Chapter 11: Avianca and LATAM Airlines hard landing flight

It was a real pleasure collaborating with America Economia in this report.

Article was written in Spanish & published by a leading Business and Economics publication in Latin America - America Economia. Author: Gianni Amador

Google translated version follows.

January 2020. The airline industry was not experiencing its best moment. International Air Transport Association (IATA) results showed a decade with numbers in red, but the estimates for the year that started allowed it to be optimistic. A global industry net profit of US$29.3B was expected, slightly higher than the US$25.9B in 2019, according to the organization's report published in December 2019. It even mentioned a better future for Latin America. "Latin American operations will benefit in 2020 ... airlines will benefit from an upturn in growth of 1.8% estimated by the International Monetary Fund," it said. With this information in hand, IATA estimated a net profit of US$500M for the region this year; about US$100M more than the previous year.

Indeed, it was a shared optimism. Latam Airlines, the largest air group in Latin America, started the year reporting a historic result in the number of passengers carried in 2019, 74 million (with a growth of 7.8% over the previous year), a milestone that it had not achieved after the merger between LAN and TAM in 2012. Additionally, it was going through a cabin renovation project valued at US$400M to improve its cabin product on more than half of its fleet. At least 170 of those planes would be ready in 2020. However, his biggest bet was on his new alliance with Delta, which involved the purchase of 20% of Latam shares for US$ 1.9B, and which became effective immediately after the end of the agreement with American Airlines on January 29 of this year. With this agreement, the Latam Airlines Group expanded the destinations to the United States and Canada to 74.

At Avianca, optimism was more cautious, but they were also betting on 2020. The Colombian airline, the second largest airline group in the region, had just celebrated its 100th anniversary and had flown by few turbulent months that left an abrupt change of direction and the exchange of US$ 484M in bonds as part of the debt restructuring process. With the sky much clearer, the company started the year by making deep adjustments to its global route network, focused on making Bogotá the most important connection center in the region. These changes also included an increase in operations in Brazil and the United States, as well as the shutdown of Peru and Honduras bases, as part of its "Avianca 2021" plan, with which it sought financial sustainability and the strengthening of its operations. "We started [the year] with a solid position," acknowledged the holding company in statements to América Economía.

While those 2 airlines were expecting a "promising" year, COVID-19 virus was already spreading across Asia. By then, no one foresaw the magnitude of what was to come. In February, infections were spreading throughout Europe and a number of governments began to restrict flights. In March, Latin America reported infections in almost all of its countries, many of which closed its borders and airspace.

The days that followed were increasingly cloudy. Global demand in the airline industry fell 52.9% at the end of March and in April fell 94.3%. Airlines almost everywhere in the world had stopped flying. In the region, a few countries such as Brazil, Mexico and Chile allowed domestic flights under strict security measures and social distancing protocols. But the crisis was already imminent for the sector. In the month of May with grounded aircraft and the deadline for bond payments was approaching, Avianca Holdings declared bankruptcy under Chapter 11 of the United States Bankruptcy Law, a legal mechanism that allows entities to restructure financially and continue operations while the process lasts. Avianca had entered "the most challenging crisis in its 100-year history," company CEO Anko van Der Werff described when announcing the decision to file.

Two weeks later, the unthinkable happened for many at the beginning of the year: The Latam Airlines Group filed for bankruptcy protection. "This path represents the best option to lay down the right foundation for the future of our group," said Roberto Alvo, CEO of Latam. In his case, its stronger financial health was not enough to cope with the collapse of demand; and so, in less than a month, Latin America had its two largest operators, which add up to 26% of the participation in the region's route system, in “bankruptcy” proceedings.

Although the path chosen by Latam and Avianca is the same, their cases are not. Neither are their chances of successfully completing the long flight of reorganization. Latam Airlines, with little room to simplify the company, but with significant financial strength, has everything to gain. While Avianca, a brand in the hearts of Colombians almost as a national sentiment, will need the "rescue" of the Government and reduce its management and operational structure considerably so as not to succumb, according to analysts and industry specialists. In addition, the impact of the restructuring process for both airlines is expected to be so significant that it might leave room for greater penetration by ULCC competitors.

