As filed with the Securities and Exchange Commission on April 30, 2013

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington,  D.C. 20549

_______________

FORM 20-F 

_______________

¨            REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934

OR

x           ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31,  2012

OR

¨            TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

OR

¨            SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 001-32221

Gol Linhas Aéreas Inteligentes S.A.

(Exact name of Registrant as specified in its charter)

Gol Intelligent Airlines Inc.

(Translation of Registrant’s name into English)

_________________

The Federative Republic of Brazil

(Jurisdiction of incorporation or organization)
Edmar Prado Lopes Neto
+55 11 5098-7872
Fax:  +55 11 5098-2341
E-mail:  ri@golnaweb.com.br
Praça Comandante Linneu Gomes, S/N Portaria 3,
Jardim Aeroporto
04626-020 São Paulo, São Paulo
Federative Republic of Brazil
(+55 11 2128-4700)

(Name, Telephone, E-mail and/or Facsimile number and Address of Company Contact Person)

___________________________________________

Securities registered or to be registered pursuant to Section 12(b) of the Act.

* Not for trading purposes, but only in connection with the trading on the New York Stock Exchange of American Depositary Shares representing those preferred shares.

___________________________________________

Securities registered or to be registered pursuant to Section 12(g) of the Act:
None

___________________________________________

Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:
7.50% Senior Notes Due 2017

___________________________________________

The number of outstanding shares of each class of stock of Gol Linhas Aéreas Inteligentes S.A. as of December 31, 2012:

143.858.204                                                         Shares of Common Stock

134.858.582                                                         Shares of Preferred Stock

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes ¨  No x

If this is an annual or transition report, indicate by check mark if the registrant is not required to file pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.  Yes ¨  No x 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No ¨ 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ¨  No ¨ 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Indicate by check mark which basis of accounting the registrant has used to prepare the financial statements included in this filing:

If “Other” has been checked in response to the previous question, indicate by check mark which financial statement item the registrant has elected to follow.

Item 17 ¨  Item 18 ¨ 

If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes ¨  No x 

Table of Contents

 i

Presentation of Financial and Other Data

The consolidated financial statements included in this annual report have been prepared in accordance with International Financial Reporting Standards (IFRS), issued by the International Accounting Standards Board (IASB), in reais. 

We have translated some of the real  amounts contained in this annual report into U.S. dollars.  The rate used to translate such amounts in respect of the year ended December 31, 2012 was R$2.044 to US$1.00, which was the commercial rate for the purchase of U.S. dollars in effect on December 31, 2012, as reported by the Central Bank.  The U.S. dollar equivalent information presented in this annual report is provided solely for the convenience of investors and should not be construed as implying that the real  amounts represent, or could have been or could be converted into, U.S. dollars at the above rate.  See “Exchange Rates” for more detailed information regarding the Brazilian foreign exchange system and historical data on the exchange rate of the real  against the into U.S. dollars.

In this annual report, we use the terms “the Registrant” to refer to Gol Linhas Aéreas Inteligentes S.A., and “Gol”, “Company”, “we,” “us” and “our” to refer to the Registrant and its consolidated subsidiaries together, except where the context requires otherwise.  The term VRG refers to VRG Linhas Aéreas S.A., a wholly owned subsidiary of the Registrant.  References to “preferred shares” and “ADSs” refer to non-voting preferred shares of the Registrant and American depositary shares representing those preferred shares, respectively, except where the context requires otherwise.

The operating results of Webjet Linhas Aéreas S.A., or Webjet, are consolidated in our financial statements as from October 3, 2011. All information in this annual report reflects the acquisition of Webjet, unless otherwise indicated. On November 23, 2012, we began the process of winding up Webjet’s activities and the consequent discontinuation of its brand. See “Item 5. Operating and Financial Review and Prospects – A. Operating Results – Webjet.”

The phrase “Brazilian government” refers to the federal government of the Federative Republic of Brazil, and the term “Central Bank” refers to the Banco Central do Brasil, or the Central Bank.  The term “Brazil” refers to the Federative Republic of Brazil.  The terms “U.S. dollar” and “U.S. dollars” and the symbol “US$” refer to the legal currency of the United States.  The terms “real” and “reais” and the symbol “R$” refer to the legal currency of Brazil.  “IFRS” refers to the international financial reporting standards issued by the International Accounting Standards Board, or IASB. We make statements in this annual report about our competitive position and market share in, and the market size of, the Brazilian and international airline industry.  We have made these statements on the basis of statistics and other information from third party sources, governmental agencies or industry or general publications that we believe are reliable.  Although we have no reason to believe any of this information or these reports are inaccurate in any material respect, we have not verified the competitive position, market share and market size or market growth data provided by third parties or by industry or general publications.  All industry and market data contained in this annual report is based upon the latest publicly available information as of the date of this annual report.

Certain figures included in this annual report have been rounded.  Accordingly, figures shown as totals in certain tables may not be an arithmetic sum of the figures that precede them.

This annual report contains terms relating to operating performance in the airline industry that are defined as follows:

·         “Aircraft utilization” represents the average number of block-hours operated per day per aircraft for the total aircraft fleet.

·         “Available seat kilometers” or “ASK” represents the aircraft seating capacity multiplied by the number of kilometers flown.

·         “Average stage length” represents the average number of kilometers flown per flight.

·         “Block-hours” refers to the elapsed time between an aircraft’s leaving an airport gate and arriving at an airport gate.

·         “Breakeven load factor” is the passenger load factor that will result in passenger revenues being equal to operating expenses.

·         “Load factor” represents the percentage of aircraft seating capacity that is actually utilized (calculated by dividing revenue passenger kilometers by available seat kilometers).

·         “Operating expense per available seat kilometer” or “CASK” represents operating expenses divided by available seat kilometers.

·         “Operating expense excluding fuel expense per available seat kilometer” or “CASK - ex fuel” represents operating expenses less fuel expense divided by available seat kilometers.

·         “Operating revenue per available seat kilometer” or “RASK” represents operating revenues divided by available seat kilometers.

·         “Passenger revenue per available seat kilometer” represents passenger revenue divided by available seat kilometers.

·         “Revenue passengers” represents the total number of paying passengers flown on all flight segments.

·         “Revenue passenger kilometers” or “RPK” represents the numbers of kilometers flown by revenue passengers.

·         “Yield per passenger kilometer” or “yield” represents the average amount one passenger pays to fly one kilometer.

Cautionary Statements about Forward-Looking Statements

This annual report includes forward-looking statements, principally under the captions “Risk Factors,” “Operating and Financial Review and Prospects” and “Business Overview.”  We have based these forward-looking statements largely on our current beliefs, expectations and projections about future events and financial trends affecting our business.  Many important factors, in addition to those discussed elsewhere in this annual report, could cause our actual results to differ substantially from those anticipated in our forward-looking statements, including, among other things:

·         general economic, political and business conditions in Brazil and in other South American, U.S. and Caribbean markets we serve;

·         the effects of global financial markets and economic crises;

·         management’s expectations and estimates concerning our future financial performance and financing plans and programs;

·         our level of fixed obligations;

·         our capital expenditure plans;

·         our ability to obtain financing on acceptable terms;

·         inflation and fluctuations in the exchange rate of the real; 

·         existing and future governmental regulations, including air traffic capacity controls;

·         increases in fuel costs, maintenance costs and insurance premiums;

·         changes in market prices, customer demand and preferences, and competitive conditions;

·         cyclical and seasonal fluctuations in our operating results;

·         defects or mechanical problems with our aircraft;

·         our ability to successfully implement our strategy;

·         developments in the Brazilian civil aviation infrastructure, including air traffic control, airspace and airport infrastructure, and

·         the risk factors discussed under “Risk Factors.”

The words “believe,” “may,” “will,” “aim,” “estimate,” “continue,” “anticipate,” “intend,” “expect” and similar words are intended to identify forward-looking statements.  Forward-looking statements include information concerning our possible or assumed future results of operations, business strategies, financing plans, competitive position, industry environment, potential growth opportunities, and the effects of future regulation and the effects of competition.  Forward-looking statements speak only as of the date they were made, and we undertake no obligation to update publicly or to revise any forward-looking statements after we distribute this annual report because of new information, future events or other factors.  In light of the risks and uncertainties described above, the forward-looking events and circumstances discussed in this annual report might not occur and are not guarantees of future performance.

PART I

ITEM 1.       Identity of Directors, Senior Management and Advisors

Not applicable.

ITEM 2.       Offer Statistics and Expected Timetable

Not applicable.

ITEM 3.       Key Information

A.      Selected Financial Data

We present in this section the following summary financial data:

·         Summary financial information derived from our audited consolidated financial statements included herein as of and for the years ended December 31, 2012, 2011and 2010; and

·         Summary financial information derived from our audited consolidated financial statements not included herein as of and for the year ended December 31, 2009 and 2008.

The following tables present summary historical consolidated financial and operating data for us for each of the periods indicated.  Solely for the convenience of the reader, real  amounts as of and for the year ended December 31, 2012 have been translated into U.S. dollars at the commercial market rate in effect on December 31, 2012 as reported by the Central Bank of R$2.044 to US$1.00.

Summary Operational Data

(1)   Our preferred shares are not entitled to any fixed dividend preferences, but are instead entitled to receive dividends per share in the same amount of dividends per share paid to holders of our common shares.  Consequently, our earnings (loss) per share are computed by dividing income by the weighted average number of all classes of shares outstanding during the year.

(2)   Trade and other receivables related to receivables from credit card administrators, travel agencies, installment sales from the Voe Fácil program, cargo agencies and others.  These receivables are stated at cost less allowances for doubtful receivables, which approximates their fair value given their short term nature.

(3)   Operating margin represents operating income (loss) before financial results divided by operating revenues.

(4)   Considering sales through our website and API (application programming interface) systems.

(5)   In October 2010, ANAC changed its calculation method for monthly traffic information and republished information for periods since January 2009. All operating data for 2009 and thereafter reflects the new methodology, whereas information for 2008 was calculated pursuant to the old methodology and may not be fully comparable. According to ANAC, the changes were designed to align data with the concepts adopted by the ICAO. The change was necessary because Brazil has joined the ICAO’s statistical program and supplies the latter’s database with several industry data. Changes in the methodology refer to the calculation of ASK (seat supply) and the classification of domestic legs in international flights, which are now considered to be part of the domestic market.

 (6)  Information regarding revenue passengers, aircraft utilization,  average fare, departures, departures per day,  average stage length, average number of operating aircraft, fuel liters consumed, percentage of sales through website and percentage of sales through website and call center include data for Webjet as of and including October 1, 2011.

(7)  ANAC has published revised available seat kilometers and revenue passenger kilometers data for 2009 and 2010. All operating data for 2009 and thereafter reflects the new DCA manual, whereas information for 2008 was calculated pursuant to the old manual and may not be fully comparable.

Exchange Rates

Brazil’s foreign exchange system allows the purchase and sale of currency and the international transfer of reais by any person or legal entity, regardless of amount, subject to certain regulatory procedures.

The Brazilian currency has during the last decades experienced frequent and substantial variations in relation to the U.S. dollar and other foreign currencies.  Most recently, the real  was R$1.566 per US$1.00 in August 2008.  Primarily as a result of the crisis in the global financial markets, the real  depreciated 31.9% against the U.S. dollar and reached R$2.337 per US$1.00, at year end 2008.  In 2009 and 2010, the real appreciated against the U.S. dollar and reached R$1.666 per US$1.00 at year end 2010. During 2011 the real depreciated and on December 31, 2011, the exchange rate was R$1.876  per US$1.00. During 2012, the real  continued to depreciate and on December 31, 2012, the exchange rate was R$2.044 per US$1.00.

The Central Bank has intervened occasionally to combat instability in foreign exchange rates.  We cannot predict whether the Central Bank or the Brazilian government will continue to allow the real  to float freely or will intervene in the exchange rate market through a currency band system or otherwise.

The following tables present the selling rate, expressed in reais to the U.S. dollar (R$/US$), for the periods indicated:

_________

Source:  Central Bank

(1) Represents the average of the exchange rates on the last day of each month during the period.

(2) Average of the lowest and highest rates in the month.

B.      Capitalization and Indebtedness

Not applicable.

C.      Reasons for the Offer and Use of Proceeds

Not applicable.

D.      Risk Factors

An investment in the ADSs or our preferred shares involves a high degree of risk.  You should carefully consider the risks described below before making an investment decision.  Our business,  financial condition and results of operations could be materially and adversely affected by any of these risks.  The trading price of the ADSs could decline due to any of these risks or other factors,  and you may lose all or part of your investment.  The risks described below are those that we currently believe may materially affect us.

Risks Relating to Brazil

The Brazilian government has exercised,  and continues to exercise,  significant influence over the Brazilian economy.  This involvement,  as well as Brazilian political and economic conditions,  could adversely affect our business and the trading price of our ADSs and our preferred shares.

The Brazilian government frequently has intervened in the Brazilian economy and occasionally makes significant changes in policy and regulations.  The Brazilian government’s actions to control inflation and other policies and regulations have often involved, among other measures, increases in interest rates, changes in tax policies, price controls, currency devaluations, capital controls and limits on imports.  Our business, financial condition and results of operations may be adversely affected by changes in policy or regulations at the federal, state or municipal levels involving or affecting factors such as:

·         interest rates;

·         currency fluctuations;

·         inflation; 

·         liquidity of capital and lending markets;

·         tax policies;

·         exchange rates and exchange controls and restrictions on remittances abroad, such as those that were briefly imposed in 1989 and early 1990; and

·         other political, social and economic developments in or affecting Brazil.

Developments and the perception of risk in other countries,  including the United States and emerging market countries,  may adversely affect the market price of Brazilian securities,  including the ADSs and our preferred shares.

The market value of securities of Brazilian issuers is affected by economic and market conditions in other countries, including the United States, the European Union and emerging market countries.  Although economic conditions in those countries may differ significantly from economic conditions in Brazil, investor’s reactions to developments in other countries may have an adverse effect on the market value of securities of Brazilian issuers.  Crises in the United States, the European Union or emerging market countries may diminish investor interest in securities of Brazilian issuers, including ours.  This could adversely affect the trading price of the ADSs or our preferred shares, and could also make it more difficult for us to access the capital markets and finance our operations in the future on acceptable terms or at all.

Government efforts to combat inflation may hinder the growth of the Brazilian economy and could harm our business.

Brazil has in the past experienced extremely high rates of inflation and has therefore followed monetary policies that have resulted in one of the highest real interest rates in the world.  Between 2004 and 2012, the base interest rate (SELIC) in Brazil varied between 19.25% p.a. and 7.25% p.a. Inflation and the Brazilian government’s measures to fight it, principally through the Central Bank, have had and may have significant effects on the Brazilian economy and our business.  Tight monetary policies with high interest rates may restrict Brazil’s growth and the availability of credit.  Conversely, more lenient government and Central Bank policies and interest rate decreases may trigger increases in inflation, and, consequently, growth volatility and the need for sudden and significant interest rate increases, which could negatively affect our business.  In addition, we may not be able to adjust the fares we charge our customers to offset the effects of inflation on our cost structure.

