In hindsight, perhaps LAN chief executive Enrique Cueto laments picking a Friday the 13th to announce such major news. It was a “historic day” for the company, Cueto told staff and the market on that date in August 2010, as he announced the merger between the Chilean airline and its Brazilian peer TAM.
The new company, which would take the name Latam Airlines Group, would fly to 115 destinations in 23 countries globally, he said.
“We are convinced this is the best way to achieve the goal which all of us at LAN have been working on for the last years: to become the best Latin American airline, and one among the top 10 in the world,” he wrote.
But a crippling economic crisis in Brazil would make goals much harder to reach for Latamwhich began operations two years after Cueto’s announcement. Headquartered in Santiago, Chile, the airline today serves 140 destinations in 25 countries, and is a dominant player in many South American markets: the airline accounts for 76% of the market in Chile and 61% in Peru. In other countries where it has domestic operations — Argentina, Brazil, Colombia and Ecuador — it accounts for 21% to 35% of the market.
Despite the airline’s broad reach, Brazilian operations provide the backbone of the company’s business, accounting for around 35% of revenues. “They entered into this acquisition at the worst time in Brazil,” says José Vértiz, an analyst at Fitch Ratings, pointing to the country’s dominance in Latam’s operations. “Whatever happens in Brazil is going to have an impact on the company.”
Demand for air travel had grown sharply in Latin America in the years prior to the group’s formation. Falling airfares encouraged Brazilians used to taking long-haul bus rides to jump on a plane, instead. Then as Brazil’s economic crisis hit, suddenly that bus ticket seemed the better option for many travelers once again. Business travelers – the golden goose of airline passengers – slashed their trips and increasingly downgraded to economy class. Leisure travelers also shrunk.
Even as air passenger numbers slumped, the cost to airlines of flying remained the same. “There was a lot of capacity,” says Fernando Abdalla, transport analyst at JPMorgan. “Airlines have high fixed costs, so if you don’t fill the aircraft then margins suffer. We joke that the airline industry is the only industry where not growing is good.”
The disappointment surrounding the merger was palpable. “The synergies were below expectations in the first years,” says Abdalla. “And 2015 and 2016 were bad years for the airline industry overall, especially for Brazil.”
The pain was reflected in the group’s stock price and ratings. Latam’s shares traded at CLP13,489 on June 22, 2012, the day the merger took effect. Investors have never been so bullish on the company. In October 2015, the share price hit the bottom, at CLP3,303 apiece. It has since recovered, but at CLP7,450 ($11.15) in mid-June, it’s a long way from the peak.
Now, perhaps, there is a break in the storm clouds: the group posted a profit in 2016. Although a mere $69 million on revenues of $9.5 billion, it represented the first such gains since the merger.
But risks are everywhere. With most revenues in local currency and costs in dollars, foreign exchange fluctuations are a big headache. Similarly, a spike in the price of oil would inflict financial pain. At the same time, questions over when Brazilians will regain lost appetite for flying, and how successfully the company can stave off new competitors, will also shape the group’s fortune.
A mid-air pivot
Five years after its inception, Latam Airlines Group remains a company in transition.
“In addition to the association, Brazil has had two difficult years, with negative GDP growth in 2015 and 2016,” Ramiro Alfonsín, Latam’s chief financial officer, tells LatinFinance.
“Nonetheless, the company has been able to improve its margins. We have paid dividends in 2017 from the 2016 results. Now we’re establishing this new business model and stimulating traffic.”
The most obvious pivot is the airline’s move to low-cost carrier practices on domestic routes. Under the new model the company will lower ticket prices, but charge for on-board food, baggage checks, better seats and other extras.
Latam Airlines Group is rolling out the strategy country by country across Latin America in a bid to head off increasing competition from budget airlines in these markets. Yet the formula, pioneered in Europe by the likes of Ryanair and Easyjet, is trickier in emerging markets, says JPMorgan’s Abdalla.
“For airlines like Ryanair and Easyjet, ancillary business accounts for around 25% to 30% of total revenues,” he says. “In Brazil, that’s closer to 10%. The profile of travelers is different in less developed countries — they spend less on [extras on] low-cost carriers. “
But looking at the metrics from a different angle — the growth in discretionary spend per passenger — Alfonsín is confident of success. “In 2016, we had a little less than $3 per passenger. We’re confident that by 2018 we should have about $8 per passenger.”
