Merger Will Keep LAN Airlines Soaring

03/08/2011 3:34 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

The proposed acquisition of Brazil’s TAM (NYSE: TAM) by Chile’s LAN Airlines (NYSE: LFL) jumped another hurdle on March 3, when the Brazilian finance ministry said the deal satisfied the country’s foreign-ownership rules.

In my opinion, those rules were the only real obstacle to the deal—a restrictive application of Brazil’s limits on foreign investment in Brazilian airlines could have killed the combination.

The companies have come up with a complex structure that will let TAM’s controlling shareholders retain 80% of TAM’s voting stock, while giving LAN shareholders about 70% of the combined airline, to be called LATAM Airlines.

The deal—which still has to pass judgment with Brazil’s civil-aviation and antitrust regulators, not to mention Chile’s—would create the largest airline in Latin America, and the third largest in the world. (From early indications, LAN might have to reduce its market dominance on routes between Santiago and Asuncion, Sao Paulo, and Rio de Janeiro in order to get antitrust approval.)

LAN’s strategy over the last decade has been to expand outside of its Chilean home—where it has an 82% share of the domestic market—to become the dominant airline in South America.

To that end, the company has expanded organically as well as through acquisitions. One example: in 2010, LAN acquired Aires, the second-largest airline (22% market share) in Colombia.

The TAM acquisition will give LAN access to the 200-million-strong Brazilian market, in addition to expanding its international reach to 102 destinations across South America (it currently serves 72).

The international market now accounts for 70% of LAN’s passenger traffic. In January, the company reported a 9.5% increase in international demand and an 8.5% increase in capacity from January 2010. The load factor climbed to 83.6%. LAN’s overall load factor increased to 82.7%, up 0.5 percentage points from January 2010.

LAN has also built an unusually large air-cargo business that accounts for about 25% of the company’s revenue. (A comparable figure for the average US airline is 10%.)

Air-cargo revenues are more stable than passenger revenue, one reason the company has been profitable every year since 1994. (The stock is a member of my Jubak Picks 50 long-term portfolio.)

Air-cargo customers are also less sensitive to price increases than air passengers are. That’s especially important right now because rising oil prices are increasing costs at all airlines. Airlines that depend on passenger traffic for 90% of their revenue and that operate in highly competitive air passenger markets will have the most trouble passing on all that cost.

That’s not to say that LAN is immune from rising oil prices—and in fact, I’d expect to see LAN’s shares face pressure from high fuel costs. Indeed, the stock is down to $26.89 at closing on March 7, from $31.88 on December 3.

I’d use the sell-off in the shares of any company that uses petroleum (or that sells a product that uses petroleum) as a buying opportunity if the price drops below $25.

(It also doesn’t hurt that Chile’s economy grew by 6.8% in February. The central bank is raising rates to fight inflation, but rates are low at 3.5%, and inflation advanced at only a 2.7% annual rate in January.)

I’d be looking for a price of $33 in a year.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this post. The fund did not own shares of LAN Airlines as of the end of January. For a full list of the stocks in the fund as of the end of January, see the fund’s portfolio here.

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