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When Chile’s flag carrier, LAN, acquired Brazil’s TAM in 2012, hopes were running high for the combined entity, LATAM Airlines Group. Now, though, at a first glance, LATAM is not too different from cash-strapped Air France-KLM, at least financially – “indeed, the two would make for a great fit,” an M&A banker in London argued this week.

“But hey, if they strike a deal, then you’d probably need a carrier from the US or the Middle East to sneak in at some point and fix the mess by 2020,” he also suggested.

A tie-up with the French and the Dutch governments “would lead to the creation of a new carrier whose name will eventually disappear from the traders’ screens soon after being acquired by its most likely suitor, American Airlines,” a second source in New York told me on Monday.

“Such talk is way premature, but LATAM management is under a huge amount of pressure to deliver,” he added.

“Its valuation is not far off all-time lows, so any scenario is possible.”

Background & financials

LAN and TAM have not been lucky.

In 2012, both companies predicted “pre-tax synergies of approximately $170m to $200m for the first 12 months after combination, gradually increasing to annual pre-tax synergies of between $600m and $700m four years after the completion of the combination”.

“Approximately 60% of the total estimated potential synergies will derive from revenue increases in the passenger and cargo businesses and, therefore, the cost savings are expected to generate the remaining 40%.”

Both carriers, with the help of McKinsey and Bain & Company, revised-up estimates for synergies only a few months before the deal was wrapped up, but the merger hasn’t lived up to expectations so far.

LATAM needs solutions, and quickly, both for its passenger and cargo units. But where can a solution be found?

The “capital risk management” section of LATAM’s annual results should give investors a clue.

“In order to maintain or adjust the capital structure, the company may adjust the amount of the dividends payable to shareholders, return capital to shareholders, issue new shares or sell assets to reduce debt,” the group said.

Here’s how its key financial metrics look, and why action is needed.

While adjusted net debt keeps rising, LATAM’s 2014 gross cash pile was $1bn lower than a year earlier.

Its core gross profit, as gauged by revenue minus cost of goods sold, was down by about $400m in 2014, which forces LATAM to trim operating costs further. But as revenues fall (-6.4%), administrative costs and distribution costs have already fallen at a faster pace (-6.6% and -13.4%, respectively) year-on-year.

Even if LATAM is successful in managing its cost base, the problem is that its annual interest costs are in the region of $430m. They are down 8.5% year-on-year, but are only $100m lower than its core operating income, which stood at $541m in 2014, down from $585m one year earlier. Meanwhile, operating cash flow is flat year-on-year.

Operationally, LATAM Airlines could find a solution, but it’s hard to see how it can sort out its finances, however, without the injection of fresh equity.

Net leverage and liquidity ratios provide little reassurance, especially when combined with the threat of corporate action and closer scrutiny from credit rating agencies, which rank it junk – although its coveted credit rating is investment grade. Its cost of debt is in the high-yield territory, of course: the issuance of new mid-term debt is doable but its cost hovers around 8%.

All this should be enough to get a feeling of the daunting task that management faces.

No synergies = cash call or takeover?

In March 2013, less than a year after the deal had closed, The Financial Times reported that LATAM’s international operations in the fourth quarter were hit by international carriers boosting capacity to Latin America, especially from the US, and weak markets in Europe.

Back then, synergies were already well below the stated targets, and trends have not played a helping hand since.

A cash call of between $1bn and $2bn would fix the balance sheet, but would command a steep discount to its current market value of $4.31bn, which equates to one-third of the implied equity value of the combined entity when the deal was struck.

LATAM finds itself in a difficult position, but it may forgo the issuance of new equity capital if a takeover either from the US (its third largest revenues contributor) or from Etihad – to name the most likely buyer from the Middle East – materialises.

While a bullish take on its financials could suggest that net economic losses are bottoming out (-$109m vs -$281m in 2013, excluding income from minorities), most of the improvement in 2014 came from lower foreign exchange losses (-$130m vs -$482m).

Its first-quarter results showed that LATAM’s performance could disappoint once again this year.

At the end of 2014, the group said that it successfully implemented a plan to reduce its short-term debt from about $840m at the end of 2013 to about $327m in December 2014, which takes some pressure off working capital management, but doesn’t change the complexity of the situation, which is critical indeed. Goodwill impairment is another risk worth talking into account.

LATAM Airlines and its cargo arm

As is the case with many of its rivals, “LATAM’s cargo business strategy aims to optimise the use of the bellies of its passenger aircraft and, as a result, implies a gradual reduction in its freighter fleet”, although this remains the largest air cargo operator in Latin America and in Brazil, in particular.

Trends are not encouraging, but the outlook could be brighter here.

“In 2014, LATAM, at a consolidated level, transported 1.1m tons of cargo, down by 3% compared with 2013, while its capacity measured in ATK dropped by 5.6%. As a result, the load factor rose by 1.4 percentage points, reaching 59.8%,” it said.

The ATK reduction was “explained by structural changes in the itinerary of passenger planes” used to transport cargo and “by discipline in the cargo fleet in the face of aggressive global and regional competition”, LATAM noted.

“This was a result of excess capacity on both passenger and cargo flights in the region.”

But its plans to reduce its freighter fleet, combined with a “constant quest for efficiency in its operating costs and support areas, and the development and improvement of the processes, systems and infrastructure of its cargo business,” which is set to continue, could perhaps render its maindeck cargo unit an appealing IPO or divestment candidate, it could be argued – proceeds of which could be used to shore up the balance sheet, right?

That’s just wishful thinking at present time.

LATAM did not respond to The Loadstar‘s requests for comment.

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