Azul S.A. (AZUL54) Earnings Call Transcript & Summary

Hello, everyone, and welcome to Azul's investor update call. My name is Beatrice, and I will be your operator for today. This event is being recorded [Operator Instructions] I would like to turn the call over to Andrea Bottcher, Investor Relations Manager. Please proceed.

Thank you, Beatrice, and thank you, everyone, for participating on such short notice. Joining me today are John Rodgerson, CEO; Alex Malfitani, CFO; and Abhi Shah, our Chief Revenue Officer. Before I turn the call over to John, I'd like to caution you regarding our forward-looking statements. Any matters discussed today that are not historical facts particularly comments regarding the company's future plans, objectives and expected performance constitute forward-looking statements. These statements are based on a range of assumptions that the company believes are reasonable and are subject to uncertainties and risks. With that, I'll turn the call over to John. John?

Thanks, Andrea. Good morning, everyone. Happy new year. We've had a very busy start to 2020, and we're very excited to share some news with you today as we further move Azul forward to be more profitable and better airline every day. So we're going to go through a few slides with you. We're going to go through the executive summary. We're going to take a look at the E2 economics and transactional review, and we're going to open it up for Q&A. I want to quickly just go through the executive summary. We have ambitious plan to transform our fleet in a very quick period of time. And we have set out to do it over approximately a 4-year period. And we're here today to tell you that we're going to try and get it essentially completed by the end of 2021. This is very exciting for us. It's very accretive, and we're very excited what this means to our shareholders and to our crew members. There's over BRL 4.8 billion of incremental EBITDA by 2027 and about BRL 16 million per E1 that we retire as we get new E2s in the fleet. I want to move quickly to Slide 5. We showed this to you on several occasions. But we have roughly 900 flights a day in our domestic fleet. And more than 50% of those are being flown by E1 aircraft. And so as you look at the opportunity for Azul moving forward, it's to transform all of the E1 flights into E2s. And I want to walk through the economics of that quickly on Slide 6. Every Embraer next-generation aircraft that we receive has 18 more seats. So we'll be producing more revenue with the larger gauge. These aircraft are coming in at a lower rent than we were previously paying for our E1s. The fuel consumption, as we've got 4 of these operating today, is around 19% better. And when we look at that on a per seat basis, it's about 26% better. The maintenance cost of this aircraft is 16% better, and we're actually utilizing these aircraft about 2 hours more than our E1s. This next-generation aircraft is really a game changer for Azul as we move forward. And it's the most economic, environmentally friendly aircraft in its class. And so the seat mile cost of this aircraft is essentially where the A320neo is or the 737 MAX and does it with a significantly lower trip cost. As you move on to Slide 7, I just wanted to give you a little bit of the passenger experience. And Azul has always been about great passenger experience. But we're finding that the NPS, our Net Promoter Score on the E2 is better than our E1s. And so this is going to help us continue to be one of the best airlines in the world. The carry-on space for our customers is significantly better. They have wider windows. We have state-of-the-art IFE system and Wi-Fi systems onboard the aircraft, it's quieter cabin. So the customer experience overall, we maintain our 2x2 seating on these aircrafts and we're taking the total fleet size of the E2s up to 75 aircraft. And so we're very excited what this will do for our customer experience and certainly for our profitability as we move forward over the next few years. I want to -- we did this transaction -- we've been working on this over the last 3 or 4 months and finally came to a conclusion with both LOT and Breeze. And so I want to have Alex walk you through the transaction overview and how this is going to take place over the next month or so. With that, I'll pass it over to Alex.

