Lan (LAN) Airlines SA regained its status as the best airline stock when adjusting for volatility, a distinction it lost after agreeing to buy Tam SA (TAMM4) almost two years ago, on prospects that a foothold in Brazil will fuel earnings growth.
Lan, the world’s safest airline investment over the past decade, returned 1.3 percent in the first quarter this year when adjusting for volatility, the best among 32 major airlines, according to the BLOOMBERG RISKLESS RETURN RANKING. Tam SA (TAM:US), the world’s most volatile airline stock in the decade before the deal was announced, moved up to third place. Lan and Tam plan to start a share swap this month after securing antitrust and shareholder approvals for the $3.8 billion transaction, which will form the world’s biggest air carrier by market value.
Lan has outperformed peers in developed markets by leveraging higher economic growth and less competition in Latin America to post 18 straight years of annual profits. The Santiago-based carrier slumped to 13th spot on the riskless ranking in the period from August 2010, when the Tam transaction was announced, through to the end of last year.
“There should be some decent upside from the idea that Lan can bring Tam in and get it operating at a similar kind of level,” said Nick Robinson, who manages $15 billion of Latin American shares at Aberdeen Asset Management Plc (ADN) in Sao Paulo. “Combined with that there should be more benefits of scale and a much larger market share in the region to help them.”
Copa Holdings SA (CPA:US), based in Panama City, gave the second- best risk-adjusted return among major airlines in the first quarter with 1.2 percent and took third spot in the past decade behind OAO Aeroflot, Russia’s biggest carrier.
The Lan-Tam deal will create the world’s 12th largest carrier by revenue and would be the biggest acquisition of an airline in at least two decades, according to data compiled by Bloomberg. The combination would have a market value of about $13 billion, overtaking Air China Ltd. and Singapore Airlines Ltd. (SIA) as the world’s biggest air carrier. LATAM will have a network of 120 destinations in 23 countries.
Lan won over Chile’s antitrust tribunal in September and Brazilian regulators in December, for a deal that will give it almost half of routes in Brazil. With Tam, Lan is gaining an airline that is 39 percent larger by sales and will give it one of the leading positions in the world’s seventh-largest economy, according to data compiled by Bloomberg. Tam (TAMM4) posted revenue of $7.8 billion last year compared with Lan’s $5.6 billion.
Juan Cueto and his sons Ignacio, Enrique and Juan Jose entered the airline industry in 1978 through freight carrier Fast Air. They became Lan’s controlling shareholders in a pact with entrepreneur-turned-politician Sebastian Pinera after the government sold its remaining shares and Scandinavian Airlines Systems offloaded its stake in 1994.
During the next 15 years, the Cuetos and Pinera turned Lan into a $6 billion carrier with service in 17 countries and units in Peru, Argentina and Ecuador. When Pinera was elected president of Chile in January 2010, the Cuetos were one of the buyers of his Lan shares, agreeing to pay about $500 million for an 8.6 percent stake. Today the family is Lan’s sole controller with a 34 percent stake.
A greater emphasis on cargo services and a more modern fleet helped make Lan more profitable than North American peers. Since 2002 Lan’s earnings before interest, taxes, depreciation and amortization margin has averaged 15 percent, compared with the 12 percent average among North American airlines, according to data compiled by Bloomberg.
“It’s a highly skilled, very strategic and forward looking management team,” said Robert Mann, president of consultant R.W. Mann & Co. in Port Washington, New York. “They’ve been able to diversify not only by acquisition but by alliance so the result has been a nice trajectory in earnings and share price.”
Lan operates a fleet of 135 passenger aircraft and 14 dedicated freighters, while Tam has 156 planes, according to a joint statement distributed in January.
In the past decade through March, Lan stock returned 2,380 percent, before adjusting for price swings. The next biggest return among major airlines in that period is Aeroflot with 344 percent. The outperformance has helped push Lan’s share price to 30 times reported profit, compared with an average ratio of 15 among global peers, according to data compiled by Bloomberg.|
‘Among the Highest’
While an attractive operating environment and strong controlling shareholders have helped the stock, Lan’s valuation is “among the highest in the world,” said George Ferguson, a senior aerospace analyst for Bloomberg Industries. “It’s more than you would have to pay for some of the fastest-growing airlines in China,” he said.
Lan’s communications department didn’t immediately respond to requests for comment made by telephone and e-mail.
Brazil was the missing element for Lan given that country’s foreign ownership restrictions. Because Brazilian law caps foreign capital in airlines at 20 percent, Tam controlling shareholders will retain 80 percent of the voting stock while Lan will have about 70 percent of the combined carrier, LATAM Airlines Group SA.
Investors will get 0.9 Lan share for each Tam share held in an exchange expected to begin later this month and conclude in May, Ignacio Cueto, currently chief operating officer of Lan, said March 7. His brother Enrique will become chief executive of LATAM, while Tam’s Mauricio Rolim Amaro will be chairman. Both airlines would continue operating separately with their own brands.
‘Lot of Faith’
“There’s a lot of faith that all the synergies they identified will be realized in short order,” Nicolai Sebrell, an airlines analyst with Morgan Stanley said from Sao Paulo. “And why not? This is the best operator in the region.”
The size of the acquisition relative to the size of Lan has added to the usual implementation risks, said Mann.
“It’s kind of drinking out of the fire hose,” he said. “You can drown if you’re not careful.
Brazil’s middle class reached 54 percent of the population of 191 million last year from 34 percent in 2005, according to a study published in March by Cetelem BGN Research and Ipsos, which said the average middle class monthly income was 1,450 reais ($777). Annual economic growth in Latin America has averaged 4.1 percent since 2005 compared with 2.4 percent globally, according to data compiled by Bloomberg.
While Lan has posted annual profits since 1994 and turned quarterly profits throughout the global financial crisis, Tam has had annual losses in two of the last four years because of increased competition and higher fuel prices.
The companies plan to develop the cargo business from Brazil. They estimate savings from the tie-up at $600 million to $700 million four years after completing the transaction.
“I would anticipate and hope that some of the management expertise on the Lan side would be able to supplement the Tam side, with the result being a less volatile more rational overall network,” Mann said.
Shares of Tam, which also has American depositary receipts (TAM:US) in the U.S., ended at 44.53 reais in Sao Paulo today, while Lan’s agreement is valued at 47.28 reais a share.
The extra yield investors demand to buy Tam’s 9.5 percent U.S. dollar bonds due in 2020 instead of U.S. Treasuries fell 118 basis points, or 1.18 percentage point, to 691 basis points on Aug. 16, 2010 from 809 basis points on Aug. 12, 2010, the day before the merger was announced, according to Trace, the bond price reporting system of the Financial Industry Regulatory Authority. The spread has since widened 10 basis points to 701 basis points on April 10.
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