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Azul: Now on a clear path to increased profitability? September 2017 Download PDF

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Azul Linhas Aéreas Brasileiras, Brazil’s third largest carrier, completed a $400m-plus IPO in April and improved profitability in Q1 and Q2. All of that was achieved against a still-weak economic backdrop in Brazil. Is Azul now set to go from strength to strength as Brazil’s GDP growth accelerates and as the airline up-gauges from E-jets to A320neos?

São Paulo-based Azul was created by airline visionary David Neeleman (also a founder or co-founder of Morris Air, WestJet and JetBlue). It adopted a business model that was unusual but tailor-made for the Brazilian market: providing affordable, high-quality, JetBlue-style service in regional markets throughout Brazil with a fleet of E190/195s and ATR72s.

While Gol brought cheap air travel for the masses in Brazil, Azul in turn has sought to make sure that even the smallest communities have air service. As a result, it carries significant volumes of business traffic. Azul accounts for 30% of the total corporate travel revenues in Brazil, compared to its 18.1% share of domestic RPKs (see table).

Azul has been able to continue to grow rapidly in part because it is the only carrier on 72% of its routes. In 2012 it acquired TRIP, which was one of South America’s largest regional carriers with a 64-strong fleet. Its formidable domestic position was the basis for launching long-haul operations to the US with leased A330s in 2014, followed by A330 flights to Europe (São Paulo-Lisbon) in 2016.

After marginal operating profits in 2011 and 2012, Azul promisingly attained 7-9% EBIT margins in 2013 and 2014. The outlook was bright enough for the carrier to file for an IPO (its third attempt) at the end of 2014 (Aviation Strategy, December 2014).

But in early 2015 the Real began to depreciate sharply and Brazil slide into its worst recession on record. Those developments scuppered the IPO plans and led Azul to report a modest R$168m operating loss and a horrendous R$1.1bn pretax loss for 2015.

In the past two years the country has also seen unprecedented political turmoil and uncertainty resulting from wide-scale corruption probes focused on the state-owned oil company and the lengthy process that led to the impeachment of former President Dilma Rousseff in August 2016.

Business travel demand and yields in Brazil declined sharply in 2015 and 2016. Domestic passenger numbers, which had tripled in the preceding decade (from 32m in 2004 to 96m in 2014), grew by only 0.3% in 2015 and fell by 7.8% last year (to 88.7m).

Azul was hit especially hard because the bulk of its operations are domestic and because it relies heavily on corporate traffic (65% of its total). Also, with an all-regional domestic fleet, Azul had no flexibility to move aircraft from the hard-hit short haul business markets to larger and more resilient long-haul leisure markets, such as those linking the southern cities with the tropical northeast (something that Gol was able to do with its 737s).

Azul did, however, take decisive action, removing 34 aircraft from its fleet in 2016. As a result (after some new deliveries), the fleet shrank by 15%, from 144 to 123 aircraft. While most of the aircraft were either returned upon lease expiry or sold, Azul found a further way to get rid of excess aircraft: pass them to new strategic partners. TAP Portugal received 17 aircraft from Azul in late 2015 and during 2016 (mainly ATR-72s and E190s but also one A330). Hainan, in turn, has been the recipient of all five of Azul’s A350-900 lease commitments. Azul was originally due to take those aircraft from ILFC starting in March 2017.

Despite the recession, Azul was also successful in raising funds for operations and for growth as its IPO was repeatedly delayed. In 2013 it secured an investment totalling R$240m from three prominent financial or private equity firms in the US and Brazil — Fidelity Investments, Peterson Partners and Bozano Investimentos.

Azul also sold equity stakes to foreign airlines. Those efforts brought in US$100m from United in 2015 (for a 5% economic stake) and US$450m from HNA’s unit Hainan in 2016 (for a 24% stake). Interestingly, Azul used part of the Hainan funds to make an investment in TAP Portugal, acquiring €90m of bonds that are convertible into up to 41.25% of TAP’s economic interest.

