With high labor and fuel costs, razor-thin profit margins, and vulnerability to economic downturns, airlines are shunned by many value investors. However, this sector faces a bright horizon south of the border, where a growing middle class is clamoring for air travel.
In much of the world, demand for international air travel capacity has been flat to falling. According to the International Air Transport Association, North American travel volume declined by 2.1 percent in July and Asian demand grew by just 0.9 percent. By contrast, Latin America has experienced consistent monthly demand growth of about 6 percent for several years.
Latin America's gross domestic product (GDP) growth is on track to average a little more than 7 percent this year, compared to average global GDP growth of 3.5 percent. As a result, the ranks of the region's middle class are expected to grow by about 75 percent over the next two decades. While that's creating huge demand for everything from cars and homes to televisions and telephones, it's also driving a huge spike in air travel as Latin American consumers demand the good life.
During the brutal economic downturn of 2008-2009, regional stars such as Latin America fared better than most. In addition to strong domestic demand, international tourism to the region barely dipped during the crisis and quickly rebounded to pre-crisis levels (see chart below).
At its current pace of growth, air traffic in the region should more than triple over the next 20 years.
Given the rosy outlook for air travel in Latin America, it's surprising that the late June marriage of the region's two largest and best-run airlines, Chile-based LAN Airlines and Brazilian TAM SA, met with very little fanfare.
With a market cap of nearly $13 billion, the newly created LATAM Airlines Group (LFL) is now one of the largest airlines in the world, second only to Air China (Hong Kong: 0753) and its market cap of $60.9 billion.
LATAM is on a flight path to becoming one of the most profitable airlines in the world, a far cry from US-based domestic carriers that seem to operate on an endless cycle of bankruptcies. LATAM realized an estimated $200 million in cost savings from the merger. LATAM management expects the airline's earnings to grow by about $600 million over the next four years, doubling the amounts the two airlines were each making as standalone entities just last year.
The combined entity now also handles 42 percent of the passenger traffic within Latin America and nearly a third of all air freight. Moreover, it's the second-largest airline on routes to the US and the third-largest to Europe.
Despite the dominant market share and operational efficiencies realized by LATAM Airlines from the merger, the share price of the combined entity has essentially been flat since the deal was completed in late June (see chart, below).
That lackluster performance largely stems from the general malaise that's still hanging over the global economy, despite the introduction of a third round of quantitative easing (QE3) from the US Federal Reserve and the European Central Bank's announcement that it will begin supporting the sovereign debt of its troubled member nations. The market's general skepticism of the effectiveness of those stimulus measures is largely justified. So far, nearly free money has yet to kick start global growth.
That said, I look for LATAM to outperform. Pre-merger, both LAN and TAM had long histories of maintaining operating costs that are among the lowest in the business. As a result, they coped well during the Great Recession. Air travel in Latin America remained amazingly resilient, reflecting the region's economic vibrancy against a drab global canvass.
With new and significant cost efficiencies embedded within its post-merger operating environment, the combined entity should hold up even better if another global recession materializes. If the economy actually rebounds, this airline's stock should soar.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.