LATAM Airlines: Restructuring organization and strategic options down the road

Three months after declaring bankruptcy, it is promising that LATAM Airlines (“LATAM”) has already secured US$2.2B in committed financing for restructuring as the company aims to reorganize its network, fleet plan and debt. According to its filing for bankruptcy on May 25, 2020, the airline had $1.3B in cash, accounts receivable and lines of credit according to its financial statements.

LATAM’s bankruptcy was a strategic management move with a number of factors coinciding to push the airline to file. First, a sharp drop in global passenger demand and in consequence a deteriorated revenue environment. Second, future demand uncertainty and marked air travel volatility including potential changing consumer behavior and attitudes. Third, fixed costs, debt refinancing and other related personnel costs that needed to be cut quickly to stay afloat. Fourth, the need to restructure its fleet and cancel or defer new aircraft orders to match seat supply with demand. Finally, divesting the business of non-core assets and lowering its cost structure and headcount per aircraft. It operated with 122 full-time employees (“FTE”) per aircraft when it should be below or close to 100, as is the case for its equity partner Delta Air Lines. Lufthansa Airlines, another large legacy carrier, manages to operate with an FTE per aircraft of 97 which is 25 fewer employees per aircraft.

Figure 1. FTE: Full Time Employee per aircraft. Source: FY 2019 reports or 2Q 2020 10K reports when available. Airlines shown in order: Lufthansa, Delta, United Airlines, Aeromexico and Avianca

Assuming LATAM could bring FTE to below 100 FTE per aircraft and an average wage of US$ 60K per year/employee and 1.3 times in labor benefits, with a fleet of 342 aircraft at the end of 2019 LATAM could potentially save US$ 667 million per year.

Bankruptcy enables LATAM, through its court-supervised reorganization process, to be restructured without delays which will allow it to renegotiate labor contracts and reduce headcount while significantly decreasing labor costs. 

Putting aside all the rationale and events that led LATAM to file for chapter 11, the airline was already facing cost issues in a number of regional and domestic markets. On the cost side, GDP contractions (for example in Brazil), volatile currency devaluations (Chile, Argentina and Brazil) and other macroeconomics factors such as raising inflation (Argentina) did have a negative impact on unit costs.

For example, looking at the airline's revenue from 2012 to 2019 and as the airline continues facing competition, it shows an operating revenue CAGR of -2.9%, while costs were reduced 3.7% per annum. Indeed, operating expenses were reduced further than the impact on revenue deceleration was which is a step in the right direction, however LATAM needs to further focus on cost cutting measures to improve its net margin and bottom-line contribution further.    

Figure 2. 2012-2019 Revenue and expenses CAGR analysis. Source: Airline 10K reports. Numbers in billions.

Especially, LATAM needs to focus on cost reduction initiatives in key domestic market operations such as Chile, Peru, Argentina, Ecuador and Colombia as they show the sharpest passenger revenue per ASK CAGR deceleration of 5.4% mainly associated with fierce ULCC price competition and penetration.

Figure 3. 2012-2019 Revenue per ASK. SSC Domestic: Domestic passenger operations in Spanish speaking countries (in Chile, Peru, Argentina, Ecuador and Colombia) carried by the airline. Source: Airline 10K reports.

Besides and when looking at 4Q 2019 % YOY figures for Spanish Speaking Countries (SSC) domestic market operations., LATAM ASK grew 9% while RPK only grew 3.8% confirming an alarming capacity/traffic trend. Moreover, and pre-virus events, the airline guidance for 2020 called for a 7% increase in ASK in those SSC markets which could further deteriorate results if traffic did not materialize. The diluted revenue per ASK is partly a consequence of Ultra Low-Cost Carriers (“ULCCs”) model penetration. The higher LATAM unit costs (than typical ULCCs leaner and cost-control focus) are negatively impacting margins and profitability while making it difficult to compete on a level field with lower cost structure operators both domestically and regionally as they keep expanding. It would appear that LATAM CASMs need to be reduced by at least 40% in order to compete head-to-head with South American ULCC competitors.

