LATAM: Successfully navigating South America's economic woes May 2015

After three years of losses, and despite surprisingly robust first-quarter 2015 results, LATAM Airlines Group is still some way from financial recovery. This is because the tough economic and airline industry conditions in South America — slowdown of GDP growth, currency woes, weakening demand and plummeting yields — have worsened further still in recent months.

LATAM was created when Chile’s LAN completed its cross-border acquisition of Brazil’s TAM in June 2012. The combine had by now hoped to show some benefits from the merger; instead, the very reason LAN wanted TAM — the huge Brazilian market — has, in the short term at least, turned into one of its biggest problems.

After four years of anaemic growth, Brazil is moving into recession this year. Its GDP is currently expected to contract by 1.2% in 2015, while inflation is set to rise to 8.3%. This spring the decline in corporate travel demand accelerated. The slump is affecting demand for international travel and the cargo business.

LATAM’s yields have been hit hard by the significant depreciation of all the local currencies in South America this year. And the cargo market — one of LAN’s traditional strengths — continues to be plagued by overcapacity.

Some of those negative effects were offset by two positives in the first quarter: the significant decline in crude oil prices and the favourable impact of the currency devaluations on costs denominated in those currencies.

But an operating margin as high as 8.1% in the latest period was no mean feat — something that LATAM attributed to its ability to “successfully manage this difficult and complex environment”.

LATAM accomplished that for two obvious reasons. First, it has a highly diversified and flexible business model. Most notably, it has domestic operations in seven different South American countries: Chile, Peru, Argentina, Colombia, Ecuador, Paraguay and Brazil.

Second, the ex-LAN management has long been regarded as the very best in the industry. It expertly guided LAN through many recessions in the past.

In recent quarters LATAM has benefitted from a number of unique strategies, including the following:

• Significantly shifting the point of sale mix within South America in response to demand weakness and yield pressures in international markets out of Brazil.
• Network and hub diversification in Brazil to take advantage of locations that enjoy relative economic strength (building Brasilia into a secondary hub, A319 expansion in regional markets, possibly developing new hub for the Northeast).
• Mitigating negative foreign exchange effects, among other things, by almost eliminating the exposure to the Brazilian real in TAM’s balance sheet (reduced from $4bn in 2012 to around $600m at present).
• Successfully completing Latin America’s first (and the largest non-US) EETC transaction of $1bn in a difficult economic climate, thus locking in low-cost long-term financing for 17 aircraft scheduled for delivery through March 2016.

Other (more conventional) strategies that LATAM is deploying to address the economic slowdown include:

Capacity discipline: Between 2012 and 2014, LATAM’s ASKs declined by 1.5% and cargo ATKs by 5.6%. In 2015, the group expects to grow ASKs by 2-4%, while cargo ATKs will be somewhere between flat and down 2%.

Cost cutting: After some very successful cost cutting in 2013, last year LATAM announced new plans to reduce non-fuel operating costs by $650m over three years, which could reduce unit costs by 15%. The programme, which consists of a multitude of small initiatives, could add up to $200m savings in 2015.

Cargo fleet reductions: To manage the continued slump in the cargo market, LATAM has leased out three of its 11 767-300Fs to an operator outside the region for a three-year period. LATAM continues to look for opportunities to lease out more freighters in the current environment.

Complex environment

LAN was consistently profitable up to and including 2011 and had earned double-digit operating margins and solid net profits since the mid-2000s. But in 2012 the newly formed combine achieved only a 0.7% operating margin, which was followed by 4-5% margins in 2013 and 2014. Since the beginning of 2012 and including Q1 2015, LATAM has incurred net losses totalling $923m.

When the merger was completed, LATAM also lost its long-held investment-grade credit ratings, essentially because of TAM’s high debt levels.

LATAM’s share price performance has been dismal. After losing more than half of its stock market value between June 2012 and August 2013 (from $26-plus to $12), the New York-listed ADRs recovered briefly to $15-16, but in the past 12 months the price has declined steadily to the $8-9 level in late May 2015.