Those ownership links have given Azul an eclectic mix of global airline partners. There is also developing commercial cooperation with JetBlue. It will be interesting to see how those relationships evolve and benefit Azul in the longer term.

Azul returned to profitability in 2016, reporting a respectable R$344m (US$100m) operating profit (5.2% of revenues) and a small R$17.7m pretax profit. The reasons for the turnaround: Azul’s exemplary response to the crisis, the Brazilian currency’s appreciation against the US dollar, deeper industry capacity cuts in the domestic market, and the start of demand and yield recovery in the international market in the second half of the year.

Currency shifts were the key. In 2014-2015 when oil prices fell sharply, Brazil’s airlines didn’t benefit much as the real plummeted against the US dollar (by as much as 42% in 2015), causing the airlines’ dollar denominated costs to soar. Last year, however, the exchange rate trends reversed while also oil prices remained low. The Brazilian Real was one of the world’s best-performing currencies in 2016.

A320neo impact

This year has seen Azul’s financial results improve significantly. In Q1 the airline had an operating profit of R$205m (up from R$7m a year earlier) or 11% of revenues (up from 0.4%). Net profit was R$55m, contrasting with a year-earlier loss of R$67m.

In Q2 — the seasonally weakest period for airlines in Brazil — Azul’s operating profit rose from R$1.3m to R$105m and the margin from 0.1% to 6.1%. Net loss was reduced from R$120m to R$34m. The improvement came despite brisk 18% capacity growth.

While Azul is benefiting from positive revenue trends, the biggest improvements have been on the cost side. In the second quarter, Azul’s ex-fuel unit costs declined by 8.1%.

Some of the unit cost reduction was because of ASK growth, but the main driver was Azul’s new up-gauging strategy — introducing 174-seat A320neos to replace 118-seat E195s on the longest domestic routes. Not only does the A320neo offer 29% lower CASK than the E195, Azul also has been able to operate the A320neos 14.2 hours per day, well above its systemwide average daily utilisation of 10.2 hours.

Although the A320neo unit revenues are also lower, Azul is seeing a much lesser RASK reduction than the 29% CASK reduction.

And there are network benefits. In the latest quarterly call, the management talked about the A320neos “widening the pipes” on the domestic trunk routes, increasing connectivity throughout the network. Azul needed a larger aircraft for such routes. The A320s are freeing the E195s to high-frequency business markets, to which they are more suited.

Azul is seeing strong margin expansion on the routes that the A320neos currently serve. The type will account for much of the 11-13% ASK growth and a 3.5-5.5% ex-fuel CASK reduction projected for 2017. Flight departures are expected to increase by only 1-2%.

Azul has only operated the A320neo since December 2016 and had only eight in the fleet in mid-August. But the type is already materially boosting  the system operating margin, which the airline currently expects to roughly double this year, to 9-11%.

The positive effects will continue as deliveries of the 2014 order for 63 A320neos (35 directly from Airbus and 28 via lessors) are scheduled through to 2023. Azul expects to have 11 A320neos in the fleet by the end of 2017 and 20 by year-end 2018. At the end of this year the type will account for about 20% of total ASKs.

Margin expansion strategy

Upgauging with A320neos was only one of several “pillars” of Azul’s margin expansion strategy Azul executives discussed on the IPO roadshow. The other pillars are: expanding TudoAzul FFP, developing ancillary revenues and benefiting from Brazil’s economic recovery.

Management sees the rapidly growing TudoAzul FFP as a key asset, with significant revenue generating potential. Founded in 2009 and wholly owned by Azul, the programme had 7.6m members in June (up 18.4% in LTM) and gross billings of R$708.7m last year (up 34% on 2015) from sales to banking partners and direct sales to members.

In addition to expanding Azul Cargo and Azul Viagens (both very promising areas), Azul expects checked bag fees and other product unbundling initiatives to become an important source of ancillary revenue from 2018 onwards. Azul was the first carrier in Brazil to implement checked baggage fees (on June 1) following the resolution of court cases that challenged ANAC’s December 2016 ruling that airlines could charge for checked bags. Gol and TAM followed suit in late June.

