GOL: The Flight Back To Quality

On July 17th 2007, GOL Linhas Areas Inteligentes S.A. (GOL) was awarded “best performing airline in the world 2006” for its revenue category (market cap of between U$1Bn and U$4Bn) by the prestigious industry magazine Aviation Week and Space Technology. However we would be surprised if many remember this, as on 17^th July a different Brazilian aviation event made far more headlines. A TAM (TAM) airlines jet slewed off the runway at Sao Paolo Congonhas airport and crashed into a nearby warehouse, killing 199 people in Brazil’s worst ever air accident.

Bad Luck

We mention the two events of 17^th July as they seem to encapsulate the bad luck suffered by GOL these last 12 months. No fatal airline accident is ever welcome of course, but the TAM crash came at a particularly bad moment for the industry. Brazil was just getting over a crisis of air confidence from previous accidents and air traffic control problems in late 2006 and early 2007. The TAM crash again knocked the stuffing out of the sector and forced us to retreat on our previous (and until then successful) buy rating on GOL.

Missing the Bullet

However, we are glad to say that we finally see light at the end of GOL’s bad luck tunnel. Ever the contrarians, the idea of getting sizeable discounts on well run but out of fashion companies showing rapid growth is tempting, especially when the drop in value is no fault of the company concerned. Just after the TAM crash, GOL dropped from $31 and then settled around a $25 to $26 trading range. But then came the second part of GOL’s recent double bad luck whammy; the August credit crunch that hit emerging markets hard, as witnessed by the 22% drop in the iShares S&P Latin America 40 Index (ILF). GOL itself went under $20, and this analyst began to wonder how low it could go, having never let it leave our radar (pardon the pun). We may have retreated from the stock at $28 before the worst of the damage was done, but the question was always not ‘if’ to return to GOL, but ‘when’. We believe the time is to return is now and there is good reason to be a confident buyer.

Buyback Marks the Bottom

The sub U$20 prices have now disappeared, but make no mistake; the present share price of $23.79 is still bargain. The reason for our revival of confidence is the latest GOL press release. Tuesday September 18th, GOL’s major shareholder, Fundo Asas, (run by the founders of Gol and holding slightly under 70% of all stock) stated in a regulatory filing to the Securities Commission of Brazil that they were considering a share buyback scheme or even a full de-listing of the company. The share jumped 11% on heavy volume on the news, as the market recognizes a bargain when it sees one. There is a clear difference between rather-too-fashionable buyback schemes of large multinational corporations that look to shore up share prices and this GOL announcement. Fundo Asas has seen its asset base drop to a level they must feel to be considerably undervalued. They are drawing a clear line in the sand, and be it OPA or bit-by-bit buyback, the controlling group will start buying the 30.4% of shares they do not own at these prices.

When coming from 70% majority holders, a complete OPA is no empty threat of course. However, we believe GOL will move one step at a time and is far more likely to initiate the stock buyback piecemeal. If, as we believe, Fundo Asas satisfies itself with a steady buyback program, the stock has minimal downside and plenty of upside. However it would still be a winning play for investors if the GOL went all way. If a full scale OPA is called by Fundo Asas they will surely have to pay a considerable premium to today’s price. One leading Sao Paolo brokerage Tuesday called the premium at 30% and we would not argue with that figure at all.

Recent Results

Looking a little closer at the company, the bad luck factor shows up clearly in recent results. If we look at a chart with GOL’s total load factor for the last 2 calendar years we begin to see the problems. Load factor is an industry standard measurement of the percentage of planes filled with passengers.

We see from load factor how airline growth was first stunted back by the sector travails in 2006. Apart from the January spike from heavy holiday traffic (the southern hemisphere vacation period), GOL load factors stayed lacklustre until June when things started to pick up. Then came the July 17^th crash; August figures speak for themselves.

Of course, load factor is not the only key passenger statistic used by airlines to gauge performance. For example, in the case of GOL capacity measured by ASK (“available seat kilometers”, seating capacity multiplied by kilometers flown) has doubled in the period January 2006 to date and is 71% up since last August. This demonstrates that GOL has aggressively expanded its fleet, route schedules, destinations etc., and once again points to the kismet suffered by GOL. At precisely the moment they have expanded aggressively, loss of confidence has put off many passengers from flying.

All this has of course been reflected in company returns. The chart below shows GOL quarterly EPS in Brazilian Reais, and even now we can safely say that the 2006 full year EPS of R$2.90 is not going to be matched in FY07.

The star-crossed expansion plans of GOL turned a 2q06 U$56.4m profit into a 2q07 U$18.7m loss. Second quarter revenues actually rose YoY by U$150m, but the added expense of running the new, larger fleet and fuel charges raised YoY costs by U$276m. GOL pointed to delays and cancellations as the cause of its woes, but in fact many analysts were pleasantly surprised by the 2q07 result. The loss of 9 US cents a share beat FirstCall expectations of a 13c loss quite handily and those we consulted concurred that “it could have been a lot worse.”

The Future Looks Brighter

The third quarter will certainly be dragged down by August’s popularity plummet, but that should not put the canny investor off from taking a position in GOL. Luck permitting, the worst is behind GOL and they can concentrate on filling those seats they have invested so heavily in bringing to the market. Also with this year’s U$285m purchase of Varig bringing them both prestige and prized international routes now nicely integrated, the expansion will not simply be focused on internal business. Already, GOL international flight loads are up 360% YoY, marking the start of an international expansion program that looks very promising.

Meanwhile, we note that main rival TAM is the defendant in lawsuits resulting from the 17^th July crash that total a cool U$3 Billion. Though TAM is clearly insured (it could not fly without such coverage), the details of accident policies do vary from airline to airline and TAM may or may not have to pay a minor tranche of any settlements from its own earnings. This may play into the hands of GOL, who could take the coveted top spot away from a weakened TAM. It can also be argued that any loss of passenger confidence will be centered on TAM, thus giving GOL a further window of opportunity to become industry leader.

Brazil Get Serious

As for the sector as a whole, it would seem that Brazil is finally doing something about its major infrastructure problems. In the immediate aftermath of the terrible accident, heads rolled from high-ranking political positions. Brazil’s major airlines have instructed pilots not to land in the rain at some airports deemed to be dangerous. Also, a damning interim report released 10^th September the International Air Transport Association (IATA) has caused the downfall of other state air functionaries who previously believed they had cushy jobs for life.

One major defect also reported by IATA centres around the so-called ATAERO airport tax, which is designed to pay for improvements in infrastructure but is currently retained by national government and does not find its way back to where it’s so desperately needed. The IATA report is being acted upon and should quickly free up cash for vital upgrades to airports and air traffic control systems. It is of course a pity that aircraft have to crash and people have to die before anything is done, but it would seem that Brazil as a country is finally getting serious about its air transport system.

Conclusion

The press release of 18^th September marks a turning point for GOL’s share price and should not be underestimated. It highlights a clear point in the fortunes of the company stock, and today’s price should be considered a strong floor level. We have watched the company go through the predicted house of pain, but now feel the time is ripe to return to this well managed and normally successful airline. The Brazilian air market is finally getting its act together, but even so there is clearly enormous growth potential in the years to come. We recommend GOL as a long position, and are pleased to have it return as an integral part of our LatAm model portfolio.

Disclosure: the author has a buy recommendation for clients on GOL