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LAN outlook brightens as strong 3Q2011 earnings are recorded and as merger with TAM nears

Analysis

Latin American airline group LAN has reported a significant improvement in its third quarter earnings following a surprisingly weak second quarter. Latin America's buoyant economy drove the strong showing and has LAN confident it can remain highly profitable in 4Q2011 and 2012 despite the challenging global market conditions. LAN's planned merger with Brazil's TAM, which will now almost certainly be completed in Mar-2012, further improves the group's medium to long-term outlook as LAN gains access to Brazil, the region's largest economy by a wide margin and one of the world's largest emerging markets.

LAN turned a net profit of USD95 million in 3Q2011 and an operating profit of USD161 million. While still representing an 11% drop in net earnings compared to 3Q2010, the performance was far better than 2Q2011, when LAN saw its net profit tumble by 74% to only USD16 million. LAN's operating margin, which in recent years has been one of the highest in the global airline industry, also returned to a respectable 10.8% in 3Q2011 compared to an unusually low 4.2% in 2Q2011.

LAN credited the improved financial performance compared to the prior quarter to stronger yields and load factors across its passenger and cargo businesses. Revenues for 3Q2011 were up 29% to USD1.487 billion. Passenger revenues increased by 33% to USD1.060 billion while cargo revenues were up by 23% to USD395 million.

LAN financial highlights: 3Q2011

Operating costs for the quarter increased 33%, including an 11% jump in non-fuel costs due partially to foreign currency fluctuations. LAN's fuel bill increased by 43% but this was offset by fuel surcharges, yield growth and higher load factors.

Passenger yields were up 17% while passenger traffic (RPKs) was up 14% despite only an 11% increase in capacity. As a result, the group's load factor increased by 1.6ppt to 80.6%. Cargo yields were also up 10% while cargo traffic (RTKs) was up 12%, outpacing an 11% increase in cargo capacity.

LAN operating income analysis: 3Q2011

Aires has first profitable month; rebranding planned for early December

LAN's new Colombian subsidiary Aires, which the group acquired late last year, remains in the red but is showing signs of improvement as restructuring efforts near conclusion. During LAN's 3Q2011 conference call with analysts, LAN executives revealed that Jul-2011 was Aires' first month in the black on an operating level since the acquisition although small losses were incurred during the months of August and September.

Aires incurred a USD10 million operating loss in 3Q2011, only slightly lower than the USD11 million operating loss incurred in 2Q2011. But the actual bottom line at Aires improved significantly more than just USD1 million because a "significant amount" of the USD10 million were one-time costs related to its upcoming re-branding.

Aires will be formally rebranded LAN Colombia in early Dec-2011. Rebranding costs already incurred during 3Q2011 include repainting Aires' fleet of 23 aircraft in LAN's livery and migrating Aires' IT systems to the LAN platform.

Aires, which now has a fleet of nine B737-700s and 14 Dash 8s, will also start operating three LAN-branded A320s in Nov-2011. Since the beginning of this year LAN has already adjusted Aires' network, dropped the carrier's previous LCC model and changed its pricing strategy. After the rebranding Aires will formally become part of LAN's full-service regional network.

LAN previously said it expects Aires will be break-even by early 2012. It expects the carrier's positioning in the Colombian market will improve following the rebranding as passengers will start to recognize the improvement in the carrier's operation and product. After initially cutting capacity as part of the restructuring process, Aires will resume expansion in 2012 as domestic capacity is increased by about 10% - matching LAN's expectations for the overall Colombian market.

Aires' entire B737-700 fleet is expected to gradually be replaced with A320 family aircraft, providing commonality with the rest of the narrowbody fleet at LAN and TAM. LAN has not formally decided whether to retain Aires' Dash 8 turboprop fleet although they will likely be returned to lessors as their leases expire. The current LAN group fleet plan already has three Dash 8s being returned in 2014.

LAN fleet plan: 2011 to 2014

LAN took delivery of four A320s and one B767-300 in 3Q2011. New aircraft deliveries planned for 4Q2011 include six additional A320s and two B767-300s. LAN plans to end this year with a fleet of 135 passenger aircraft and 14 freighters.

LAN's fleet plan for 2012 includes 13 additional A320s, seven B767-300s, two B777Fs and its first five B787-8s. LAN also plans to sell its last five A318s in 2012 while returning two B767-300s and three of Aires' nine B737-700s. As a result it expects to end 2012 with a fleet of 150 passenger aircraft and 16 freighters.

LAN net fleet deliveries: 2011 to 2014

LAN expects demand will remain robust enough to keep up with double-digit capacity growth. LAN is now projecting full-year passenger capacity growth of 14% to 16% in 2011 followed by capacity growth of 12% to 14% in 2012.

