016.

Brazil strategy

Before the economic crisis, LATAM was actually doing quite well in Brazil, having turned TAM’s domestic operations profitable relatively quickly (in 2013).

The turnaround was a result of capacity reductions, cost cutting and improved yield management and market segmentation. The latter enabled TAM to maintain its corporate market share in Brazil. TAM’s long-haul passenger operations were restructured and cut back. Its oldest A330s were replaced with LAN’s 767s. TAM and American began codesharing, and TAM joined oneworld — the global alliance selected by LATAM.

In the past couple of years, LATAM has made two important hub-building moves in Brazil. First, it has been developing São Paulo’s Guarulhos as TAM’s main hub for regional and long-haul traffic in South America. Second, it has been building Brasilia, the country’s capital, into a secondary hub.

Both of those strategies appear to be paying dividends. Thanks to easy connections, TAM’s long-haul services out of Guarulhos now get significant feed from countries such as Argentina and Chile. New long-haul routes such as São Paulo-Barcelona (October 2015) and planned routes such as São Paulo-Johannesburg (pending approval) would probably not be possible without feed from elsewhere in South America.

Brasilia has the attributes for a successful hub: strong local traffic, high GDP per capita, good geographical location for capturing domestic traffic flows and infrastructure for further growth. TAM already had a 45% passenger share there when it began expanding those operations in earnest in early 2015.

It is indicative that while pulling out of the Belo Horizonte-Miami market this month, TAM boosted its Brasilia-Miami services from three to six per week. However, Brasilia is getting its share of this year’s Brazil-US service rationalisation; TAM is pulling out of the Brasilia-Orlando market.

Connectivity is the new buzz word at LATAM. The group’s executives have stressed that while reducing capacity in Brazil, LATAM has been careful to protect its hub strategy and connectivity and to maintain a focus on corporate passengers.

In April 2015 LATAM announced that it was exploring developing a new hub for the Northeast region of Brazil and that it would decide between three locations — Fortaleza, Natal or Recife — by year-end. The main objective would be to expand operations between Europe and South America.

The move makes sense, but it is turning out to be tough to decide on the location. In November LATAM delayed the decision until at least the first half of 2016, saying that it needed more time to analyse the timing of airport infrastructure, which is one of three key criteria — the other two are passenger experience and cost competitiveness.

Fleet renewal and cash preservation

LATAM has made good progress with fleet renewal, which aims to reduce the number of types and replace older models with the latest-technology, more efficient aircraft.

The process has accelerated considerably in the past year or so, because LATAM decided that it needed to “adjust capacity to the prevailing market conditions in Latin America” and reduce capital spending to maintain a healthy balance sheet and adequate liquidity.

So, through aircraft sales, lease returns and order deferrals (after extensive negotiations), LATAM has reduced its total fleet obligations in the 2016-2018 period from $7.7bn in January 2015 to $4.8bn in March 2016.

2017 and 2018 will see the biggest reductions in commitments ($1.1bn and $1.4bn), but this year’s $391m reduction will also help. LATAM is disposing of as many as 20 older aircraft in 2016. As there are currently 22 new deliveries scheduled (11 A321-200s, six A350-900s and five 787-9s), the fleet will grow by only two units in 2016.

Although the fleet obligations will peak this year at about $2bn, fleet capex will be only $900m as the remainder will be financed through sale-leasebacks. And the $900m capex is already financed (with $500m of EETCs issued in mid-2015, plus $400m of ECA-backed financial leases and commercial loans).

The 2017 and 2018 fleet obligations are now very manageable, with only 7-9 deliveries and $1.4-1.5bn of commitments each year. This will help LATAM preserve its cash position, which at year-end amounted to $1.5bn (including available credit facilities) or 14.5% of 2015 revenues. LATAM described that as “adequate under current market conditions”, but it is a little low by international airline standards.

With continued significant widebody aircraft deliveries, it is hard to see LATAM not increasing its debt, which stood at $9bn at year-end. Adjusted net debt/EBITDAR ratio was 5.8. It is not too bad, but LATAM is clearly a long way from returning to investment grade.

As to the aircraft types, LATAM’s fleet renewal can be summarised as follows:

In the short-haul fleet, two types were completely phased out in 2014: the Dash Q400 and the 737-700. LATAM is also slightly reducing its A319/A320 numbers in favour of taking more of the larger A321s.

The first two A320neos will arrive this year and that fleet will build rapidly to 24 by the end of 2018. The first six A321neos will enter the fleet in 2018.

As to the long-haul fleet, LATAM has phased out its A340s and will have disposed of its 10 remaining A330s by the end of this year. Four of the A330s have been sold, three have been returned to lessors and three are currently for sale, with their exit planned in the second half of 2016.

Having received ten 787-8s and seven 787-9s as of the year-end, LATAM plans to build the 787-9 fleet to 18 units by the end of 2018.

In December LATAM received its first A350-900, becoming the first airline in the Americas to operate the type. The A350 fleet will grow to 18 units by the end of 2018.

With cargo, LATAM’s focus has shifted to filling bellyhold capacity, especially with the arrival of the A350s and 787s. The company foresees reducing its current 11-strong freighter fleet (excluding four aircraft that are leased out) by three units by the end of 2017.

Longer-term prospects

LATAM clearly has the potential to return to the double-digit operating margins and solid net profits it was earning before the merger, but that will not happen until Brazil makes an economic recovery.

But even if that takes a while, the tough times have not changed LATAM management’s thinking on the merger. It was a unique opportunity to create a dominant airline combine for a region that will one day again see robust economic and air travel demand growth.

In the meantime, there is still much work to be done in terms of integration. Having focused on internal processes, network optimisation and fleet restructuring and modernisation in the initial three years, last summer LATAM announced a single brand for LAN, TAM and their affiliates. Its implementation will be a gradual, three-year process. LATAM is moving cautiously in part because both LAN and TAM have strong brands.

LATAM still has the toughest hurdle in merger integration ahead of it: a move to a single reservations system. The combine earlier selected the Sabre technology, which LAN adopted in 2012, for the common platform, and last year there was talk of a possible 2017 switchover.

Having a single reservations system will unlock opportunities, especially on the revenue side. So there could be additional revenue tailwinds and the original targeted $600-700m annual synergies could be exceeded.

Another potential bright spot on the horizon is the development of immunised JVs. It is not clear why these moves took so long, but in January LATAM finally submitted applications for deeper JVs with its two key oneworld partners, American and IAG.

LATAM believes that securing regulatory approvals in different countries could take 12-18 months, so it will not be possible to start developing the JVs until 2017 at the earliest. An immunised JV on the US-Brazil routes is also not possible until Brazil has ratified the open skies agreement between the two countries.