Risks Relating to Us and the Brazilian Airline Industry

Substantial fluctuations in fuel costs or the unavailability of fuel would harm our business.

Historically, international and local fuel prices have been subject to wide price fluctuations based on geopolitical issues and supply and demand.  Fuel costs, which at times in 2007 and 2008 were at historically high levels, constitute a significant portion of our total operating expenses, accounting for 42% of our operating expenses for the year ended December 31, 2012.  Fuel availability is also subject to periods of market surplus and shortage and is affected by demand for both home heating oil and gasoline.  In the event of an international or local fuel supply shortage, our fuel prices may increase.  Although we enter into hedging arrangements to reduce our exposure to fuel price fluctuations and have historically passed on the majority of fuel price increases by adjusting our fare structure, the price and future availability of fuel cannot be predicted with any degree of certainty.  Our hedging activities or the extent of our ability to adjust our fares may not be sufficient to protect us from fuel price increases.

Substantially all of our fuel is supplied by one source, Petrobras Distribuidora S.A. If Petrobras Distribuidora is unable or unwilling to continue to supply fuel to us at the times and in the quantities that we require, our business and results of operations would be adversely affected.

Events resulting from prolonged instability in the Middle East or other oil-producing regions or the suspension of production by any significant producer, may result in substantial price increases, adverse exchange rates, or the unavailability of adequate supplies and adversely affect our profitability. In addition, the same effect may be caused by natural disasters or other large unexpected disrupting events in regions with significant consumption of other energy sources. No assurances can be given about trends in fuel prices, and average fuel prices for the 2013 fiscal year or for future years may be significantly higher than current prices.

The airline industry is particularly sensitive to changes in economic conditions and continued negative economic conditions would likely continue to negatively impact our results of operations and our ability to obtain financing on acceptable terms.

Our operations and the airline industry in general are particularly sensitive to changes in economic conditions.  Unfavorable general economic conditions, such as higher unemployment rates, a constrained credit market and increased business operating costs, can reduce spending for both leisure and business travel.  Unfavorable economic conditions can also impact our ability to raise fares to counteract increased fuel, labor, and other costs.  Any of these factors may negatively impact our results of operations.

Unfavorable economic conditions, a significant decline in demand for air travel, or continued instability of the credit and capital markets could also result in pressure on our debt costs, operating results and financial condition and would affect our growth and investment plans.  These factors could also negatively affect our ability to obtain financing on acceptable terms and our liquidity generally.

Exchange rate instability may materially and adversely affect our financial condition and results of operations and the market price of the ADSs and our preferred shares.

The Brazilian currency has during the last decades experienced frequent and substantial variations in relation to the U.S. dollar and other foreign currencies.  Most recently, the real  was valued as high as R$1.566 per US$1.00 in August 2008.  Primarily as a result of the crisis in the global financial markets, the real  depreciated 31.9% against the U.S. dollar and reached R$2.337 per US$1.00, at year end 2008.  In 2009 and 2010, the real appreciated against the U.S. dollar and reached R$1.666 per US$1.00 at year end 2010. Driven principally by the European financial crisis, during 2011 the real depreciated and at year end 2011, the exchange rate was R$1.876  per US$1.00.  In 2012, the real  continued to depreciate, primarily due to a slowdown in the Brazilian economy and government efforts to keep the exchange rate at current levels.  At December 31, 2012, the exchange rate was R$2.044 per US$1.00.

Depreciation of the real  against the U.S. dollar could create inflationary pressures in Brazil and cause increases in interest rates, which could negatively affect the growth of the Brazilian economy as a whole and harm our financial condition and results of operations, may curtail access to foreign financial markets and may prompt government intervention, including recessionary governmental policies. Depreciation of the real  against the U.S. dollar can also, as in the context of an economic slowdown, lead to decreased consumer spending, deflationary pressures and reduced growth of the economy as a whole.  On the other hand, appreciation of the real  relative to the U.S. dollar and other foreign currencies could lead to a deterioration of the Brazilian foreign exchange current accounts, as well as dampen export-driven growth.  Depending on the circumstances, either depreciation or appreciation of the real  could materially and adversely affect our business, financial condition and results of operations.

Substantially all of our passenger revenue and cargo revenue and temporary investments are denominated in reais, and a significant part of our operating expenses, such as fuel, aircraft and engine maintenance services, aircraft rent payments and aircraft insurance, are denominated in, or linked to, U.S. dollars.  We maintain U.S. dollar-denominated deposits and maintenance reserve deposits under the terms of some of our aircraft operating leases.  For the year ended December 31, 2012, 54% of our operating expenses were either denominated in or linked to the U.S. dollar.  In addition, the purchase price of the Boeing 737 Next Generation aircraft for which we had 155 firm purchase orders outstanding as of December 31, 2012, is denominated in U.S. dollars.  At the end of 2012, 70% of our indebtedness was denominated in U.S. dollars.  While in the past we have generally adjusted our fares in response to, and to alleviate the effect of, depreciation of the real and increases in the price of jet fuel (which is priced in U.S. dollars) and have entered into hedging arrangements to protect us against the short-term effects of such developments, there can be no assurance we will be able to continue to do so. In addition, there is no effective hedging alternative for medium- and long-term depreciation of the real.  To the extent we are unable to adjust our fares or effectively hedge against any such developments, this may lead to a material decrease in our profit margins or to material operating losses caused by increases in U.S. dollar-denominated costs, increases in interest expense or exchange losses on unhedged fixed obligations and indebtedness denominated in foreign currency.  We had total U.S. dollar-denominated future operating lease payment obligations of R$3,033.7 million and R$3,637.4 million regarding other U.S. dollar-denominated liabilities and indebtedness at December 31, 2012.  We may incur substantial additional amounts of U.S. dollar-denominated operating lease or financial obligations and U.S. dollar-denominated indebtedness and be subject to fuel cost increases linked to the U.S. dollar.

Depreciation of the real  also reduces the U.S. dollar value of distributions and dividends on the ADSs and the U.S. dollar equivalent of the market price of our preferred shares and, as a result, the ADSs.

Changes to Brazilian rules regarding slots distribution, fare restrictions and fees associated with civil aviation may adversely affect our business and results of operations.

In February 2013, ANAC announced a series of public hearings to discuss proposed changes to rules governing the allocation of slots at Brazilian airports, which would consider operational efficiency (punctuality and regularity data) as the main determinant for the allocation of slots.

Also in February 2013, the Civil Aviation Secretary, or SAC, announced a new proposal focused specifically on slot distribution rules at Congonhas airport. Current rules governing the allocation of slots at Congonhas Airport, which favor us, require that 80% of new slots are assigned to airlines already operating in that airport. SAC’s proposal alters current regulations by taking into account operational efficiency as a principal determinant for slot allocation at Congonhas airport, as well as domestic market (main cities) and regional market share as complementary factors.

The new proposals, which are under public hearing, may change the current slot allocation criteria and as a result reduce our number of slots at Brazil’s main airports.  As of the date of this document, no decision has been made regarding these proposals. If there is a change in the rule regarding slots redistribution we could be negatively affected by higher competition in this airport from new competitors.

In 2010, ANAC approved the deregulation of international airfares for flights departing from Brazil to the U.S. and Europe, gradually removing the prior minimum fares. In addition, in 2010 the National Civil Aviation Council (Conselho de Aviação Civil), or CONAC, approved the continuity of bilateral agreements providing for open skies policies with other South American countries and a new open skies policy with the United States.  In March, 2011 Brazil also signed an open skies agreement with Europe. The agreements with the United States and Europe are expected to be in operation by 2015 and 2014, respectively. These regulations increase competition in the market and may negatively affect our results of operations.

Until 2010, landing and navigation fees charged in Brazilian airports were similar in all airports independent of whether they were busy or not. In 2011, the Brazilian government increased landing and navigation fees at the busiest airports as compared to less busy airports and at peak hours. As a result, secondary hubs and off-peak flights may benefit in light of the differences in fees for the airlines that choose to operate in these airports or times. Changes in landing, navigation or other fees have in the past and may continue to increase our CASK, lower our efficiency and profitability and may provide other market players with a cost or operational advantage.

Changes to the Brazilian civil aviation regulatory framework may adversely affect our business and results of operations.

Brazilian aviation authorities monitor and influence the developments in Brazil’s airline market.  For example, the National Civil Aviation Agency (Agência Nacional de Aviação Civil), or ANAC, addressed overcapacity by establishing strict criteria that must be met before new routes or additional flight frequencies were awarded. ANAC has more recently set minimum turnaround times.  ANAC’s policies as well as those of other aviation supervisory authorities may negatively affect our operations.

The Brazilian congress is currently discussing a draft bill that would replace the current Brazilian Aeronautical Code (Código Brasileiro de Aeronáutica).  In general, this draft bill deals with matters related to civil aviation, including airport concessions, consumer protection, limitation of airlines’ civil liability, compulsory insurance, fines and the increase of limits to foreign ownership in voting stock of Brazilian airlines from 20% to 49%.  This draft bill is still under discussion in the House of Representatives and, if approved, must be submitted for approval to the Federal Senate, before being sent for presidential approval. If the Brazilian civil aviation framework changes in the future, or ANAC implements increased restrictions, our growth plans, our business and results of operations could be adversely affected. If the limits to foreign ownership in or influence on Brazilian airlines are increased, our current or new competitors may increase their financial strength and may have a competitive advantage over us, which would negatively affect our business and results of operations.

In August 2011 the Brazilian government privatized the new Natal airport, which will have its construction completed and further operation by the winners of the privatization auction. In February 2012, the Brazilian government privatized the Guarulhos, Brasília and Campinas international airports, which will be operated by the winners of the privatization auction for periods of 20 to 30 years. In December 2012, the Brazilian government announced its intention to privatize the Galeão (in Rio de Janeiro) and Confins (Belo Horizonte) airports by September 2013, and other airports are also expected to be privatized in the near future. Although such measures may serve as a potential positive catalyst to accelerate investments in airport infrastructure, we are unable to foresee the effects of any such measures, especially regarding operational efficiencies and costs, as well as airport and other fees, on our business and results of operations. See “Item 4. Information on the Company – B. Business Overview - Regulation of the Brazilian Civil Aviation Market – Airport Infrastructure.”

Changes to the Brazilian civil aviation regulatory framework may change the competitive dynamics of our industry and may adversely affect our operations, see “−We operate in a highly competitive industry.”

As a result of significant losses in 2011 and 2012, our financial condition has been materially weakened.

We incurred significant losses in 2011 and 2012 which have materially weakened our financial condition. We had net losses of R$752 million in 2011 and $1,513 million in 2012. These losses were mainly a factor of increased operating expenses that we do not control, including: an increase of 45% in average aircraft fuel prices, an average depreciation of the real of 13%, which affects a significant part of our operating expenses, and an increase of 71% in average airport fees during the period.

Although we have taken a number of steps to reduce the effects of these increased operating expenses, such as reducing capacity and focusing on more profitable routes, we cannot assure you that such measures will be sufficient to offset the effects of these increased expenses, that these expenses will not continue to increase and, if they continue to increase, that we will be able to pass on these increases to our customers or otherwise compensate for the increases, which would materially and adversely affect our results of operations.

We are highly leveraged and may be unable to reduce our leverage ratios over time.

We are highly leveraged, which means we have a large amount of indebtedness in relation to our equity. As of December 31, 2012, we had approximately R$5,191 million of consolidated indebtedness as compared to a shareholders’ equity of R$733 million. This increased leverage is a result of our recent significant losses. See “—As a result of significant losses in 2011 and 2012, our financial condition has been materially weakened” above.

In addition, as a result of our increased leverage, our credit ratings were downgraded. Credit ratings affect the cost and other terms upon which we are able to obtain funding. Credit rating agencies regularly evaluate us and their ratings of our long-term debt are based on a number of factors, including our financial strength. We cannot assure you that credit rating agencies will not downgrade our credit ratings any further, even in the absence of new losses.

Our substantial indebtedness or any further downgrades to our credit ratings could adversely affect our ability to obtain new financings or refinance our existing indebtedness on terms that are favorable to us or at all and could also make us more vulnerable to the impact of unexpected events or to the deterioration of the operating environment (such as a significant increase in operating expenses).

Our increased leverage could also affect our ability to comply with the restrictive covenants contained in certain of our existing debt agreements, which, among other things, could result in an event of default that, if not cured or waived, could have a material adverse effect on our business or our prospects. See “—Certain of our debt agreements contain financial covenants and any default under such debt agreements may have a material adverse effect on our financial condition and cash flows” below.

In addition, our strategy to strengthen our cash position, and as a result reduce our leverage over time, may not be successful, which could further emphasize the risks described above.

Technical and operational problems in the Brazilian civil aviation infrastructure,  including air traffic control systems,  airspace and airport infrastructure may have a material adverse effect on our business,  our results of operations and our strategy.

We are dependent on improvements in the coordination and development of Brazilian airspace control and airport infrastructure, which, mainly due to the large growth in civil aviation in Brazil in recent years, require substantial improvements and government investments.  This is further emphasized by the need for additional infrastructure investments in the context of the Soccer Confederations Cup (2013) and World Cup (2014) and the Summer Olympics (2016) in Brazil. Infraero has announced a list of investments in major Brazilian airports of approximately R$7.0 billion to be implemented between 2011 and 2014.

If the measures taken and investments made by the Brazilian government and regulatory authorities do not prove sufficient or effective, air traffic control, airspace management and sector coordination-related difficulties might reoccur or worsen, which might have a material adverse effect on our business, our results of operations and our growth strategy.

Slots at Congonhas Airport in São Paulo, the most important airport for our operations, are fully utilized.  The Santos-Dumont airport in Rio de Janeiro, a highly utilized airport with half-hourly shuttle flights between São Paulo and Rio de Janeiro, has certain slot restrictions.  Several other Brazilian airports, for example the Brasília, Campinas, Salvador, Confins and São Paulo (Guarulhos) international airports, have limited the number of slots per day due to infrastructural limitations at these airports.  Any condition that would prevent or delay our access to airports or routes that are vital to our strategy, or our inability to maintain our existing slots, and obtain additional slots, could materially adversely affect our operations.  In addition, we cannot assure that any investments will be made by the Brazilian government in the Brazilian aviation infrastructure to permit a capacity increase at busy airports and consequently additional concessions for new slots to airlines.

We operate in a highly competitive industry.

We face intense competition on domestic routes in Brazil from existing scheduled airlines and charter airlines and potential new entrants in our market.  In addition to competition among scheduled airline companies and charter operators, the Brazilian airline industry faces competition from ground transportation alternatives, such as interstate buses.  We may also face competition from international airlines as they introduce and expand flights between Brazil, other South American and U.S. and Caribbean destinations.

