murat4art
Azul (NYSE:AZUL) is one of the three main Brazilian airlines.
I have been writing about Azul since December 2021, when the stock traded at $14, always with a Hold rating, recommending not to buy. In my last article from November 2023, I argued that despite Azul trading at an unjustified discount to Gol (a discount that later closed because the latter went bankrupt with its stock falling 90%), Azul was not an opportunity either.
In this article, I review the company’s Q4 results and earnings call, the bankruptcy proceedings, and Gol and what that could mean to Azul and provide a new valuation analysis, given that the stock price has fallen 30% since November. I believe the stock is a Hold, not an opportunity.
The reasons are similar to the ones wielded so far: a fiercely competitive industry, high leverage putting the company’s viability at risk, and cyclicality in profitability boosting FY23 results.
Q4 and FY23 results
Azul posted what can be considered a great year and quarter, with revenues surpassing FY19 levels for the first time and achieving close to a 15% operating margin.
Fuel advantage: When we look at the reasons for the improvement, we can cite the company’s capacity improvements (ASK expanded 11%), some fuel efficiencies (4% lower consumption per ASK), and some operating leverage. However, the main reason for the company’s profitability has been a decrease in fuel prices paired with an increase in ticket prices. Despite ASK increasing by 11% and marginal efficiency improvements, aggregate fuel costs decreased close to 10% compared to last year, with costs per liter falling 15/20%.
In fact, every expense account except for fuel went up more than revenues (therefore deleveraging) in FY23. Management has mentioned that investments in personnel and maintenance cause this, and that these expenses should leverage with higher revenues in FY24.
Competitive peace: This could not have happened if Azul’s competitors had passed the savings to consumers, putting pressure on Azul’s prices and top-line. However, as seen below with data from ANAC, the median real yield for the three leading airlines, Azul, Gol (OTCPK:GOLLQ) and LATAM (OTCPK:LTMAY) has been historically high in 2023.
Management has commented on the latest earnings call that profitability is at the top of airlines’ minds rather than price-destroying competition. The usual ‘Azul premium’ (coming from better operations and lower competition given that 82% of routes have no overlap with the two other large competitors) is still valid. The data for late 2023 and early 2024 shows a decrease in yields, which is relatively seasonal.
Median yield per kilometer, main Brazilian airlines (Brazil’s Civil Aviation Administration (ANAC))
Gol’s Chapter 11 does not change the picture
One of Azul’s largest competitors, Gol, has recently filed for Chapter 11 bankruptcy in the US. The question for investors is whether this could lead to lower competition for Azul and better profitability. I believe this will not be the case, and the reason is at the core of why many airline markets are undesirable.
Gol is treated under Chapter 11, which means the court will try to keep the company operational and avoid liquidation. If Gol’s debt and leases are restructured, shareholders and debtors will eat the loss, and the company will continue operating (probably as unprofitable as ever, but with new capital).
The Brazilian government is considering a help plan for up to BRL 6 billion (about $1.2 billion) in soft credit, to be distributed among the three main airlines, as part of a bigger plan to bring down airfares.
This all points in the same direction. The government, regulators, consumers, and industry insiders (pilots, attendants, technicians, etc.) all want high competition, which is arguably the best for society but bad for shareholders.
I believe Gol will be recapitalized and will not leave the market; competition will increase, not decrease, and Azul’s current high margins will decrease as a result.
Revisiting the valuation
Azul is posting record operational profitability while its share price fell 30% from my last article. Is it maybe an opportunity now? I believe not.
First, we need to consider the viability of the company.
According to the latest financial statements (unaudited), Azul owes about $2 billion in plain debt, most of it maturing after 2028. It also has $250 million in debt convertible at BRL 22 per share, representing a potential dilution of 54 million shares (about 18 million ADRs) or 15% of the company’s current shares. For this debt it pays about 11% interest on average, meaning about $250 million in interest expenses (BRL 1.25 billion).
The company also has to pay interest on its aircraft leases, which is not included in its operating income. With lease liabilities (undiscounted) of about BRL 20 billion ($5 billion), the yearly minimum payments exceed BRL 3.5 billion ($700 million) for FY24. The average rate on leases is pretty high at 16%.
This means we are considering about BRL 5 billion in interest and financial lease payments for FY24, similar to the BRL 5.5 billion for FY23. Then, we need to add about BRL 1.4 billion from maintenance CAPEX, using the figure for Q4 (BRL 350 million), which management said would be approximately correct for FY24 CAPEX.
The aggregate indicates Azul needs to generate about BRL 6.5 billion EBITDA to break even. Coincidentally, this is the figure that management has guided for FY24. The company can barely pay interest and CAPEX without repaying debt principals.
The guidance assumes a margin improvement in FY24 compared to the already record FY23. This does not seem sustainable, in my opinion, considering current EBITDA margins of 30% against a pre-pandemic average of 11%.
Therefore, we are considering a company that can cover interest and maintenance only at record margins in a fiercely competitive industry. Azul would have trouble covering recurring expenses if competition increased and yields decreased.
This does not seem attractive to equity at almost any price (the company’s profitability is fundamentally questioned). Trading at a market cap of $860 million, we should at least expect $90 million in net income (considered pre-tax given the company’s NOLs) or about BRL 7 billion in EBITDA (add the $90 million ~ BRL 450 million to the previous BRL 6.5 billion). This doesn’t seem easy.
The company’s low EV/EBITDA of 2.3x (EV of $3 billion against guided EBITDA of $1.3 billion) is low because of the above-mentioned failure risk. True, the company could represent an opportunity if it can grow from here, but that is uncertain given the industry’s history.
For that reason, I continue to consider Azul a Hold. It is difficult to buy the equity of a company whose profitability and viability are fundamentally questioned by its industry characteristics. The recent high margins should be read in light of historical price-destroying competition and, therefore, projected with a grain of salt. Even when projecting record margins, the company can barely break even, at lower margins it is at risk of not meeting regular payments. This does not offer any margin of safety, and it’s therefore a Hold.
