Can we still be friends? As the Brazilian economy strengthens, a merger of latin America's two biggest airlines seems less likely than ever.

A year ago, executives of Varig and TAM, Brazil's two largest airlines, were shaking hands amid popping flashbulbs as they announced plans for a merger that would create Latin America's largest carrier. Once complete, it would command 67% of the Brazilian market and account for 36% of passenger miles flown by Latin American carriers, compared to No. 2 AeroMexico's 14% share. Varig at the time was seen as a company running on fumes, likely to go bankrupt or just stop flying for lack of cash to pay for fuel, which was being demanded up-front by suppliers. A merger with TAM, a leaner though also-troubled company, was a final attempt to save Brazil's oldest airline.

Twelve months later, TAM's helping hand no longer seems so necessary. Instead, Varig has been trying hard to show it can fly under its own power. The company's financial outlook, although still awash with red ink, has improved considerably, with losses in the third quarter of 2003 cut to US$183 million, a fifth of 2002's gigantic-$780 minion year-end loss. The company posted an operational profit of $47 million.

"The first merger proposal was presented when Varig was going through its worst moment. We couldn't wait for the end of the negotiation" says Luiz Martins, Varig's executive vice president. "Today, Varig has a different situation.... This new 'picture' has to be taken into account."

Although Brazil's economy is still struggling, the dollar has slipped back to a more comfortable level, from almost four reals per dollar to just under three, and fuel prices have stabilized. Economic activity slowly picked up in the second half of 2003, and the government expects 2004 economic growth between 3.5% and 4%. Varig seems viable again. Summa, the attempted union of three Colombian airlines, ended instead as a glorified marketing and code-sharing deal. Will yet another aviation merger fail in Latin America?

The answer is probably yes, although most observers say that some kind of consolidation would help the airline sector in Brazil, and Varig in particular. Reaching some kind of deal has always been a goal for Brazil's airlines. Besides Varig and TAM, No. 3 carrier Vasp and Transbrasil, which went bankrupt in late 2001, have attempted many times to reach agreements, always to no avail. Under one plan, Varig and TAM were to absorb the two smaller and weaker companies.

Such plans never got off the ground, both for technical and political reasons, not to mention the fact that the heads of the companies, all strong personalities, repeatedly failed to agree on how to split power and balance complicated shareholding arrangements. In the meantime, Transbrasil went bankrupt, Vasp's situation worsened quickly and Varig started to fall apart. At roughly the same time, TAM rolled out an aggressive and risky strategy of replacing its 75-airplane fleet, grounding the old Fokker 100s, many of which had sketchy safety records, and bringing in a whole fleet of new Airbuses. The bold new plan loaded the company with heavy dollar-denominated lease payments, obligations that almost grounded it when Brazil's currency plummeted 46% during 2002.

O Grande Brasil. Under the new government of Luiz Inacio Lula da Silva, the idea of Brazilian companies as the center of the national economy got a shot in the arm. Although Lula's economic team is very conservative and market-oriented, a politically important faction of his left-wing Partido do Trabalhadores believes Brazil must have a number of companies big enough to compete with the multinational groups. Although this line of economic thinking has been purged from the economic area of the government, it found a home--in what was seen locally as a political consolation prize--in the presidency of Brazil's development bank, the Banco Nacional de Desenvolvimento Economico e Social (BNDES). The world's largest development bank, bigger even than the World Bank, the BNDES is run by Carlos Lessa, a renowned leftist economist.

As in any country in the world, too, airlines are considered a strategic industry, with defense implications, as well as a matter of sovereignty and, as is the case in Brazil, national pride. In United States, airlines went begging to Congress for billions after 9/11 and got it. In Argentina, the decline of Aerolineas Argentinas was a national issue. In Switzerland, the bankruptcy of Swiss International Airlines, known domestically as simply Swiss, was cause for national grief. In Brazil, all the elements were in place for a big helping hand for its beleaguered national carriers.

There were, however, two problems: BNDES' wallet wasn't as fat as initially thought, and public opinion wouldn't support the estimated $300 million Varig bailout. After eight years under the administration of Lula predecessor Fernando Henrique Cardoso, many Brazilians have taken a tougher stance toward poorly managed companies. By late 2002, Varig's image was that of a company stuck in the past, unable and unwilling to change. Pouring money into such a rathole, some argued, would have been throwing good money after bad.

That's when the idea of the merger came back to life. The newer, leaner company, TAM, would scoop up Varig, the aging behemoth, inheriting its wide net of domestic and international flights, as well as the remaining prestige of the 75-year-old company, along with fresh BNDES money. It would also enjoy renewed support, from creditors such as Boeing, General Electric, and Infraero, the state-owned company that runs Brazil's airports. In addition, thousands of layoffs could be avoided, helpful to former union leader Lula's political base.

A sound plan, were it not for the fact that Varig's shareholders weren't willing to relinquish power so easily. Executives and board members of Ruben Berta Foundation, a cooperative whose shareholders include Varig's pilots, in-flight attendants and other workers, and which owns 87% of the company's voting shares, were fiercely opposed to the merger, which they saw as a simple takeover of their airline by TAM. Under the plan drafted by investment bank Fator, Varig shareholders would own no more than 15% of the company resulting from the merger, with TAM holding 25% and the rest split among creditors.