The group spent the first half of the year rolling out the new formula on its domestic routes. Although it’s too early to judge whether the strategy will help Latam’s bottom line, Alfonsín says the initial reception from passengers is encouraging.
Simultaneously, the airline is at the tail end of a major efficiency drive. It cut staff across the region and has sharply reeled in spending on aircraft. In 2016, Latam cut capacity on domestic flights in Brazil by 13% and capacity on routes between Brazil and the US by 36%. That opened the way for a 15% surge in revenue per available seat kilometer — RASK — a measure of income as a proportion of capacity.
Across the region, Latam’s capacity reduction has been more cautious, falling 3% since 2013. But combined with other efforts, it has helped slash spending.
“We’ve reduced our operating costs since 2014 by 16%,” says Alfonsín. “That’s excluding the reduction on fuel costs. We’ve done this in an environment of high inflation in certain countries. So the effort that we have put into that is much larger than that 16%. In addition if you look at the past 12 months, we’ve reduced headcount by 11%. That’s a significant reduction.”
Still, cutting costs is difficult for a company that books most revenues in local currency but pays its biggest expenses in dollars. Despite continuing to lay off staff in the first quarter, Latam spent 7.5% more on wages than a year earlier as the Brazilian real soared and inflation in the country remained persistent. Similarly, a fuel hedge saved the company $2.4 million in the first quarter, and it used 4.6% less fuel than a year earlier. But with oil prices up a whopping 44%, the company’s overall fuel bill rose 29%.
One area where Latam has taken greater control over its expenses is in its funding costs. Here, the company has aggressively sought to cut costs at every opportunity, tapping a diverse range of financing sources. It has dipped into new markets when the conditions are optimal and has not been afraid to step back if the best deal is not available.
“I don’t think another airline in the world has touched every available market,” says Tom Hollahan, head of Citigroup’s global aviation industry business. The bank has worked with Latam Airlines on multiple financing operations in recent years.
The company has aggressively extended its financing base since the bottom fell out of the export credit agency (ECAs) market, once a stellar source of cheap capital for customers of Airbus and Boeing, such as Latam. Mandated to help their companies sell to overseas customers, the ECAs, including the US Eximbank, extended highly attractive financing to aircraft buyers.
“Back in 2014, they were very reliant on ECA funding,” notes Hollahan. “Latam went to the US Eximbank for their Boeing aircraft and to the European ECAs for their Airbus aircraft. They got incredibly good pricing.”
Even as the ECA financing market dried up, Latam’s rating, weighed down by the sinking Brazilian economy, slumped. “At one point, the company was rated investment grade by Fitch,” says Hollahan. “Now they are in the low-BB, high single-B cross-over range. This reflects just how difficult the environment has been for them.”
Still, the company has pushed ahead with sophisticated structured notes, bank loans, liquidity lines, and bonds in local currencies and dollars. It has nimbly hopped between markets, depending on which offers the best pricing at any given moment. “They are very adept at tapping the markets that are most attractive to them,” observes Hollahan.
In an early transaction in 2014, Latam securitized $150 million in future credit card receivables. The following year, it pioneered an issue of Enhanced Equipment Trust Certificates — known in the industry as EETCs — which mimicked an aircraft financing structure common in the US but rare elsewhere. Latam’s multi-country structure made the deal particularly complex. LatinFinance awarded the transaction 2015 Structured Financing of the Year for its sophistication, novelty and complexity.
Soon after, Latam launched a $500 million senior unsecured bond. In 2016 the company stepped back from the capital markets, turning to bank lenders instead. In addition to a $250 million term loan paying a mere 200 basis points over Libor, the airline set up a $275 million revolving credit facility.
The revolver “is a very different structure to their other debt, and a different group of banks,” says Scott Debano, a managing director in Citi’s global structured finance division. “The transaction provides unfunded capital.”
Additionally, late last year the airline received a major infusion of capital from Qatar Airways, which bought a 10% stake in the company for $613 million.