An industry in crisis

The airline industry in Latin America started 2020 facing a loss of profitability and an overcapacity due to the rise of low-cost airlines, especially in important markets for Latam Airlines and Avianca, such as Colombia, Peru and Chile. “Globally speaking, airlines were already facing problems before the pandemic crisis,” explains René Armas Maes, Vice President Commercial at Jet Link International LLC and an air transportation consultant. The expert refers, on the one hand, to the pressures that excess of capacity had been exerting on profitability performance and, on the other, to cost pressures associated with rising unit costs, which have become "a key challenge" and continue putting pressure on margins and returns.

Due to these pressures and to enhance route returns, Latam Airlines responded by expanding its long and ultra long haul operations with the Santiago-S?o Paulo-Milan and Santiago-S?o Paulo-Johannesburg routes, with which it attempted to offset the loss of market share and profitability in domestic markets, mainly in Chile, Peru, Argentina and Brazil. At the same time, it proceeded to reduce costs in terms of wages and passenger services while implementing a number of technologies to reduce costs. In the case of Avianca, the Colombian group responded with the closure of its domestic operation in Peru and cancelled aircraft deliveries while it continues restructuring its debt and business.

The financial results of both airlines in 2019 demonstrated Armas Maes said. Latam Airlines' costs increased 2% compared to 2018, mainly associated with maintenance and leasing costs, which caused a negative impact on its operating margin of -1.4% (the result was 7.1% in the year) and its net earnings were US$ 190M (39% lower than what was achieved in 2018). Still, the company maintained a solid financial footing. "Among cash, lines of revolving facilities and account receivables, Latam Airlines had more than US$ 2B at the end of 2019," says the consultant. However, an additional element overshadows this "financial strength": the debts recognized by the airline reached US$10.3B. Although it’s considered high, its levels are manageable, explains the expert. "In the case of Latam Airlines, 62% of its debt is based on fixed interest rates (ideally a debt is composed of 70% fixed interest rates and 30% floating rates) and shows a debt leverage of 4.4 times to EBITDA when it is recommended that it does not exceed 6.0 in the airline business”.

For Avianca Holdings, the difficult 2019 year left the airline with diminished income that, between cash, lines of credit and account receivables, reached some US$800M. Passenger and cargo revenue slowed down 6% to US$4.6B, while costs rose 11%. The airline ended 2019 with net losses of US$893M and a debt of more than US$7B (18.6% more than the previous year while it shows a leverage of 7.0 times, much higher than recommended in the business). In addition, the Colombian holding company had significant financial weaknesses, represented by high levels of leverage, expansion on unprofitable routes and the erosion of business on its best routes due to the entry of low-cost airlines. Additionally, a pilot strike of more than 50 days in 2017 strongly impacted its operational capacity, leaving it with little room to maneuver with any upcoming crisis.

"Avianca was going through a difficult situation that was not going to be sustainable over time," says Carlos Gutiérrez, general manager of the Association of International Air Transport Companies (AETAI). And although the airline was highly leveraged, its potential opportunities landed on the ground when the Colombian government ordered the closure of the airspace due to the pandemic. "In the case of Latam Airlines, rather than forced [to take advantage of Chapter 11], it was a bold decision, which was given by the uncertainty of the crisis," says the expert.

Strategic decision?

Avianca filed for bankruptcy on May 10th. Fifteen days later, Latam Airlines filed as well. In both cases, airlines argued that it was a "necessary" measure in the face of the impact of a lackluster demand crisis that will reduce industry revenues worldwide by US$314B according to IATA. With this in mind, airlines are protecting themselves from eventual lawsuits from creditors, while they are able to reduce their structures to make them more financially viable in the midst of a post-pandemic scenario. In other words, the measure "falls like a ring to a finger," according to René Armas Maes, because it gives them a break to pay creditors and helps them renegotiate in a more balanced field.

And this is recognized by the CEO of Latam. "Chapter 11 gives us the advantage of sitting down to negotiate with the lessors and financial creditors who own part of our fleet while we can jointly redefine the terms of those commitments," Roberto Alvo told América Economía at a recent press conference. In fact, Avianca - which reported an 80% drop in earnings due to the pandemic - announced the start of bankruptcy protection the same day it went into default after it was unable to pay a US$65M in bond commitments. Likewise, Latam Airlines –explains Armas Maes– made the decision to file for Chapter 11 because it did not find itself strong enough, financially speaking, to survive a rapid slowdown in passenger demand, in a context it did not know by when it will be able to restart operates including international flights.