Thanks, John. Yes. Good morning, everyone. So as you know, we've been talking about this for a while. We've told you that the performance of the E2 is so positive for Azul, that it almost makes sense for us to just ground the E1 and accelerate an E2. While it wasn't exactly there, we needed a little bit of revenue to make that transaction work, so we went to the market and made sure we got the best deal we could find. And we found a good partner with LOT, who had already bought 7 of our E1s and for whom the aircraft's operating very well and LOT pays much less on per -- fuel on a per liter basis than we do. And so for them, E1 makes so much sense and for us the E2 makes so much sense. So we were able to get to a market-based agreement with them. And then we just replicated essentially that deal for Breeze. So they are economically equivalent. They are essentially identical and so these aircraft are going away. And once they go away, they never come back to Azul. So the sub-lessee is going to take this aircraft, and manage -- they're going to have the responsibility to deliver these aircraft back to the lessors. So this clearly resolves our goal of accelerating the exit of our E1s. When you look at Page 9, just to illustrate what that means, this -- the natural replacement line is how we would exit the E1 fleet naturally if we just waited until the end of the original operating lease, right? So essentially, we would have E1s flying with us until 2027, but obviously, we can't wait to get the E2 into our operation. And with this agreement, with these 2 transactions, we'll be able to say it could be essentially done by 2021, as John said, right? We still have 7 aircraft, but I think this is a conservative assumption, most likely will be done by 2021. So it's a significant acceleration, obviously, from the natural exit of the E1s. It's also a significant acceleration from the previous fleet plan that we had published originally. So this is good news all around. And then I think on Page 10, I think there's a summary really in terms of economics. If we follow the natural replacement line, what you would see is that our cash flow generation would follow the lower line in this chart. By accelerating, we're going to follow the upper line in the chart, and we're going to create all this incremental value that you see here. So essentially, almost BRL 3 billion of incremental cash flow that would never be materialized unless we accelerate the exit of the E1. So obviously, by 2027, these lines meet each other because that's when we would have naturally been done with our E1 replacement. But that way, we can generate a significant amount of incremental value for Azul and its shareholders. As we've also been communicating to you, on Page 11, we talk a little bit about the accounting impact. With IFRS 16, all of these aircraft, whether they are operating leases or finance leases or owned aircraft, they get treated as owned aircraft. And obviously, we had a number in the books that assume that the aircraft would stay in the fleet until 2027. Since these aircraft are going to leave prior to that, we need to take a noncash reduction to the book value, but this is purely accounting. Obviously, in terms of decision-making, what matters is the billions of reais that we're generating by accelerating the exit of the E1s. We also put in some comps here so that you can see the magnitude of the charge. We had other airlines writing off their E1 fleet. They had younger -- had older aircraft than us, our fleet is younger. And that naturally means that our write-off is going to be a little bit higher. We also have more operating leases than the other carriers. The operating lease write-off is also higher because you write it off to 0 and with an owned aircraft, you can write it off with the residual value. So naturally, our write-off is slightly higher than our cost, but that's all explained by the age of the fleet and the fact that we have operating leases at Azul. Like I said the LOT deal is a market-based transaction. And the Breeze deal essentially replicates the LOT's deal. Breeze is a related party. So we will need shareholders' approval for this transaction. But that's -- obviously, we believe very strongly that this is very positive for Azul. This is how we're going to create billions of reais in incremental value. To make everybody feel very comfortable, yes, we also got strong independent party verification of the deal. So we got an independent consultant who's heavily specialized in Embraer, Azorra Aviation. So it basically does all of our analysis of whether this deal is market-based, whether the 2 transactions are essentially equivalent, and whether this is a good deal for Azul, which is what Azorra is tasked to do. We also had EY do an audit of our agreed-upon procedures as well. And so we're very confident with this transaction, and we're publishing on Page 13 our new 5-year operating fleet projection. This is our expectation. So here, you can see the exit of the E1s. Like John and I said, we want to be done by 2021, so think this is a good working assumption. And this is our expectation, right, given what we know now and what we expect for the future, this is what we expect to be flying over the next 5 or 6 years. But obviously, we have flexibility to adjust this as necessary, right? If market conditions are better or worse, the macroeconomic conditions change, we can flex up or down as required. But this is sort of the expected value of the fleet that we should be operating over the next few years. So with that, I'll turn it over back to John.