Our existing competitors or potential new entrants into the markets in which we operate may be financially stronger than us. They have in the past and may again undercut our fares, increase capacity on their routes in an effort to increase their market share or attempt to conduct low-fare or low-cost airline operations of their own, emulating our strategy.  In any such event, we cannot assure you that our level of fares or passenger traffic would not be adversely affected and would not have an adverse impact on our business and results of operations or that our competitive advantage would not be reduced.

Further consolidation in the Brazilian and global airline industry framework may adversely affect our business and results of operations. 

As a result of the competitive environment there may be further consolidation in the Brazilian and global airline industry, whether by means of acquisitions, joint ventures, partnerships or strategic alliances.  We cannot predict the effects of further consolidation on the industry. To the extent we act as consolidators, we may not be able to successfully integrate the business and operations of companies acquired, governmental approvals may be delayed, costs of integration and fleet renovation may be greater than anticipated and synergies may not meet our expectations, our costs may increase and our operational efficiency may be reduced, all of which would negatively affect our business and results of operations and may distract our management.

In the event we do not act as a consolidator our competitors may increase their scale, diversity and financial strength and may have a competitive advantage over us, which would negatively affect our business and results of operations. Consolidation in the airline industry and changes in international alliances will continue to affect the competitive landscape in the industry and may result in the formation of airlines and alliances with increased financial resources, more extensive global networks and reduced cost structures.

We have significant recurring aircraft lease costs,  and we will incur significantly more fixed costs that could hinder our ability to meet our strategic goals.

We have significant costs, relating primarily to leases for our aircraft and engines.  As of December 31, 2012, we had commitments of R$32,462.5 million to purchase additional Boeing 737-800 Next Generation aircraft, based on aircraft list prices, although the actual price payable by us for the aircraft will be lower due to supplier discounts.  As of December 31, 2012, we had R$4,825.4 million in short- and long-term indebtedness, excluding our perpetual bonds in the amount of R$365.8 million.  We expect that we will incur additional fixed obligations and debt as we take delivery of the new aircraft and other equipment to implement our strategy.

Having significant fixed payment obligations could:

·         limit our ability to obtain additional financing to support expansion plans and for working capital and other purposes;

·         divert substantial cash flow from our operations to service our fixed obligations under aircraft operating leases and aircraft purchase commitments;

·         if interest rates increase, require us to incur significantly more lease or interest expense than we currently do; and

·         limit our ability to plan for or react to changes in our business and the airline industry and to general economic conditions.

Our ability to make scheduled payments on our fixed obligations, including indebtedness we will incur, will depend on our operating performance and cash flow, which will in turn depend on prevailing economic and political conditions and financial, competitive, regulatory, business and other factors, many of which are beyond our control.  In addition, our ability to raise our fares to compensate for an increase in our fixed costs may be adversely affected by any imposition of fare control mechanisms by the Brazilian civil aviation authorities.

We may have to use our cash resources to finance a portion of our firm purchase order aircraft.  We may not have sufficient cash resources to do so.

We currently finance our aircraft principally through operating leases.  As a result of our 155 firm purchase orders for Boeing 737-800 Next Generation aircraft outstanding as of December 31, 2012, we expect to own a larger portion of our fleet as well as continue to lease aircraft through principally long-term operating leases.  The firm purchase orders represent a significant financial commitment for us.  We have in recent years financed and intend to continue financing our new Boeing 737-800 NG aircraft with a commitment we received from the Export-Import Bank of the United States, or Ex-Im Bank, providing guarantees covering 85% of the aggregate purchase price for the firm purchase order aircraft.  While we expect that the guaranty from the Ex-Im Bank will help us in obtaining low-cost financing for the purchase of the firm purchase order aircraft, we may be required to use our own cash resources for the remaining 15% of the aggregate purchase price for the firm purchase order aircraft. 

In 2010, the Ex-Im Bank agreed on a common approach with European export-credit agencies on offering export credits for commercial aircraft.  Among other things, the new Sector Understanding on Export Credits for Civil Aircraft, or the ASU, sets forth minimum guarantee premium rates applicable to aircraft to be delivered on or after January 1, 2013, or under firm contracts entered into after December 31, 2010 and also changes the maximum amount that may be financed.

In light of our current credit ratings and the introduction of the ASU, we expect our minimum guaranty premium rate applicable to aircraft delivered on or after January 1, 2013 will increase substantially from a previous rate of 4%. In addition, the Ex-Im Bank may not guarantee this increased amount to be financed, which could cause us to have to seek other more expensive financing alternatives or use our own cash resources to finance the additional amount.

As of December 31, 2012, we had R$1,585.1 million of cash, cash equivalents, short and long term restricted cash, short-term investments in overnight deposits and deposit certificates of highly-rated Brazilian banks and marketable securities, mainly Brazilian government bonds and short- and long-term restricted cash.  If the value or liquidity of these investments were to decrease, or we do not have sufficient cash resources, we may be required to modify our aircraft acquisition plans or to incur higher than anticipated financing costs, which would have an adverse impact on the execution of our strategy and business and could have an adverse impact on our results.

We rely on one supplier for our aircraft and engines.

One of the key elements of our current business strategy is to save costs by operating a standardized aircraft fleet.  After extensive research and analysis, we chose the Boeing 737-700/800 Next Generation aircraft and CFM 56-7B engines from CFM International.  We expect to continue to rely on Boeing and CFM International into the foreseeable future and have made a purchase order for 60 Boeing 737 Max-7/8 aircraft (the newest generation of our current aircraft and still under development), to be delivered starting 2018. If either Boeing or CFM International were unable to perform its contractual obligations, we would have to find another supplier for a similar type of aircraft or engines.

If we had to lease or purchase aircraft from another supplier, we could lose the benefits we derive from our current fleet composition.  We cannot assure you that any replacement aircraft, including the Boeing 737 Max-7/8 aircraft, would have the same operating advantages as the Boeing 737-700/800 Next Generation aircraft or that we could lease or purchase engines that would be as reliable and efficient as the CFM engines.  We may also incur substantial transition costs, including costs associated with retraining our employees, replacing our manuals and adapting our facilities, to the extent that such costs would not be covered by the alternate supplier.  Our operations could also be disrupted by the failure or inability of Boeing or CFM International to provide sufficient parts or related support services on a timely basis.

Our business would also be significantly harmed if a design defect or mechanical problem with the Boeing 737-700/800 Next Generation aircraft or the CFM engines used on our aircraft were discovered, causing our aircraft to be grounded while any such defect or problem is being corrected, assuming it could be corrected at all.  The use of our aircraft could be suspended or restricted by ANAC in the event of any actual or perceived mechanical, design or other problems while ANAC conducts an investigation.  Our business would also be significantly harmed if the public avoids flying on our aircraft due to an adverse perception of the Boeing 737-700/800 Next Generation aircraft or the CFM engines because of safety concerns or other problems, whether real or perceived, or in the event of an accident involving Boeing 737-700/800 Next Generation aircraft or the CFM engines.

In addition to Boeing, other manufacturers have also released new aircraft that when delivered and operational may be more appealing to the market or customers, in which case we may be forced to deviate from our one-aircraft fleet policy, thereby losing the benefits of operating only one type of aircraft, which could reduce the market value of aircraft and would adversely affect our operational costs and results of operation.

We have made purchase orders for new aircraft that is still being developed, any project delays or operational difficulties would adversely affect our operational costs and results of operation.

In 2012 Boeing and CFM released new aircraft and engines, the Boeing 737 Max-7/8 and LEAP-1B engines, to replace the Boeing 737-700/800 Next Generation aircraft engines used on these aircraft any project delays or operational difficulties would adversely affect our operational costs and results of operation.

In addition, when these aircraft and engines are delivered and operational it may cause the market value of our aircraft and engines to decrease, which would negatively affect the value of our assets and could result in us recording impairment charges.

We rely heavily on automated systems to operate our business,  and any failure of these systems could harm our business.

We depend on automated systems to operate our business, including our computerized airline ticket sales system, our telecommunication systems, our scheduling system and our website.  Our website and ticket sales system must be able to accommodate a high volume of traffic and deliver important flight information.  Substantial or repeated website, ticket sales, scheduling or telecommunication systems failures could reduce the attractiveness of our services and could cause our customers to purchase tickets from another airline.  Any disruption in these systems could result in the loss of important data, increase our expenses and generally harm our business.

We rely on maintaining a high daily aircraft utilization rate to increase our revenues and reduce our costs.

One of the key elements of our business strategy is to maintain a high daily aircraft utilization rate.  High daily aircraft utilization allows us to generate more revenue from our aircraft and dilute our fixed costs, and is achieved in part by operating with quick turnaround times at airports so we can fly more hours on average in a day.  Our rate of aircraft utilization could be adversely affected by a number of different factors that are beyond our control, including, among others, air traffic and airport congestion, adverse weather conditions and delays by third-party service providers relating to matters such as fueling and ground handling.

Certain of our debt agreements contain financial covenants and any default under such debt agreements may have a material adverse effect on our financial condition and cash flows.

Certain of our existing debt agreements contain restrictions and covenants and require the maintenance or satisfaction of specified financial ratios. Our ability to meet these financial ratios can be affected by events beyond our control and we cannot assure that we will meet those ratios, especially given the lower yield environment in which the industry currently operates. Failure to meet or satisfy any of these covenants, financial ratios could result in an event of default under these and other agreements, as a result of cross-default provisions. If we are unable to comply with our debt covenants, we could be forced to seek waivers. We cannot guarantee that we will be successful in obtaining any waivers or renewing existing waivers. As of December 31, 2012, we were not in compliance with certain financial covenants under our Debentures IV and V. Although on February 1, 2013 we obtained a waiver approval from the debenture holders for the December 31, 2012 and June 30, 2013 measurement dates, according to IFRS, because we did not receive the waiver by December 31, 2012, we reclassified our debentures in the amount of R$1,091.0 million from long-term debt to short-term debt as a result of this non-compliance. For our financial statements for the first quarter of 2013 we will again reclassify this amount as long-term. The first measurement after the waived periods will be based on our financial statements as of and for the year ended December 31, 2013.. See “Item 5. Operating and Financial Review and Prospects–B. Liquidity and Capital Resources–Indebtedness–Covenant Compliance” and note 19 to our financial statements for more information. If we are unable to renew these and/or receive other waivers, a large portion of our debt could be subject to acceleration.  While we believe such eventuality to be remote, should it come to pass, we may need to renegotiate, restructure or refinance our indebtedness, seek additional equity capital or sell assets, which may materially and adversely affect us.

Our reputation,  financial results and the market price of our ADSs and preferred shares could be harmed by events out of our control

Accidents or incidents involving our aircraft could involve significant claims by injured passengers and others, as well as significant costs related to the repair or replacement of a damaged aircraft and its temporary or permanent loss from service.  We are required by ANAC and lessors of our aircraft under our operating lease agreements to carry liability insurance.  Although we believe we currently maintain liability insurance in amounts and of the type generally consistent with industry practice, the amount of such coverage may not be adequate and we may be forced to bear substantial losses in the event of an accident.  Substantial claims resulting from an accident in excess of our related insurance coverage would harm our business and financial results.  Moreover, any aircraft accident or incident involving our aircraft, even if fully insured, or an accident or incident involving Boeing 737 Next Generation aircraft or the aircraft of any major airline could cause negative public perceptions about us or the air transport system, which would harm our business and results of operations as well as the market price of our ADSs and preferred shares.

We may also be affected by other events that affect travel behavior, such as the potential of epidemics or acts of terrorism.  These events are out of our control and may affect us even if occurring in markets where we do not operate and/or in connection with other airlines.  For example, in the second quarter of 2009 an outbreak of the H1N1 virus had an adverse impact on global air travel and on our operations to and from Argentina.  In addition, in the past there have been concerns about outbreaks or potential outbreaks of other diseases, such as avian flu and Severe Acute Respiratory Syndrome, or SARS, which had an adverse impact on global air travel.  Any outbreak of a disease that affects travel behavior could have a material adverse impact on us and the trading price of shares of companies in the worldwide airline industry, including our ADRs and preferred shares.  Outbreaks of disease could also result in quarantines of our personnel or an inability to access facilities or our aircraft, which could adversely affect our operations.

Natural disasters may affect and disrupt our operations. For example, in 2011, a volcanic eruption in Chile had a prolonged adverse effect on air travel, halting flights in, Argentina, Chile, Uruguay and the southern part of Brazil for several days. As a result, our operations to and from these regions were temporarily disrupted, including certain aircraft being grounded in the affected regions.  Any natural disaster that affects air travel in the regions in which we operate could have a material adverse impact on our business and results of operation.

Our ability to use tax loss carryforwards to offset future taxable income is subject to limitation.

As of December 31, 2012, we had reported approximately R$1,056.3 billion of tax loss carryforwards and negative basis of social contribution mainly as a result of the acquisition of VRG in 2007 and Webjet in 2011 and accumulated losses. Under Brazilian tax laws we may only use our tax loss carryforwards to offset taxes payable up to 30% of the taxable profit for each year. Thus, despite having a balance tax loss carryforwards we may have to pay higher taxes in case we reach the compensation limits for any given year that we are entitled to use under Brazilian tax laws.

Our controlling shareholder has the ability to direct our business and affairs and its interests could conflict with yours.

Our controlling shareholder has the power to, among other things, elect a majority of our directors and determine the outcome of any action requiring shareholder approval, including transactions with related parties, corporate reorganizations, dispositions, and the timing and payment of any future dividends, subject to minimum dividend payment requirements imposed under Law No. 6,404 of December 15, 1976, as amended, or the Brazilian corporation law.  Although you are entitled to tag-along rights in connection with a change of control of our company and you will have specific protections in connection with transactions between our controlling shareholder and related parties, our controlling shareholder may have an interest in pursuing acquisitions, dispositions, financings or similar transactions that could conflict with your interests as a holder of the ADSs or our preferred shares.

Risks Relating to the ADSs and Our Preferred Shares

The relative volatility and illiquidity of the Brazilian securities markets, and securities issued by airlines in particular, may substantially limit your ability to sell the preferred shares underlying the ADSs at the price and time you desire.

Investing in securities that trade in emerging markets, such as Brazil, often involves greater risk than investing in securities of issuers in the United States, and such investments are generally considered to be more speculative in nature.  The Brazilian securities market is substantially smaller, less liquid, more concentrated and can be more volatile than major securities markets in the United States.  Accordingly, although you are entitled to withdraw the preferred shares underlying the ADSs from the depositary at any time, your ability to sell the preferred shares underlying the ADSs at a price and time at which you wish to do so may be substantially limited.  There is also significantly greater concentration in the Brazilian securities market than in major securities markets in the United States.  The ten largest companies in terms of market capitalization represented 52% of the aggregate market capitalization of the BM&FBOVESPA S.A. Bolsa de Valores, Mercadorias & Futuros (“BM&FBOVESPA”) as of December 31, 2012.  The top ten stocks in terms of trading volume accounted for 49.7%, 53.6% and 47% of all shares traded on the BM&FBOVESPA in 2010, 2011 and 2012, respectively.