Azul kept things simple: offering two fare types, one with no checked baggage and one with a 23kg baggage allowance. The latter costs R$30 more online and R$50 more at the airport. The airline said in August that there had been little negative feedback and that a high percentage of travellers were buying the baggage upgrades.

Azul executives said that the bag fees were “just the start of unbundling as you see in the US and Europe”. The airline is now exploring the “typical things that come with unbundling”, such as seat assignments.

The message Azul is sending to investors is that it is on a “clear path to increased profitability” and that it is well positioned to benefit from Brazil’s economic recovery.

Brazil officially exited recession in the second quarter, when its GDP grew by 0.3% year-on-year. It followed a stronger than expected Q1, when GDP expanded by 1% over Q4 but still declined by 1.4% year-on-year. In July the IMF slightly raised its 2017 GDP growth forecast for Brazil to 0.3%.

But the recovery is still expected to be slow. The IMF actually revised down the 2018 growth forecast from 1.7% to 1.3%, citing “ongoing weakness in domestic demand and an increase in political and policy uncertainty”. President Michel Temer has found it hard to push through his programme of comprehensive market reforms, and he has only a 5% public approval rating having been drawn into ever-expanding bribery scandals (though congress recently voted against a trial).

IPO benefits

After three attempts to launch an IPO in 2013-2014 that were scuppered by market conditions, Azul was finally able to go public in April 2017. It completed vastly oversubscribed local and international offerings totalling R$2bn (US$644m) and listed its shares in São Paulo and New York (NYSE). It was the first dual-listed IPO for a Brazilian company since 2009.

R$315m of the R$1,288m (US$406m) net proceeds collected by Azul were allocated for repaying debt coming due within 12 months and which carried a horrendously high weighted interest rate of “123% of the CDI rate”, which itself was 14.9% at that time.

As a result of the IPO, Azul now has a relatively healthy balance sheet. At the end of June, cash and short-term investments amounted to R$1.5bn or 20.5% of LTM revenues, up from only R$417m (6.4% of revenues) in June 2016. Net debt was $1.4bn, down from R$3.3bn a year earlier. Adjusted net debt/EBITDAR fell from 8.8x to 4.5x. Shareholders’ equity rose from R$364m negative to R$2.3bn positive.

The initial post-IPO debt reduction led to a saving of R$60m on financial expenses in the second quarter, and there is a good opportunity to further reduce interest costs through refinancings. In mid-May Azul had around R$1.7bn of expensive working capital debt with Brazilian banks. The management said that since the IPO they had received numerous refinancing offers and planned to “aggressively” tackle that debt this year. The process began in Q2 with the refinancing of a R$200m loan that resulted in a lower interest rate and an extended term.

In addition to having a stronger balance sheet, Azul benefits from being less exposed to foreign currencies than its peers. Only 46% of its debt is denominated in US dollars. In Q2 its dollar-denominated assets (cash in the US, cash deposits and maintenance reserves, TAP bond) exceeded the dollar liabilities by over R$500m. Being “long on the US dollar” is quite unique for a Latin American carrier.

Azul has successfully sold itself as a margin recovery and deleveraging story to global investors. The São Paulo-listed shares and NYSE-listed ADSs have performed well, increasing by 43-44% since the IPO. Analysts who cover Azul continue to recommend it as a buy or strong buy.

In mid-September Azul completed a US$362.3m follow-on global offering, in which some of the smaller shareholders cashed in more of their stakes. The sellers did not include founder David Neeleman or the key strategic partners such as HNA or United, and the airline did not receive any proceeds.

Unusual ownership structure

Azul’s post-IPO ownership structure is unusual. First, Neeleman holds 50.8% of the company’s stock and 67% of voting rights. He continues to control all shareholder decisions, including the right to appoint the majority of the board of directors. Neeleman has made it clear in interviews that he did not like the way he was ousted from JetBlue by its board of directors after the New York-based carrier’s poor response to a snowstorm in 2007.