Thanks, Alex, and thanks, everybody, for joining us. We've got Abhi here as well. And so we'd like to open it up for any questions that you may have for the management team as it relates to this transaction.

[Operator Instructions] Our first question comes from Mike Linenberg, Deutsche Bank.

Just a couple of questions here. John, I just want to make sure I heard you right. You talked about the incremental benefit to EBITDA for -- to 2027 is BRL 4.8 billion. And I didn't hear if it was BRL 16 million per conversion or is it BRL 60 million?

It's BRL 16 million per year per plane in cash flow.

I see. So it's BRL 16 million per year per aircraft, okay.

And I would like to -- this is Alex. Just if I can chime in how we did this analysis. Obviously, the cost that we have on E1s is a sunk cost, right? So we've looked at how much incremental benefit we would have by accelerating an E2, how much incremental cost we would have by bringing in an extra E2 and then what's the benefit from the sublease transaction itself, right? So when you bake that all in, we're not assuming a way to ramp on E1. We're stuck with that cost until the end of the original lease, right? So that's not a benefit. But the incremental revenue that obviously we can get from [ E2 ], obviously, we assume marginal load factor, marginal fares for that capacity, right? We don't assume average load factor. We assume that only a small portion of those seats will get filled with a small fare. We get a much lower fuel burn, as John mentioned. We get a little bit of a maintenance benefit because of high -- of longer maintenance intervals, but that's not material. And we get the incremental cost of operating the E2 -- of owning the E2, right, which is the rent. Then we get the sublease from LOT and Breeze and some additional cash for maintenance. And we avoid the redelivery costs that we would have at the end of the original lease, but we incurred some costs now to deliver the aircraft as is to the operator. So when you bake all that in, it translates to a cash flow of about BRL 16 million per year per aircraft, 1-6, which translates to roughly BRL 2.9 billion of incremental cash flow. And once -- obviously, EBITDA, you don't consider rent and maintenance roughly, so that's the BRL 4.8 billion of EBITDA for the full term of the transaction.

Okay. No, that's actually very helpful. And then the airplanes that are being subleased, do you have just the split of which airplanes are going to LOT and which -- the number of airplanes that are going to Breeze?

Yes, we do. So you'll see that on Slide 8.

Yes. So what happened -- so LOT has first pick, Mike. So they have 18 firm and they have 14 options that they can exercise. And then Breeze can take up to 28. Obviously, we only have about 53 of these which is the opportunity that we have. Because some of these aircraft are so close to their natural delivery, it doesn't really make sense for us to sublease them. But the 53 remaining, LOT can take up to 32, and then Breeze will take the remaining.

Okay. Great. And just lastly, just to be clear, all the E1s, are they all on operating leases? I just want to be clear on that.

No, we have some -- we have about 12 that are on finance leases today. Because all of these will be -- yes, so actually -- yes, 17, it's here on Page 8. 17 are on finance leases, but these will be leased to LOT and Breeze. And so the plan is to sell these aircraft, and there's already a lot of interest for them because you're selling an aircraft with a lease already attached to it, which makes it an even more attractive aircraft, right? We have already been selling aircraft to LOT and other operators without the lease attached. Now we have a lot of interest from lessors, who would like to buy these aircraft with already 4 years of guaranteed revenue attached to them.

Our next question comes from Savi Syth, Raymond James.

Just a couple of clarifying questions first. Just on the -- what would you say kind of the savings is on the combined EBITDA -- sorry, EBIT sense? And then also, does that include kind of the incremental cargo opportunity that comes with these E2s?

So let me answer the second question, and I'll pass it over to Alex for the first question. We've included nothing in here for our cargo operation. So this is just a pure E1 going out to E2. All we've done in this analysis is include the incremental seats, the 18 seats that Abhi will have the opportunity to sell, but we have not included that. And then for EBIT, you can kind of see impact on Slide 10.

Yes, it's essentially the same number as the actual. It's pretty similar to the cash flow number that we published.

