Controladora Vuela Compania de Aviacion, S.A.B. de C.V. | CIK:0001520504 |

 

3.  Financial instruments and risk management

 

Financial risk management

 

The Company’s activities are exposed to different financial risks stemming from exogenous variables which are not under their control but whose effects might be potentially adverse such as: (i) market risk, (ii) credit risk, and (iii) liquidity risk. The Company’s global risk management program is focused on uncertainty in the financial markets and tries to minimize the potential adverse effects on net earnings and working capital requirements. The Company uses derivative financial instruments to hedge part of such risks. The Company does not enter into derivatives for trading or speculative purposes.

 

The sources of these financial risks exposures are included in both “on balance sheet” exposures, such as recognized financial assets and liabilities, as well as in “off-balance sheet” contractual agreements and on highly expected forecasted transactions. These on and off-balance sheet exposures, depending on their profiles, do represent potential cash flow variability exposure, in terms of receiving less inflows or facing the need to meet outflows which are higher than expected, therefore increase the working capital requirements.

 

Also, since adverse movements erode the value of recognized financial assets and liabilities, as well some other off-balance sheet financial exposures such as operating leases, there is a need for value preservation, by transforming the profiles of these fair value exposures.

 

The Company has a Finance and Risk Management department, which identifies and measures financial risk exposures, in order to design strategies to mitigate or transform the profile of certain risk exposures, which are taken up to the corporate governance level for approval.

 

Market risk

 

a)  Jet fuel price risk

 

Since the contractual agreements with jet fuel suppliers include references to the jet fuel index, the Company is exposed to fuel price risk which might have an impact on the forecasted consumption volumes. The Company’s jet fuel risk management policy aims to provide the Company with protection against increases in jet fuel prices. In an effort to achieve the aforesaid, the risk management policy allows the use of derivative financial instruments available on over the counter (“OTC”) markets with approved counterparties and within approved limits. Aircraft jet fuel consumed in the years ended December 31, 2017, 2016 and 2015 represented 29%, 28% and 30%, of the Company’s operating expenses, respectively.

 

During the years ended December 31, 2017 and 2016, the Company entered into US Gulf Coast Jet fuel 54 Asian call options designated to hedge 61.1 million gallons and 134.3 million gallons, respectively. Such hedges represent a portion of the projected consumption for the next nine and twenty-one months respectively.

 

The Company decided to early adopt IFRS 9 (2013), beginning on October 1, 2014, which allows the Company to separate the intrinsic value from the extrinsic value of an option contract; as such, the change in the intrinsic value can be designated as hedge accounting. Because extrinsic value (time and volatility values) of the Asian call options is related to a “transaction related hedged item”, it is required to be segregated and accounted for as a cost of hedging in OCI and accrued as a separate component of stockholders’ equity until the related hedged item matures and therefore impacts profit and loss.

 

The underlying US Gulf Coast Jet Fuel 54 of the options held by the Company is a consumption asset (energy commodity), which is not in the Company’s inventory. Instead, it is directly consumed by the Company’s fleet at different airport terminals. Therefore, although a non-financial asset is involved, its initial recognition does not generate a book adjustment in the Company’s inventories. Rather, it is initially accounted for in the Company’s OCI and a reclassification adjustment is made from OCI to profit and loss and recognized in the same period or periods in which the hedged item is expected to be allocated to profit and loss. Furthermore, the Company hedges its forecasted jet fuel consumption month after month, which is congruent with the maturity date of the monthly serial Asian call options.

 

As of December 31, 2017 and 2016, the fair value of the outstanding US Gulf Coast Jet Fuel Asian call options was Ps.497,403 and Ps.867,809, respectively, and is presented as part of the financial assets in the consolidated statement of financial position (See Note 5).

 

The amount of positive cost of hedging derived from the extrinsic value changes of these options as of December 31, 2017 recognized in other comprehensive income totals Ps.163,836 (the positive cost of hedging in 2016 totals Ps. 218,038), and will be recycled to the fuel cost during 2018, as these options expire on a monthly basis and the jet fuel is consumed. During the years ended December 31, 2017, 2016 and 2015, the net cost of these options recycled to the fuel cost was Ps.26,980, Ps.305,166 and Ps.112,675 respectively.

 

The following table includes the notional amounts and strike prices of the derivative financial instruments outstanding as of the end of the year:

 

 

* US Gulf Coast Jet 54 as underlying asset

** Weighted average

 

 

* US Gulf Coast Jet 54 as underlying asset

** Weighted average

 

b)  Foreign currency risk

 

While Mexican Peso is the functional currency of the Company, a significant portion of its operating expenses is denominated in U.S. dollar; thus, Volaris relies on sustained U.S. dollar cash flows coming from operations in the United States of America and Central America to support part of its commitments in such currency, however there’s still a mismatch. Foreign currency risk arises from possible unfavorable movements in the exchange rate which could have a negative impact in the Company’s cash flows. To mitigate this risk, the Company may use foreign exchange derivative financial instruments.

 

Most of the Company’s revenue is generated in Mexican pesos, although 30% of its revenues came from operations in the United States of America and Central America for the year ended at December 31, 2017 (33% at December 31, 2016) and U.S. dollar denominated collections accounted for 40% and 38% of the Company’s total collections in 2017 and 2016, respectively.