Second, Neeleman has only a 6% economic interest in Azul. Having a controlling shareholder with considerably less economic interest in the results may potentially create a conflict of interest with other regular shareholders.

Third, as much as 37.1% of the economic interest in Azul is held by three current or former airlines. They include Hainan, the single largest holder of preferred stock with a 22% stake. Former shareholders of TRIP have an 11.3% economic interest, while United owns 3.8%.

Even though the IPO provided an exit opportunity for Azul’s original investors, many have stayed onboard, including private equity firms Weston Presidio and TPG Growth. Such minority investors hold a combined 28% of the economic interest in Azul, with the remaining 29% accounted for by the new IPO shareholders.

The former shareholders of TRIP — the Chieppe and Caprioli families, which founded and owned the regional carrier prior to its acquisition by Azul — also hold the 33% of Azul’s capital that is not owned by Neeleman. Those investors, along with strategic investors Hainan and United, have rights, including board representation, that are safeguarded by a post-IPO shareholders’ agreement.

Azul has a prestigious board made up of experienced financial executives of big-name private equity firms and founders or senior executives of airlines in different parts of the world. The striking feature is that so much of it is inter-linked. Many of Azul’s original investors were also investors in Neeleman’s earlier ventures, such as Morris Air. Board director Michael Lazarus, co-founder of Weston Presidio, was also the founding chairman of JetBlue. Many of the top Azul executives, including the current CEO John Rodgerson who took up his position in July, originally came from JetBlue. The former CEO of Azul, Antonoaldo Neves, moved to join European partner TAP’s board and is tipped to become TAP’s next CEO. Board director Henri Courpron, formerly CEO of lessor ILFC, also sits on TAP’s board. And so on.

Network and growth plans

Azul has the largest airline network in Brazil in terms of cities served (202) and daily departures. The airline covers all of Brazil and offers high frequencies in many markets, operating a hub-and-spoke network.

Azul’s home base and main hub is at Viracopos Airport in the city of Campinas, just 50 minutes from downtown São Paulo. The airport has a brand new terminal (April 2016) with capacity of 25m passengers/year.

The airline operates a secondary hub at Belo Horizonte’s Confins airport. It has also recently built a regional hub in Recife in Brazil’s northeast, from which it currently serves 25 destinations, including Orlando in the US. Recife is the closest hub for direct flights to both Europe and the US.

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 72% of its existing routes and the frequency leader on another 17% of routes.

A strong brand, superior offerings (leather seats, more legroom, free LiveTV) and customer focus all contribute to Azul achieving significantly higher unit revenues than other carriers. The PRASK premium, consistently high load factors, high efficiency and a competitive cost structure offset the poorer economics of smaller aircraft.

The strategically located hubs and the feed generated by the domestic network made going international an attractive option. Azul launched its first US services, linking the Campinas hub with Fort Lauderdale and Orlando with newly delivered A330-200s in December 2014. That was followed by Recife-Orlando flights in December 2016.

Azul made its European debut in June 2016 when it introduced four-per-week A330-200 flights on the Campinas-Lisbon route.

And most recently, in August Azul announced plans to expand the US network in December 2017 with two new routes: Belo Horizonte-Orlando and Belém-Fort Lauderdale. The latter is possible because of the availability of the A320neos.

Since Azul also plans to increase the frequencies on the US routes out of Campinas in December, it will be offering a total of 34 weekly flights to two US gateways from four cities in Brazil.

Azul has also added service to select destinations in South America, which it can serve with narrowbody aircraft. From Porto Alegre it currently offers flights to Montevideo and Punta del Este in Uruguay; from Belém it serves Cayenne (French Guiana); and earlier this year it began serving Buenos Aires (Argentina) from Belo Horizonte.

The US and European services are feasible essentially because of strategic partnerships, including codeshares, with United and TAP, respectively. The latter was established in March 2016 and is highly beneficial to Azul because TAP is the number one European carrier to Brazil in terms of seats and flights and serves as many as 10 destinations in Brazil. Azul also gets feed from TAP’s European network.

