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Scott Myers

Dan Pan

TAM S.A. (NYSE:TAM) is the largest domestic airline in Brazil, both in terms of passengers carried and revenue. ^[1] As of the end of 2007, the airline serves 47 domestic and 17 international destinations, controlling approximately 40% of domestic air travel in Brazil and 67.5% of international air travel originating or terminating in Brazil as of the end of 2007.^[2]

While TAM's total revenue grew by 10% to $8.5 billion, the company's operating and net incomes decreased by 62% and 42% respectively due to costs of increasing fleet size. ^[1] The airline makes the majority of revenue on domestic flights, a quarter on international flights, and the rest on cargo fees and partnership commissions.^[1] TAM's financial statements are greatly dependent upon the currency exchange rate between the US dollar and Brazilian Real because the majority of TAM's expenses are in US Dollars and the majority of its revenues are in the Brazilian Real.^[3] Furthermore, TAM is dependent upon the macroeconomic stability and appropriate government intervention in Brazil. Although inflation has been controlled in Brazil in the past three years, high inflation rates or recessions both negatively impact the company's ability to profit. ^[3] Fuel represents approximately 32% of the company's expenses, so the wide fluctuations of crude oil prices also affects TAM's bottom line. ^[4]

Corporate Overview

Although TAM's gross revenues have increased since 2005, increased expenses caused both operating and net income to drop by 62% and 42% over 2007, respectively. ^[1] In that year, all main reported expenses increased as a result of an increase in the use of the company's aircraft by 18.3% and an increase in the fleet of 20 new aircraft. ^[5] These cost increases were accompanied by a 34% increase in available seat kilometers (ASM), or the capacity of the airline as measured by the number of 'air kilometers' offered to passengers. ^[6] The company continues to expand as of autumn 2008. In 2008, the company has increased service to Lima (Peru), and started service to Orlando (Florida), and several Canadian cities. ^[7]

Due to TAM's 2007 addition of 20 aircraft and increased use of its planes, available seat kilometers and revenue passenger kilometers (RPK), or billable kilometers of travel, have been increasing since 2005. ^[5] The load factor after the 2007 expansion dropped to 70%, meaning that only 70% of available seats on flights are filled with paying customers. ^[5]

Business segments

TAM 2007 Revenues by Segment ^[1]

• Domestic Flights ($4,834m, 57% of total revenue^[1]) is the largest segment in terms of revenues generated. TAM is the largest domestic airline in terms of customers transported throughout Brazil with a reported 49.1% market share within the domestic flight market in Brazil (in terms of passengers carried). TAM serves 47 cities within Brazil, in addition to 34 other domestic destinations served through alliances with other regional airlines. ^[8]In 2007, TAM carried approximately 22.9m passengers on domestic flights. ^[8]

• International Flights ($2,130m, 25% of total revenue^[8]): The airline offers flights to 17 international destinations and connects to other destinations through partnernships with Lufthansa and United Airlines among others. ^[8] In 2007, TAM carried approximately 2.6m passengers on international flights. ^[8]

• Cargo ($777m, 9% of total revenue^[8]) refers to the transfer of cargo in the cargo area of the plane. This segment's revenues increased by over 50% between 2006 and 2007.^[1] This was a result of the increase in international flights available as many of the new cargo transport revenues were gained in the sale of cargo transport service to other Latin American countries, North America, and Europe. ^[9]

• Other ($714m, 8% of total revenue^[8]): This last segment includes revenue earned from commissions, partnerships with the TAM loyalty program, subleasing of aircraft, and revenues earned through the Other sub-segment which primarily consists of the TAM travel agency (Viagen). ^[10] The commissions are those revenues earned in exchange for providing service to external companies while the TAM loyalty program's revenues are those that are derived from agreements with external companies, primarily credit card companies, to exchange frequent flier miles for revenues. ^[10]

Key Trends and Forces

Fluctuating fuel costs pressure company margins

Cruel oil prices have varied between $147 and $70 per barrel in the period between July and October 2008. ^[7] These fuel price variations are significant changes in costs for airlines. Fuel represented 32.2% of all Tam's operating expenses in 2007, which is only slightly (1-2%) above its average over the past three years. ^[4] The airline typically hedges its fuel expense, or purchases forward contracts to offer it the possibility to purchase fuel in the future at set prices, between 30% and 80%. The airline had between 30% and 80% of its fuel expenses hedge as of the end of 2007. ^[4]

Brazilian macroeconomic stability and low inflation necessary for proper business functioning

The Brazilian government often changes monetary and fiscal policy in efforts to address inflation and avoid recessions. These changes have had significant impacts on the economy. ^[3] In the 1990s, government policies led to hyperinflation that reached over 1000% in some years. In recent years, inflation has been much more controlled (3.64% in 2007, 4.18% in 2006, and 6.87% in 2005); however, excessive inflation can also reduce consumer purchasing power and reduce the sale of tickets. ^[11]