LAN passenger capacity growth: 2009 to 2012

LAN VP commercial planning Luis Eduardo Riquelme told analysts during this week's earnings conference call that LAN is confident the double-digit capacity increase planned for 2012 can be absorbed despite the relatively bleak global economic outlook because demand for services within Latin America is expected to remain very strong, offsetting the expected slowdown in its long-haul markets. "Most of the growth is driven within Latin America and within some of our domestic markets, which are doing pretty well," Mr Riquelme explained. "We see strong demand in Chile in general and we expect also that with the integration [with TAM] there will be new opportunities within the region ... Brazil is a market that has been doing very well this year and we expect that to continue in the future."

Passenger capacity growth was 11% in 3Q2011. Almost half of this gain was driven by the Aires acquisition, which gave LAN access to the Colombian domestic market. Colombian domestic capacity now accounts for 5% of total capacity at LAN.

Domestic capacity in Chile, which has increased 11% over the last year, now accounts for 14% of the group's total capacity. Domestic capacity in the smaller Ecuadorean market has more than doubled over the last year, driven by the launch of flights to the Galapagos Islands.

Over the last year LAN also has been rapidly expanding its regional international operation, in response to growing demand for international services within Latin America. The group's regional international operation recorded 18% ASK growth in 3Q2011 and now accounts for 24% of its total capacity.

LAN passenger capacity breakdown: 3Q2011 vs 3Q2010

Cargo capacity growth is forecast to come in at 12% to 14% this year, followed by 7% to 9% in 2012.

LAN Cargo VP Claudio Silva told analysts that despite the recent slowdown in global air cargo traffic, LAN still expects "modest" cargo traffic and revenue growth in 2012. "We will face in 2012 no doubt a more challenging market but we will face very strong northbound markets ... both to Europe and to the US," Mr Silva said.

LAN cargo capacity growth: 2009 to 2012

LAN is bullish on its overall outlook as it expects to continue to cash in on its leading position in the Latin American market, which will be further augmented once it merges with Brazil's TAM. LAN says its strong 3Q2011 performance shows its "ability to leverage continued growth opportunities in both cargo and passenger markets, enhancing the company's leadership position in Latin America and reflecting its ability to face and mitigate impacts of adverse scenarios such as fuel price volatility".

Appeal of mitigation measures will not result in any further delays to LAN-TAM merger

Boosting its short and long-term outlook, LAN is now confident it will be able to finally conclude in late 1Q2012 its proposed merger with TAM, which was first forged in Aug-2010. The biggest obstacle was cleared last month when Chilean anti-trust approved the merger on the condition that 14 mitigation measures are implemented.

LAN has since appealed three of the proposed mitigation measures to Chile's Supreme Court, claiming they are "unconstitutional and disproportionately severe". But the airline group says it does not expect the appeal to result in any further delays in completing the merger. LAN CFO Alejandro de la Fuente told analysts during this week's conference call that the carrier expects a ruling from the Supreme Court by the end of December.

If the ruling is delayed until 2012, LAN will likely decide to move forward with the merger without a final decision on the three challenged mitigation measures. "For us the priority is to not delay the process," Mr de la Fuente told analyst. "The objective is to go with the synergies as soon as we can."

As LAN is moving forward with other parts of the merger transaction while it awaits the Supreme Court decision, the appeal for now is not slowing down the merger process. As LAN has determined the mitigation measures would have minimal impact on the synergies that are to be generated by the merger, it would not be in LAN's interest to continue the appeal if it the appeal for any reason later threatens to result in a further delay to the merger process.

The three mitigation measures being reviewed by the Supreme Court include a requirement for special approval of any codeshare outside the single global alliance LATAM selects (LAN and TAM have up to 24 months after closing the merger to select a single alliance, which is expected to be oneworld); a requirement to give up four fifth-freedom rights to Lima in Peru; and a requirement that LATAM gives unrestricted access to a consultant which will be used by TDLC as part the post-merger surveillance process.

Chilean carrier PAL drops appeal to LAN-TAM merger

Small Chilean carrier PAL also initially appealed the TDLC ruling to the Supreme Court, arguing that the mitigation measures proposed by TDLC were not sufficient. But PAL this week dropped its appeal as part of a settlement with its rival. LAN has reported that it will incur a one-time charge of USD5 million related to its settlement with PAL as it has agreed to cover the legal costs PAL incurred in fighting the proposed merger to the TDLC and Supreme Court.

With the TDLC having now approved the merger, LAN and TAM are now only waiting for approval from Brazilian anti-trust authority CADE. This approval is believed to be forthcoming with few or no mitigation measures expected.

LAN says all required approvals in Europe, including from anti-trust authorities in Germany, Italy and Spain, have also now been secured. As a result the long-planned merger is on course to finally be concluded "towards the end of 1Q2012".

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