Description

Summary Thesis

I am recommending a short position in the shares of Latam Airlines Group S.A (LTM), the largest Latin American airline, currently trading at $15.54 per share.

The stock has had an impressive (230%) recovery from its trough in January 2016, driven by a strong recovery in earnings and significant deleveraging. Operating trends are likely to continue to be favorable in the next several quarters. However, at a multiple of 24x 2018 and 17x 2019 consensus earnings, the stock already discounts a cyclical recovery. By 2018, I think the company will begin to experience pressure on yields and profit margins as new competition ramps up in certain core markets, namely Chile, Argentina, and Peru. This is not factored into consensus estimates and should lead to a downward revision in earnings and a derating in the multiple.

History and Background

Latam Airlines Group is the largest Latin American airline and a member of the One World Alliance. It has 43 thousand employees. It operates 303 aircraft. And, it flies 67 million passengers a year to 130 destinations in 25 countries.

LAN Chile, the predecessor company, was started by the Chilean government in 1929.  In 1994, the privatization of the company was completed.  The company, whose shares are listed on the Chilean Stock Exchange, launched an ADR program on the NYSE in 1997. Over the ensuing decades, under the leadership of the controlling shareholders, the Cueto family and Sebastian Pinera, LAN Chile expanded rapidly and profitably. The stock traded at a premium multiple. It consolidated a leadership position in Chile. It expanded its international routes. And, it established domestic operations in Argentina, Colombia, Ecuador, and Peru.  In 2010 Sebastian Pinera exited the control group in order to assume the office of President of the Republic of Chile.

The poorly timed acquisition of TAM Airlines of Brazil marked a defining turning point in the fortunes of the company. The merger was announced in August of 2010. It was supposed to take 9 months to complete, but it was not completed until June of 2012 due to regulatory hurdles. The acquisition coincided with close to peak margins at TAM, growing overcapacity in the Brazilian market, a 50% devaluation of the real, and the start of the deepest recession in Brazil since the Great Depression. The combined company posted a loss of $286 million in 2013 and $357 in 2015. The shares declined 86% from the peak in from the peak in 2011 ($31.59/ADR) to the trough in 2016 ($4.34/ADR).

In the past two years, Latam Airlines has seen a dramatic improvement in profitability driven by: lower oil prices, an appreciation of the currencies in the countries in which it operates, an improvement in Brazil’s economy and a dramatic reduction in domestic capacity by the two large players (GOL and TAM).  Operating margins troughed at 2.5%, supported by the non-Brazilian operations. In 2017 operating margins will be roughly 7% for the full year. The company recently guided to 7.5% to 9.5% operating margins for 2018. To management’s credit, the company has taken steps to cut costs, rationalize its fleet, and shore up its balance sheet through a rights issue. As a result of the latter, Qatar Airlines, now is the second largest shareholder with a 10% stake versus the Cueto family’s 28% stake. Leverage has declined from 8.2x gross debt/EBITDA in 2012 to 5.1x gross debt/EBITDA in the trailing twelve months. The shares have rallied from a low of $4.34/ADR in 2016 to a current $15.55/ADR.

Short Thesis

The reasons not to short the stock are the following:

• Operating trends are still improving and the company is benefiting from the operating leverage inherent in a cyclical business. Yields are improving. Load factors are improving. Costs per available seat mile are growing at a lower rate than revenues.

• The balance sheet is improving.

• The economies in which the company operates are all improving.

• The company is being disciplined about capacity addition, and large competitors (GOL, Avianca, Copa) are playing along.  

• Sentiment is muted with only 25% of analysts bullish, down from 43% three months ago. Short interest is 6.6%.

• The long term secular story is attractive. The IATA sees Latin America as an underpenetrated region for air travel and expects it to be the second fastest growing region in the world after Asia.

• Management is decent, and the Cueto family has a vested interest in the success of the company.  

• The business is OK as far as airlines go. The company has a decent network. Its hubs, while not as structurally attractive as Copa’s (CPA) Panama City hub, do provide attractive connectivity to smaller, less competitive cities.

• The stock is a member of four indices, and inflows into EM Funds are surging.

The reasons to short the stock are the following:

• The valuation is rich and already prices in a recovery. The stock trades at 24x 2018 consensus eps for 2018 and 17x consensus eps for 2019. Consensus eps for 2019 assumes a 10% operating margin which is approaching historical cyclical peak margins of 12%. The multiples seem rich for a relatively mature, incumbent, legacy airline expected to be operating near cyclical peak margins.

Please see comps below, courtesy of Michael Lineneberg and team of Deutsche Bank:

• I do not see a lot of upside to consensus earnings, especially in 2019.  Consensus eps estimates for 2018 are at the midpoint of management guidance and assume an 8.7% operating margin versus guidance of 7.5 to 8.5%. Management has slightly missed guidance in the past six quarters. The consensus for 2019 already assumes a 10% operating margin which is approaching historical peaks.

• The dividend yield is quite unattractive at 0.7% based on the trailing twelve month dividend and 1.3% based on 2019 estimates.