In addition, the trading price of shares of companies in the worldwide airline industry are relatively volatile and investors’ perception of the market value of these shares, including our ADSs and preferred shares, may also be negatively impacted with additional volatility and decreases in the price of our ADSs and preferred shares.

Holders of the ADSs and our preferred shares may not receive any dividends.

According to our by-laws, we must pay our shareholders at least 25% of our annual net income as dividends, as determined and adjusted under Brazilian corporation law.  This adjusted income may be capitalized, used to absorb losses or otherwise appropriated as allowed under the Brazilian corporation law and may not be available to be paid as dividends.  We may not pay dividends to our shareholders in any particular fiscal year if our board of directors determines that such distributions would be inadvisable in view of our financial condition.

If you surrender your ADSs and withdraw preferred shares,  you risk losing the ability to remit foreign currency abroad and certain Brazilian tax advantages.

As an ADS holder, you benefit from the electronic foreign capital registration obtained by the custodian for our preferred shares underlying the ADSs in Brazil, which permits the custodian to convert dividends and other distributions with respect to the preferred shares into non-Brazilian currency and remit the proceeds abroad.  If you surrender your ADSs and withdraw preferred shares, you will be entitled to continue to rely on the custodian’s electronic foreign capital registration for only five business days from the date of withdrawal.  Thereafter, upon the disposition of or distributions relating to the preferred shares, you will not be able to remit abroad non-Brazilian currency unless you obtain your own electronic foreign capital registration.

If you attempt to obtain your own electronic foreign capital registration, you may incur expenses or suffer delays in the application process, which could delay your ability to receive dividends or distributions relating to our preferred shares or the return of your capital in a timely manner.  The depositary’s electronic foreign capital registration may also be adversely affected by future legislative changes.

Holders of ADSs may be unable to exercise preemptive rights with respect to our preferred shares.

We may not be able to offer our preferred shares to U.S. holders of ADSs pursuant to preemptive rights granted to holders of our preferred shares in connection with any future issuance of our preferred shares unless a registration statement under the Securities Act is effective with respect to such preferred shares and preemptive rights, or an exemption from the registration requirements of the Securities Act is available.  We are not obligated to file a registration statement relating to preemptive rights with respect to our preferred shares, and we cannot assure you that we will file any such registration statement.  If such a registration statement is not filed and an exemption from registration does not exist, Citibank, N.A., as depositary, will attempt to sell the preemptive rights, and you will be entitled to receive the proceeds of such sale.  However, these preemptive rights will expire if the depositary does not sell them, and U.S. holders of ADSs will not realize any value from the granting of such preemptive rights.

ITEM 4.       Information on the Company

A.      History and Development of the Company

General

The Registrant was formed on March 12, 2004 as a sociedade por ações, a stock corporation duly incorporated under the laws of Brazil with unlimited duration.  The Registrant’s material assets consist of the shares of VRG, three offshore finance subsidiaries, cash and cash equivalents and short-term investments.  The Registrant owns all of VRG’s shares, except for shares held by members of VRG’s boards of directors for eligibility purposes.  Our principal executive offices are located at Praça Comandante Linneu Gomes, S/N, Portaria 3, Jardim Aeroporto, CEP:  04626-020, São Paulo, SP, Brazil, and our general telephone number is +55 11 2128-4000.  The telephone number of our investor relations department is +55 11 2128-4700.  Our website address is www.voegol.com.br.  Investor information can be found on our website www.voegol.com.br/ir. Information contained on our website is not incorporated by reference in, and shall not be considered a part of, this annual report.

Capital Expenditures

For a description of our capital expenditures, see below “Item 5. Operating and Financial Review and Prospects—Liquidity and Capital Resources.”

B.      Business Overview

We are one of the largest low-cost carriers in the world, according to the International Air Transport Association, or IATA, in terms of passengers transported in 2012, and the largest low-cost carrier in Latin America. We provide frequent service on routes connecting all of Brazil’s major cities and from Brazil to major cities in South America and selected tourist destinations in the Caribbean and the U.S. With our young and standardized operating fleet of 125 Boeing 737-700/800s, or Boeing 737 aircraft, we serve the most comprehensive network of any airline in the Brazilian air passenger transportation market.

Since the beginning of our operations in 2001, our affordable, reliable and simple service, and our focus on markets that were either underserved or did not have a lower-fare alternative, have led to a strong awareness of our brand and a rapid increase in our market share.  We were the first company to successfully introduce low-cost carrier industry practices and technologies in Latin America.  We have a diversified revenue base, with customers ranging from business passengers to leisure passengers traveling throughout Brazil, other South American countries and select destinations in the Caribbean and the U.S.  Our strategy is to increase our market share by attracting new passengers and business travelers as well as to diversify our revenue portfolio through our consolidated flight network, a modern aircraft fleet, targeted marketing and our loyalty program Smiles  (one of the largest loyalty programs in Latin America with more than 9.0 million members and 150 partners, as of December 31, 2012), a variety of attractive ancillary businesses (cargo and other) such as our air cargo services (Gollog), and various payment mechanisms designed to make the purchase of our tickets easier for customers in lower income classes.  Passenger transportation revenues represented 88% and ancillary revenues represented 12% of our net revenues of R$8,103.6 million in 2012.

As of March 31, 2013, we offered approximately 970 daily flights to 65 destinations connecting the most important cities in Brazil as well as key destinations in Argentina, Bolivia, Paraguay, Uruguay, Venezuela, the U.S. and the Caribbean region.  We strategically focus on the Brazilian and South American markets, and will continue to carefully evaluate opportunities to continue growing by increasing the frequency of flights to our existing high-demand markets and adding new routes to new markets with high potential (for example, in the U.S. and Caribbean region), all of which can be reached with our Boeing 737 Next Generation (NG) aircraft.

Our Competitive Strengths

We Have a Strong Market Position Based on Slots at the Most Important Airports in Brazil.  Since 2007, we have been the carrier with the most flights connecting the busiest airports in Brazil:  Congonhas and Guarulhos (São Paulo), Santos Dumont and Galeão (Rio de Janeiro), Juscelino Kubitschek (Brasília), Confins (Belo Horizonte), Salvador (Bahia), Porto Alegre (Rio Grande do Sul), Recife (Pernambuco) and Curitiba (Paraná).  Routes between these airports are among the most profitable routes in our markets, with strong yields achieved mostly from business travelers. 

We Keep Our Operating Costs Low.  Our operating expense per available seat kilometer (CASK) ex-fuel for 2012 was R$10.2 cents.  We believe that our CASK for 2012, adjusted for the average number of kilometers flown per flight, or adjusted by stage length, was the lowest in the domestic market and among Latin American low-cost carriers, based upon our analysis of data collected from publicly available information.  Our business model is based on innovation and best practices adopted to improve our operating efficiency, including:

·         Operation of a young and standardized fleet.  At December 31, 2012, our operating fleet of 125 Boeing 737 aircraft was one of Latin America’s largest and youngest fleets, with an average age of 7.2 years.  Having a young fleet reduces fuel costs due to the more advanced technologies incorporated in newer aircraft. We plan to  keep our operating fleet exclusively comprised of Boeing 737 aircraft, until the arrival of our newly ordered Boeing 737 Max-7/8 aircraft (the newest generation of our current aircraft), which we expect will be delivered beginning in 2018.  Having a standardized fleet reduces inventory costs, as it requires fewer spare parts, and reduces the need to train our pilots to operate different types of aircraft.  It also simplifies our maintenance and operations processes.

·         State of the art maintenance.  We carry out heavy maintenance on our Boeing 737 aircraft internally at our IOSA (IATA Operational Safety Audit) certified Aircraft Maintenance Center at the Tancredo Neves International Airport located in Confins, in the State of Minas Gerais. Since April 2012, our Aircraft Maintenance Center has also been certified by ANAC to provide conventional and electrostatic painting, weighing and recalibration services for aircraft owned or operated by other airlines. With our system of phased maintenance for our Boeing 737 fleet, we are able to perform maintenance work every day without sacrificing aircraft revenue time, and schedule preventative maintenance with more regularity and without interrupting the utilization of our aircraft, which further dilutes fixed costs.

·         We have one of the largest e-commerce platforms in Brazil.  Our effective use of technology helps to keep our costs low and our operations highly scalable and efficient.  We seek to keep our distribution channels streamlined and convenient so as to allow our customers to interact with us via the Internet.  In 2012, we booked 88.8% of our ticket sales through a combination of our website and application programming interface, or API, systems, 5.7% through our call center and 5.5% through Global Distribution System, or GDS. In addition, our customers can check in using kiosks, online and through mobile devices, which in December 2012 represented 55% of all check-ins, an increase of 12.0 p.p. versus December 2011.

We Have One of the Largest Loyalty Programs in Latin America.  Since the VRG acquisition in April 2007, we have had a loyalty program (Smiles), which is available to all our passengers and which we consider a strong relationship tool.  As of January 2013 our Smiles  program was effectively segregated into a separate entity and we are analyzing a potential initial public offering of Smiles. See “—Smiles Loyalty Program—Segregation of the Smiles Program.” The Smiles  loyalty program has partnerships with more than 150 partners, including hotel chains, car rental companies, restaurants, insurance companies, publishers and schools and also forms the basis for partnerships with some of Brazil and South America’s largest banks and credit card companies.  The Smiles  loyalty program had over 9.0 million members at December 31, 2012.

We Stimulate Demand for Our Service.  We believe that through our differentiated services we create demand for air travel services.  We identify and stimulate demand among both business and leisure passengers for air travel that is safe, convenient, simple and a reasonably priced alternative to traditional air, bus and car travel.  By combining low-fares with simple and reliable service, we have successfully improved our brand awareness, product quality, punctuality and regularity as well as strengthened customer loyalty. As a consequence, we have been able to attract new groups of air travelers in our markets.

We Have Strong Brand Recognition.  We believe that the Gol brand has become synonymous with innovation and value in the airline industry.  Our customers identify Gol as being safe, accessible, friendly, fair, intelligent and reliable and distinguish Gol in Brazil’s domestic airline industry on the basis of its modern and simplified approach to air travel services.  Our Smiles  and Gollog  brands and our website provide valuable customer recognition in various businesses and create a tool for brand diversification for us.

We Have High Corporate Governance Standards and Proven Management.  We have three independent board members and one board member who is nominated by Delta Air Lines Inc., or Delta, pursuant to our partnership agreement. Our top managers have broad experience in many sectors of the Brazilian economy, including air and ground transportation, telecommunications and consumer products.  This experience has helped us to develop the most effective elements of our low-cost model and we expect will help us further penetrate the Brazilian middle-class and generate ancillary revenues.

Our Strategies

Our strategy is to capitalize on our competitive advantages to achieve sustainable growth, based on four main strategic pillars:  increase passenger revenue, expand ancillary revenues, further reduce costs and improve our financial resilience.  In order to implement our strategies we intend to:

Capitalize on Our Strong Market Position in Brazil and Latin America.  We intend to capitalize on our strong market position, with our widespread brand recognition, the greatest number of routes and highest frequencies between the most important airports in Brazil, our consolidated flight network and our Smiles  loyalty program, to increase penetration across all segments of travelers.  We will focus on Brazilian operations and selected South American destinations. We will also consider new routes to foreign markets with high growth potential (for example, in the U.S. and Caribbean region), that are, or we expect to become, profitable and fit into our flight network and may be reached with our current Boeing 737 aircraft.  In addition, we believe that the airline industry may experience further consolidation in the future and therefore believe that establishing partnerships and alliances with other airlines will be a key factor to our success.  In this environment we intend to play a leading role in the Latin American airline industry and to strengthen our position as a long-term player in the face of potential consolidations of the industry.

Improve Operating Efficiency.  Reducing our operating expense per available seat kilometer and adjusting capacity are key to improving our profitability.  We aim to maintain our position as one of the lowest cost airlines in the world.  We intend to adjust our strategy to focus on more profitable routes and to further reduce the average age of our fuel-efficient fleet, to ensure we are responsive to current market conditions while maintaining high utilization rates. Our aircraft utilization rate was 12.1 block-hours per day in 2012, as compared to 13.0 block-hours per day in 2011 and to 12.9 block-hours per day in 2010.

We seek to reduce our operating expense per available seat kilometer by using our aircraft efficiently, concentrating on minimizing our turnaround times at airports and maintaining a high number of daily flights per aircraft. We will continue to utilize technological innovations wherever possible to reduce our distribution costs and improve our operating efficiency.

Strengthen our Cash Position. We seek to strengthen our balance sheet and meet financial targets that will allow us to improve our financial resilience, which we believe will facilitate the implementation of our growth strategy and increase our capacity to establish partnerships, negotiate with suppliers and mitigate the impact of volatility in the financial markets on our results.  We currently seek to maintain an adequate cash position and to lengthen the maturity profile of our financial liabilities, avoiding the concentration of significant debt maturities over the next three years.

Expand Our Customer Base.  In planning the growth of our business, we will continue to select our routes and build the frequency of our service based on the extent and type of demand in the areas we serve in Brazil, South America, and the U.S. and Caribbean.  We are committed to providing air travel to a wide range of travelers.  We will continue to offer products across all traveler segments, offering convenient and flexible alternatives to business travelers while still making low-fare flights more accessible to a larger portion of the population, through the following measures:

·         Increased focus on business travelers. We intend to maintain our high punctuality, 87% and 94% in 2011 and 2012, respectively, and regularity, 95% in both 2011 and 2012, rates along with our network with the most flights connecting the busiest airports in Brazil, which are all key drivers in the purchase decision of business travelers. In addition, we offer higher-rate fares that allow flexibility to reschedule or cancel tickets with little advance notice and no additional costs, higher mileage multiplier in our Smiles program and, in São Paulo – Rio de Janeiro shuttle flights, comfort seats. In March 2013 we implemented a new route network designed to better meet the needs of business travelers by offering yet more convenient flight times and connections.

·         Stimulating demand.  Our widely available service is also designed to popularize air travel and stimulate demand, particularly from fare-conscious leisure travelers and small-to mid-size business travelers who might otherwise use alternative forms of transportation or not travel at all. The Brazilian middle class has grown significantly in the last few years, from 66 million in 2003 to 105 million in December 2011, according to Fundação Getúlio Vargas, or FGV, and the Brazilian Geographical and Statistical Institute (Instituto Brasileiro de Geografia e Estatística), or IBGE.

·         Overhubbing.  We estimate that between 40% and 50% of our passengers are connecting to other flights operated by us and, as a result, we may expand our network by adding capacity or creating new direct flights between two given cities, avoiding the need to connect through a third city. This may also help us to increase our flights and the number of passengers we transport despite current limitations on slot availability in Brazil’s busiest airports.

