Latam: The Biggest Bankruptcy Yet
Covid sends another airline to the courts
Virgin Australia produced $4b in revenue last year. Avianca, roughly $5b. Thai Airways, $6b. All are now bankrupt. And they were joined last week by an even larger airline.
Latam, with more than $10b in revenue last year, became the latest bankruptcy casualty of the Covid pandemic. Latin America’s largest airline filed for bankruptcy protection in the U.S., where it can take advantage of helpful restructuring procedures under Chapter 11 of the U.S. Bankruptcy Code. The filing covers the airline’s subsidiaries in Chile, Peru, Colombia, and Ecuador. It does not apply to its Brazilian unit, which happens to be its largest revenue generator. Nor does it apply to units in Argentina or Paraguay. That’s mostly just a technical distinction — those units are no less keen on restructuring.
Latam, to be sure, will continue to operate as it reworks contracts with lenders, suppliers, unions, and other stakeholders. To finance current operations, two of its top shareholders — the Cueto/Amaro families and Qatar Airways — pledged to lend it $900m under debtor-in-possession privileges. This DIP financing, a feature of U.S. bankruptcy law, will ensure that the lenders are first in line to get repaid, ahead of all pre-bankruptcy lenders. Latam hopes to secure additional DIP financing, more than $2.1b in fact. Delta, which owns 20% of Latam, hasn’t provided any DIP money so far and likely won’t due to provisions in the U.S. CARES Act limiting investments in foreign companies. Delta, though, remains an important commercial partner, even if it does wind up losing the nearly $2b it invested in Latam just last fall.
Latam’s bankruptcy is not only the biggest of the crisis, but also its most surprising. Thai and Virgin were deeply flawed companies even before the crisis. Avianca, though profitable at the operating level, narrowly avoided bankruptcy just before the crisis. Latam by contrast was heavily indebted for sure, but nowhere near running out of money before the Covid crisis. In fact, it had a pretty good 2019, earning net profits of more than $300m and a respectable if uninspiring 7% operating margin. In fact, performance improved as the year progressed, with first half operating margins weak but second half margins reaching double digits.
The improvement, furthermore, continued into early 2020. Late last week, the airline reported its results for the year’s first quarter (January-to-March), which were better than its results — at the operating level anyway — from the same quarter last year. More specifically, Latam earned a 4% Q1 operating margin, up a point from its Q1, 2019 figure. The Covid crisis hit late in South America, with only the final few weeks of the quarter affected. Latam did have to slash capacity in March, such that ASKs for the entire quarter declined 7% y/y. Revenues declined 7% too. But operating costs fell 8%. Even with forex and hedge headwinds, the airline’s fuel bill came down by 13%. Labor costs dropped 15%, aided by the impact of currency depreciation on local wages.
But below the operating line, things got hairy. The company’s debt burden drove $127m in interest expenses during the quarter, equivalent to more than 30% of what it paid its workers. Net results, meanwhile, were disfigured by a massive impairment charge to Latam’s goodwill, an accounting concept designed to capture value obtained through a merger. This impairment caused a monstrous $2.1b net loss, almost equal to its total revenues for the quarter.
Latam’s pre-crisis problems weren’t negligible. Many were macroeconomic, including its extreme difficulties navigating Argentina’s battered economy. Currency depreciation, a frequent headache for Latin American companies, reared its ugly head again last year. The Brazilian real, most importantly, was worth about 30 U.S. cents at the start of 2018, only 27 cents at the start of 2019, and only 24 cents at the start of 2020. Last week it was worth just 19 cents. Separately, Latam’s sizeable cargo business encountered yield headwinds as global trade weakened. Chile, where the airline has its main headquarters, suffered civil unrest that erased tens of millions of dollars from earnings. Latam was still dealing with disruptive B787 engine problems last year. LCCs like JetSmart, Sky, and Viva were starting to spread across South America. Before arranging its autumn deal with Delta, Latam’s North American and European alliance strategy, then involving American and IAG, was stymied by Chile’s supreme court.
Even so, Latam entered 2020 with optimism. As late as March 3, when it reported Q4 earnings, management still believed it could hit its goal of a full-year 2020 operating margin of between 7% and 8.5%. It also planned to grow ASKs this year, by between 3% and 5%. Most pleasingly, the Brazilian domestic market had suddenly become a profit paradise after Avianca Brasil collapsed last May. Brazilian overseas routes, most importantly to the U.S., were also improving thanks to competitor capacity cuts. In Colombia, Avianca itself was retreating from markets like Peru. Latam managed to buy back full control of its loyalty plan, creating a unified program with close to 40m members. The carrier was spending $400m to upgrade its inflight product. This included new premium economy seats on shorthaul planes. Last year, it added 29 new planes while also deeply scaling back its future aircraft commitments. Notable route additions in recent years include Sydney, Melbourne, Boston, Tel Aviv, Johannesburg, and Lisbon. Then came the Delta deal, in which Latam received $1.9b for a 20% ownership stake and another $350m to support its transition from oneworld. It also agreed to sell Delta four of its A350s, plus future orders for another 10. After a quarter century at the helm, Enrique Cueto was leaving his successor with a new and exciting path to prosperity.
Unfortunately, Covid’s scourge was already evident during Latam’s March 3 earnings call, when it reported signs of softness in international demand and cancelled flights to Milan. By the time new CEO Robert Alvo took over on March 31, the crisis was in full swing. In April, Latam’s passenger ASK capacity was down 94% y/y. Even so, it filled just half its seats.
With minimal revenues and cash coming in, and $57m in dividends and $130m in debt repayments due in the coming days and weeks, the company on May 26 made its decision to seek refuge in bankruptcy. That allowed for immediate suspension of dividend payments and the rejection of 19 aircraft leases (four B787-9s, two A350-900s and the rest A319/20/21 CEOs.
The airline is currently operating just 5% of its normal capacity, hoping to increase that to 9% this month, and to 18% next month. The restoration partly depends on the lifting of government travel restrictions, which vary by country. In Argentina, airlines aren’t even allowed to sell tickets until September.
That could be one reason to pull out of Argentina altogether — it wouldn’t miss the many union and political headaches it’s faced there over the years. Overall, Latam aims to be about 30% smaller than its pre-crisis size, and 40% smaller intercontinentally. It’s currently chasing cargo revenues with success. It has assurances from Delta that their joint venture of the Americas, finalized just last month, will remain valid. São Paulo, Santiago, and Lima are likely to remain key hubs. Miami, New York, and Madrid are likely to remain key overseas markets. In Brazil, help is on the way — better late than never — in the form of government aid. Other governments might contribute to Latam’s revival as well.
Beyond all this, it will be management’s task to craft a new business plan appropriate for new post-Covid era realities. Bankruptcy will definitely make that easier, if painful for all existing stakeholders. One thing bankruptcy can’t change though, is South America’s susceptibility to currency volatility and broader macroeconomic distress, a major problem for all of the region’s airlines. South America, meanwhile, has in recent weeks become a new epicenter of infection, with Brazil alone having just surpassed Spain in Covid-related deaths. Recovery, both economic and medical, seems distant. But so too, just a few months ago, did the chances of Latam filing for bankruptcy.