Analysis-Azul-Gol airline merger could be a 'necessary evil' in bumpy Brazil market

By Patricia Vilas Boas and Kylie Madry

SAO PAULO (Reuters) - A plan to merge two of Brazil's top airlines to create a dominant carrier will likely win regulatory approval as a government push for a financially healthy sector outweighs concern about restricted competition, experts and lawyers told Reuters.

A floated combination of Gol and Azul, formalized with a memorandum of understanding last week, would give the new firm overwhelming control over the country's domestic market.

But both have faced financial turbulence since the pandemic, along with Brazil's current No. 1 carrier, LATAM Airlines' local unit. Costs remain high and air travel remains restricted in Latin America's largest nation and top economy.

The cocktail of factors - and support from the administration of President Luis Inacio Lula da Silva - means that the merger process, while likely to face some pushback, is likely to proceed.

"The impact (of the merger) needs to be thought about in the context of what the alternative is," said Andre Castellini, a senior partner at Bain & Company. "It's a necessary evil."

THUMBS UP FROM LULA OFFICIALS

Airlines in Brazil are hit by high taxes, strict consumer protections and face headwinds with the recent weakening of the Brazilian real against the U.S. dollar - used for expenses such as jet fuel and aircraft leasing contracts - said Nicole Villa, a lawyer specialized in aviation law.

Lula's administration has promised support for airlines, as Azul has needed to restructure its debt with bondholders and cut a deal with suppliers, and with Gol currently in Chapter 11 bankruptcy proceedings in the United States.    

Gol and Azul have likely "gotten that thumbs up from the government, and they see a real possibility (of the merger being approved)," said lawyer Xavier Rosales.

Ports and Airports Minister Silvio Costa Filho told journalists last week that the merger could be positive. 

"A worse scenario would be the companies going bankrupt," he said.    

Given current travel demand in Brazil, only two airlines are needed to operate in the country, Seaport Research Partners analysts argued in a note.

If the merger is blocked, the domestic market could shrink even more, Castellini and Villa said. 

"Azul was already reducing its network," Castellini said. 

Azul CEO John Rodgerson told Reuters that the airline had trimmed some routes due to the weakened real, a measure he described as "normal."

"Without (CADE) approval the market may not be as large as with approval (of the merger)," he said, though he brushed off concerns that Azul would have to downsize if the deal with Gol did not go through.

OPPOSITION, CONCESSIONS LIKELY 

Still, the merger "will not be an easy process," Rosales said, with LATAM likely opposing the deal and competition regulator CADE seen ruling the carriers give up flight frequencies and time slots at busy airports.

LATAM declined to comment on the matter.

Gol and Azul's flights at Brazil's biggest airports will likely be on the chopping block, Castellini said, adding LATAM could take over some of those operations. Internationally, routes to and from Miami are likely to be scrutinized, Rosales said.

But LATAM would also have to prove it had the capacity to provide the additional service, according to Villa.

GOOD FOR COMPETITION?

Despite the weight the merger will give Gol and Azul, the deal could ultimately present opportunities for competitors, analysts said.

Much of the market remains untapped in a country as large as Brazil, Villa said.

LATAM has the "critical mass" to remain competitive, and could even benefit in the short term from the distraction the merger would pose to Gol and Azul, Castellini said.

In the years after the merger, the new airline could also lack the agility to make aggressive expansion plans, Santander analysts wrote in a note to clients.

Excluding Gol's Chapter 11 proceedings, which are set to wrap up by May, a merger could be closed "in a little more than a year," Rosales said. "There's a real chance of success here."

(Reporting by Patricia Vilas Boas and Kylie Madry; Editing by Christian Plumb and Nick Zieminski)