Okay. Got it. And then just on the timing of it, there is a pretty big drop off in 2020. Just -- is that pretty ratable through the year? Or how should we think about the timing? And I know you mentioned, Alex, that there is some delivery cost in there. So is kind of the BRL 16 million is more kind of over time, and it's a little bit less early on and then kind of builds up? Or how should we think about kind of the timing of this.

So Savi, Abhi will kind of talk through when each E1 will go out. And Alex will kind of talk through the cost.

Savi, Abhi here. Yes, actually, the E2s actually -- the E1s have actually -- some of them have already left and we have a bunch now starting to leave in February. So we're approaching the end of our summer peak season here. And so February, March, April, May, June is a very good time, given the seasonality of demand late first quarter and second quarter. So we have a bunch of airplanes starting to leave in February already. Makes sense also because for LOT, they want to have them in time for their summer, and so it makes sense to get the aircraft out now. So we have a bunch of airplanes leaving now starting in February. So we have a little bit of a valley in our capacity, which ties up very well with the seasonality of second quarter. And then it will continue through second half of the year. But the E2 deliveries, we have some coming now, but they really ramp up in the second half of the year. So you can expect airplanes -- more airplanes leaving now and then the E2s will come to backfill them second half of the year.

There has been a cut over at Embraer. So they're actually shut down for the first month of the year as they cut over between kind of old Embraer to new Embraer, so there's a little bit of a timing lag there. But -- and just to clarify something that Abhi said, some have left the fleet in preparation to be sent to LOT and Breeze. They're still on our books today, and we're not getting revenue for them, but they're still kind of in our books today, yes.

Yes. And in terms of the cost, I think, again, another value of this transaction is we were selling the aircraft essentially as is, but they need to be compliant with the regulation in each country, right? So with LOT, there's a little bit more cost because they need to be EASA compliant. And we have to install some equipment in the aircraft and that's essentially the bulk of the cost that we're seeing today. So it's sort of in the order of magnitude of a couple of million dollars per aircraft, which is also, again, baked into the projections.

That's helpful. And if I might sneak in one more for Abhi. Abhi, what kind of market -- is it just kind of strictly E1 markets or is there some markets that maybe you would want to put the E2s because they have a better range?

Yes. So first of all, of course, our priority is to replace all of the E1 routes that we have. So we have roughly 500 departures a day, we talked about that a lot. And our priority is to swap those over. The E1s primarily are, in our network, a lot in Campinas, in Belo Horizonte and then like Curitiba, Porto Alegre, places like that. So on corporate market, high-frequency markets, the first route that the E2 has been flying is via -- Campinas to Brasilia. And we increased frequency on that route from 5 to 6 flights a day. There are some connect-the-dot opportunities that are very interesting that the E2 economics enables. And especially when it comes to increased utilization, which we are doing with E2, we're able to fly the E2 also slightly higher stage lengths that we're not able to do with the E1. So we're able to connect dots that were further away that didn't make sense with E1. We're able to add nonstop destinations from Campinas, for example, that were longer, that were thinner, too small for the 320 and the economics didn't work for the E1. So it really, really opens up a lot of opportunities for us not only in the 500 flights a day that we have that we want to switch over, but connect-the-dot opportunities. And you can expect, along with the higher utilization, a higher stage length as well for this aircraft.

Our next question comes from Lucas Barbosa, Morgan Stanley.

I have 2, actually. The first one, will Azul assume any credit risks from LOT and Breeze group or the lease agreements will be transferred to the new lessees?

Yes, I think it's similar to other lease agreements. You essentially have the aircraft as the underlying collateral of the deal, right, which is very powerful, right? It's a very movable asset. With special jurisdictions that we're talking about, it's very easy to repossess the aircraft in case of a credit risk. And then there is the buildup of the maintenance reserves that are in the deal as well. So we'll be building a cash balance throughout the length of the contract.