Mergers 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 that also began in 2012: rising costs, declining yields and weakening demand in key markets.

The adverse external effects felt by LATAM have intensified in the past three years, as economic growth has weakened throughout South America and, more recently, as local currencies have weakened against the US dollar.

The latter caused some wild fluctuations in costs and revenues in LATAM’s first-quarter financials. The Brazilian real weakened by around 20%, the Chilean and Argentine currencies by 13-14% and the Colombian peso by over 20% during Q1. Domestic Brazil accounts for 32% of LATAM’s total ASKs, while “SSC Domestic” (Spanish speaking countries) accounts for 17% and international the remaining 51% of ASKs. As a result, LATAM’s operating revenues plummeted by 12.2% and RASK by 14.7% in the first quarter.

Most of the RASK decline was due to the local currency devaluations, though in Brazil there was also impact from weaker corporate demand. Domestic Brazil RASK was down by 19.6% in US dollar terms but only 5% down in Brazilian real terms.

But the revenue declines were more than offset by 16.3% and 17% reductions in total operating costs and CASK, respectively. The main contributor was obviously fuel (down 40%), but as the 9.6% decline in ex-fuel CASK indicated, LATAM also benefited from its cost-cutting programme and the favourable impact of local currency depreciations on the cost side. As much as 40% of LATAM’s costs are in local currencies.

LATAM has maintained high passenger load factors in all of its network segments. In the first quarter, the system passenger load factor was 83.4%, up 0.7 points.

The result of the complex dynamics was a doubling of LATAM’s operating income to $227m in Q1. But a $205m non-cash foreign exchange loss, resulting mainly from the Brazilian real’s depreciation, led to LATAM reporting a $40m net loss for the period.

Brazil strategy

LATAM's performance in Brazil has actually been better than expected. Against the odds, it turned TAM’s domestic operations profitable relatively quickly (in 2013) — a result of capacity reductions, cost-cutting and improved yield management and market segmentation. LATAM claims to have maintained its corporate market share in Brazil. And now LATAM has even managed to compensate for some of the Brazil demand decline by shifting the point of sale to stronger markets, such as Uruguay, Paraguay and the rest of the Southern Cone.

TAM’s long-haul passenger operations out of Brazil were restructured and cut back quite drastically in 2013. Its 10 oldest A330s were grounded and replaced with LAN’s 767s. TAM and American began codesharing in August 2013, and in March 2014 TAM joined oneworld — the global alliance selected by LATAM.

Last year LATAM began developing São Paulo’s Guarulhos as TAM’s main hub for regional and long-haul traffic in South America. This was possible because more capacity became available at the airport, including a renovated Terminal 3. It has essentially meant improving itineraries to make them more attractive to connecting passengers.

LATAM has also been building Brasilia, the country’s capital, into a secondary hub. Brasilia has a strong local market (third largest in Brazil) and the highest GDP per capita in South America. It is well located for capturing domestic traffic flows, has opened up some new international opportunities and has the infrastructure for further growth. TAM, which already has a 45% passenger share there, is expanding its Brasilia operations from 30 to at least 43 nonstop destinations this year, which will include three international points (Miami, Orlando and Buenos Aires).

In December LATAM announced plans to expand in regional markets in Brazil. Those operations, which utilise TAM’s A319s and also involve codesharing with regional carrier Passaredo, focus on high GDP cities. Many of the regional economies in Brazil have continued to grow even as overall GDP has stagnated. The plan is to add 4-6 new regional destinations each year, starting in 2015.

The A319 regional expansion is independent of the Brazilian government’s planned regional aviation development programme, which would pay subsidies to airlines to operate in specific regional markets (but which may be at risk because of the government’s spending cuts). If that programme materialises, TAM will be adding regional jets to its fleet.

In a notable move, LATAM disclosed in April that it was exploring developing a new hub for the Northeast region of Brazil. The location — Natal, Fortaleza or Recife — will be decided by year-end and the hub could be operational from December 2016.