Azul’s international growth spurt has meant that in 2016 international revenues accounted for 10.1% of its total revenues, up from 6.8% in 2015. Also, in the past year Azul has overtaken Gol as Brazil’s second largest international airline (after TAM). In June 2017 Azul accounted for 12.2% of the total international RPKs by Brazilian carriers, compared to Gol’s 8.6% share — a rough reversal of the year-earlier shares.

With the IPO behind it, profit margins recovering and Brazil’s economic recovery slowly gathering strength, Azul is stepping up growth. In 2017 it expects ASKs to increase by 11-13%, mostly through the A320neo introductions. It will be adding the A320neos at a rate of about 6-8 per year.

However, Azul will also continue to grow in its traditional markets with smaller aircraft. The management said earlier this year that the airline could add 32 new cities over the next five years or so and that 30 of those would be cities where there is no airline service today. “That is really a huge part of our growth strategy going forward”, Neeleman noted.

Over the next few years Azul will be going through a significant fleet transformation process in which it will replace older-generation aircraft with next-generation models, namely the A320neos and the E2s (the latter starting in 2019).

But Azul is really moving to operate multiple fleet types. The shortest and lowest-density routes will be flown by ATRs. The medium-haul, high-frequency business-oriented routes of less than two hours will be flown primarily by the E195s. The A320neos will operate on sectors longer than two hours.

The management estimates that for the route system today the A320neos would ideally account for 35-40% of ASKs, which means “a lot of margin expansion going forward”.

On September 21, just as Aviation Strategy was going to press, Azul announced an order for five A330-900neos, which it will take on operating lease from Avolon. The aircraft will strengthen international flights to the US and Europe and allow Azul to “explore select new destinations”.

TOTAL 100% 100%
% of total domestic RPKs
June 2017 June 2013
TAM 32.7% 39.7%
Gol 35.2% 36.0%
Azul 12.8%
TRIP 3.9%
Azul+TRIP 18.1% 16.7%
Avianca Brasil 13.4% 6.9%
Others 0.5% 0.7%

Source: ANAC

TOTAL 118 133 138 144 123 121 128 141 154
  Number of aircraft at year-end
  2012 2013 2014 2015 2016 2017 2018 2019 2020
E2 2 8
E-Jets 69 78 81 88 74 69 69 69 64
ATRs 49 55 52 49 39 35 35 38 40
A320neo 5 10 17 25 35
A330 5 7 5 7 7 7 7

Note: Operating fleet, excluding aircraft that are leased out.

Source: Azul's IPO Prospectus (April 2017)

Total 102
Type Number Schedule
E195/E2 33 From 2019
ATR 8 2019-2021
A320neo 58 2017-2023
A350 3 Transfer to Hainan expected

Source: IPO Prospectus (April 2017)

Total 100% 100%
  % of total international RPKs
  June 2017 June 2016
TAM 78.7% 81.1%
Azul 12.2% 7.4%
GOL 8.6% 11.5%
Avianca Brasil 0.5% 0.1%

Source: ANAC

gnuplot Produced by GNUPLOT 5.0 patchlevel 5 0 10 20 30 40 50 60 70 80 90 100 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 -10 -5 0 5 10 15 20 25 Pax (millions) Yr-yr pct change Pax Pct Chg Passengers Pct Chg

Source: ANAC

gnuplot Produced by GNUPLOT 5.0 patchlevel 5 -1,200 -1,000 -800 -600 -400 -200 0 200 400 600 2009 2010 2011 2012 2013 2014 2015 2016 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 Operating result Pretax result Revenue Operating result Pretax result Revenue

Source: Azul's IPO Prospectus (April 2017) and earlier SEC filings

gnuplot Produced by GNUPLOT 5.0 patchlevel 5 8,000 10,000 12,000 14,000 16,000 18,000 20,000 22,000 24,000 26,000 2012 2013 2014 2015 2016 2017F* RPKs (m) ASKs (m) RPKs (m) ASKs (m)

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