 

However, certain of its expenditures, particularly those related to aircraft leasing and acquisition, are also U.S. dollar denominated. In addition, although jet fuel for those flights originated in Mexico are paid in Mexican pesos, the price formula is impacted by the Mexican peso U.S. dollar exchange rate. The Company’s foreign exchange on and off-balance sheet exposure as of December 31, 2017 and 2016 is as set forth below:

 

 

At April 25, 2018, date of issuance of these financial statements, the exchange rate was Ps.18.8628 per U.S. dollar.

 

 

During the year ended December 31, 2017, the Company entered into foreign currency forward contracts in U.S. dollars to hedge approximately 9% of the aircraft rental expense for the second half of 2017. As of December 31, 2016, the Company did not enter into foreign exchange rate derivatives financial instruments.

 

All of the Company’s position in foreign currency forward contracts matured throughout the second half of 2017 (August, September, November and December), therefore there is no outstanding balance as of December 31, 2017. For the year ended December 31, 2017, the net loss on the foreign currency forward contracts was Ps.11,290, which was recognized as part of rental expense in the consolidated statements of operations. As there were no foreign currency forward contracts as of December 31, 2016, no impact was recognized in the consolidated statements of operations.

 

c)  Interest rate risk

 

Interest rate risk is the risk that the fair value of future cash flows will fluctuate because of changes in market interest rates. The Company’s exposure to the risk of changes in market interest rates relates primarily to the Company’s long-term debt obligations and flight equipment operating lease agreements with floating interest rates.

 

The Company’s results are affected by fluctuations in certain benchmark market interest rates due to the impact that such changes may have on operational lease payments indexed to the London Inter Bank Offered Rate (“LIBOR”). The Company uses derivative financial instruments to reduce its exposure to fluctuations in market interest rates and accounts for these instruments as an accounting hedge. In most cases, when a derivative can be tailored within the terms and it perfectly matches cash flows of a leasing agreement, it may be designated as a CFH and the effective portion of fair value variations are recorded in equity until the date the cash flow of the hedged lease payment is recognized in the consolidated statements of operation.

 

As of December 31, 2016, the Company had outstanding hedging contracts in the form of interest rate swaps with notional amount of US$ 70 million and fair value of Ps.14,144, respectively, recorded in liabilities. For the years ended December 31, 2017, 2016 and 2015, the reported loss on the interest rate swaps was Ps.13,827, Ps.48,777 and Ps.46,545, respectively, which was recognized as part of rental expense in the consolidated statements of operations. All of the Company’s position in the form of interest rate swaps matured on March 31 and April 30, 2017 consequently there is no outstanding balance as of December 31, 2017.

 

d)  Liquidity risk

 

Liquidity risk represents the risk that the Company has insufficient funds to meet its obligations.

 

Because of the cyclical nature of the business, the operations, and its investment and financing needs related to the acquisition of new aircraft and renewal of its fleet, the Company requires liquid funds to meet its obligations.

 

The Company attempts to manage its cash and cash equivalents and its financial assets, relating the term of investments with those of its obligations. Its policy is that the average term of its investments may not exceed the average term of its obligations. This cash and cash equivalents position is invested in highly-liquid short-term instruments through financial entities.

 

The Company has future obligations related to maturities of bank borrowings and derivative contracts. The Company’s off-balance sheet exposure represents the future obligations related to operating lease contracts and aircraft purchase contracts. The Company concluded that it has a low concentration of risk since it has access to alternate sources of funding.

 

The table below presents the Company’s contractual principal payments required on its financial liabilities and the derivative financial instruments fair value:

 

 

 

e)  Credit risk

 

Credit risk is the risk that any counterparty will not meet its obligations under a financial instrument or customer contract, leading to a financial loss. The Company is exposed to credit risk from its operating activities (primarily for trade receivables) and from its financing activities, including deposits with banks and financial institutions, foreign exchange transactions and other financial instruments including derivatives.

 

Financial instruments that expose the Company to credit risk involve mainly cash equivalents and accounts receivable. Credit risk on cash equivalents relate to amounts invested with major financial institutions.

 

Credit risk on accounts receivable relates primarily to amounts receivable from the major international credit card companies.

 

The Company has a high receivable turnover; hence management believes credit risk is minimal due to the nature of its businesses, which have a large portion of their sales settled in credit cards.

 

The credit risk on liquid funds and derivative financial instruments is limited because the counterparties are banks with high credit-ratings assigned by international credit-rating agencies.

 

Some of the outstanding derivative financial instruments expose the Company to credit loss in the event of nonperformance by the counterparties to the agreements. However, the Company does not expect any of its counterparties to fail to meet their obligations. The amount of such credit exposure is generally the unrealized gain, if any, in such contracts.

 

To manage credit risk, the Company selects counterparties based on credit assessments, limits overall exposure to any single counterparty and monitors the market position with each counterparty. The Company does not purchase or hold derivative financial instruments for trading purposes. At December 31, 2017, the Company concluded that its credit risk related to its outstanding derivative financial instruments is low, since it has no significant concentration with any single counterparty and it only enters into derivative financial instruments with banks with high credit-rating assigned by international credit-rating agencies.

 

f)  Capital management

 

Management believes that the resources available to the Company are sufficient for its present requirements and will be sufficient to meet its anticipated requirements for capital expenditures and other cash requirements for the 2017 fiscal year.

 

The primary objective of the Company’s capital management is to ensure that it maintains healthy capital ratios to support its business and maximize the shareholder’s value. No changes were made in the objectives, policies or processes for managing capital during the years ended December 31, 2017 and 2016. The Company is not subject to any externally imposed capital requirement, other than the legal reserve (Note 18).