Specifically, Latam Airlines plan considers a financing of US$2B, obtained thanks to a US$1.3B from the US fund Oaktree Capital Management, and which is in addition to a US$0.9B initially credited by Qatar Airways (owner of the 10% of the airline) and the Cueto and Amaro families, its shareholders, to stay afloat. Certainly, a clear advantage that evidences its financial strength compared to that of Avianca, which in early July had not obtained financing means yet required for its reorganization. In addition, the Colombian company has not reported the amount it aspires to, but in late April its CEO, Anko van der Werff, assured that the airline needed at least US $1.2B to weather the crisis.

However, financing is only one stretch of a long road. According to Armas Maes, the objectives of Latam Airlines and Avianca should be focused on renegotiating and reducing debt, accelerating the divestment of non-core assets, negotiating lower aircraft rental between 10% and 15%, reducing their management structure, as well as unit costs and closing unprofitable operations; in addition to postponing - and in some cases cancelling - the delivery of aircraft.

And in that line Avianca commented, "Restructuring the company and comprehensively addressing debt commitments, leases, aircraft orders and other commitments is our main goal as we plan to emerge from this as a stronger and more efficient airline," the company stated. This, while they continue to negotiate financing that prioritizes payment to those who contribute funds today in the bankruptcy process, known as debtor in possession (DIP) financing and the support that governments - including that of Colombia - can provide. "We are confident that we will be able to obtain funds in the coming months," the airline said.

To execute this, Avianca plans to reduce its fleet "to an appropriate and productive size" that meets the needs of a post-COVID world, although it does not specify the number it plans to right size. However, Adrian Neuhauser, the airline's CFO, said in an interview with Bloomberg in late May that the airline will exit Chapter 11 as a smaller company. "We got into this with 151 planes in our fleet. We are going to cancel a lot more than we have rejected until now before we exit this proceeding", he said. Regarding its network restructure, Avianca reported that it will depend on customer demand needs, once travel restrictions are lifted.

In the case of Latam Airlines, the plans focus on transforming the group to make it more competitive and more agile, according to Alvo. “We have quite aggressive plans to reduce [the fleet], but at the same time be flexible, in the sense of being able to recover quickly. The reduction that we are proposing with respect to our 340 aircraft is significant, at least initially," he says. The executive clarifies that they are still working on that plan and that the number of planes to be eliminated from their fleet will be informed when it is presented to the New York Court, which is the filing jurisdiction in its bankruptcy proceeding. However, the airline anticipated in early July that it expects to exit Chapter 11 with 70% of the size it had before the pandemic and will seek in that process to reduce its liability load by at least 40% to around US$6B. Achieving this goal will depend on aircraft contract term extensions and revised leasing rate that can be renegotiated, as well as the number of aircraft that can be returned.

"The strategies of these two airlines should focus on the number of frequencies or routes that have provided them with the greatest profitability and liquidity historically that will allow them to reengage customers, also taking advantage of the fact that in both cases, they are companies that started as flag carriers in their countries and should focus on those markets while they recover”, comments Ricardo Delpiano, aviation analyst and director of Aero-Naves.

Routes for survival

Avianca has operated for 100 years and there it concentrates one of its greatest strengths to face its second bankruptcy restructuring process. The first occurred in 2003 and ended up with the departure of the Santo Domingo Group and the purchase of the majority of the shares by businessman Germán Efromovich. In its statement to América Economía, the Colombian holding company affirms that over the years they have proven to be “a company resilient in the face of crises” and trusts that this time it will be no different. "We are confident that through Chapter 11 we can become a stronger and more efficient Avianca," the company says.

Its national roots, added to the size of the market that Colombia represents - the second most important in South America -, for specialists in the airline industry, give the airline some strength to go through the restructuring process, in which it hopes to have the help from the Colombian government. "We are participating in discussions with the government and they are moving forward, being constructive," says Avianca. A point that the specialist Carlos Gutiérrez considers key for the survival of the company. "Although the government's decision to support or not has a political cost, they will have to assume it and act in the rescue with transparency," he points out.