And plus, each transaction has security deposits, which is a few months' rent in advance. And so there's enough security for what we're doing.

Okay. Makes sense. Thanks for the color. And the second question is, with the new fleet commitment, what would you expect in terms of ASK growth for 2020?

Yes. So we haven't given out a 2020 guidance yet. But what we've been saying all along, and we continue to say this, is that our ASK guidance has been very, very consistent, 2018, 2019. And so you can expect something similar in terms of ASK guidance compared to what we've done in the last couple of years. So it will be a very similar ASK guidance.

Our next question comes from Renata Faber, Itaú

I have a question related to Breeze. If anyone from Azul leadership is going to Breeze with David or not.

So first of all, welcome back Renata. No, nobody from Azul management is leaving. David has an agreement with the Board of Directors of Azul that he can't, and they've got a great management team. They already have a CFO in place, a chief commercial officer in place. And so he's built a good management team. And so we're working with them on the fleet transaction, but no senior member of the Azul team will be joining Breeze Aviation group. Why would we leave at this point in time, when the best years of us are in front of us? And so we're super excited to transform this fleet. And we've all done a start-up and so we're ready to continue running Azul.

Our next question comes from Stephen Trent, Citi.

I had joined a little bit late, so I apologize if I missed this, but just 2 quick ones for me. The first, just a quick question from a mission capability standpoint. I'm also getting that the E2 is still small enough to serve a bunch of those kind of medium-sized airports that don't have particularly long runways. And just to make sure that's -- my understanding is correct.

Yes, Steve. We have no mission restrictions in our domestic network with the E2.

Great, great, great. And just one other quick one. I know from some time ago, you guys, if my memory serves me correct, had a very, very small exposure to, I believe, Hong Kong Airlines from the, I guess, an HNA holdover. And maybe it was just 2 or 3 planes that -- I guess, in a worst-case scenario, 2 or 3 E1s we have to take back. Any sense as to where that stand now? And if those 2, 3 aircraft are wrapped into this deal?

They're not wrapped into this deal. We actually have no guarantees on any E-Jets that have gone to Hong Kong Airlines. I think what you're referencing, Steve, was on the widebodies that they have. And I think it's an unfortunate situation that's happening in Asia right now and so we work closely with this, with the lessors, and we do a lot of business with the lessors. And so we're working through solutions jointly with them as things settle in China and with the HNA Group. But we don't have any news to report at this time.

Our next question comes from Matthew Wisniewski, Barclays.

Just wanted to understand the utilization a little bit more, the jump up. I think you mentioned a little bit more capability to longer-haul flying. But is there assumption you'd just be running the aircraft a little bit harder, doing additional frequencies. And in the past, is that just kind of a function of the E1s? Were they just not capable? Or just any color on kind of the step-up in utilization?

Yes, Matt. So yes, so normally, utilization comes from stage lengths. It also comes from flying at night and on weekends as well. So the E1 really is a greater plane for your 1-hour 15-minute high-frequency corporate routes, where you have 6, 7, 8, 9, 10, 11 times a day. But the problem with that is you have an hour flight, but then you have a 30-minute turn time in between those hour flights. So that's not very good in terms of utilization. And then you end up hitting the limit of the day, 5:30 a.m. flights, 5 a.m. flights or 11:00 p.m. flights that are not very good in terms of demand. So what the E2 is able to do is fly those corporate routes just as well, but also be able to fly longer haul routes that are 2-hour stuff, even 2.5 hours that perhaps is too thin for the 320. We're able to do red eyes with the E2 that we're not able to profitably do with E1s. That increases utilization. We could even use the E2s on weekends for our vacations business, connecting dots that is too small for the 320. And so utilization really will come from stage lengths. It comes from extra red-eye flying. And you're able to access parts of the day -- because of the trip cost and the unit cost, you're able to access parts of the day profitably that you're not able to do with the E1. So it really opens up windows -- scheduling windows that were not available with the E1. So that's really where the utilization comes from. And it's going to open up new market opportunities, new route opportunities that frankly were never served in Brazil ever. And so we're going to be able to connect dots with this airplane that were never served before, and I expect -- first nonstop stimulation, I expect the market to grow as a result.

