Azul: Dip In Capacity Expected, Investment Thesis Intact

Summary

• Azul reported the slowest traffic growth rate since the company went public in April 2017, driven by lower domestic capacity.
• But I believe the headwinds are short term in nature, and the fleet refresh should help push available seats and traffic up in the long run.
• I continue to be as bullish on this stock as I have been for the past six months.

Despite the Brazilian stock market having ended the day up strongly this Tuesday, shares of Brazilian airline Azul (NYSE:AZUL) fared about four percentage points worse by comparison, following the company's most recent traffic update. Consistent with my goal of keeping a finger on the pulse of my November Idea of the Month, today, I assess whether the most recent figures disclosed might negatively impact my investment thesis.

Source: Airline Reporter

On the metrics

At first glance, the headline numbers were not the greatest. Azul's RPK (passenger traffic) YOY grew by 10% in the month of March. This figure may sound robust to most investors who follow the more mature U.S. airline industry. But in this case, it represented Azul's slowest traffic growth rate since the company went public in April 2017 (see graph below). Behind the seemingly soft numbers was a domestic business that, for the first time, saw a YOY contraction in traffic that came along with a correspondent drop in available seats as Azul continues to refresh its fleet.

In my model that conservatively predicts a 4% CAGR in passenger revenues through 2022, I assume that domestic capacity will eventually increase at a 6% clip over the next five years in a decelerating trend. I continue to believe that this scenario will materialize, as new A320 aircraft continue to be added to the asset base, possibly at a faster pace in 2018 and 2019. For now, I expect domestic capacity to reverse course and return to growth in the next few quarters, with the recent dip phasing away as the retirement of E-Jets tails off. As a consequence, traffic growth should also climb back into the teens.

Source: DM Martins Research, using data from company reports

Less concerning was total load factor, which once again improved YOY by 40 bps. On the domestic side, load factor of 79.2% was consistent with February's number and higher than last year's 78.5%, suggesting that Azul once again did a good job matching supply and demand. In international, capacity utilization rose sequentially, after having dipped to all-time lows in February.

As I had mentioned in the past, the international side of Azul's business is both the most profitable, by my estimates, and the least protected from competition by local and foreign companies. Despite seeing a shallower moat within this segment, international continues to perform very well, with YOY growth in capacity and traffic having reached a very robust 80% and 69% in March, respectively. As a result, I expect Azul's 1Q18 revenues and margins to be aided by a heavier international mix that tends to carry richer per-seat prices.

Thesis still intact

The past couple of traffic updates came along with a few developments (drop in international seat occupancy rate in February, dip in domestic capacity in March) that could look concerning to some. However, I continue to believe that Azul's operational and financial health remains very strong, with the company positioned to benefit from a slowly recovering Brazilian economy and from what I believe to be an under-served domestic market.

The stock has climbed nearly 30% since I issued my original bullish call on the name. Yet, I still see modest upside potential going forward. I believe the stock will be worth $45/share in the next three years, particularly if the value of the company's TudoAzul business is unlocked - either through a spin-off or non-core earnings generated.

AZUL remains in my portfolio, and I continue to be as bullish on this stock as I have been for the past six months.

Analyst’s Disclosure: I am/we are long AZUL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.