• Operating metrics, such as the spread between RASM (revenue per available seat mile) and CASM (cost per available seat mile) have recovered and are close to 80% of historical levels for Latam and for its competitors. They are not at depressed levels any  more.

• The improvement in yield over the past two years has been driven to a large extent by the real appreciation of the Brazilian Real, Chilean Peso, and Peruvian Sol.  I believe this tailwind has already played out. The Brazilian Real is unlikely to appreciate further.  

• Leverage is still relatively high with gross debt at 5x EBITDA.

• The market has been focused on the improvements in the competitive environment in Brazil, but remains pretty oblivious to the wave of LCC competition that is about to hit Chile, Peru, Argentina, and, to a lesser extent, Colombia.

The Entry of Low Cost Carriers (LCC’s)

In the past two decades there have been three important episodes of LCC’s aggressively expanding in Latin American markets: Mexico 2006 to 2008, Brazil 2001 to 2007, and,  to a much lesser extent, Brazil 2008 to now. In all instances, incumbents have suffered significant market share losses to the LCC’s and a degradation of yields and margins.  

In Mexico, six LCC’s began operations in 2006. Ultimately, three survived (Volaris, Viva Bus, and Interjet). Collectively they took over half of the domestic market. One of the incumbents, Mexicana, and half of the start-ups filed for bankruptcy. Interjet remains financially challenged. Domestic yields remain very depressed. This is due to a combination of excessive capacity growth and to the  Mexican Peso devaluation. Unlike the currencies in South America, the Peso devalued later and has not bounced back.

GOL’s entry into the Brazilian market in 2001 ultimately led to the bankruptcy of legacy carriers Varig, VASP, and Transbrasil. TAM Airlines initially suffered market share losses and a decline in profitability. Gol grew from zero to 40% share of the domestic market. More recently, Azul (backed by David Neeleman founder of Jetblue) and Avianca Brasil have been ramping up capacity aggressively. More recently yields have not seen a degradation yet mainly because the incumbents (now GOL and Latam) are ceding share and because the currency is appreciating and the economy is recovering. In local currency terms, Latam Airlines revenues in Brazil have been relatively flat despite the economic recovery.

Latam Airlines does not disclose margins by region, but it does disclose revenues by region. Eighty three percent of revenues come from passenger travel with the balance coming from cargo and other. Forty one percent of revenues come from Chile (16%), Argentina (12%), Peru (7%), Colombia (4%), and Ecuador (2%). Thirty three percent of revenues come from Brazil. Twenty five percent of revenues come from international: US (10%), Europe (8%), Asia Pacific and rest of Latin America (7%). One can infer from GOL’s margins and GOL’s cost structure, that the Spanish Speaking Countries (SSP’s) represent at least 41% of operating earnings. These markets are about to experience an expansion of LCC’s similar to what Mexico and Brazil experienced in the recent past.

Below is a list of new entrants into Latam Airlines’ SSP markets. The majority of these airlines began operations in the 2H17. One, Norwegian Air Shuttle, is beginning operations in the 1H18. The rest are existing players that have recently raised capital and are ramping up capacity aggressively. I believe that these entrants will have an impact on yields and margins and that that impact has yet to be felt and yet to be discounted in the stock price.

Chile

Jetsmart- Backed by Indigo Partners, Bill Franke of (Volaris (VLRS), Frontier Airlines, Wizz Air (WIZZ LN), previously Spirit Air (SAVE) and Tiger Airways (acquired by Singapore Air).

Sky Air- Existing player that recently raised funds to expand operations.

Varmontt Express

Latin American Wings

Plus Ultra – Focusing on Chile and, to a lesser extent, Peru.

Argentina

Norwegian Air Shuttle – Has been granted concessions to operate 153 routes domestically. Plans to offer service to London, Paris, Barcelona, Oslo, Copenhagen, Stockholm. Has begun selling tickets and is launching operations in February 2018.

Flybondi- Five airplanes operating, nine on order. Will focus on domestic routes.

Peru

Viva Peru- Backed by the Ryan family (originally of Ryannair). Recently started operations to domestic cities.

Conclusion

Latam Airlines’ (LTM) valuation is rich. It is already pricing in a cyclical recovery. More importantly, the current valuation does not price in the risk of disruption from new entrants into the Spanish Speaking Markets.The balance sheet is in better shape than before. However, at 5x gross debt/ebitda,  it is still vulnerable to degradation in margins due to heightened competitive pressures.

Risks

Operating momentum continues.  

Operating margins expand beyond prior levels.

Price momentum. People (or machines) buy the stock because it’s going up. Latin America ETF’s are getting inflows. EM is still “cheap” relative to US markets and may continue to attract more capital.

Improvements in Brazil and international route profitability offset the negative impact of higher competition in the Spanish Speaking Markets (SSP)

Catalyst

The impact of competition begins to affect yields and margins. Estimates need to come down.

Credit spreads in Latin America, which are at all time tights, begin to widen and levered equities, such as Latam, suffer disproportionately.

The increase in oil prices begins to affect profitability for the entire sector.