Figure 4. Average CASM analysis US$ cents. Source: 2019 selected airline 10K reports. European ULCCs: Ryanair and Wizz Air. US ULCCs: Spirit and Allegiant airlines. US majors: American, Delta and United airlines. MEX ULCCs: Volaris and Vivaaerobus. FSCs: Full-Service Carriers: Avianca, Aeromexico ad Azul Airlines

Therefore, and as the airline continues its restructuring reorganization, a number of potential strategic options down the road are shown in figure 5. 

Figure 5. Consultant analysis. Notes: (1) and (2) are applicable to domestic, regional and international markets.

With regard to domestic and regional market options, LATAM should exit unprofitable and small volume size markets. For example, Colombia and Peru domestic markets are 5 and 3 times larger than Ecuador, respectively. With liquidity conservation being a key concern during this crisis, accompanied by lackluster demand, smaller sized markets might represent a key airline management distraction and poor resource allocation. 

Furthermore, the airline must reduce its CASM and evaluate a “mixed” business model. For example, a number of airlines have launched ULCC subsidiaries to ward off competition, added flights in major domestic markets, or re-configured aircraft to match rivals’ all-economy offerings. In the case of Copa Airlines (fleet 102 aircraft, 80 destinations), it operates Wingo (fleet 19 aircraft, 19 destinations) with some degree of success. 

Figure 6. Selected list of global mainline operations and its ULCC subsidiaries.

The main goal of launching an ULCC subsidiary is to enable the airline to compete with low cost competition while maintaining the core higher-yielding brand. If a mixed model is a viable option, LATAM needs to consider if two separate brands would generate synergies and if it can operate a dual management model efficiently. If it were to do this, when compared to its mainline operation, a successful ULCC recipe should include CASM ex fuel below US$ 6.0 cents, crew labor productivity improvements on rosters including flexible working patterns, leaner management structures, lower wages, sound ancillary revenue and fleet up-gauging strategies among others. 

Other LATAM strategic options could include evaluating a feeder traffic business model where a lower cost base ULCC competitor in the region feeds traffic to its regional and international operations. Through this model, the airline could concentrate on premium higher yield segments while being able to optimize loads in its long-haul operations and even ensure that marginally operated routes become profitable. Other options on the table could include additional network partners further allowing  carriers to jointly market each other’s routes to stimulate demand through the exploration of new routes, cargo in-cabin services to stabilize revenue especially as regional borders may open and close due to the pandemic, and merger and acquisitions which seem unlikely at this point. Finally, LATAM should explore further employee productivity improvements through digitalization.  

On the international market front, LATAM should continue expanding its long and ultra haul long point-to-point services to further optimize premium revenue. However, it might not be feasible soon due to network rightsizing and reduced demand in the wake of the current crisis. In addition, LATAM should explore new network connectivity opportunities in the United States, Europe, Oceania, Asia-Pacific, and the Middle East with current equity partners and other potential allies. 

Another strategic option would be to assess potential areas of cooperation with equity partners as well as evaluate new equity participations. Likewise, it should focus on increasing product differentiation especially in its premium cabin segment as well as focusing on selling vertical travel experience solutions to optimize revenues per passenger. Related to this, and to benefit from premium revenue opportunities, LATAM should further micro segment the market, personalize offerings, expand premium product mix while increasing customer engagement and revenue conversion among others. However, those initiatives will need investment and management might decide to put them aside as LATAM concentrates on preserving liquidity and restructuring its business. 

In summary, LATAM needs to thoroughly rethink its business strategy. The airline should be looking to cut close or more than US$4B in costs and the opportunity to make the top to bottom reorganization that Chapter 11 status affords is not one to be wasted. LATAM may never have another opportunity like this one to review its business from operations to processes, headcount to route network. As ULCCs are expected to continue growing, LATAM’s next moves related to the company's organic versus inorganic growth could end up being one of the company’s most strategic moves it ever needed to execute in its entire corporate history.

- René Armas Maes