Hunting for attractively priced cyclically exposed securities in an economy emerging from a deep recession can be beneficial to one’s wealth. Azul, the Brazilian airline founded by David Neeleman (ex boss of JetBlue in US), is just such a security.
Appendix: Financial forecast
Brazil is recovering from its worst recession in modern history. After contractions of 3.5% in each of the 2015 and 2016, Brazil’s GDP increased 1% in 2017. OECD forecasts GDP growth of 2.2% and 2.4% in 2018 and 2019 respectively. Domestic air passenger numbers grew by double digits last year and is set to grow at a similar clip over the next few years as the economy expands.
Azul’s stock offers one of the best opportunities to tap into Brazil’s recovery with a potential ~60% upside over a 2 year investment horizon and an attractive risk-reward profile.
Azul’s investment case
Brazil’s best positioned airline
Azul is the fastest-growing, most profitable and best positioned airline in Brazil. It serves 100 destinations in Brazil and is the only carrier in 71% of its routes, making it an indisputable leader in most of the routes it serves. Limited number of local passengers in these key routes provides strong barriers to entry for competition. In addition, Azul’s high frequency of flights per day on its key routes makes it the preferred carrier for business travelers - the customer segment that should grow the most as the economy recovers.
All of the above means that top line should growth at a healthy ~18% - ~20% CAGR over the next three - four years as the economy expands.
Fleet upgrade to propel margin expansion
Azul is currently upgrading its fleet by replacing the older generation E-195 aircraft with new generation E2 and A320neo aircraft. The E2 and A320neo reduce Cost per Average Seat Kilometer (CASK) by ~28% compared to the E-195s. By 2020 Azul expects 47% of its Average Seat Kilometer (ASK) to be served by these new generation aircrafts which should help lift its EBIT margins to 15% by 2019 and close to ~18% by 2020. The new generation aircrafts, being larger in size, should also support further growth in Azul’s cargo segment.
Management are excited about the margin expansion which is going to come from the fleet upgrade. Here are just couple of quotes from management on the fleet update.
John Peter Rodgerson - Azul S.A. - CEO & Member of Board of Executive Officers
“We're very excited about the next couple of years. As David mentioned earlier, we're going through a significant fleet transformation process as we replace older generation aircraft with next-generation aircraft, namely the A320neos and the Embraer E2. In addition to being extremely fuel-efficient, these aircraft have more seats than the older-generation aircraft they will be replacing, contributing to a significant increase in margins going forward. Our A320s have the lowest CASK in Brazil and are currently flying, on average, 14 hours a day. The neos have a 29% CASK advantage over our current E-Jet and are expected to represent 27% of our total ASK in 2018, and that will go up to 41% in 2020.”
Abhi Manoj Shah - Azul S.A. - Chief Revenue Officer & Member of Board of Executive Officers
“We have the A320s that we're just beginning the process. To give you an idea, the A320s are currently in only 32 of our nonstop routes, and Azul has almost 250 nonstop routes. So still very much a long way to go in putting in the 320s, and that's just going to be really exciting as we go forward.”
Other revenues set to grow healthily
Ancillary revenues, mainly from checked baggage fee, grew 22% in the fourth quarter 2017 and represent 14% of total revenue. Azul expects ancillary revenues to continue to increase thanks to a new law allowing checked baggage fee.
Azul’s cargo revenue increased an impressive 60% in the fourth quarter, mostly driven by the larger cargo compartments of the A320neos and the growth in international capacity. Further, in December 2017, Azul and Correios, the Brazilian Postal Service, signed an MOU for the creation of a private integrated logistics company. Once approved by Brazilian authorities, this new company will further strengthen Azul’s cargo business. None of the upside from this venture is in my forecast.
TudoAzul, Azul’s high-growth, high-margin loyalty program
Azul’s loyalty program, TudoAzul has maintained a strong growth. Management believe TudoAzul to be the fastest growing loyalty program in Brazil. It has more than 9 million members at the end of 2017, with 2 million members were added in the last 12 months alone. TudoAzul now has 16% gross billing share across airline loyalty program’s in Brazil, up from 13%, but management believe that the pie in the entire industry is growing and Azul is still well below what management believe is its fair market share in this business. Further, it is worth noting that two of the major carriers in Brazil – LATAM and Gol – both have their loyalty program separately listed with R$3.5 billion-plus valuations. Azul owns 100% of TudoAzul and given it doesn’t provide detailed breakdown of this business, the true independent value of TudoAzul is unlikely to be reflected in the current share price. A future listing of TudoAzul is a free option with great upside potential.
Azul’s 41.25% interest in TAP
In early 2016, as part of a consortium, Azul invested €90m in the then bankrupt Portuguese airline, TAP Portugal. The investment was structured as a convertible bond giving Azul 41.25% of the equity value of TAP. HNA, the distressed Chinese investor has a call option to buy 1/3rd of the bond from Azul at the end of 2017 but did not exercise (given the situation HNA are in, this is not surprising). Azul now own the 41.25% exclusively. Based on recent communications, management appear extremely excited of the value this investment could unlock. According to management, TAP is going really well right now. Given the leadership at TAP today is former Azul members, management have a very good sense of the direction the business is taking. This again is a fantastic option (potentially worth 2x – 3x the current book value of R$836m if the turnaround is successful) which is not reflected in the current share price and my forecast.
US – Brazil open skies agreement provides Azul an opportunity to add to profitable international routes
The US – Brazil open skies agreement, which was approved in March this year, offers Azul an opportunity to add to its international routes (international revenues currently account for ~10% of Azul’s total revenues). Azul has already entered talks with United to establish a JV and expect to accelerate this process.
Strong balance sheet and operational resilience
Azul has a strong balance sheet, with cash and equivalents of R$ 3.6 billion against total debt of R$ 3.5 billion. Capitalising all of Azul’s leases at 7x rents takes Azul’s adjusted net debt to just over R$ 9.1 billion. Adjusted net debt is 3.9x EBITDA at the end of 2017, from 5.7x in 2016. This should continue to fall.
Operationally, Azul is exposed to depreciation in the Brazilian Real and oil price increases. However, the company was able to successfully pass on recent oil price increase to consumers via ticket price increases. And its strong balance sheet, in particular high cash balance equating to ~50% LTM revenue, gives a strong base to withstand adverse FX moves.
Based on the current share price of R$ 33.48, Azul trades at 6.7x forecast 2018 EBITDAR and 5.3x forecast 2019 EBITDAR. In comparison, Copa Airlines, the leading Latin American carrier, trades at 8.2x forecast 2018 EBITDAR. Azul, given its strong EBITDAR growth combined with a dominant market position with little to no competition in its main routes and barriers to entry, merits a similar multiple to Copa. However, even assuming a 7x multiple to forecast 2019 EBITDAR gives a per share value of R$ 53 for a 59% upside to the current share price. A 7.5x multiple, which in my opinion is perfectly reasonable, equates to a per share value of R$ 59 for a 76% upside. See appendix at the end for my summary financial forecast.
My valuation doesn’t take account of the multiple free options available to a shareholder. These include the upside to Azul’s cargo business from the JV with Brazilian Postal Service, potential value unlock from a future listing of TudoAzul royalty program, the significant potential upside from the 41.25% stake in TAP Portugal, and the increase in international revenues from the US-Brazil open skies agreement.
Appendix: Financial forecast