Merry-go-round. A fierce legal battle followed between those for and against the merger with in the foundation. Both groups were able to get rulings in Brazilian courts against the other side; a merry-go-round of foundation executives came and went, sometimes in a matter of weeks. As a consequence, Varig has had many different chief executives in a short period of time. The pro-merger group within the foundation eventually prevailed and, by the beginning of the second half of 2003, it was finally prepared to begin the long and complicated process of combining the two airlines. One of the first steps was establishing a code-sharing agreement. The two companies were thus able to trim their number of seats offered, eliminate overlapping flights, raise the occupancy rate and strengthen their profit margins.

The agreement worked pretty well. In fact, it might have worked too well. Some in both Varig and TAM now believe they don't need to marry, just to be good code-sharing friends. A recovering economy, a falling dollar and a steadier oil price, plus the agreement, helped both companies make more money. Varig still loses a lot of money, but the flow of red ink has been staunched. TAM even delivered a small net profit of $31 million in the nine months of 2003, after losing $270 million in 2002.

Also, under pressure to merge, both Varig and TAM tightened their belts to the very last notch. Varig slashed 30% of its seats and returned 23 leased jets. TAM has also put in place a strong cost cutting program. "We have done our homework in terms of adjusting to a more contracted market," says Wagner Ferreira, TAM's rice president of sales and marketing. Besides optimizing its lines with the Varig agreement, the company took measures such as lending two Airbus jets to South African Airlines. "All these actions were important to go through a year that started badly for the industry, with a 7% decline in air traffic up to November," Ferreira says.

Both companies are still under confidentiality agreements regarding the merger plans. TAM executives, however, are making it clear that they are looking in other directions. "We see other solutions than the merger," Ruy Amparo, TAM's technical and operational vice president, told Bloomberg TV late last year. "We are reviewing every concept of the company conceived in the first agreement signed at the beginning of 2003, as the expectations for demand, fleet and shareholders' stake have changed."

Martins at Varig is careful to say that the merger process remains on schedule, adding that a cash infusion from the development bank is key for expansion plans, which include new, increasing business travel to South Africa and to China, a country that has become a hot destination for Brazil's exports.

Analysts agree that the two companies are variable alone, with appropriate macroeconomic conditions. "In Varig's case, it needs strong management," says Robert Booth, president of Aviation Management, a Miami airline consultancy. Part of the airline's problem, Booth says, "is the number of CEOs they've had in the past several years. The revolving door in the corner office is never good in this business." In 2002 alone, Varig had three CEOs, and that was before shareholders started to wage war tot control.

Court fight. Martins has been on the job since August. His arguments are mostly the same ones the company has made since the early 1990s, when debt-restructuring attempts began. Varig, he has contended in the past, needs new capitalization to overcome a crisis fostered by judicial battles that began after government price freezes in 1986, designed to curtail hyperinflation. The airlines and the government have been in court ever since. The airline claims it is owed $1.4 billion because of the price freezes. The government, meanwhile, wants hundreds of millions from Varig to pay Varig's obligations to the public pension system. In Brazil, companies pay a part of every employee's retirement fund.

For the two companies, the best scenario is no change at all: They'd keep the code-sharing, which boosts profitability for both, but wouldn't have to undertake a complex merger in which the odds of something going wrong are high. There are other obstacles. Brazil's antitrust authority, the Conselho Administration de Defesa Economica (CADE), has started to review the initial merger agreement. A completed merger would result in a concentration of the domestic market in the hands of a single company and heavily concentrate the international market as well, although in that case there would be some competition from foreign carriers.

That's not good news for consumers since other airlines in Brazil such as Vasp, which has had its own problems, and Gol, a new and highly successful low cost carrier, are too small to offer real competition on most routes, especially international. Under Brazilian law, every merger that would result in a concentration of more than 20% of the market must undergo a wide review by many offices in the government. CADE, says Booth, "doesn't seem to understand that Brazil needs a strong international airline, which may require that they forget about domestic competition and let the market work."

Some say a solid regulatory model would preserve competition and still make the merger, or at least code-sharing, possible. "Price increases were never a consequence of code-sharing agreements. What it does is optimize supply," says Amaryllis Ribeiro, an aviation analyst with Brazilian consultancy Tendencias.

Yet regulation might not be the solution. Brazil doesn't have a regulatory agency dedicated to aviation. Infraero, the airport administration body, taxes airlines heavily. Regular business taxes in the airline business area burden. All these factors eat up profitability in a sector that, worldwide, is brutally competitive and traditionally runs on very tiny profit margins. Consolidation is a global trend in the aviation business, but it might not be time yet in Brazil for fewer and stronger, just more of the same, come what may.

                 Varig                     TAM

Fleet            100--Boeing 737s, 767s,   75--51 Airbuses and 24
                 777s and MD 11s           Fokkers
Employees        14,000                    7,000
Destinations     48 domestic, 25           42 domestic, 3 international
                 international
Occupancy rate   64% on domestic, 67% on   60% on domestic flights
                 international flights
Passengers       15 million                13.7 million
  annually
Founded          1927                      1976

SOURCE: Company reports