Currency exchange rates affect net income

Most of TAM's expenses are incurred in the US Dollar whereas the majority of the company's revenues are gained in the Brazilian currency (the real). Historically, inflation has caused the real to fall over the long term against the US Dollar (in 2002, for example, the real fell 34.3% against the US dollar). Since 2005, the real has increased in value against the US Dollar every year (13.4%, 9.5%, and 17.2% in 2005, 2006, and 2007); however, this trend reversed in the summer of 2008. ^[3]

If the real falls against the US dollar and other further increases, its operating and net incomes will decrease whereas the inverse is true in the opposite case. ^[3]

Competition and Market Share

• Domestic Routes: Within Brazil, TAM controls the largest amount of market share in terms of passengers carried. Its only major competitor is Gol, which controls approximately 39% of the passengers carried. ^[2] As in other areas of the world, airline competition in Brazil is based on the price of airline tickets, the perception of quality in flight, the available connections within the country, and the established loyalty programs that there are for airlines within the industry. ^[2] TAM offers more connections to domestic cities than any other Brazilian airline, especially when considering the additional connections offered through partnerships with regional airlines. The airline also considers itself to have a well-developed frequent flier program which does not have many of the date and other restrictions that other airlines have. ^[2]

Domestic Market Share ^[2]

• International Routes: The competition for international destinations is not limited to the few companies that compete within the domestic Brazilian market. The competitors are mainly determined by the destinations served, but are here analyzed on the basis of flights that originate or terminate in Brazil.^[2] Competition is more intense within the international market because the number of competitors increases based on target destination; however, TAM's strategy of expansion has made it the clear market leader in terms of passengers carried and RPM with approximately 67.5% of the market share considering these metrics. ^[2]

International Market Share ^[2]

TAM's main competitors are:

• GOL is a Brazilian air carrier that serves both domestically and internationally. It considers itself to be a low fare carrier. ^[12]
• Varig is the next largest competitor in terms of passengers carried; however, the company filed for bankruptcy in 2006 and was sold to new investors. It still operates although with more limited capacity. The airline offers both domestic and international service. ^[13]

References

1. ↑ ^{1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7} TAM 2007 20-F Filings, Section 1, Page 11
2. ↑ ^{2.0 2.1 2.2 2.3 2.4 2.5 2.6 2.7} ANAC
3. ↑ ^{3.0 3.1 3.2 3.3 3.4} 2007 TAM 20-F SEC Filings, Section 1, Page 14
4. ↑ ^{4.0 4.1 4.2 4.3} 2007 TAM 20-F SEC Filings, Section 1, Page 15
5. ↑ ^{5.0 5.1 5.2} TAM 2007 20-F Filings, Section 4, Page 56
6. ↑ ^{6.0 6.1} TAM 2007 20-F Filings, Section 1, Page 12
7. ↑ ^{7.0 7.1} Reuters Business News, "Tam: Key Developments," October 2008
8. ↑ ^{8.0 8.1 8.2 8.3 8.4 8.5 8.6} 2007 20-F Filings, Section 1, Page 24
9. ↑ 2007 20-F Filings, Section 1, Page 31
10. ↑ ^{10.0 10.1} 2007 20-F Filings, Section 1, Page 32
11. ↑ Euromoniter Statistics on Brazil
12. ↑ Bloomberg Company Profile: Gol Linhas Aereas Inteligentes SA
13. ↑ AirWise News, "Varig to Boost Fleet to 45 By End 2006 October 26, 2008

References

1. ↑ ^{1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7} TAM 2007 20-F Filings, Section 1, Page 11
2. ↑ ^{2.0 2.1 2.2 2.3 2.4 2.5 2.6 2.7} ANAC
3. ↑ ^{3.0 3.1 3.2 3.3 3.4} 2007 TAM 20-F SEC Filings, Section 1, Page 14
4. ↑ ^{4.0 4.1 4.2 4.3} 2007 TAM 20-F SEC Filings, Section 1, Page 15
5. ↑ ^{5.0 5.1 5.2} TAM 2007 20-F Filings, Section 4, Page 56
6. ↑ ^{6.0 6.1} TAM 2007 20-F Filings, Section 1, Page 12
7. ↑ ^{7.0 7.1} Reuters Business News, "Tam: Key Developments," October 2008
8. ↑ ^{8.0 8.1 8.2 8.3 8.4 8.5 8.6} 2007 20-F Filings, Section 1, Page 24
9. ↑ 2007 20-F Filings, Section 1, Page 31
10. ↑ ^{10.0 10.1} 2007 20-F Filings, Section 1, Page 32
11. ↑ Euromoniter Statistics on Brazil
12. ↑ Bloomberg Company Profile: Gol Linhas Aereas Inteligentes SA
13. ↑ AirWise News, "Varig to Boost Fleet to 45 By End 2006 October 26, 2008