Strengthen our Smiles Program.  We intend to further strengthen our Smiles  program by increasing interaction with members and adding perceived value to its members through the following initiatives:

·         Separate entity. On December 21, 2012, we approved the segregation of the activities related to our Smiles  loyalty program, which began to be conducted by Smiles S.A., a recently incorporated subsidiary, as of  January 1, 2013. We believe that segregating the Smiles  program will allow us to have a fully dedicated management team to pursue all business opportunities from the growth of this market in Brazil.

·         New Products. In 2012, we launched, among others: (i) an online platform allowing members to redeem tickets in partner airlines though our website; (ii) miles purchase program, creating an alternative for members to supplement their balance and adding to our revenues; and (iii) Smiles  Shopping, a platform through which clients can use miles to acquire not only air tickets, but also approximately 300,000 new product and service options distributed through several partners.

·         Partnerships. Fostering existing and new partnerships with large international airlines, in the form of code-share arrangements, financial institutions, retail chain-stores, car rental and insurance companies, among others, offer our Smiles  members more opportunities to earn and redeem miles.

·         Expand our airline partnerships.  We believe we have the best platform to expand our customer base in the markets in which we operate through partnerships. We intend to strengthen our existing airline partnerships and build new ones with large international airlines in the form of code-share arrangements to further increase our international feeder network, load factors and profitability. We have a strategic MRO (maintenance, repair and operations) partnership agreement with Delta TechOps, the maintenance division of Delta. Delta TechOps provides certain engine overhaul, aircraft maintenance and maintenance consulting services and is also assisting us with our efforts to secure FAA (Federal Aviation Administration) certification for our maintenance center. We assist Delta with certain line maintenance services for Delta aircraft with extended ground time in Brazil. As of December 31, 2012, we had 65 interline agreements and 6 code-share agreements, with: Delta Airlines, Iberia, KLM, Air France, Qatar Airways and Copa Airlines.

Further Innovate, Establish and Increase Our Ancillary Revenue Businesses.  Our ancillary revenues are derived from Gollog, ticket change fees, excess baggage charges and other services.  We expect further growth in these businesses, which will provide us with additional revenue at low incremental cost by:  

·         Focusing on express delivery services. Through Gollog, our cargo transportation service, we make efficient use of extra capacity in our aircraft by carrying cargo. With a comprehensive service portfolio, express delivery accounted for approximately 25% of our cargo revenue in 2012. 

·         Continuously innovating and introducing new businesses to the Brazilian market.  We have a strong track record of innovation and introduction of new business practices in Brazil. For example, in June 2009, we introduced the sale of beverages and food on board (buy on board) in Brazil, generating ancillary revenue without increasing our cost structure or fare price. As of December 31, 2012 we offered buy on board service on more than 50% of our flights. In addition, in 2012, we introduced the sale of comfort seats (rows in which the middle seat is blocked) in the Rio-São Paulo route, which are available at an additional fee.

Airline Business

Routes and Schedules

Our operating model is a highly integrated, multiple-hub route network that is different from the point-to-point model used by other low-cost carriers worldwide.  The high level of integration of flights at selected airports permits us to offer frequent, non-stop flights at low fares between Brazil’s most important economic centers and ample interconnections through our network linking city pairs through a combination of two or more flights with little connecting or stop-over time.  Our network also allows us to increase our load factors on our strongest city pair routes by using the airports in those cities to connect our customers to their final destinations.  This strategy increases our load factor by attracting customers traveling to secondary markets who prefer to pay lower fares even if this means making one or more stops before reaching their final destination.  Between 40% and 50% of our passengers connect or fly through one or more destinations before reaching their final travel destination.  Our operating model allows us to build our flight routes to add destinations to cities that would not, individually, be economically viable to serve in the traditional point-to-point model, but that are feasible to serve when simply added as additional points on our multiple-stop route network.  We do this by offering low-fare, off-peak, minimum stay or night (red-eye) flights to lower-traffic destinations, which can be the first or last stops on our routes, allowing us to increase our aircraft utilization and generate additional revenues.  By offering international flights to destinations in South America, the United States and the Caribbean (using our current Boeing 737 aircraft), with stops integrated in our network, we create opportunities for incremental traffic, feeding our network and increasing our overall load factor and our competitive advantage and supporting our strategy of expanding our network and stimulating demand for our services.

We have been increasing the number of flights to and through the major Brazilian airports and prudently adding more routes to Caribbean and U.S. destinations, which we expect to give us additional growth opportunities in the Brazilian and international markets. In addition, we consider expanding to potential new destinations in Latin America in regions with medium density, represented by airports with a population of up to one million within a 200 km radius.

As of March 2013, we offered over 970 daily flights to 65  destinations connecting the most important cities in Brazil as well as the main destinations in Argentina, Bolivia, Paraguay, Uruguay, the United States, Venezuela and the Caribbean region.

On October 26, 2012 we began selling tickets for daily flights from São Paulo and Rio de Janeiro to Miami and Orlando, with stops in Santo Domingo, in the Dominican Republic. These flights commenced on December 15, 2012 and are operated by our standardized fleet of Boeing 737 aircraft.

Services

Passenger Transportation

We recognize that we must offer excellent services to our corporate and leisure customers.  We pay particular attention to the details that help to make for a pleasant, complication-free flying experience, including:

·         ticketless travel;

·         convenient online sales, check-in, seat assignment and flight change and cancellation services;

·         high frequency of flights between Brazil’s most important airports;

·         low cancellation and high on time performance rates of our flights;

·         online flight status service;

·         web-enabled cell phone ticket sales and check-in;

·         self check-in at kiosks at designated airports;

·         designated female lavatories;

·         friendly and efficient in-flight service;

·         modern aircraft interiors;

·         quick turnaround times at airport gates;

·         free or discounted shuttle services between airports and drop-off zones on certain routes;

·         buy on board services on certain flights;

·         mobile check-in and boarding pass (100% paperless boarding);

·         iPhone application for check-in, electronic boarding pass and Smiles account management; and

·         in-flight entertainment (Gol in the air) provided through passengers’ personal communications devices.

We seek to achieve punctual operations, which are of primary importance to our customers.  According to internal data, corrected for delays out of our control and pre-advised flight schedule changes, our average punctuality rate for 2012 was 87%, as compared to 94% in 2011. 

We experience greater passenger demand during the summer and winter vacation periods, in January and July, respectively, and during the last two weeks of December, during the holiday season.

In general, flight revenues and profitability reach peak levels during the January (summer) and July (winter) vacation periods and in the final two weeks of December, during the Christmas holiday season.  Conversely, we often witness a decrease in load factors during the week in which annual Carnival celebrations take place in Brazil.  Given our high proportion of fixed costs, this seasonality is likely to cause our results of operations to vary from quarter to quarter.

Ancillary Revenues and Gollog Cargo Transportation

Ancillary revenues include revenues from our Gollog services as well as baggage excess and ticket change fees. Buy-on-board and travel insurance fees are also becoming an increasingly important part of this revenue. Further development and growth of our Gollog services is a key part of our strategy to increase ancillary revenue.

We are constantly evaluating opportunities to generate additional ancillary revenue such as sales of travel insurance, marketing activities and other services which may help us to better capitalize on the large number of passengers on our flights and the high volumes of customers using our website.

We plan to integrate the Smiles and Gollog platforms into our air travel portal to provide further convenience and simplicity to our customers.

We make efficient use of extra capacity in the stronghold of our aircraft by carrying cargo, through our cargo transport service – Gollog.  Gollog’s success is the result of the unique service we offer to the market:  the Electronic Air Waybill that can be completed online.  The Gollog system provides online access to air waybills and allows customers to track their shipment from any computer with Internet access.  Our  65 destinations throughout Brazil, South America, the United States and the Caribbean provide access to multiple locations in each region.  With our capacity of approximately  970 daily flights, operated by 125 Boeing 737-700/800 aircraft, in addition to a fleet of 147 vehicles, we can guarantee quick and reliable delivery. 

Our express delivery products – Gollog VOO CERTO, Gollog EXPRESS, Gollog DEZ HORAS and Gollog DOC – were developed to meet the growing demand for door-to-door deliveries, defined deadlines and additional optional services. We intend to intensify our efforts in the express delivery services by further strengthening our logistics capability, mainly by expanding our ground distribution network and further intensifying our commercial efforts.

Aircraft Fleet

On December 31, 2012, we had an operational fleet of 125 aircraft and a total fleet of 147.

The following table sets forth the composition of our fleet at the dates indicated:

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(1) All B737-300 aircraft result from the acquisition of Webjet.  See “—Non-operating Fleet” below.

As of December 31, 2012, of our total 147 aircraft: 96 were under operating leases, 45 were under finance leases and six were owned by us.

As of December 31, 2012, our operating leases had an average remaining term of 65 months and original total terms of up to 144 months from the date of delivery of the relevant aircraft.

As of December 31, 2012, our finance leases had an average remaining term of 96 months and we had purchase options for 39 of our aircraft under finance leases.

We believe that leasing our aircraft fleet under operating leases provides us with flexibility to adjust our fleet size.  We make monthly rental payments, some of which are based on floating rates,  but we are not required to make termination payments at the end of our leases.  Under our operating lease agreements, we do not have purchase options and for some of our lease agreements we are required to maintain maintenance reserve deposits and to return the aircraft and engine in the agreed condition at the end of the lease term.  Title to the aircraft remains with the lessor.  We are responsible for the maintenance, servicing, insurance, repair and overhaul of the aircraft during the term of the lease. 

In line with our strategy of combining the renovation of our fleet with disciplined growth in our seat supply, in 2012 we received seven aircraft based on operating lease contracts and also returned four aircraft under operating lease contracts.

Operating Fleet

The average age of our operating fleet of 125 Boeing 737-700/800 aircraft as of December 31, 2012, was 7.2 years.  The average daily utilization rate of our operating fleet in 2012 was 12.1 block hours as compared to 13.0 block hours in 2011.

Each Boeing 737 aircraft in our fleet is powered by two CFM International Model CFM 56-7B22 engines or two CFM International Model CFM 56-7B24 engines. All Boeing 737-800 NG Short-Field Performance are equipped with an upgrade thrust plug in each engine, which allows it to operate as a CFM 56-7B27/B3 engine with 27,000 lbs. 

The Boeing 737-700 Next Generation and Boeing 737-800 Next Generation aircraft currently comprising our fleet are fuel-efficient and very reliable.  They suit our cost efficient operations well for the following reasons:

·         they have comparatively standardized maintenance routines;

·         they require just one type of standardized training for our crews;

·         they use an average of 7% less fuel than other aircraft of comparable size, according to Boeing; and

·         they have one of the lowest operating costs in their class.

In addition to being cost-efficient, the Boeing 737-700/800 Next Generation aircraft are equipped with advanced technology that promotes flight stability, providing a more comfortable flying experience for our customers.  We use a single type of aircraft to preserve the simplicity of our operations and the introduction of any new aircraft type to our fleet will only be done if, after careful consideration, we determine that such a step will reduce our operating costs. As such, we plan to continue keeping our operating fleet exclusively comprised of Boeing 737-700/800 aircraft, until the arrival of our newly ordered Boeing 737 Max-7/8 aircraft (the newest generation of our current aircraft) which we expect will be delivered starting 2018.

Most of our Boeing 737-800 Next Generation aircraft are equipped with blended winglets and all Boeing 737-800 Next Generation aircraft from our purchase order will be equipped with winglets, which reduce our fuel and maintenance costs.  Our experience with the new winglets has shown operating fuel consumption reductions from 3% to 5%.  In addition, the winglets improve airplane performance during take-off and landing on short runways.  The new Boeing 737-800 NG aircraft will be delivered with short-field performance (SFP) with technical modifications that we expect to significantly improve flight performance, the ability to operate non-stop flights, reduce noise during take-off and to enable us to fly with our Boeing 737-800 Next Generation aircraft to the airport of Santos Dumont in Rio de Janeiro, an important link to the most important routes in Brazil.

In 2011, we announced the delivery of the first Next Generation 737-800 equipped with the new Sky Interior standard and since then all our new aircraft are equipped with this standard.

Non-operating Fleet

As of December 31, 2012, we had a non-operating fleet composed of 19 B737-300 aircraft, resulting from the acquisition of Webjet, and three B767-300, all of which were grounded at the time.

Of the 19 B737-300, 13 aircraft are leased and in the process of being returned. As of March 31, 2013 we had already returned three such aircraft and expect to complete the return of the remaining aircraft by the end of 2013. In addition, six B737-300 aircraft are owned by Webjet and we plan to sell according to market conditions.

Two of the B767-300 aircraft were in the final process of being transferred to Delta Airlines, of which one was transferred in January 2013 and the other we expect will be transferred by May 2013, and the third B767-300 aircraft is grounded. The lease agreement for this aircraft expires in December 2014 and we do not expect to be able to transfer this aircraft prior to such date.

Fleet Plan

The following table sets forth our year-end projected operating fleet through 2017:

* Includes SFP aircraft (Short Field Performance)

**Non-operational aircraft (grounded). See “—Non-operational Fleet” above.

We will revise this fleet plan according to our expectations for the growth potential in the markets in which we operate.

In 2012, we announced a purchase order for 60 Boeing 737 Max-7/8 aircraft (the newest generation of our current aircraft and still under development), to be delivered starting 2018.

Sales and Distribution

Our customers can purchase tickets directly from us through a number of different channels, such as our website including our Booking Web Services (BWS), our call center, at airport ticket counters and, to a lesser extent, GDS.

Our low-cost low-fare business model utilizes website ticket sales as its main distribution channel, especially in the local market.  For the year ended December 31, 2012, 88.8% of our passenger revenues, whether directly from the customer or through travel agents, were booked online, making us a global leader in this area.  In the same period, 5.7% of our passenger revenues were booked through call centers, airport sales counters, and our BWS and 5.5% of our total sales were made through the GDS.

Our customers can purchase tickets indirectly through travel agents, who are a widely-used travel service resource in Brazil and South America, Europe, North America and other regions.  For the year ended December 31, 2012, travel agents provide us with more than 30.000 distribution outlets throughout these regions.

GDS allows us access to a large number of tourism professionals who are able to sell our tickets to customers throughout the globe, and enables us to enter into interline agreements with other airlines to offer more flights and connection options to our passengers and add incremental international passenger traffic, especially to our international network.

On October 21, 2009, we became an issuer of cards for Universal Air Travel Plan, or UATP, a payment network owned and operated by several foreign airlines.  UATP allows us access to a payment network with lower costs than those offered by credit cards and other means of payment.  In addition, as a UATP card issuer we are able to maintain a closer relationship with our corporate customers.

Partnerships and Alliances

General

Our strong market positioning enables us to successfully negotiate a number of arranged partnerships with supplementary major carriers worldwide, mostly in the form of code-share agreements and interline agreements.  Additional passenger inflows generated by these strategic partnerships help improve revenues at low incremental costs.

