Brazilian Airlines Tam and Gol Have Credit Rating Downgraded

Airplanes from Gol and Tam in Congonhas, São Paulo, Brazil, airport Concerned with the challenges facing the airline industry. Fitch Ratings downgraded, this Friday, June 20, its rating of TAM and Gol, Brazil's leading airlines. Both companies had their outlook revised from stable to negative.

Fitch has affirmed the 'BB' Foreign and Local Currency Issuer Default Ratings of TAM. Fitch has also affirmed the 'BB' rating of its US$ 300 million senior unsecured notes due in 2017 as well as the company's 'A+(bra)' national scale rating and its first debentures issuance of BRL 500 million.

The Outlook revision, says Fitch, reflects concerns regarding the challenges that the company is expected to face in 2008 to improve its operating performance. The unprecedented rise in crude oil over the last several months has and will continue to put pressure on TAM's margins and cash flow generation capacity throughout 2008. The ability to restore profitability to prior levels which should enable it to achieve credit ratios consistent with the current rating category remain key in maintaining credit quality.

The current sharp escalation of oil prices has imposed a direct challenge to TAM's strategy to improve operational profitability. The pressure from fuel prices will be the company's main challenge in 2008 and is expected to test TAM's efficiency in reducing its operational costs.

In recent years, the company has been successful in reducing costs, but was unable to significantly increase profitability due to its quest for market share and leadership in the Brazilian market. In 2007, TAM's yield for the domestic market fell 19% compared with 2006.

The company's capacity to pass-through increased fuel costs to its customers should prove challenging in 2008. In Fitch's opinion, the company should be able to offset around 40/50% of the fuel cost increase with hedging policy and fuel surcharge, the remaining 50% will be offset with continued cost reductions and fare increases. For 2008, the company's strategy is to reduce costs, excluding fuel, by 7% and increase yields by 7% and 5% in the domestic and international markets, respectively.

Fitch believes that the company will need to go beyond these levels mentioned above to restore its profitability and says it will closely monitor the situation. Fitch expects that continued growth of demand in the Brazilian airline sector, a more rational competitive environment and the development of new international routes could favor the company's strategy. The second half of the year is traditionally the most profitable and the period in which the company will seek to increase fares.

TAM's financial profile and credit protection measures deteriorated significantly in 2007 and are weak for the rating category and the current capital structure is leveraged.. For the 12 months ended March 2008, adjusted total-debt-to-EBITDAR ratio was 7.3 times (x) and adjusted net-debt-to-EBITDAR was 5.3x, compared with 7.0x and 4.9x and 3.7x and 2.3x respectively, in 2007 and 2006. At the end of March 31, 2008, total balance sheet debt was BRL2.2 billion, comprised of mainly long-term capital leases and working capital lines. Adjusted total debt, including operating leases, was BRL8.3 billion.

Difficulties in the Brazilian air transportation sector including infrastructure issues, competition, and the fatal accident involving a TAM plane in July 2007, have also pressured TAM's yields and load factors, translating to a drop in margins and cash-flow generation. For the 12 months ended March 2008,

EBITDAR margins fell to 13.4%, versus 14.9% at the end of 2007 and 23% in 2006. During the first quarter of 2008, RASK-CASK spread diminished to BRL0.1 versus BRL0.6 in 2007 and BRL2.8 in 2006. Cash-flow generation, measured by EBITDAR, totaled BRL1.2 billion compared with BRL1.7 billion in 2006, while Funds From Operations (FFO) reached BRL206 million in 2007 and BRL695 million in 2006. For the 12 months ended March 31, 2008, EBITDAR totaled BRL1.1 billion, while FFO was BRL358 million.

TAM's liquidity remains solid with BRL2.2bn in cash and marketable securities for the first quarter ending March 31, 2008. The company's strategy is to maintain a minimum cash position of around 3.0x monthly revenue (equivalent to about BRL1.4 billion), to prevent against short-term refinancing and sector volatility risks, as well as improving its position to negotiate better conditions for lease contracts. TAM's solid financial profile and cash sources are expected to help mitigate short-term risks and the volatility of the turbulent Brazilian air transportation sector.

TAM is a holding company that operates through its wholly owned operating subsidiaries, TAM Linhas Aéreas and TAM Airlines. It provides regular air transportation services in Brazil and overseas. TAM is one of the leaders in the Brazilian market, with an approximate 49% market share and 37% of the international market.

The company provides nationwide coverage, directly serving 47 destinations in Brazil and another 34 national destinations through regional alliances with other airlines. TAM directly serves 17 international destinations. and offers connections to several other overseas destinations through code-sharing agreements with Air France, LAN, TAP, Lufthansa, among others.


GOL ratings downgrades reflect the deterioration of the company's credit profile, as well as the reduction in its historical solid liquidity position, according to Fitch. The Brazilian airline sector problems experienced in 2007 coupled with competition, losses from recently acquired VRG Linhas Aéreas S.A. and rising fuel prices have resulted in negative pressure in GOL's performance.

