GOL - Gol Linhas Aereas Likely To Greatly Dilute Its Shareholders

2023-11-28 19:45:00 ET

Summary

• Gol Linhas Aereas has seen margin expansion due to cheaper jet fuel and recovery in the Brazilian airline market.
• However, the company's margin expansion may be limited due to more expensive fuel and increased competition.
• Gol's recapitalization plan through convertible debt and warrants will lead to significant dilution for future shareholders.

Gol Linhas Aereas ( GOL ) is one of the three airlines that dominate the Brazilian domestic market.

I have written three articles on the company since December 2021 ( January 2023 , September 2022 , and December 2021 ). My take has been negative, as I did not consider Gol to be an investment with good potential.

The reasons have been the company's leverage, its difficulty in earning a return on assets above the cost of its capital, and, more generally, the difficulty of running a profitable airline business.

In this article, I will limit myself to commenting on two recent important developments of FY23: the company's margin expansion, fueled by cheaper jet fuel in Brazil; and the recapitalization plan via convertible debt and warrants.

I believe the company's margin expansion has reached a limit via more expensive fuel and higher competition among airlines in Brazil. Also, the recapitalization is very needed but will lead to massive dilution to future shareholders.

For these reasons, I maintain my hold rating on Gol.

Some people have asked me why I don't issue a sell recommendation on Gol, given my previous hold articles. The reason is that I am not recommending shorting Gol; simply not buying it. Short selling has a very different risk/reward ratio than long buying and should be left, for the most part, to professionals only.

Note: Unless otherwise noted, all information has been obtained from the company's filings with the SEC.

Margin expansion via fuel prices

The most positive point this year for Gol has been the expansion of its margins, with growing revenues and falling or stagnant costs.

In fact, in 3Q23, Gol was close to covering all of its financial expenses (BRL 830 million) with operating income (BRL 800 million).

There are two reasons behind this margin expansion. The first is the recovery in the Brazilian airline market. Today, domestic traffic is at pre-pandemic levels, as informed by ANAC .

The second one is a reduction in the cost of jet fuel, from records in July 2022. As can be seen in the chart below, also published by ANAC , jet fuel prices were 35% lower in August 2023 than one year before. Those prices still represent an increase of 100% to 200% compared to pre-pandemic levels.

The effect of fuel recovery can be seen easily in Gol's income statement for 3Q23 , which shows comparative figures for each cost category YoY. Revenues increased by 16%, and most cost categories increased similarly. There is one cost category that decreased by 21%, and that is fuel. Since fuel represents 50% of the company's operational expenses, it carries cumulative costs down and provides for a massive increase in operating income.

Fuel and competition going forward

The Brazilian jet fuel market is a monopoly controlled by the public-private company Petrobras ( PBR ). The company's policy has maintained export parity costs for its refined products, albeit sometimes working as a cushion from the international market.

Unfortunately for Gol, Petrobras announced in September an increase of 21% in the cost of jet fuel , followed by another 5% in October . With this, the cost of jet fuel is only 12% lower in 4Q23 than it was during 4Q22.

In my opinion, this will have two effects. The first one is cost pressure on the Brazilian airlines; this is obvious. The second one is the contraction of their margins via a ceiling in ticket prices. Gol has already decreased its ticket prices, as measured in average yield (cost per kilometer flown), in an effort to gain market share and increase utilization. I believe they will avoid raising prices to avoid losing market share.

One potential help to the airlines might come from the Brazilian government. The Minister of Tourism and the Minister of Airports and Ports have called for Petrobras to reduce jet fuel costs and shield the industry from price increases. The export cost parity is always under scrutiny in a country where a state enterprise dominates the petrochemical market.

Expensive dilution is coming

One of the most significant concerns for Gol shareholders is the precarious capital condition of the company. Gol has negative equity and financial commitments (debts plus lease obligations) over BRL 24 billion (close to $5 billion at a $0.2 exchange rate).

Among these debts, there were notes maturing in 2024 and 2025 for more than $1 billion. Between March and August 2023, the company announced and implemented a series of financing rounds with its controlling shareholder, Abra Group. Gol issued BRL 6.5 billion to Abra in the form of exchangeable notes and used the proceeds to retire most of the 2024 notes, 50% of the 2025 notes, and 61% of the 2026 notes.

According to Gol, the notes are exchangeable into company shares, although the mechanism has not been adequately disclosed. Below is my understanding of how it was accounted for.

Abra gave BRL 6.5 billion to GOL, which the company used to repurchase debt. Initially, the debt was accounted for as pure debt in a single entrance. However, the company separately issued 1 billion warrants to purchase 1 billion preference shares at BRL 5.82 at no cost and decided to account for half of the debt as a warrant liability.

If Abra decided to exercise those warrants (currently deep in the money as GOL's Brazilian shares trade close to BRL 9), they would have to give about BRL 6 billion to GOL. GOL could then use that money to repay the debt with Abra. The effect is the same as in a conversion, more or less.

However, three aspects that make the treatment of the debt as half warrants half debt improper have not been considered. First, if by 2028, when the warrants and the debt expire, GOL's share price is below BRL 5.82, Abra will not decide to exercise, and GOL will need to repay BRL 6.5 billion, not BRL 3.4 billion as currently recorded. Second, the extreme interest cost of 18% (4.5% cash and 13.5% PIK) over the debt is also calculated over BRL 6.5 billion. Further, that PIK interest is increasing the debt overhang in a portion that is not convertible and will, by the debt expiration in 2028, be almost equivalent to the current notes.

Finally, even if Abra decided to exercise its warrants, it would dilute the current shareholders to 25% of their participation. GOL currently has 336 million preference shares traded in Brazil and ADR form in the US. Abra received 1 billion 100% warrants.

Conclusion

The situation is dire for GOL shareholders. The company needs equity to reduce its financial risks, but it comes in the form of highly dilutive and costly "exchangeable debt" (which in reality is normal debt plus warrants).

Further, the recent positive trends in jet fuel behind the uplift in margins and profits have started to reverse in 4Q23, putting a significant brake on operational profitability and debt sustainability.

My conclusion is similar to previous articles in that GOL is not attractive to long-term shareholders.

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