At December 31, 2012, we had code-share agreements with Delta, Iberia, Air France, KLM, Copa Airlines and Qatar Airways. Our Smiles  program is linked to the various frequent flyer programs of our code-share partners, enabling travelers to accrue and redeem miles between the programs (however, the partnerships are not integrated among themselves).  In addition, passengers of our partner airlines are able to connect to Gol-operated flights within Brazil, marketed as a code-share partner flight.  We intend to enter into similar agreements with other long haul airlines serving or intending to serve Brazil.

At December 31, 2012, we had interline agreements with 65 airlines, including Korean Airlines, Emirates Airlines, Avianca, Continental Airlines, Japan Airlines, TAP Air Portugal, and others.  An interline agreement is a commercial agreement between individual airlines to handle passengers traveling on itineraries that require multiple airlines. This type of agreement allows passengers to utilize a single ticket and to check their baggage through to the passengers’ final destination.  Interline agreements differ from code-share agreements in that code-share agreements usually refer to numbering a flight with the airline’s code (abbreviation) even though the flight is operated by another airline.  These agreements provide for better marketing and customer recognition of the links between the airlines.

In February 2011, we entered into a strategic MRO (maintenance, repair and operations) partnership agreement with Delta TechOps, the maintenance division of Delta, which will provide overhaul service for approximately 50% of our CFM 56-7 engines, maintenance for parts and components on our fleet of Boeing 737NG aircraft and also, consulting services related to maintenance workflow planning, materials and facility optimization and tooling support. Delta TechOps will also assist us with our efforts to secure FAA (Federal Aviation Administration) Certification. In addition, we will assist Delta with certain line maintenance services for Delta aircraft with extended ground time in Brazil.

An important element of our business strategy is to cater to the corporate client.  To further develop our business relationship with our corporate customers, we have entered into partnerships with hotel chains, rental car agencies and insurance providers to offer our corporate customers the convenience of the combination of transportation and accommodation arrangements.

Delta Investment and Commercial Agreements

On December 7, 2011 our controlling shareholder and Delta entered into an investment agreement providing for the sale of 8,300,455 preferred shares in the form of ADSs owned by our controlling shareholder to Delta at a price per share equivalent to R$22.00, or the Delta Investment. Our controlling shareholder used the entire net proceeds from the sale of preferred shares to Delta to subscribe for new common and preferred shares in a rights offering issued by us at the same price per share paid by Delta.

Our controlling shareholder further agreed to elect a Delta representative to our board of directors as long as Delta holds at least 50% of the ADSs acquired in the investment, among other conditions. Delta agreed, for a period of 12 months, not to sell the acquired ADSs (lockup) and not to acquire any further Gol shares, including in the form of ADSs (standstill), without our consent.

In the context of the Delta Investment, we entered into a long-term commercial agreement with Delta that included exclusivity provisions designed to strengthen the operational cooperation and synergies between the two companies, including:

·         an increase in the scope of the code-share agreement (flight sharing), subject to the relevant approvals, allowing Delta to use its code for more Gol flights in Brazil, South America, the U.S. and the Caribbean, and Gol to add its code to Delta’s flights between Brazil and the United States, and from the U.S. to other destination, thereby increasing the number of flight options for passengers of both airlines and expanding our geographical reach;

·         the optimization of connecting services in order to increase the attractiveness of the companies’ joint services, facilitating flight connections and cargo and passenger movement among the nearly 380 destinations in over 60 countries served by Gol and Delta;

·         the increase in passenger comfort by aligning services and benefits for members of both the Smiles  and SkyMiles mileage programs;

·         joint commercial and promotional activities, encouraging both airlines’ sales forces to cooperate in Brazil, the United States and, eventually, in other countries;

·         the exploration of synergies in passenger services, maintenance, VIP lounges and logistical support; and

·         the transfer of the lease of the two remaining Boeing 767 aircraft in our fleet and their spare parts to Delta.

Pricing

Brazilian airlines are permitted to establish their own domestic fares without previous government approval. Airlines are free to offer price discounts or follow other promotion activities.  Airlines must submit, 30 days after the end of each month, a file containing fares sold and quantity of passengers for each fare amount, for all markets. This file lists regular fares and excludes all contracted, corporate and private fares. The objective is to monitor the average market prices. The procedure same applies for international fares. The only difference is that all fares sold for interline itineraries are also excluded from the file sent to ANAC.

Yield Management

Yield management involves the use of historical data and statistical forecasting models to produce knowledge about our markets and guidance on how to compete to maximize our operating revenues.  Yield management forms the backbone of our revenue generation strategy and is strongly linked to our route and schedule planning and our sales and distribution methods.  Our yield management practices enable us to react quickly in response to market changes.  For example, our yield management systems are instrumental in helping us to identify the flight times and routes for which we offer promotions.  By offering lower fares for seats that our yield management indicates would otherwise remain unsold, we capture additional revenue and also stimulate customer demand.

Maintenance

According to ANAC regulation, we are directly responsible for the execution and control of all maintenance services performed on our aircraft.  The maintenance performed on our aircraft can be divided into two general categories:  line and heavy maintenance.  Line maintenance consists of routine, scheduled maintenance checks on our aircraft, including pre-flight, daily and overnight checks and any diagnostics and routine repairs.  All of our line maintenance is performed by our own highly experienced technicians at our line maintenance service bases throughout Brazil and South America.  We believe that our practice of performing daily preventative maintenance helps to maintain a high aircraft utilization rate and reduces maintenance costs.  Heavy maintenance consists of more complex inspections and servicing of the aircraft that cannot be accomplished overnight.  Heavy maintenance checks are performed following a pre-scheduled agenda of major overhauls defined by the aircraft’s manufacturer, based on the number of hours and flights flown by the aircraft.  Our continued high aircraft utilization rate will result in shorter periods of time between heavy maintenance checks for our aircraft in comparison to carriers with lower aircraft utilization rates.  In addition, engine maintenance services are rendered in different MRO (Maintenance, Repair and Operations) facilities.  We do not believe that our high aircraft utilization rate will necessarily result in the need to make more frequent repairs to our aircraft, given the durability of the aircraft type in our fleet.  Our aircraft are covered by warranties that have an average term of 48 months for products and parts and 12 years for structural components.  The warranties on the aircraft we received in 2012 under our firm purchase order with Boeing will start expiring in 2016.

We internalized heavy maintenance on our Boeing 737 aircraft in our Aircraft Maintenance Center at the Tancredo Neves International Airport in Confins, in the State of Minas Gerais.  We use this facility for airframe heavy checks, line maintenance, aircraft painting and aircraft interior refurbishment.  We have three hangars in our Aircraft Maintenance Center, with a capacity to perform maintenance on 120 aircraft per year, and we have available space to build more hangars in the future if needed. With our system of phased maintenance for our Boeing Next Generation 737-700 and 737-800 aircraft fleet, we are able to perform maintenance work every day without sacrificing aircraft revenue time and to schedule preventive maintenance with more regularity and around the utilization of our aircraft, which helps to maintain high levels of block hours per day and reduces costs.  We are one of the few airlines in the world that takes full advantage of the Boeing 737 Next Generation phased maintenance philosophy, supported by extensive investments we made in human resources, material, tools and equipment.

We have also entered into a strategic MRO (maintenance, repair and operations) partnership agreement with Delta TechOps, the maintenance division of Delta, in order to provide overhaul service for approximately 50 percent of our CFM 56-7 engines, maintenance for parts and components on our fleet of Boeing 737 NG aircraft and also, consulting services related to maintenance workflow planning, materials and facility optimization and tooling support. Delta TechOps will also assist us with our efforts to secure FAA (Federal Aviation Administration) Certification. In addition, we will assist Delta with certain line maintenance services for Delta aircraft with extended ground time in Brazil.

We have been certified by ANAC under Brazilian Aeronautical Certification Regulations to perform heavy maintenance services for third parties.  We expect to utilize this certification, a potential source for ancillary revenues, now that the construction of an additional maintenance facility has been completed.

Fuel and Hedge

Our fuel costs totaled R$3,742.2 million in 2012, representing 42% of our operating expenses for the year.  In 2012, we purchased substantially all of our fuel from Petrobras Distribuidora S.A., a retail subsidiary of Petrobras, principally under an into-plane contract under which the supplier supplies fuel and also fills our aircraft tanks.  In 2012, fuel prices under our contracts were re-set every 30 days and were composed of a variable and a fixed component.  The variable component is defined by the refinery and follows international crude oil price fluctuations and the real/U.S. dollar exchange rate.  The fixed component is a spread charged by the supplier and is usually a fixed cost per liter during the term of the contract.  We currently operate a tankering program under which we fill the fuel tanks of our aircraft in regions where fuel prices are lower.  We also provide our pilots with training in fuel management techniques, such as carefully selecting flight altitudes to optimize fuel efficiency.

Fuel costs are extremely volatile, as they are subject to many global economic and geopolitical factors that we can neither control nor accurately predict.  Because international prices for jet fuel are denominated in U.S. dollars, our fuel costs, though payable in reais, are subject not only to price fluctuations but also to exchange rate fluctuations.  We maintain a fuel hedging program, based upon policies which define volume, price targets and instruments, under which we enter into fuel and currency hedging agreements with various counterparties providing for price protection in connection with the purchase of fuel.  Our hedging positions cover short- and long-term periods, and are adjusted weekly or more frequently as conditions require.  Our hedging practices are executed by our internal risk management committee and overseen by the risk policies committee of our board of directors.  The risk policies committee of our board of directors meets monthly or more often, if called, and its main responsibilities are to assess the effectiveness of our hedging policies, recommend amendments when and where appropriate and establish its views regarding fuel price trends.  We use risk management instruments that have a high correlation with the underlying assets so as to reduce our exposure.  We require that all of our risk management instruments be liquid so as to allow us to make position adjustments and have prices that are widely disclosed.  We also avoid concentration of credit and product risk.  We have not otherwise entered into arrangements to guarantee our supply of fuel and we cannot provide assurance that our hedging program is sufficient to protect us against significant increases in the price of fuel.

As of December 31, 2012, we had hedged 11% on average for our projected fuel requirements for 2013. We also have an interest hedge program and we have hedged 44% of the leases for aircraft to be delivered in 2013 and 2014.  The fuel hedge is based on call options, swap and collar contracts, and the interest hedge is based on forward swap contracts.

The following chart summarizes our fuel consumption and costs for the periods indicated:

We continuously invest in initiatives to reduce fuel consumption. Between 2008 and 2012 we reduced our fuel consumption per flight hour from 2.91 to 2.85. For example, we started using Aircraft Communications Addressing and Reporting System, or ACARS, in 2010. ACARS is a system that permits real-time digital transmission, via satellite, of  important flight data between aircraft and our bases, allowing routes and flight times to be automatically updated. We had installed ACARS in 67 aircraft by the end of 2012. We decided to increase ACARS coverage and create the CCD (Digital Communications Center) within the Operational Control area, which started operating in May 2011. The Center is responsible for monitoring aircraft in real time, as well as streamlining operations and managing various flight data. We also started using GPS Landing System in January 2010 and we expect to have the system implemented in all our fleet by the end of 2014.  This system reduces fuel consumption during take-off and landing, increases precision and safety.

Safety and Security

Our most important priority is the safety of our passengers and employees.  We maintain our aircraft in strict accordance with manufacturer specifications and all applicable safety regulations, and perform routine line maintenance every day.  Our pilots have extensive experience, with flight captains having more than 10,000 hours of career flight time, and we conduct ongoing courses, extensive flight simulation training and seminars addressing the latest developments in safety and security issues.  We closely follow the standards established by ANAC’s Air Accident Prevention Program and we have installed the Flight Operations Quality Assurance System, which maximizes proactive prevention of incidents through the systematic analysis of the flight data recorder system.  All of our aircraft are also equipped with Maintenance Operations Quality Assurance, a troubleshooting program that monitors performance and aircraft engine trends.  The Brazilian civil aviation market follows the highest recognized safety standards in the world.  We are also an active member of the Flight Safety Foundation, a foundation for the exchange of information about flight safety.  In June 2009, we created the office of Safety Officer which reports directly to our board of directors and whose main goal is to oversee flight safety and report directly to our highest management level.

Environmental Sustainability

Since 2010, we have been preparing an Annual Sustainability Report based on Global Reporting Initiative (GRI) guidelines, an international standard for reporting economic, social and environmental performance. By adopting these parameters, we are reinforcing our accountability with various stakeholders through added transparency and credibility.

We also constantly invest in becoming more environmentally sustainable and have recently implemented the following actions:

·         Expansion of our Aircraft Maintenance Center at the Tancredo Neves International Airport located in Confins, in the State of Minas Gerais:  we have reduced costs by decreasing the necessity of flying our aircraft overseas to be serviced. We also treat all of the effluents generated in our facilities and are committed to the reuse of water.  The Maintenance Center was designed to comply with environmental responsibility requirements and all of the conditions imposed by the environmental licenses and current legislation.

·         We were the first Brazilian airline selected to join the Sustainable Aviation Fuel Users Group (SAFUG), an international aviation biofuel research group, and we participate in biofuel feasibility tests.

·         We have a partnership agreement with the Fuel and Carbon Services Division of GE Aviation, which envisages the creation of studies and systems to reduce fossil fuel consumption and green house gas emissions.

Insurance

We maintain passenger liability insurance in an amount consistent with industry practice and we insure our aircraft against losses and damages on an “all risks” basis.  We are required by ANAC to maintain insurance coverage for general liability against terrorist acts or acts of war with a minimum amount of US$800 million.  We have obtained all insurance coverage required by the terms of our leasing agreements.  We believe our insurance coverage is consistent with airline industry standards in Brazil and is appropriate to protect us from material loss in light of the activities we conduct.  No assurance can be given, however, that the amount of insurance we carry will be sufficient to protect us from material loss.

Competition

Domestic

Airlines in Brazil compete primarily on the basis of routes, fare levels, frequency of flights, capacity, airport operating rights and presence, reliability of services, brand recognition, frequent flyer programs and customer service.

Our main competitor in Brazil is the recently-formed LATAM Airlines Group, or LATAM, the result of a June 2012 merger between TAM Airlines of Brazil and LAN Airlines of Chile. LATAM is a full-service scheduled carrier offering flights on domestic routes and international routes.  We also face domestic competition from other domestic scheduled carriers, regional airlines and charter airlines, which mainly have regional networks.

As the growth in the Brazilian airline sector evolves, we may face increased competition from our primary competitors and charter airlines as well as other entrants into the market that reduce their fares to attract new passengers in some of our markets.