The negative outlook reflects Fitch's concerns regarding the challenges that the company is expected to face in the near-term to turn VRG into a positive cash flow generator while implementing countermeasures to mitigate cost pressures due to higher oil prices.

In order to maintain its current ratings, the company will need to improve its operating performance and improve its profitability in order to more adequately align GOL's credit ratios with that of the rating category.

GOL's current ratings contemplate Fitch's expectation that the company will continue to maintain a competitive cost structure vis-a-vis the global industry and its significant market share position in the Brazilian airline sector. The ratings also incorporate the company's exposure to fuel cost volatility and other industry-related risks, such as revenue volatility, high correlation with the domestic economy, high operating leverage and competitive threats.

Management's expectation of strengthening its business with the acquisition of Varig has yet to materialize including to have VRG achieve positive earnings. Restrictions at Congonhas Airport, lower than expected feeder traffic on long-haul international route to Europe, high fuel prices, the lack of approval from the Brazilian anti-trust authorities for the integration of the two companies and the still ongoing replacement of VRG's less fuel efficient 737-300s and 767-300s with more efficient aircrafts frustrated management's initial objectives at the time of the acquisition.

In 2008, the escalation of oil prices is expected to pressure more intensely the cost structure of the airlines companies globally and Brazil will not be an exception, warns Fitch.

GOL's ability to reduce fuel consumption through more efficient aircrafts, operate efficient hedge instruments and pass-through higher costs to customers will be the predominant factors for improved profitability and credit metrics, Fitch believe. Now that the company reports that VRG's CASK (Cost of Available Seat-Kilometer) have recently reached the level of GOL's, for the success of the operations acquired an increase in yields and low factor will be key for VRG's profitability.

Recent measures taken by GOL in the strategic repositioning of VRG, continued growth of demand in the Brazilian airline sector and a more rational environment in terms of competition could favor a moderate recovery in GOL's profitability. Margin recovery, increased cash generation, preservation of liquidity and improvements in its main credit metrics will be fundamental to avoid additional rating downgrade.

During the past 15 months an imbalance between supply and demand impacted consolidated GOL's load factors and the strong competitive environment pressured its yields, translating to a fall in margins and cash generation. Besides the difficulties faced by the global and Brazilian airline industry, the growth in operations with the acquisition of VRG impacted substantially GOL's historical profitability track-record.

In 2007, flight delays, cancellations and restrictions in one of Brazil's most important airports (Congonhas) restricted GOL's ability to maximize aircraft utilization and the advantages of operating with a much interconnected air transportation network. The spread between RASK (Revenue per Available Seat-Kilometer) and CASK was a negative BRL 0.1 in 2007 and remained a negative BRL 0.2 in the first quarter of 2008, compared with a historic average of BRL 4,1 up to 2006.

In 2007, cash generation measured by EBITDAR totaled BRL 600 million compared with BRL 985 million in 2006, while Funds From Operations (FFO) decreased to BRL 21 million in 2007 versus BRL 583 million in 2006.

GOL continued to report weak performance during the first quarter of 2008. For the 12 months ended March 31, 2008, EBITDAR was BRL 565 million and FFO was a negative BRL 80 million. During this period, the company reported EBITDAR margin of 10.2% compared with 12.1% in 2007 and very robust figures of 25.9% and 29.5%, respectively in 2006 and 2005.

GOL's liquidity position has deteriorated somewhat in the last 18 months but remains satisfactory. Cash and marketable securities were equivalent to BRL 1.0 billion at the end of March 2008, reaching 19% of its total revenue, compared with a historical level close to 35%. The company's liquidity position still represents 2.5 times (x) its short-term obligations.

Fitch says it expects that GOL will preserve its liquidity at least close to its current level in order to mitigate short-term risks and sector volatility. Managements considers that the company has access to additionally liquidity with the discount of its large receivables portfolio (BRL 354 million), bank credit lines not yet drawn (some BRL 550 million), and the replacement of aircraft prepayments with letters of credit.

The company's current credit metrics remain weak for the BB rating category. For the last-twelve-months ended March 31, 2008, the company recorded an adjusted total-debt-to-EBITDAR ratio of 10.5x, adjusted net debt-to-EBITDAR of 8.7x. At the end of March, the company registered adjusted total debt of BRL 5.9 billion, a growth of 92% compared to 2006 due to aircraft fleet expansion. Around BRL 4.4 billion consists of aircraft lease obligations. The company's principal debts are perpetual bonds (BRL 345 million), bonds due 2017 (BRL 388 million) and pre-delivery deposits (BRL 455 million).

GOL is a holding company that controls a low cost airline, GOL Transportes Aéreos S.A. (GTA), and VRG, providing frequent service on routes linking the main cities of Brazil and South America. In May 2008, GTA operated 78 Boeing 737 aircrafts with an average age of 6.8 years, and VRG, 32 aircrafts (21 Boeing 737s and 11 Boeing 767 ) with an average age of 13 years.


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