Description

Admin note re: headline numbers above: GOL has a dual-class share structure. There are 274mm preferred shares outstanding (Bloomberg ticker GOLL4 BZ Equity), which trade in Brazil, and which carry no voting rights. There are 2.864bn common shares, which are held by the founder and controlling family. Those are convertible to preferred shares at 35:1. Hence 274 + 2864/35 = 355.8mm preferred share equivalents, which can be converted to the USD-denominated ADR (NYSE:GOL) at 2:1, for 177.9mm basic ADR units outstanding. Financial information above contains BRL-denominated capital structure and earnings estimates; my equity price targets below are based on the USD-denominated ADR.

GOL is a catalyst-rich situation with something for everyone regardless of mandate. I think investors can earn equity-like returns in GOL's unsecured bonds and think GOL's equity has 50% upside over the next year for the following reasons:

• Despite utter mismanagement of Covid-19 by the Bolsonaro administration, new case growth is decelerating and hospital admissions are declining in Brazil as the pace of vaccination accelerates
• GOL is positioned to be a structural winner in the Brazilian airline space, with the lowest unit costs and premium customer focus set to deliver industry-leading returns on invested capital
• The company's take-in of Smiles, its loyalty program, is significantly more accretive than priced in by the market
• There are abundant market misperceptions around GOL's balance sheet, lease structure, and ability to access liquidity during what will be a tough operating environment in 2021, leading to an overly pessimistic equity valuation and bond spreads 

I prefer credit exposure in the 7s due 2025 as they offer a nice combo of current yield (13%) and convexity (significant spread tightening potential from 1200bps starting point and 103.5 2022 call). They are also the most liquid among the options below, with US$3-4mm trading every few days. I also think the 8% secured notes issued in December offer attractive total return potential below par for those with less risk tolerance. As mentioned above, I think GOL deserves a premium multiple within the Brazilian airline space owing to its strong growth potential and superior returns on invested capital. I see 50% upside over the next year based on a fundamentally-driven discounted economic profit analysis, which backs into an implied 5.7x multiple of my 2023 EBITDAR estimate.

Business description and GOL's competitive advantage

Gol Linhas Aereas Inteligentes ("GOL") was founded in 2001 as Brazil's first low-cost carrier by Constantino de Oliveira Jr. The company listed its ADR in the NYSE in 2004. Funds controlled by Oliveira hold a ~52% economic stake and 100% voting stake in GOL. GOL can rightly be credited with the popularization of air travel in Brazil. Management likes to cite the 'GOL effect': The Brazilian market grew at 4.7% annually from 1980 to 2001, and has grown at 6.3% annually since GOL's 2001 entry. Moreover, air transport passengers carried per 100 population has grown from 20 in 2001 to ~50 by 2019 (see chart).

GOL emulates Southwest Airlines with a fleet 100% comprised of Boeing 737s (gradually swapping out 737-NGs for 737 MAXes), which advantages the company relative to its competition thanks to more seats per aircraft, lower fuel consumption per ASK, higher aircraft utilization, shorter turnarounds, less complicated ground support, and greater part availability/fungibility. GOL focuses its domestic capacity on higher-value business travelers, and has dominant positions across the Sao Paulo-Rio-Brasilia triangle. Pre-Covid, business travelers accounted for 27% of passenger volumes and 50% of revenues. GOL's low-cost strategy has been borne out in the numbers (see chart below from GOL's June 2020 NYSE investor roundtable presentation). I reach the same conclusion on my own calculations: when looking at adjusted operating costs (total revenue less EBITDAR plus operating lease cash outflows), GOL outperformed fast-growing competitor Azul by an average of 7 BRL cents per ASK from 2014-2019.

GOL's primary competitors are LATAM (headquartered in Chile and currently in Chapter 11 bankruptcy) and Azul (founded in 2008 by JetBlue and WestJet founder David Neeleman). Azul has grown market share primarily at the expense of LATAM, but GOL has ceded some share as well (see chart). While Azul competes in GOL's primary domestic markets, its primary focus is on Brazil's interior. This strategy carries benefits (Azul is the only carrier on 80% of its routes) and disadvantages (requires a diversified and higher-cost fleet to service smaller cities).

Positive reopening trends are not priced into GOL's spreads/stock

Recent headlines out of Brazil portray an abject failure by its government to seriously address the Covid crisis (and also seems to contradict my subheader above). GOL's CFO said investor psychology a few weeks ago was the worst it has been throughout Covid, with things on the ground at "maximum awfulness": hospitals at 100% capacity, the government inventing a new 'purple alert' tier, 8pm to 5am curfews, etc.