For the consultant René Armas Maes, there are two other additional aspects that give Avianca strength to get through this turbulence: It has the backing of a major ally such as United Airlines and it owns 113 aircraft - out of the total of 158 from its fleet - which gives Avianca space to sell and collect much-needed financial resources due to the inability to generate revenue due to border lockdowns especially in Colombia that will remain close until September”. Only on July 1 was it able to start selling tickets, after almost four months without doing so. "Avianca needs to fly and it needs to do it soon," agrees Delpiano, who also considers it essential that the airline focus on reducing costs, cutting subsidiaries as it has done in Peru. "It is a necessary step," stresses the expert.

But, can this restructuring lead Avianca to reposition its business model? The analysts consulted see it as unlikely, but they do agree that Avianca to stay afloat needs to right size and reduce its units costs to compete in a market in which low-cost carriers could further continue market penetration. "At Avianca we are always learning from our peers, including low-cost airlines, and we are continually evaluating ways to be more efficient," says the company when asked about it.

"We could observe Avianca launching a low cost operation - as Copa Airlines did with its subsidiary Wingo, although I observe Latam Airlines with perhaps more aggressiveness in that front because its management team seems to be more agile and open," says Armas Maes, however, “that it is difficult pill to swallow for airlines due to pride as well as having to recognize the success of a low-cost airline model".

Analyst Ricardo Delpiano is convinced that this is the opportunity for low cost carriers and that both Avianca and Latam Airlines will have to deal with it. “The structure [of low cost] and its business model are simple. They are able to better manage costs and capture demand,” he says. In this regard, he believes that Latam Group could have a lower opportunity to restructure, considering that it operates a “simplified” airline model, without much room to restructure or reduce itself other than to eliminate unprofitable subsidiaries, as it has just done with Latam Argentina.

And the airline is focused on that, according to the CEO of Latam, Roberto Alvo, when asked by América Economía about its restructuring plans at a recent press conference. “Until today, Latam Airlines has been a great company and has contributed to the development of the [Chilean] State in a fundamental way, but it does not mean that what we have done already cannot be improved and we must take advantage of the opportunity this crisis bring us, considering our paradigms, our beliefs, put aside our feelings and think on what things we can do better and what things we should try to overcome compared to what we have already done”, he said.

In any case, Latam Airlines has in its favor that its key markets, Chile and Brazil, have not stopped flying. It has even been able to increase its operations to 7% in June compared to May and expects it to rise them to 15% in July. In addition, it has just signed a code share agreement with Azul Airlines, one of the main Brazilian airlines, which will allow both to control 60% of the South American giant's domestic market.

"Latam Airlines will take advantage of the markets it dominates, the strength of its partners like Delta and Qatar and its stronger loyalty program when compared to Avianca's," says René Armas Maes are perhaps its best bets. Although it will also have to somehow overcome the loss of market share, its higher unit costs and reduce the number of employees per plane. Regarding this last point, he explained that Latam Airlines shows 122 full time employees per aircraft that need to be trimmed down to 100 per aircraft or less. “With 22 surplus employees per plane and a fleet of 342, we are talking about 7,524 workers who must be cut from payroll”, explains the consultant.

To date, Latam has laid off 4,000 employees, out of a total of 41,700, belonging to subsidiaries in Chile, Ecuador, the United States, Mexico and Uruguay. For its part, Avianca reported that it will not renew contracts for 3,500 workers and presented a plan that includes unpaid leave from six up to 12 months in addition to voluntary retirements.

The journey will be long. About two years it might take Avianca and Latam Airlines to reorganize and complete their proceedings under Chapter 11 and, although they could come out before that time, it might not be recommended, according to experts, due to the level of demand uncertainty that will remain until a COVID-19 vaccine is discovered and becomes mass produced, in addition to the negative impact on the global economy including a recession that will lead future passengers to cut their budgets and fly less.

IATA has estimated that it will take almost three years to recover to pre-crisis demand 2019 levels. “It is a long race; it will not be a short-term one. We are going to have to work a lot, “said Peter Cerdá, vice president for the Americas of the organization. An industry with fewer routes, fewer connectivity and airlines is expected as to yield markets for which carriers would have fought in normal situations while once gain passenger demand recovers to optimal levels. Avianca and Latam Airlines know this and are getting ready to land in this new scenario.

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