The following table sets forth the historical market shares on domestic routes, based on revenue passenger kilometers, of the significant airlines in Brazil for each of the periods indicated:

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Source:  December Advanced Comparative Data (Dados Comparativos Avançados), 2008—2012

(1)           In October 2010, ANAC changed its calculation method for monthly traffic information and republished information for periods since January 2009. All operating data for 2009 and thereafter reflects the new methodology, whereas information for 2008 was calculated pursuant to the old methodology and may not be fully comparable. According to ANAC, the changes were designed to align data with the concepts adopted by the ICAO. The change was necessary because Brazil has joined the ICAO’s statistical program and supplies the latter’s database with several industry data. Changes in the methodology refer to the calculation of ASK (seat supply) and the classification of domestic legs in international flights, which are now considered to be part of the domestic market.

(2)          On October 3, 2011, we acquired Webjet.

(3)          Known as TAM Airlines prior to its June 2012 merger with LAN Airlines of Chile.

(4)          In May 2012, Azul acquired TRIP.

Until 2010, landing and navigation fees charged in Brazilian airports were similar in all airports independent of whether they were busy or not. In 2011, the Brazilian government increased landing and navigation fees at the busiest airports as compared to less busy airports and at peak hours. As a result, secondary hubs and off-peak flights may benefit in light of the differences in fees for the airlines that choose to operate in these airports or times.

Domestically, we also face competition from ground transportation alternatives, primarily interstate bus companies. Given the absence of meaningful passenger rail services in Brazil, travel by bus has traditionally been the only low-cost option for long-distance travel for a significant portion of Brazil’s population.  We believe that our low-cost business model has given us flexibility in setting our fares to stimulate demand for air travel among passengers who in the past have traveled long distances primarily by bus.  In particular, the highly competitive fares we have offered for travel on our night flights, which have often been comparable to bus fares for the same destinations, have had the effect of providing direct competition for interstate bus companies on these routes.

International

As we expand our international services in South America, the United States and the Caribbean, our pool of competitors will increase and we will face competition from Brazilian, U.S. and South American airlines that are already established in the international market and that participate in strategic alliances and code-share arrangements. In addition, non-Brazilian airlines may decide to enter or increase their schedules in the market for routes between Brazil and other South American, U.S. and Caribbean destinations.

Smiles Loyalty Program

Segregation of the Smiles Program

On December 21, 2012, we approved the segregation of the activities related to our Smiles loyalty program, or the Smiles program, previously managed by us, and which began to be conducted by Smiles S.A., or Smiles, a recently incorporated subsidiary, as of January 1, 2013. On April 25, 2013, Smiles priced an initial public offering (IPO) in which it issued a number of common shares equivalent to 40% of its total capital for R$1.0 billion. The proceeds of this IPO will be used entirely for the purchase by Smiles of advanced tickets from us at a discount rate equivalent to between 140% and 150% of the CDI. This IPO is subject to customary closing conditions and we expect it will close on May 2, 2013.

General Atlantic Investment Agreement

On April 5, 2013, we entered into an investment agreement with General Atlantic Service Company LLC., or General Atlantic, providing for an investment by General Atlantic in Smiles. Under this agreement, G.A. Smiles Participações S.A., or G.A. Smiles, an affiliate of General Atlantic, purchased in the IPO a number of Smiles common shares equivalent to R$400.0 million, equivalent to 15.8% of Smiles total capital. G.A. Smiles also agreed to not sell or otherwise transfer these Smiles common shares for a period of nine months following the closing of this offering.

In connection with G.A. Smiles’ investment, on April 23, 2013, we entered into a shareholders agreement granting G.A. Smiles the right to appoint one member of Smiles’ board of directors and certain veto rights regarding: amendments to the Operational Agreement or the Miles and Tickets Purchase Agreement (as defined below), certain related party transactions in excess of R$2.0 million, and certain advance ticket purchases. On April 24, 2013, we granted G.A. Smiles an option, exercisable within 12 months of the IPO, to purchase from us an additional number of Smiles common shares equivalent to 20% of G.A. Smiles’ initial investment, at the same price per share set in the IPO as adjusted by the CDI.

Overview

Smiles is one of the largest coalition loyalty programs in Brazil, with over 9 million members as of December 31, 2012.  Its business model is based on developing a coalition loyalty program consisting of a single platform for accumulating and redeeming miles through a broad network of commercial and financial partners.

The Smiles program was originally launched by Varig in 1994 as a frequent flyer program and was acquired by us in 2007, together with other assets of the Varig business.  Beginning in 2008, the Smiles program, which had been essentially inactive for years, underwent a complete restructuring and revitalization.  In 2010, we continued with the Smiles program restructuring and, since then, the program has gained significant market share.  The Smiles program has been transformed from a stand-alone program to a coalition loyalty program.

Currently, Smiles allows members to accumulate miles through: (1) flights with us and our international partners, (2) the main Brazilian commercial banks, including through co-branded credit cards issued by Bradesco and Banco do Brasil and (3) a broad network of more than 150 retail partners, including Petrobras Distribuidora, the largest fuel distributor in Brazil, among others.  We are Smiles’ primary redemption partner but members may also redeem miles to purchase products and services from commercial partners.

The agreements that govern our commercial relationship with Smiles allow unrestricted access to seats on our flights.

Products and Services

Smiles’ main business is the sale of miles.  Its commercial partners purchase miles to distribute to Smiles program members when members purchase products or services from these partners.  Members accumulate miles, which are redeemed in exchange for rewards, which in turn are acquired from commercial partners. 

Smiles earns revenue mainly by (1) selling miles to its commercial partners and (2) providing loyalty program management services to commercial partners, including our loyalty program.

To become eligible to earn miles, individuals enroll in the Smiles program through its website.  Members have a single account for accumulating and redeeming miles, and are not required to transfer miles or pay additional redemption fees. 

A Smiles program account permits members to accumulate miles by purchasing products or using services offered by any of its commercial partners.  Members may redeem and convert their miles into travel or non-travel rewards. Current policy is to cancel all miles in member accounts when they expire, which varies from three to five years.

In addition to selling miles, Smiles manages our loyalty program and intends to expand its loyalty program management services to its other commercial partners.

Miles Redemption

Travel rewards represented the majority of redemptions as of December 31, 2012.  However, with the option of redeeming miles  through Smiles Shopping, a platform through which redemption commercial partners offer a variety of reward products, we expect that the proportion of reward redemptions for products other than airline travel will increase. 

Miles Sales to Members and Smiles and Money

Smiles was the first Brazilian loyalty program to sell miles to members to allow them to add  miles to their account balances in order to facilitate redemption of higher value rewards.  Currently, members may purchase miles through its website. Miles purchases are automatically credited to member accounts and can later be used for reward tickets or rewards through Smiles Shopping.

Smiles and Money allows members to redeem rewards using a combination of miles and money.  We believe that Smiles and Money and miles sales encourages member engagement, as it expands access to rewards.

Commercial Partners

As of the date of this offering memorandum, the Smiles network of commercial partners is composed of over 150 companies, including more than 120 partners from which members may earn miles and 30 partners from which members may redeem rewards. Its partners span various industries and include airlines, financial institutions, travel agencies, hotels, car rental companies, food and non-food retailers, gas stations, bookstores, car manufacturers, real estate developers, media companies, drugstores, restaurants and parking lot operators, among others. 

•               Airlines.  We are the single most important commercial partner in terms of miles and rewards volumes.  We purchase miles from Smiles to distribute to our passengers. Additionally, Smiles has agreements with our airline partners, which are currently Qatar  Airways, Delta, Air France, KLM, and in the near future will include Iberia.

•             Financial Institutions.  Smiles has commercial partnership agreements with 22 Brazilian and international financial institutions, including the five largest Brazilian commercial banks in terms of total assets as of September 2012, according to the Central Bank.  Smiles sells miles to these commercial partners, which distribute them proportionately to credit card spending by cardholders who are Smiles program members. Smiles also sells miles for co-branded credit cards issued by Bradesco and Banco do Brasil.

•              Travel Companies, Hotels and Car Rental Agencies.  Currently, Smiles has approximately 40 commercial partnership agreements with well known domestic and international travel companies, hotels and car rental companies. These partners include Unidas Locadora de Veículos Ltda. (a Brazilian car rental company), Hilton HHonors Worldwide LLC, Marriott International, Starwood Hotels and Resorts Worldwide, Inc, Atlântica Hotels International (Brasil) Ltda, and Sauípe S.A. (a tourism complex in Brazil), whose agreement with us is in the final stages of negotiation.  This network allows Smiles program members to accumulate miles at a variety of locations worldwide and throughout the course of their travels.

•              Brazilian Retailers and Distributors.  Smiles has commercial agreements with approximately 40 important Brazilian retailers, including Petrobras Distribuidora S.A. (a fuel distributor), Camisaria Colombo (a menswear retail chain), Polishop (a domestic electronics and merchandise retailer), Cybelar (an electronics and furniture store chain), NET Serviços de Comunicação S.A. (a telecommunications provider), the newspapers Jornal o Globo and Jornal Valor Econômico, JAC Motors, Kawasaki Motores do Brasil Ltda, B2W – Companhia Global do Varejo (Brazil’s largest e-commerce company), Sociedade Comercial e Importadora Hermes S.A. (a Brazilian retailer), Editora Abril S.A. (one of the largest Brazilian publishing companies) and Walmart.com.

Competition

Smiles faces the following types of competition in Brazil: (i) frequent flyer programs, (ii) the loyalty programs of financial institutions and similar entities and (iii) other loyalty programs in general.  The first group includes Multiplus, the current market leader, and other players such as the Tudo Azul program.  The second group includes a variety of large financial institutions and similar entities that have their own loyalty programs, such as the SuperBônus Program of Banco Santander (Brasil) S.A., the Bradesco Loyalty Card Program of Banco Bradesco S.A., the Sempre Presente Program of Banco Itaú Unibanco S.A. and the American Express Membership Rewards Program.  The majority of these programs allow members to transfer accumulated reward points to programs like Smiles.  The third group of competitors includes companies such as Dotz and Netpoints, among others.

There is currently no publicly available data on the loyalty industry in Brazil.  However, information disclosed by Multiplus suggests that they have approximately a 74% market share and Smiles has a 26% market share, excluding other smaller industry players.

If foreign loyalty programs such as Aeroplan or Air Miles enter the Brazilian market, Smiles may face additional competition. However, entry of foreign loyalty programs would also present new opportunities for commercial partnerships.

Agreements with Smiles

Operating Agreement

On December 28, 2012, we entered into an operating agreement with Smiles, or the Operating Agreement, that establishes the terms and conditions of our relationship. This agreement went into effect on January 1, 2013, when Smiles began to manage and operate the Smiles program.

The Operating Agreement established the terms of the transfer of Smiles program management to Smiles.  In the context of the transfer, we divided reward costs as follows: the cost of rewards redeemed with legacy miles (i.e., those earned through December 31, 2012) is supported by us, while the cost of rewards redeemed with new miles (i.e., those earned beginning January 1, 2013) is supported by Smiles.

Pursuant to the Operating Agreement, the Smiles program will be our sole loyalty program.  We are currently Smiles’ sole partner in the air transportation industry, but Smiles is free to establish new partnerships in this industry with our prior authorization.  We may require Smiles to enter into a partnership agreement with new partners in the air transportation industry or with a global alliance of airlines in the event we become a party to one.

We have a preference to enter into partnerships in certain segments, such as travel agencies (including on-line travel agencies), rental cars and travel insurance.  However, Smiles may establish partnerships in these industries with our prior authorization.

Outside of the air transportation industry and certain segments in the travel industry, Smiles does not need to inform or request our authorization to establish partnerships.  We may establish partnerships outside the air transportation industry as long as such partnerships do not involve miles or benefits accumulation in a frequent flyer program other than the Smiles program.

The 20-year Operating Agreement will be automatically renewed for successive five-year periods if neither party objects at least two years prior to its expiration.  If a party is given notice of non-renewal, it may terminate the Operating Agreement early by providing written notification to the other party six months prior to the termination date.

We pay Smiles a monthly fee for managing our frequent flyer program. This fee will be adjusted on each anniversary of the Operating Agreement in accordance with our gross monthly miles purchases.  For 2013, the management fee will be 6.0% of gross miles sales.  After 2013, this fee will remain between 3.5% and 6.0%, depending on our gross miles purchases.

Miles and Tickets Purchase Agreement

On December 28, 2012, we entered into a miles and tickets purchase agreement with Smiles, or the Miles and Tickets Purchase Agreement, that establishes the terms and conditions of our purchases of miles and our sales of tickets.

In order to govern pricing and availability of reward tickets and satisfy customer demand, the agreement establishes three seating classes: standard, commercial and promotional for ticketing purposes. 

• Standard seats:  Pricing will take into account the variation of the economic cost of the fare over the last 12 months and the characteristics of each route. The economic cost is equivalent to the sum of (i) the opportunity cost of not selling a ticket to a traveler when the flight is full – or displacement; (ii) the opportunity cost of a passenger redeeming a reward ticket who would have purchased the ticket using cash, had he or she not had available miles – or dilution; and (iii) the direct cost that we incur in transporting an additional passenger on a given flight – or marginal cost.  The availability of standard seating on planes is limited and controlled by us, although Smiles is assured a minimum aggregate number of standard seats out of total seats on all flights.
• Commercial seats:  Pricing is subject to the same price and/or discount applied by us to third parties (subject to thej conditions and characteristics of each product). The availability of commercial seats on flights is unrestricted, but limited to the capacity of the flight, pursuant to applicable restrictions.
• Promotional seats:  Pricing is determined by an established discount table agreed upon by us and Smiles on a case-by-case basis, which may be revised, suspended or revoked at any time at our discretion. There is no minimum availability obligation for promotional seats. 

The price that we pay for miles will be calculated based on the economic cost specified above, minus a portion of the breakage rate, which is the expected percentage of miles that will expire without being redeemed.

Pursuant to the Miles and Tickets Purchase Agreement, any material change to our miles accumulation policy must be discussed in advance by a loyalty committee whose members will be appointed by Smiles and us, proportionally. Smiles must notify us of material changes to miles redemption policy relating to reward tickets and hold discussions of such changes in the loyalty committee.  The loyalty committee will be an advisory committee with no decision-making power.

Smiles may sell miles directly to its clients, subject to certain limits on miles sold per client and per period, minimum prices and the length of redemption periods.

The 20-year Miles and Tickets Purchase Agreement will be automatically renewed for successive five-year periods if neither party objects at least two years prior to its expiration.  If a party is given notice of non-renewal, it may terminate the agreement early by providing written notification to the other party six months prior to the termination date.

The parties will annually review the contract’s compliance conditions according to certain parameters established in the agreement, and may amend these conditions in order to reestablish the originally agreed-upon economic balance.  In extraordinary circumstances, the parties may also amend the agreement in the event of significant changes to (i) the economic cost of flights (including changes in the average occupancy rate of our flights or ticket prices); (ii) our destinations; or (iii) applicable law or regulation.

Back Office Services Agreement

On December 28, 2012, we entered into a back office services agreement with Smiles, or the Back Office Services Agreement, that contains the terms, conditions and levels of certain services to be provided to Smiles by us. These services will be provided in connection with certain back office activities including controllership, accounting, internal controls and auditing, finance, information technology, call center, human resources, inventory and legal matters.