Brazilian air traffic recovered strongly last fall (into mid-Southern hemisphere summer) but has fallen off steeply again amid the recent explosion in cases (see chart). On GOL's Q3 earnings call last November, management guided to Q4 ASKs down 40% from Q4'19 and guided to Q1'21 ASKs down just 24% from Q1'19 levels. But following the recent uptick in traffic, management brought down Q1'21 capacity guidance to down 45-46% from Q1'19 levels on the Q4 call last month. 

However, there is cause for optimism with the daily vaccination rate nearing 1mm as of April 4th and with cases and hospitalizations appearing to begin to crest (see charts). 

GOL's take-in of its Smiles loyalty program is significantly more accretive than the market is pricing in

I believe GOL's take-in of its Smiles loyalty program is underappreciated by the market on two fronts: (1) GOL is likely to earn greater than 40% returns on net incremental capital invested into the take-in, and (2) the take-in transaction is likely to be net accretive to GOL's liquidity position, vs. market perceptions that the company is spending down already constrained available liquidity. 

I will not do a deep dive on airline loyalty programs here and should note I do not share the view held by some airline bulls that these programs deserve eye-watering valuation multiples within the context of the airline, but I think one can make the case that the programs are significantly more valuable when fully captive to the airline. These programs capture the spread between the unit price of miles sold to partners (banks, credit card issuers) and the unit cost of rewards redeemed by members (in Smiles' case, 90% of redemptions are on GOL airline tickets). Loyalty programs also earn interest income on the float (typically there is an 8-10 month gap between miles sales and redemptions of points) and earn revenue from 'breakage', i.e., points that expire without being redeemed. The main source of profit--the spread mentioned above--can be meaningfully enhanced when the airline fully controls the mileage program because the airline gains the ability to control the value of its the program's currency by dynamically shifting redemption costs. United, Delta, and American Airlines have each published investor presentations walking through the mechanics of their programs as they successfully raised billions of dollars in secured debt backed by the programs over the last year. Each airline has pointed to significant yield premiums on ticket sales to loyalty program customers. 

GOL currently owns 52.6% of Smiles shares and recently won the approval of Smiles' minority shareholders to buy in the remaining 47.4%. Smiles shareholders can choose a cash-heavy or stock-heavy option as outlined in the table below. While it appears the rational shareholder would opt for the cash-heavy option (I calculate GOLL4 preferred shares would have to rise 25% to R$27 for Smiles shareholders to be neutral), GOL's CFO recently walked me through a few technicals that show 70% or more of minority holders are likely to take the stock option. First, a little over 30% of minority holders either must choose the stock-heavy option for tax reasons or will not elect any option whatsoever, and receive the stock-heavy option as the default. Second, an additional ~40% of holders have told the company that they prefer stock over cash and will choose stock if the spread is close enough. While one could say the spread is currently not very close at ~25%, investors must choose an election 30 days before the mark-to-market they will receive when the deal closes. As Covid recedes in Brazil and vaccinations accelerate, it is not hard to see more holders wanting to avoid the transaction costs and taxes involved with taking more cash and wanting a 30-day call option on GOLL4 stock as improving fundamentals begin to be reflected in the stock. 

If 70% of Smiles minority holders electing stock, GOL will pay R$537mm of cash and will issue 30.1mm GOLL4 preferred shares, or 15.1mm US ADR equivalents, to complete the transaction. However, that dramatically overstates the effective cash outlay GOL faces. Smiles currently has R$735mm of cash on its balance sheet, which is included in GOL's consolidated cash balance but which is inaccessible to GOL (although GOL has historically accessed this cash intermittently through forward miles sales). Smiles is paying a R$500mm special dividend before the deal closes. The upshot of all of this is that GOL will be able to access an incremental R$498mm of incremental cash on the day the transaction is completed, reducing the effective cash outlay to just R$39mm, or US$7mm. 

In exchange, the take-in could increase GOL's free cash flow by R$300mm annually as outlined below. As an independent entity, Smiles has been a full cash taxpayer; by contrast, GOL enters 2021 with US$1bn of NOLs and is likely to be able to offset Smiles' profits with airline losses for at least the next year. In addition, Smiles has paid an average of R$200mm in dividends to minority shareholders going back to 2016. The R$300mm in incremental FCF to GOL represents a 25% annual return on net invested capital (full cash plus stock components) and a 44% annual return on capital when the upfront investment is adjusted downward by the incremental cash available to GOL on day one. 

GOL management believes it can achieve an additional one cent in revenue in real terms per ASK as a result of bringing Smiles fully under the GOL umbrella through improved pricing on Smiles loyalty program members. That would be an additional R$500mm of revenue at close to 100% flow-through, representing a roughly 12% uplift to current 2022 consensus EBITDAR. 

