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The general perception investors have about airlines is that they are highly capital intensive with high fixed costs and a lot of uncertainty. This might be the reason that in the recent past many airline stocks have not done well. But there are exceptions to this rule.

One such company is LAN (NYSE:LFL) airlines. This is the leading South American airline whose revenues have increased from $1.45bn in 2002 to $3.03bn in 2006. The operating income has increased five times from $62mn in 2002 to around $302mn in 2006. The net income has increased 8 times, from $30mn in 2002 to $241mn in 2006. The stock has risen from 70 cents in Aug-2002 to $14 (Aug-17,2007). LAN's market cap was 220mn in 2002 and is now $4.4bn. The book value in 2002 was $258mn, and as of Dec-31/2006, was $626mn. It is certainly disqualified from being a pure value investment. However, LAN's great business model roused my curiosity, and I peeked into its annual report(form 20-f).

The number of international passengers has increased from 2.58 in 2002 to 6.36 mn in 2006. However, the number of domestic passengers has slightly decreased from 2.73mn in 2002 to 2.51mn in 2006. The passenger revenues have increased from $803mn to $1.81bn from 2002 to 2006. The cargo revenues during this period have risen from $520mn to $1.07bn. One of the most striking features of this company is its low tax rate. The average tax rate in the last three years has been around a mere 15%, thanks to liberal corporate tax rates in Chile.

Business Highlights

Distribution channels: 76% of passenger ticket sales were through travel agents. The commission paid was between 0 and 9%. However, the company is aggressively pursuing the strategy of reducing this indirect distribution channel by slashing the commissions for agents and encouraging passengers to buy tickets from their web site. In Chile, the commission for economy tickets was slashed from 6% to 1%, but the commission for first class and business class customers remains the same. The sales through the internet were $142mn in 2006.

Etickets: In 1997, LAN introduced electronic tickets, commonly referred to as e-tickets, and the company is working to increase their use. E-tickets create a significant reduction in distribution costs. E-tickets, which accounted for approximately 83% of tickets sold during 2006, are currently available on more than 94% of LAN routes.

Emphasis on self check kiosks: During 2006, LAN continued promoting Internet-based check-in service for domestic flights, allowing passengers who are not checking in bags to obtain their boarding passes from their home or office, thus avoiding traditional airport counter procedures. In 2006, in order to complement the Internet-based check-in service, LAN introduced the airport self-check kiosks, which allow the passengers who are not checking bags to bypass the check-in counter and go directly to the gate.

As of February 2006, LAN had self-check kiosks in Santiago, in Calama, Chile and in Lima, Peru. The pilot program for the self-check kiosks was successfully completed in Calama, a medium-size city in northern Chile. As of February 2007, the program showed a 60% kiosk and Internet check-in utilization rate. In 2006, approximately 27% of the Chilean domestic passengers were using the check-in and self-check services, compared to 12% in 2005. As of February 2007, the kiosk and Internet check-in utilization rate had increased to 45% for domestic routes in Chile.

Frequent flyer program LANPASS: This has 2.3 mn members. In 2006, the LANPASS members grew 34% in Peru, 25% in Ecuador and 58% in Argentina. This is a great way to retain customer loyalty.

Cargo Business: Cargo demand is limited to salmon and produce exports from Chile and Peru and fresh flowers from Ecuador and Columbia. In general terms, cargo flows in one direction. This characteristic is a key determinant of the structure of cargo operations as well as of the commercial conditions in the cargo business. This is especially relevant in markets featuring structural imbalances between inbound and outbound flows or during specific periods of such dis-equilibrium.

Lack of demand in one particular direction may force airlines to rely on different markets in order to maximize loads on return flights. Furthermore, demand weakness in one direction may limit capacity which is profitable to allocate to some routes, therefore creating pressure to raise fares to compensate for weaker revenues in one particular direction. The evolution of LAN's international cargo operations has always been affected by the flow imbalances of the Latin American cargo markets, resulting in a dramatic shift in the relative weight of southbound and northbound cargo flows throughout the years.

What is increasing the operating margin for the company? Compared to a 50% rise in revenues from $2.09bn in 2004 to $3.03bn in 2006, the cost of fuel has increased from $414mn to $764mn (63% increase), the wages in 2004 were $292mn and in 2006 were $443mn (a 51% increase). The depreciation has widened from $77mn to $122mn (58% more). However, the company has done a great job in controlling other expenses:

  • Passenger services - Increase from $45mn to $56mn (25% increase).
  • Aircraft rentals - Increase from $132mn to $157mn (18% increase).
  • Aircraft maintenance - Decreased from $120mn to $117mn.
  • Other rentals and landing fees - Increased from $287mn to $336mn (17% increase).
  • Other operating expenses - Increased from $258mn to $329mn. (27%).
  • Commission to agents: This increased from $291mn to $403mn (38%). But the company is trying hard to improve their sales, to reduce their dependency on agents and to develop technology to market their products directly to customers.

    Accounting Changes: Much of LAN's strong performance has been attributed to a change in accounting for aircraft maintenance. In January 2006, LAN modified the accounting policy governing its aircraft maintenance expenses. Under the new policy, heavy aircraft and engine maintenance costs related to their owned aircraft are capitalized and amortized to the next overhaul. This change is driven by the growth of LAN’s fleet and operations in recent years.

    The new policy became effective retroactively from January 1, 2006 and generated a non-operating, non-recurrent pre-tax benefit of US$40.3 million, due to the elimination in provisions constituted using the previous method. This extraordinary gain was recorded in 2006 as other income under the miscellaneous item. Finally, income tax expense increased by 65.4% to US$46.8 million in 2006, mainly as a result of higher pre-tax income, as the effective tax rate remained at approximately 16.2%.

    Working Capital Scenario: As of December 31, 2006, there was a working capital deficit (that is, their current liabilities exceeded current assets) of US$170 million. On December 31, 2005, there was a working capital deficit of US$105.2 million. However, as of December 31, 2004, there was a working capital surplus of US$70.3 million. Working capital deficit in 2006 was mainly related to the air traffic liability and accounts payable. Air traffic liability refers to tickets that have been sold but which have not yet been used for travel. The price paid for the ticket is recognized as revenue when the tickets are used. Except in the case of refunds, most of the traffic liability will not result in cash outflows.

    U.S. GAAP is more Aggressive than Chilean Standards: Net income determined under U.S. GAAP would have been US$209.7 million in 2006, US$156.3 million in 2005, and US$164.7 million in 2004 as compared with net income under Chilean GAAP of US$241.3 million in 2006, US$146.6 million in 2005, and US$163.6 million in 2004. In 2006, the main factor determining net income was the accounting change for maintenance charges.

    Shareholders’ equity determined under U.S. GAAP would have been US$592.7 million at December 31, 2006; US$526.8 million at December 31, 2005; and US$447.8 million at December 31, 2004 as compared with shareholders’ equity under Chilean GAAP of US$626.3 million at December 31, 2006; US$502.7 million at December 31, 2005; andUS$434.6 million at December 31, 2004. This was due principally to differences in purchase accounting adjustments, adjustments for the provision for deferred income taxes, and goodwill amortization.

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    LFL 1-yr chart:
    LFL

    Source: LAN Flying High With Low Fixed Costs