The main objective of the Northeast hub would be to expand LATAM’s operations between Europe and South America. The move is seen as a response to TAP Portugal’s upcoming privatisation and the high likelihood that TAP will end up in the hands of either Azul or the Synergy Group. TAP operates more Europe-South America flights than any other airline and serves a large number of cities in Brazil.

The move makes sense. It would tap into a potentially strong new market, improve connectivity for the northern part of Brazil, offer significantly shorter flights and connecting times to Europe, better utilise aircraft and improve productivity. LATAM has said that the new hub would be operated using the current fleet plan.

LATAM currently serves only five European cities (London, Paris, Frankfurt, Milan and Madrid), though Barcelona will be added as the sixth destination in October (from São Paulo).

Overall, LATAM is maintaining capacity discipline in the Brazilian domestic market, with plans to keep ASKs flat in 2015. The international passenger business and SSC Domestic offer some modest growth opportunities, resulting in 4-6% ASM growth in those segments this year.

Fleet renewal

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

As to the long-haul fleet, LATAM continues to phase out A330s and A340s. Having received 10 787-8s and its first two 787-9s in Q1, LATAM plans to build the 787-9 fleet to 13 units by the end of 2016. Later this year LATAM will be the first airline in the Americas to take delivery of the A350.

With cargo, LATAM’s focus has shifted to almost exclusively filling bellyhold capacity, and the company foresees reducing its 15-strong freighter fleet by a couple of units by the end of 2016. But the management believes that LATAM will always need a certain number of freighters.

Balance sheet considerations and longer-term prospects

LATAM has had to give up hopes of an early return to investment grade. In April Fitch downgraded LATAM to “BB-“, which is three notches below investment grade, while Moody’s assigned the company a “Ba2” rating (two notches below investment grade).

Fitch cited LATAM’s high gross adjusted leverage, which it estimated at 5x after taking into account a gradual debt reduction in 2015-2016. At year-end 2014 LATAM’s total lease-adjusted debt was $12.4bn. LATAM faces substantial debt repayments in the next 18 months, which are expected to be mainly refinanced.

The rating agencies acknowledged that LATAM has adequate liquidity, with cash and available credit facilities adding up to about 15% of LTM revenues.

Last year LATAM reduced its planned 2016-2018 fleet capex by $1.8bn, but Fitch notes that it will still amount to $878m in 2015 and $1bn in 2016, keeping free cash flow “neutral to slightly negative”.

The rating agencies, like the rest of the financial community, see LATAM gradually improving its operating results and FCF generation. But there is concern about Brazil’s worsened macroeconomic outlook and FX trends, which will keep passenger yields declining in 2015.

LATAM is currently guiding for a 6-8% operating margin in 2015 (based on oil at $77 in 2H15). The consensus seems to be that, unless the situation in Brazil worsens significantly, the margin is trending to the 8%-level in 2015 or 2016, which would be a solid improvement on last year’s 4.1%.

These tough times have not changed the thinking on the 2012 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.

But the many risks include potential setbacks with merger integration. One of the biggest risks will be the move to a single passenger reservations system — an event that has proved highly disruptive in some other airline mergers. Having just selected the Sabre technology, which LAN adopted in 2012, for the common platform, LATAM intends to move slowly and is looking at a 2017 switchover.

A full open skies US-Brazil regime should be implemented in early 2016 (though it is yet to be ratified by President Rousseff).  By this stage one might have expected American and LATAM to be talking about enhancing their cooperation and even applying for antitrust immunity, but it seems that neither party is yet ready to do that because both are integrating after recent mergers. In any case, the initial impact of open skies may not be that great, because US carriers are cutting capacity on US-Brazil routes in response to Brazilian economic conditions.

LATAM’s longer-term prospects remain excellent. When South America recovers from its economic doldrums, LATAM will reap significant benefits from its geographic diversity, strong regional market position (leading market shares both internationally in Latin America and in the Brazil, Chile and Peru domestic markets) and the enhanced network and other benefits resulting from the merger. LATAM clearly has the potential to return to the double-digit operating margins and the solid net profits it was earning before the merger.

By Heini Nuutinen

hnuutinen@nyct.net