For years, Chile’s LAN Airlines and Brazil’s TAM Airlines have been two of the biggest, most important foreign airlines that went largely unrecognized among air travelers in North America. Now the merger of the two airlines, announced on August 13, could help carry the two South American carriers squarely into the spotlight. The deal would create a mega-airline with an impressive market capitalization of around $13.2 billion as of mid-September, far exceeding the current US$6.6 billion in combined market capitalization of United Airlines and Continental Air, the two U.S.-based giants planning to merge by the end of this year.
Stock market observers see these figures as a notable reflection of the appreciation of South American equities on global markets. While the combined market capitalization of LAN and TAM was about double that of the two U.S.-based air giants last year, the South American airlines’ combined revenues of $8.5 billion were far lower than the combined US$29 billion recorded by United and Continental last year. LAN and TAM carried a combined 45.8 million passengers last year, which would have ranked them a combined 11th in the world. In terms of available seat kilometers, LAN and TAM, if combined, would currently account for over 40% of Latin America's capacity and offer the second-largest capacity on routes to the United States and Canada after only American Airlines.
Much remains to be resolved in this merger of South American aviation giants, however. If the two airlines continue to operate under their own brands, will the character suffer from a lack of consistency? Will the leadership of the new airline be able to achieve the synergies and cost savings that motivate today’s trans-national mega-mergers? Which worldwide airline alliance – Oneworld or Star Alliance – will the new airline belong to? LAN belongs to Oneworld, while TAM belongs to Star Alliance. Over the long term, what will the merger portend for the much smaller, regional airlines that compete for market share on the fast- growing South American continent?
“This is a merger, not an acquisition, and it is unprecedented,” says Felipe Monteiro, a professor of management at Wharton. In recent years, Monteiro notes, “it has become normal for Brazilian companies to buy smaller companies but less usual for players to join forces. This [deal] involves two large Latin American airlines with very important operations.” Brazilian companies have acquired smaller firms in sectors such as beverages, power, telecommunications and financial services. Recent important deals include the merger of the banks Itaú and Unibanco; the takeover by Perdigao, Brazil’s largest food company, of its rival Sadia; the foreign acquisitions made by Brazilian food processors JBS and Marfrig; the merger of Brazilian brewers Brahma and Antarctica, which created AmBev, which then merged with the Belgian company Interbrew, creating InBev, and the recent purchase of Burger King by 3G Capital, a Brazilian firm.
The new South American airline will dwarf in size such smaller players as Brazil’s Gol, Colombia’s Avianca and Argentina’s Aerolineas Argentinas. Monteiro suggests that the TAM-LAN deal is much more akin to the high-value consolidation that has been taking place elsewhere in the aviation world, including the pending merger of United and Continental and recent capital ties established between KLM-Air France and privately owned Alitalia.
Monteiro adds that a key reason for the TAM-LAN merger is that Brazil restricts foreign ownership in a Brazilian air carrier to just 20%. “This is a very regulated market,” in which it would otherwise be very hard for foreign players like LAN to play a major role. “There will be discussions in the Brazilian congress about changing this [restriction] to 49%,” notes Monteiro. The new company will have to find ways to respect the foreign participation laws in each country, he points out. The new airline “will be scrutinized by governments in both Chile and Brazil. Everyone knows that if you want to be an important player in this industry, it is very hard to be a purely local player.”
Capturing the Public’s Imagination
This deal “has captured people’s imagination because of its huge scale,” says Mauro Guillén, a Wharton management professor and director of Wharton’s Joseph H. Lauder Institute of Management & International Studies. “It is a major event for emerging economies. I am optimistic. It makes all the sense in the world.”
The merger is important, notes Guillén, not only because of its own scale but because of what it portends for other cross-national mergers in Latin America. “There will be other mergers” in various sectors in Latin America, “and they will get bigger and bigger.”
But does the merger make business sense? According to Germano Glufke Reis, lecturer at the Getulio Vargas Foundation/EAESP (Sao Paulo Business School) in Brazil, “This merger has a very clear set of motivators: The opportunity to create synergies and to improve operational efficiency; gains related to scale, and the fact that it creates entry barriers to foreign airline companies.” Reis adds, “In Brazil, airlines have experienced an extremely competitive industry, a hard price-based competition. Small companies with regional routes already hold a 19% market share and foreign companies have operated with low prices in Brazil. On the other hand, the increase in the purchasing power of the population has increased ticket sales. Never before in Brazil have people traveled abroad so much as currently. Airline industry growth has been at a rate of 13%, or double the growth rate of the gross domestic product [GDP)].”
The timing of the merger is also critical. Brazil is preparing to host both the next World Cup in 2014 and the Summer Olympic Games in 2016, and “that means investments in airport infrastructure and creation of new business opportunities,” notes Reis. For both major events, South America’s new mega-airline will play a role that “is less symbolic and more operational,” says Monteiro. “The air traffic infrastructure for these big events will become a major issue with an unprecedented volume of traffic,” highlighting the need for smooth functioning of South America’s transportation connections with the rest of the world. These events can be a “make or break” moment for the new airline to prove to the world that it is a major-league player worth remembering. “It is very important to have an airline big enough to deal with these issues,” suggests Monteiro. Through its various branches throughout South America, “LAN has a really good network” for handling traffic in Latin America and the U.S. “while TAM’s strengths are its connections to Europe. Now they will really be able to combine the two networks,” adds Monteiro.
