1 Airline Cutting Through the Industry's Headwinds

Most investors would not disagree with the views of Warren Buffett, who has been a longtime critic of airline investing, and even once quipped that he should have gone back in time to shoot the inventor of planes to save investors' money. I beg to differ about investing in air carriers, and feel strongly that every investment should be judged on its own merits, including airlines.

The issues with most airlines include muted revenue growth (high operating leverage increases the breakeven point), low regulatory barriers to entry (more competition) and excessive leverage. But, one airline formed by a merger between Chile's LAN Airlines and Brazil's TAM S.A., LATAM Airlines (NYSE: LFL  ) , boasts good growth prospects, leading market shares, and manageable debt levels, thus avoiding the usual problems associated with airlines. It is the top airline in Chile, Peru, and Brazil, sporting market shares of 77.2%, 62.2%, and 43.7% of domestic operations, respectively. It also has operations in Ecuador, Argentina, and Colombia. 

Why Latin America?
According to research published by the International Civil Aviation Organization in July 2013, Latin America is expected to be the second-fastest growth region in terms of scheduled air passenger traffic in 2014 and 2015, after the Middle East. The organization forecasts scheduled air passenger traffic for the Latin America-Caribbean region to grow by 8.7% and 8% in 2014 and 2015, respectively.

Another point is that airline profitability is a function of regulatory barriers to entry. Incumbents and domestic airlines in Latin America, like LATAM, are relatively more protected by airline regulations that are in place. For example, the cap on foreign investment in Brazilian airlines is currently 20%, although there is a possibility of the cap increasing to 49%, based on a Sept. 2013 news report. Furthermore, in countries such as Peru and Ecuador, only domestic airlines are allowed to ply domestic routes.

Revenue mix with cargo makes a difference
Firstly, LATAM's cargo business helps to improve fleet utilization, partly mitigating the negative impact of operating leverage. Aircraft rentals, landing fees, depreciation and amortization, and salaries all represent fixed costs that have to be paid for, even if the planes are not at full capacity or flying. By using excess belly capacity to carry cargo, LATAM improves fleet utilization, thereby lowering the breakeven point on a fleet-by-fleet basis.

Secondly, the cargo business has historically been a source of stability for LATAM, due to its relatively steadier demand and higher margins. Cargo customers tend to be less sensitive to price because of the time-sensitive nature of delivery. Furthermore, cargo demand is also more consistent. While consumers may cut off leisure air travel completely in bad times, businesses that are still running continue to rely on cargo services, albeit at lower volumes.

While LATAM's cargo business has recently suffered from lower volumes as a result of a weaker economy, I am optimistic that any economic recovery will be positive for LATAM, in view of its status as the largest air cargo operator in Latin America.

Future outlook
LATAM reported a loss of $330 million for the second quarter of fiscal 2013, compared with a $449 million loss in the second quarter of 2012, due to weak Latin American economy. Despite this, investors seeking to pick up a few signs of potential recovery, could find some bright spots among the gloom.

LATAM achieved an operating margin of 1.3%, notwithstanding the fact that the second quarter is the weakest quarter on a seasonal basis. This represents an improvement of 550 basis points from the negative 3.8% recorded in the second quarter of 2012. In Brazil, its largest revenue contributor, capacity reduction efforts have continued to deliver results, with LATAM increasing its load factors by about 900 basis points year on year to 78% for the most recent quarter. 

In light of these positives, LATAM has guided for a full year 2013 operating margin of between 4% and 6%. While it is tough to know exactly when macroeconomic conditions in Latin America will turn for the better, my take is that the worst could be over.

Peer comparison
LATAM's peers include GOL Linhas Aereas Inteligentes (NYSE: GOL  ) and Copa (NYSE: CPA  ) Astute readers will ask if they should consider other listed Latin American airlines instead. I will examine the alternatives below.

GOL is not as attractive as LATAM as a proxy for Latin American air travel growth for two reasons. Firstly, it pays to diversify when it comes to emerging markets and GOL is very much a pure play on Brazil. In contrast, LATAM is a much more diversified play, providing investors with a broad-base exposure to growth in the region. Secondly, a mix of financial leverage and operating leverage is usually a receipe for disaster. GOL's gearing of 411% is almost double that of LATAM, and this figure does not yet take into account the significant off balance sheet liabilities in terms of aircraft leases. GOL's  full year 2013 operating margin guidance of between 1% and 3%, is also inferior to that of LATAM.

Copa's strategic geographic location and cost efficiency are key contributors to its excellent profitability. Copa is centrally situated at Tocumen International Airport in Panama, which allows it to capitalize on traffic demand in its key markets in North, Central and South America and the Caribbean. Relatively low labor costs in Panama and Copa's focus on maintaining a modern fleet (which reduces maintenance costs) have helped Copa remain cost competitive. Unfortunately the market is efficient and has factored Copa's competitive advantages and strong financial results into its stock price, which is up by 68% on a 52 week basis.

Conclusion
It is easy for investors to be clouded by short-term cyclical macro factors and pass on the opportunity to invest in good companies that have become cheap. Weak economic conditions and currency depreciation in Latin America have weighed heavily on LATAM's stock price, which has fallen by about 40%, on a 52-week basis. This looks like an attractive opportunity to seriously consider a top Latin American airline with a diversified revenue mix in terms of geography and business.

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