LAN's Buyout of TAM Offers Compelling Merger Arbitrage Opportunity

Includes: LFL
by: Ian Bezek

The ongoing unrest in the Middle East is offering interesting discounts for companies vulnerable to volatile oil prices. One of the more interesting of these is the increasingly lucrative merger arbitrage situation created by LAN Airlines S.A.'s (NYSE:LFL) proposed takeover of TAM S.A. (NYSE:TAM) which would create a combined entity named Latam. LAN is Chile's principal airline and flag carrier, and TAM is Brazil's largest airline.

With oil prices surging for the moment, the share prices of both companies have been headed south, making both players in the proposed deal better values for investors. The two companies tentatively agreed to merge last summer, but the deal has not yet been consummated.

At the end of January, the Chilean government threw an obstacle in the path of the proposed merger by denying LAN's request to have the merger quickly approved and instead sent the proposed to Chile's TDLC, a court that hears anti-trust related cases. The TDLC now must sign off before the merger can be completed. Shares of both companies fell, with TAM getting comparatively crushed.

If the merger is completed, TAM shareholders will receive .9 shares of LAN's stock. However, TAM shares, which were already trading at a significant discount to their value in the acquisition, saw the discrepancy widen further -- with a more than 15% profit now available to TAM owners if the deal closes. Here's a chart (source: Google Finance) showing the relative performance of TAM and LFL in the past month:

click to enlarge

After the initial setback to the merger on January 31st, both company's shares fell, with TAM falling much more harshly than LAN. The Chilean government's decision to delay the merger was unexpected as the Chilean government is known for being an avid supporter of free markets. The Heritage Institute's annual Index of Economic Freedom ranked Chile #11 in the world, leading all of Latin America and trailing the ninth-ranked United States by only two spots.

That said, in 2009 Chile did significantly strengthen (link in Spanish) its TDLC court, which hears anti-competition cases. This law brought sweeping changes to the court, increasing its autonomy, authority, and the frequency of its hearings. If the court wanted to take a bold step in showing that it is going to more seriously enforce antitrust concerns, the proposed LAN/TAM merger provides ample opportunity.

Numerous observers think it is unlikely that the court will ultimately block the merger, however. Citi's Latin American transportation analyst Stephen Trent is bullish on TAM shares in the near-term due to the M&A activity. Leading Chilean bank Banco de Chile raised (Spanish) its one-year price target to 17,738 for the Chilean-listed shares of LAN airlines last Friday (this price target represents a more than 30% gain for the U.S. ADR shares). Banco de Chile cited LAN's strong fundamentals, low probability that the merger will be blocked, and aggressive investment plans that will help the newly-merged airline continue to grow throughout the next decade.

And Chile's newspaper-of-record, El Mercurio, wrote a guardedly positive editorial (Spanish) about the proposed merger, noting benefits for Chileans should the LAN/TAM merger be approved. They noted that the combined Latam would be one of the world's ten largest airlines, and could provide more frequencies of flights on its routes, provide better point-to-point service, and even improve business conditions in Chile. It's hard to see Chile's generally pro-business government putting its foot down and blocking this deal.

The fundamentals at both LAN Airlines S.A. and TAM S.A. are also positive. The South American economy has weathered the economic storm much better than North America, and as such, its airlines are outperforming. According to Yahoo Finance, LAN's revenue growth is 34% year-over-year and TAM's revenue growth is 23%, compared with figures in the 10-15% range for US airlines such as Southwest (NYSE:LUV), American (AMR), and Jetblue (NASDAQ:JBLU). While the P/E ratios of LAN and TAM are a bit high, the combined Latam will squeeze out hundreds of millions of dollars a year in cost savings, boosting operating margins at least several percentage points.

The combined post-merger Latam will be roughly as profitable on a per-share basis as its North American competitors while possessing much faster revenue growth, and a much more attractive and less mature regional market. Unless the Middle Eastern political situation sends oil shooting back to 2008-heights (while the occasional Middle Eastern geopolitical situation actually sets off an oil crisis, most flare-ups rapidly fizzle out), it seems like both LAN Airlines S.A. and TAM S.A. represent good buying opportunities after Tuesday's sharp oil-driven declines in both companies' shares. TAM, in particular, is a compelling opportunity due to the merger arbitrage situation. If the merger succeeds, buying TAM today gets you LAN shares at a 15% discount to their market price. That's an offer that should be carefully considered.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.