Access to liquidity is better than appreciated

The second knock on GOL is its poor liquidity position, particularly in contrast to Azul (this is a common theme in many sell-side reports). Azul enters 2021 with R$3.1bn of cash on the balance sheet and total potential available liquidity of R$7.9bn when including accounts receivable, long-term investments, security deposits and maintenance reserves, and unencumbered assets. GOL's equivalent 'headline' number is R$5bn, but I believe the buy side heavily discounts that number due to worries GOL will pay a large cash component to take in Smiles (discussed above), the heavy remaining amortization profile of Delta's loan to GOL backed by GOL's Smiles stake, and R$2bn+ of current operating lease liabilities (see 'lease renegotiations' below). 

I think base liquidity is closer to R$3bn excluding cash currently trapped at Smiles and with sizeable haircuts to GOL's deposits, which it views as sources of liquidity. When accounting for Smiles, the remaining Delta loan amortization, and operating FCF burn in 2021, liquidity does indeed looked stretched (R$700mm as of December 2021).

Less appreciated by the market are incremental capital sources that I believe will bring 2021 year-end liquidity to R$3.2bn. First, GOL issued US$200mm of 8% senior secured notes in December 2020 to a small group of mutual fund and hedge fund investors. The bond is backed by substantially all of GOL's IP, including patents, trademarks, and brand names, and all of GOL's aircraft spare parts. GOL's CFO has said he believes he can issue up to an additional US$300mm under the current collateral package, and may start to approach the market later this month or in May now that a substantial portion of GOL's leases have been renegotiated. In addition, 60% LTV on another R$1.3bn of currently unencumbered assets would bring total available liquidity to R$5.6bn, or R$3.2bn by the end of 2021. The R$1.3bn estimate of unencumbered asset value excludes Smiles, which GOL could use to raise another R$1bn or more, even taking a sizeable haircut to LTVs seen in UAL, DAL, and AAL mileage program deals mentioned above. For context, GOL historically kept c. R$1.6bn of liquidity pre-Covid. 

GOL has outplayed Azul with respect to lease renegotiation

Another significant misperception in the market is that Azul's lease structure is better than GOL's. I believe the opposite is true. Azul's CFO said at a recent sell-side conference that it has been able to generate positive operating free cash flow with lower fares early in 2021 because of its favorable fixed lease structure, particularly compared to GOL, which negotiated power by the hour agreements on roughly half of its aircraft. Following this line of thought, GOL incurs incremental variable costs on its PBH leases as it flies more, while Azul sees significant operating leverage on its fixed leases. That is true as far as it goes, but I believe it obscures the magnitude of GOL's successful lease renegotiations in 2020 and significant optionality going forward with respect to its 737 MAX order book. 

Azul said it will pay roughly 70% of its current lease liability of R$2.6bn in 2021, with catch-up payments beginning in earnest in 2023. By contrast, GOL marked  roughly half of its leases to post-Covid market lease rates, and variabilized roughly half of its leases by converting them to a power by the hour format with fixed payments as low as 10% of the original lease cost. As a result, GOL is maximizing its utilization of lower-cost fixed lease planes while it targets Q1'21 capacity down 45% from Q1'19, and will gradually bring PBH planes into the mix as flight activity ramps. 

Pre-Covid, GOL enjoyed a nearly BRL 3 cent per ASK advantage over Azul (see chart below). Because Azul focused on deferrals and not haircuts, I expect GOL to increase its cost advantage on the lease side coming out (my estimates 2021-'24). 

Valuation 

With the 2020-'21 Covid-impacted operating environment rendering valuation multiples nearly meaningless, I look at GOL's enterprise valuation using a discounted economic profit model. From 2016-'19, GOL earned an average lease-adjusted return on invested capital of 16.3%. The discounted economic profit analysis below assumes secured and unsecured debt costs come down by 50 bps and 150 bps in a year, as investors see a path to lease-adjusted leverage falling below 4x by year-end 2023. Assuming a 3% terminal growth rate (compare to 6% estimated nominal Brazilian GDP growth and above-trend airline passenger growth) and 14% long-run return on incremental capital, GOL ADRs should be worth nearly US$12 a year from now, nearly 50% above the current trading price.

For HY investors, I believe there is an attractive trade to be had either long GOLLBZ 7% unsecureds due 1/31/25 and short AZULBZ 5 7/8% unsecureds due 10/26/24, or just outright long the GOLLBZs (see my price and total return targets at the top of the write-up). If the GOL '25s tighten to 1000 bps a year from today and remain 150 bps wide of the AZULs, the pair trade (on market value neutral up front) would net 7% on a total return basis. I have lease-adjusted leverage for GOL at 4.5x, 3.6x, and 3.0x for 2022, 2023, and 2024, and Azul at 5.4x, 4.6x, and 3.7x for the same periods. If both trade to an 850 OAS a year from today, the pair trade would net you 11.1% on a total return basis. 

Appendix: Capital structure and current valuation

Catalyst

Increased pace of vaccinations, declining cases, new secured debt issuance, completion of Smiles take-in transaction