Okay. Great. That's really helpful. And then forgive me if you touched on this before, but I think it was discussed briefly. But operationally, bringing a new aircraft in, I assume there's some minimal training, but any other operational impact of bringing a new aircraft in [indiscernible]?

No. So I think that's the benefit. So we've suffered through the last couple of years bringing all the A320s with the pilot training, but it's 2.5 days of training. I think we are the launch customer of the 195 E2s. Embraer is a very strong partner of ours, so in the State of São Paulo, they're giving us tremendous support. And so we've been flying for about 3, 4 months now with E2, and it's been terrific. And so the distance, reliability of E2 have been above the A320neos and so I think that's a testament to the great job that Embraer has done from an engineering standpoint. I think this aircraft work, and so this is something that we're working very closely with them on. And so any time you take a new aircraft, there are little problems, but engines are performing unbelievably well, and the operation has been fantastic so far. So we're pretty excited about that.

Our next question comes from Alberto Valerio, UBS.

Two from my side. First one, actually, the new fleet plan that some of the A320neos was delayed 1 year. I would like to know if [indiscernible] Azul or are those [indiscernible]? And my second question is about the lease of the new aircraft. Could you provide additional info about the new kind of the lease? What's the percentage of the operational lease and financial lease?

So there's been no delay in the Airbus. It kind of delivers the new volume seen in our fleet plans. We've just taken a more realistic approach as to when we'll put them into service. And that's the only adjustment we've seen. So because the OEMs have delayed aircraft that we've put a more realistic plan in place that we can execute to it. So that's the only difference. As for the lease rate, I think we made it pretty clear that we were a start-up airline in Brazil 11 years ago when the aircraft market was very tight. And so what we paid for our E1s is actually more expensive than we're going to pay for our E2s. And so that is a pretty phenomenal thing for an airline to do, to pay less for a next-generation aircraft that's got 18 more seats, 19% better fuel burn, lower maintenance cost. And so some of that was just paying for sins of the past, just being the startup airline in Brazil in 2008. And -- but we're -- this transaction kind of cleans us up once and for all and gets us moving forward in a new direction. But for sure, from a cash flow perspective, the E2s are significantly cheaper for us than the E1s are. And we have better conditions with financing, better conditions with the lessors in terms of cash reserves than we have on the E1s that we don't have on E2s. And so overall, this transaction is very positive.

In terms of financing, some -- we like to have a good portion of our fleet that is finance lease that is owned. And so over the couple of years that we have the crisis in Brazil, that served as a very good protection for us, right, because the owned aircraft was easier for us to remove from the fleet and adjust our capacity. And so over time, over the next few years, we will pay the finance leases. So that we can build up this portion of our fleet that is debt financed and has more flexibility. Like we're showing right here, even the operating leases we can find home for, but it's not as easy, right? In an emergency, it's much faster for you to eliminate capacity with debt-financed aircraft. And so we will pay for the majority of our aircraft going forward, especially on the back end of our 5-year plan, not as much in the first couple of years. But more towards the back end, they will be finance leases.

Can I consider this likely as a ratio of 70% operational lease and 30% financial lease?

Yes, we should get -- that's the point we want to get to by 2024, 2025.

[Operator Instructions] Ladies and gentlemen, this concludes today's question-and-answer session. I would like to invite John to proceed with his closing statements. Please go ahead, sir.

Great. Thanks, everybody, for the short-notice hopping on the call. We're very excited about what this brings to us from a transaction standpoint. We look forward to seeing you all at conferences over the next couple of months. And if anybody would like to follow up individually, obviously, our team will be prepared to speak to each of you. Thanks, everybody. Have a great day.

That does conclude the Azul's audio conference for today. Thank you very much for your participation, and have a good day.