LAN Takes the Lead?
Of the two airlines, LAN has the upper hand in taking the lead role in the new air carrier because the Chilean airline “is extremely well managed,” Guillén notes. “LAN has new planes and excellent services and good on-time performance. They seem to know how to make money in the industry and they are expanding…. They are better run.”
When it comes to financial performance, there is a striking contrast in the two airlines’ recent histories. In terms of revenue, TAM is significantly larger than LAN. In 2009, TAM’s revenue was US$9.8 billion, versus only $3.52 billion for LAN. Meanwhile TAM’s earnings per share were US$2.90, versus US$0.68 for LAN. But LAN’s market capitalization, as of mid-September, was nearly three times – US$9.85 billion – that of TAM, which was US$3.38 billion. While TAM’s share price has fluctuated wildly since 2005 -- from a high of US$36 in 2007 to a low of US$5 in 2009, to about US$21 this summer – LAN’s shares have more than quadrupled in value over the past two years, from a low of US$7 in 2009 to about US$30 today.
Just before the merger was announced, LAN reported that its passenger traffic rose 13.7% in August from a year earlier, after gaining 14.5% in July. LAN said the increase was due to a 15.1% jump in domestic passenger traffic in Argentina, Chile, Peru and Ecuador. According to LAN officials, a greater presence in its U.S. operations helped boost international traffic by 13.1%. LAN's cargo operations rose 16% in August because imports recovered in Latin America, especially in Brazil, and activity grew in Europe, the company said. The airline's load factor grew 1.3% to 77.8%. Just days before the merger was announced, TAM announced a US$88 million second-quarter net loss, generated by major losses in its fuel hedging strategy. However, TAM’s second-quarter revenue rose to $1.457 billion, compared with $1.14 billion a year earlier.
Under the proposed arrangement of the merger, LAN Airlines would change its name to LATAM Airlines Group and become the holding company for the two airlines and their subsidiaries. Yet LAN and TAM would preserve their traditional brands and continue to be headquartered in Santiago, Chile and São Paulo, Brazil, respectively. The choice of LAN head Enrique Cueto as the CEO of the new company, says Reis, “suggests that there will a common direction to both companies ... distinct identities with a single management model.”
To implement the merger, LAN Airlines would issue new shares. Shareholders in TAM would receive 0.9 shares in LATAM for each TAM share. Thus, LAN's existing shareholders would hold an estimated total of 71% of LATAM, headed by the controlling Cueto family with approximately 24% of LATAM. TAM’s controlling Amaro family would have around a 14% stake in the new company. However, under a shareholders' agreement, control of the merged operation would be shared by the Cueto and Amaro families, each with an equal (but yet to be defined) number of directors on LATAM's nine-seat board. “Both TAM and LAN are companies that have family origins,” notes Monteiro. “A major challenge will be “how well the controlling families will work together.” The two sides will have to decide whether the new airline will have a distinctively South American flavor; or have a flavor – either Chilean or Brazilian – that is more in tune with one of the two partners.
By the terms of LAN's statutes, the merger will require approval of two-thirds of its shareholders; the Cueto family, although the largest single shareholder, controls only 34%. For shareholders of TAM -- in which the Amaro family holds a 48% stake -- the proposed share swap would reportedly provide an attractive premium over the company's current market value.
Commonalities and Complexities
Another challenge involves the personal relationships between the largest shareholders in the two companies, says Reis. That is to say, “How to achieve the necessary alignment between the Amaro and Cueto families in the management of this new giant of the airline sector and how to preserve this alignment over time.”
Even though both companies are located in Latin America, “Chile and Brazil have many differences regarding geography, history, institutions, culture, and so on,” notes Reis. “It is also important to observe that mergers are not the preferred entry mode of Brazilian companies when they expand internationally.” On the contrary, Reis suggests, Brazilian companies prefer to make acquisitions of foreign companies because their management style typically seeks to minimize risks and to grant control to the managers of their foreign-based operations. “This cultural trait tends to reduce interest in strategic alliances and mergers,” Reis points out. “However, learning through internationalization, Brazilian firms have started to experience alternative approaches.”
Despite such complexities, notes Guillén, “there are no big competition issues here because these two airlines operate in different parts of Latin America. Customers won’t be hurt, and they may get more choice” as a result of the merger. “To the extent that they have more integrated services, this will help travelers,” he says.
Another positive, Reis says, is that both partners are modern companies that “have truly professional management models, and have advanced fleets and technologies, besides having a well-prepared team. They have a lot of experience in performing in partnership and alliances. LAN has subsidiaries in other countries and partnership with foreign companies. So LAN and TAM have both capabilities and competencies that will surely ease the management of their cultural alignment and the gradual construction of a common identity” to the extent that it might be required.
Republished with permission from http://www.knowledge.wharton.upenn.edu -- the online research and business analysis journal of the