“Over the last five years, Latam has increasingly established itself as a global airline — not just as an operational entity, but also in terms of capital resourcing, structuring and pricing,” says Emily DiStefano, a partner at Clifford Chance, which has advised Latam Airlines on multiple financial transactions. “What they’ve done is very similar to what companies like Delta and American Airlines have done, which is to get a diversity of funding sources for their aircraft, for their general day-to-day needs, for all their capital needs. Unlike US airlines, they also have access to export credit financings.”
The wide range of funding sources provides comfort to all creditors concerning Latam’s creditworthiness. “They recognize that a diversity of capital sources adds value to each individual tranche, whether that’s tangible in terms of pricing, or whether it’s simply access,” says Gary Brooks, a Clifford Chance partner.
The deals Latam has not executed are perhaps even more illustrative of the company’s focused financing strategy than those that have gone through. Its EETC landmark is a good example.
The first two tranches of the deal were a resounding success, raising a little over $1 billion. But the company held a third tranche for which it had prepared documentation, deciding that pricing for the deeply subordinated C tranche was simply not worth pushing. Regardless of its junior ranking, the C tranche would have used some collateral, but market conditions meant Latam would have paid a similar yield to unsecured paper.
With access to other markets available, Latam bided its time.
“By 2017, the market for that C tranche rallied a lot — that market was looking for paper,” says Hollahan. “There was no question that the C tranche pricing was coming in way inside where it had been in 2015, or where Latam could do an unsecured bond, and it became attractive again.” Latam ultimately issued the $140 million C-tranche earlier this year.
Latam burnished its reputation for a disciplined approach again last October when it backed away from a benchmark-sized senior unsecured bond. It planned to use the cash to buy back old debt issued by TAM, a 7.375% 2017 and an 8.375% 2021. But the market quickly turned as the deal advanced, and the company decided that no deal would be better than a poorly priced one.
“They didn’t need to chase the market if it wasn’t presenting them with the terms that made sense,” says Hollahan. “They waited until the market improved and went back to the unsecured market this year and raised $700 million in an excellent execution.” The new 6.875% 2024 bond was priced to yield 7%.
Latam is “very disciplined,” says Debano. “They don’t chase – they let the market come to them.”
That controlled approach to finance, in addition to the wide range of sources of capital it has accessed over the past year, made Latam Airlines stand out in LatinFinance’s 2017 Best Corporates in the Capital Markets Awards. The company takes this year’s awards for Andean Corporate with the Best Capital Markets Strategy, and Overall Best Corporate in the Capital Markets.
Latam Airlines Group is liquid and agile in the financial markets. But the company will have to tackle some big problems in the years ahead. One is balancing its scaled-back capacity with increasing competition in the markets in which it competes. Despite the difficult years for airlines in Latin America, new brands are already popping up.
VivaAir began flying two Airbus 320s in Peru in May. The country’s first low-cost airline was set up by Irelandia Aviation, the brains behind Europe’s RyanAir. In Argentina, Norwegian Airlines is preparing to launch a budget operator later this year. Norwegian Air Argentina is expected to have 10 planes on domestic routes.
The threat posed by new entrants — and existing rivals — is front of mind for Alfonsín, who lists competition as the biggest threat for the group. “I would say a risk going forward is that in Latin America we’ll see additional competition. And that’s why we’re establishing this new business model: to continue being a leading player in Latin America.”
The company has shown that it can turn an annual profit — even in a dire year for Brazil. So can the trend continue? For Abdalla, that depends on the recovery in demand for plane tickets, although he insists that “the crisis is behind us.”
The company’s executives
remain highly cautious about a pick-up in demand in Brazil in the coming years.
Presenting the company’s first quarter results to analysts, corporate controller
Gisela Escobar said Latam would take “a very cautious approach with respect to
But already, the group’s EBIT margin has picked up, hitting 6% in 2016, says Alfonsín. Latam hopes to boost that number by as much as two points this year, despite registering one-off hits from staff cuts and rolling out the new domestic business model, he says. The group’s targets are even more ambitious for the years ahead. “We’re confident that by 2019 we should have a double-digit EBIT margin,” says Alfonsín.
Latam has been “very proactive during the last two years in taking measures to adjust its credit risk, by working on liquidity and reducing capex,” says Vértiz from Fitch. While the capex and competition challenges remain, the indications from the executive team are promising, he says. “Management is showing a lot of commitment. It’s very challenging but the company has been making very tough decisions over the last three years. And because of that I think the business model will continue to work.” LF