The three-year Back Office Services Agreement will be automatically renewed for successive three-year periods if neither party objects 12 months prior to its expiration. Smiles may terminate portions of the Back Office Services Agreement at any time by providing prior written notice to us.

Corporate Governance

We will amend Smiles’ by-laws to provide that certain related party transactions will require the approval of an independent committee or all members of its board of directors. These related party transactions include: amendments to the Operational Agreement or the Miles and Tickets Purchase Agreement and certain advance ticket purchases, among other transactions.

Industry Overview

Since air transportation has historically been affordable only to the higher income segment of Brazil’s population, resulting in a comparatively low level of air travel, we believe that a low-cost low-fare business model has the potential to significantly increase the use of air transportation in Brazil.  According to ICAO, Brazil is the third largest domestic aviation market in the world and, according to ANAC, there were 92 million domestic enplanements and 9.1 million international enplanements on Brazilian carriers in Brazil in 2012, out of a total population of approximately 195 million, according to IBGE.  In contrast, according to the U.S. Department of Transportation, the United States had 650 million domestic enplanements and 99 million international enplanements in 2012, out of a total population of approximately 315 million, based on the latest U.S. census estimates.

The business travel segment is the largest component of Brazilian air transportation demand and the most profitable in the market. According to company data, business travel represented around 70% of the its total demand for domestic air travel in 2012, which we believe is significantly higher than the business travel portion of domestic air travel in the global aviation sector.  According to the latest data collected by ANAC, flights between Rio de Janeiro and São Paulo accounted for 6.2% of all domestic passengers in 2010.  The ten busiest routes accounted for 22.2% of all domestic air passengers in 2010, while the ten busiest airports accounted for 70% and 73% of all domestic passenger traffic through INFRAERO airports in terms of arrivals and departures in 2011 and 2010, respectively.

In light of economic growth, the consumer domestic market (A, B and C classes) has significantly increased in the last years, from 66 million in 2003 to more than 105 million in 2012, according to FGV and IBGE. Due to increased passenger volume, in addition to the upcoming Soccer Confederations Cup (2013), World Cup (2014) and Summer Olympic Games (2016) in Brazil, domestic airport infrastructure will require substantial improvements.

In 2009, CONAC proposed to the Brazilian government a change to the regulatory limit of foreign ownership in Brazilian airline companies from 20% to 49% or higher, however, we are unable to anticipate if and when there will be a final decision on the matter.

In August 2011, the Brazilian government privatized the new Natal airport, which will have its construction completed and further operation by the winners of the privatization auction. In February 2012, the Brazilian government privatized the Guarulhos, Brasília and Campinas international airports, which will be operated by the winners of the privatization auction for periods of 20 to 30 years In December 2012, the Brazilian government announced its intention to privatize the Galeão (in Rio de Janeiro) and Confins (Belo Horizonte) airports by September 2013, and other airports are also expected to be privatized in the near future.  See “−Regulation of the Brazilian Civil Aviation Market−Airport Infrastructure” below.

Brazilian Civil Aviation Market Evolution

Since 1970, Brazil has for the most part experienced stable growth in revenue passenger kilometers.  From 1970 to 2009, domestic revenue passenger kilometers grew at a compound annual rate of 8.9%. In the past 40 years, the domestic market generally experienced year-over-year growth in revenue passenger kilometers except in times of significant economic or political distress, such as the petroleum crisis in the 1970s, the Brazilian sovereign debt crisis in the early 1980s and the economic and political distress in Brazil in the early 1990s.

From 2000 to 2012, the compound annual growth rate in industry passenger traffic, in terms of domestic revenue passenger kilometers, was 10.8%, versus a compound annual growth rate in available industry domestic capacity, in terms of available seat kilometers, of 8.8% . Domestic industry load factors, calculated as revenue passenger kilometers divided by available seat kilometers, averaged 65.4% over the same period.  The table below shows the figures of domestic industry passenger traffic and available capacity for the periods indicated:

________________

Source:  ANAC, Dados Comparativos Avançados.

Note:        In October 2010, ANAC changed its calculation method for monthly traffic information and republished information for periods since January 2009. All operating data for 2009 and thereafter reflects the new methodology, whereas information for 2008 was calculated pursuant to the old methodology and may not be fully comparable. According to ANAC, the changes were designed to align data with the concepts adopted by the ICAO. The change was necessary because Brazil has joined the ICAO’s statistical program and supplies the latter’s database with several industry data. Changes in the methodology refer to the calculation of ASK (seat supply) and the classification of domestic legs in international flights, which are now considered to be part of the domestic market.

The 2012 traffic figures reflect the industry’s current trend of controlling domestic supply through the main airlines, in response to the new cost level, as well as the sluggish growth of Brazil’s economy.

In 2010, Brazil was the third largest market in domestic revenue passenger kilometers and according to ANAC, in 2011, the Brazilian aviation industry showed the strongest market growth in the world. According to IATA, global domestic air travel markets expanded 4% in 2012 in terms of RPK; China led global domestic markets growth, followed by Brazil in second place.

Regulation of the Brazilian Civil Aviation Market

The Brazilian Aviation Authorities and Regulation Overview

Air transportation services are considered a public service and are subject to extensive regulation and monitoring by CONAC and ANAC.  Air transportation services are also regulated by the Brazilian Federal Constitution and the Brazilian Aeronautical Code.  The Brazilian civil air transportation system is controlled by several authorities.  ANAC is responsible for the regulation of the airlines, whereas DECEA is responsible for airspace control and INFRAERO is responsible for airport administration.

The following chart illustrates the main regulatory bodies, their responsibilities and reporting lines within the Brazilian governmental structure.

In March 2011, the SAC (Secretaria de Aviação Civil) was created to supervise civil aviation in Brazil. The Civil Aviation Secretary oversees ANAC and INFRAERO and reports directly to the Brazilian President. SAC is also responsible for implementation of the airport infrastructure concession plan and the development of strategic planning for civil aviation.

In August 2011, the National Commission of Airport Authorities (Comissão Nacional de Autoridades Aeroportuárias) or CONAERO, was created as a commission of SAC to coordinate the different entities and public agencies related to airports.  This commission shall have a normative role in the search for efficiency and security in airports operations.

CONAERO is composed by representatives of the following entities: (i) SAC, which chairs the commission; (ii) Department of Administration of the Presidency; (iii) Agriculture, Livestock and Supplies Ministry; (iv) Defense Ministry; (v) Finance Ministry; (vi) Justice Ministry; (vii) Planning, Budget and Administration Ministry; (viii) Health Ministry; and (ix) ANAC.

ANAC is currently responsible for guiding, planning, stimulating and supporting the activities of public and private civil aviation companies in Brazil, and also regulates flying operations generally and economic issues affecting air transportation, including matters relating to air safety, certification and fitness, insurance, consumer protection and competitive practices.

The Department of Air Space Control (Departamento de Controle do Espaço Aéreo), or DECEA, reports indirectly to the Brazilian Minister of Defense which is responsible for planning, administrating and controlling activities related to airspace, aeronautical telecommunications and technology.  This includes approving and overseeing the implementation of equipment as well as of navigation, meteorological and radar systems.  The DECEA also controls and supervises the Brazilian Airspace Control System.

INFRAERO, a state-controlled corporation reporting to the Civil Aviation Secretary, is in charge of managing, operating and controlling federal airports, including control towers and airport safety operations.  See “Airport Infrastructure” below.

CONAC is an advisory body of the President of Brazil and its upper level advisory board is composed of the Minister of Defense, the Minister of Foreign Affairs, the Minister of Treasury, the Minister of Development, Industry and International Trade, the Minister of Tourism, the Minister Chief of the Civil Cabinet, the Minister of Planning, Budget and Management, the Minister of Justice, the Minister of Transportation and the Commandant of the Air Force. CONAC has the authority to establish national civil aviation policies that may be adopted and enforced by the High Command of Aeronautics and by ANAC.  CONAC establishes guidelines relating to the proper representation of Brazil in conventions, treaties and other actions related to international air transportation, airport infrastructure, the granting of supplemental funds to be used for the benefit of airlines and airports based on strategic, economic or tourism-related aspects, the coordination of civil aviation, air safety, the granting of air routes and concessions, as well as permission for the provision of commercial air transportation services.

The Brazilian Aeronautical Code sets forth the main rules and regulations relating to airport infrastructure and operation, flight safety and protection, airline certification, lease structuring, burdening, disposal, registration and licensing of aircraft; crew training; concessions, inspection and control of airlines; public and private air carrier services; civil liability of airlines; and penalties in case of infringements.

In February 2009, the Brazilian government approved the new Civil Aviation National Policy (Política Nacional de Aviação Civil), or PNAC.  Although the PNAC does not establish any immediate measure, it contains the main guidelines for the national civil aviation system.  It encourages the Ministry of Defense, CONAC and ANAC to issue regulations on strategic matters such as safety, competition, environmental, and consumer issues, as well as to inspect, review and evaluate the activities of all operating companies.

The Brazilian government recognized and ratified, and must comply with, the Warsaw Convention of 1929, the Chicago Convention of 1944, and the Geneva Convention of 1948, the three leading international conventions relating to worldwide commercial air transportation activities.

Route Rights

Domestic routes.  For the granting of new routes and changes to existing ones, ANAC evaluates the actual capacity of the airport infrastructure where such route is or would be operated.  In addition, route frequencies are granted subject to the condition that they are operated on a frequent basis.  Any airline’s route frequency rights may be terminated if the airline (a) fails to begin operation of a given route for a period exceeding 15 days, (b) fails to maintain at least 75% of flights provided for in its air transportation schedule (Horário de Transporte Aéreo), or HOTRAN, for any 90-day period or (c) suspends its operation for a period exceeding 30 days.  ANAC approval of new routes or changes to existing routes is given in the course of an administrative procedure and requires no changes to existing concession agreements.

Once routes are granted, they must be immediately reflected in the HOTRAN, which is the official schedule report of all routes that an airline can operate.  The HOTRAN provides not only for the routes but also the times of arrival at and departure from certain airports, none of which may be changed without the prior consent of ANAC.  According to Brazilian laws and regulations, an airline cannot sell, assign or transfer its routes to another airline.

International routes.  In general, requests for new international routes, or changes to existing routes, must be filed by each interested Brazilian airline that has been previously qualified by ANAC to provide international services, with the SRI (International Relations Superintendence of ANAC), which, based on the provisions of the applicable bilateral agreement and general policies of the Brazilian aviation authorities, will submit a non-binding recommendation to ANAC’s president, who will decide on approval of the request.  International route rights for all countries, as well as the corresponding transit rights, derive from bilateral air transport agreements negotiated between Brazil and foreign governments.  Under such agreements, each government grants to the other the right to designate one or more of its domestic airlines to operate scheduled service between certain destinations in each country.  Airlines are only entitled to apply for new international routes when they are made available under these agreements.  For the granting of new routes and changes to existing ones, ANAC has the authority to approve Brazilian airlines to operate new routes, subject to the airline having filed studies satisfactory to ANAC demonstrating the technical and financial viability of such routes and fulfilling certain conditions in respect of the concession for such routes.  Any airline’s international route frequency rights may be terminated if the airline fails to maintain at least 80% of flights provided for in its air transportation schedule HOTRAN for any 180-day period or suspends its operation for a period exceeding 180 days.

In 2010, ANAC approved the deregulation of international airfares for flights departing from Brazil to the U.S. and Europe, gradually removing the prior minimum fares. Also in 2010, CONAC approved the continuity of bilateral agreements providing for open skies policies with other South American countries and a new open skies policy with the United States.  In March 2011, Brazil also signed an open skies agreement with Europe. The agreements with the United States and Europe are expected to be in operation by 2015 and 2014, respectively.

Slots Policy

Domestic.  Under Brazilian law, a domestic slot is a concession of ANAC, which is reflected in the airline’s HOTRAN.  Each HOTRAN represents the authorization for an airline to depart from and arrive at specific airports within a predetermined timeframe.  Such period of time is known as an “airport slot” and provides that an airline can operate at the specific airport at the times established in the HOTRAN.  An airline must request an additional slot from ANAC with a minimum of two months’ prior notice.

Congonhas airport in the city of São Paulo is a “coordinated” airport, where slots must be allocated to an airline company before it may begin operations there.  Although it is difficult to obtain a slot in Congonhas airport, on March 8, 2010, ANAC reallocated 202 idle Congonhas’ slots. When the capacity at the airport increases and more slots become available, 20% of those slots must be distributed to new entrants who will have a preference to their assignment.  The remaining slots will be allocated among other airline companies already in operation at Congonhas, including us.  The Santos-Dumont airport in Rio de Janeiro, a highly utilized airport with half-hourly shuttle flights between São Paulo and Rio de Janeiro, is also a coordinated airport, with certain slot restrictions.  Several other Brazilian airports, including Brasília’s International Airport and São Paulo’s International Airport in Guarulhos, have limited their number of slots per day due to airport infrastructure limitations.

ANAC has imposed schedule restrictions on several Brazilian airports from which we operate.  Operating restrictions, including the prohibition of international flights’ operations and the prohibition of civil aircraft’s operation after 11:00 p.m. and before 6:00 a.m., were imposed for Congonhas Airport, one of the busiest Brazilian airports and the most important airport for our operations.  No assurance can be given that these or other government measures will not have a material adverse effect on our business and results of operations.

CONAC has taken certain measures to minimize recent technical and operational problems at São Paulo’s airports, including the redistribution of air traffic from Congonhas Airport to the International Airport in Guarulhos. CONAC has also mentioned its intention to adjust tariffs for the use of busy airport hubs to encourage further redistribution of air traffic.

In the last quarter of 2008, ANAC proposed a new regulation for the allocation of slots to domestic airlines.  This regulation governs the manner of allocation of slots, by organizing rotations among the concessionaires, determining the procedures for registration, qualification, judgment and homologation of a request for slot concessions in coordinated airports.  Additionally, such regulation also establishes the rules permitting transfers of slots between concessionaires.  ANAC’s resolution has not yet been released.

Also, in 2008, ANAC enacted a regulation providing that the minimum ground time for aircraft between landing and take-off must be 40 minutes at São Paulo’s International Airport in Guarulhos, the international airport of Rio de Janeiro (Galeão) and at Brasília’s airports, and 30 minutes at all other Brazilian airports.  This regulation negatively affected our ability to increase aircraft utilization by minimizing turnaround times between flights.

In February 2013, ANAC announced a series of public hearings to discuss proposed changes to rules governing the allocation of slots at Brazilian airports, which would consider operational efficiency (punctuality and regularity data) as the main determinant for the allocation of slots.

Also in February 2013, the Civil Aviation Secretary, or SAC, announced a new proposal focused specifically on slot distribution rules at Congonhas airport. Current rules governing the allocation of slots at Congonhas Airport, which favor us, require that 80% of new slots are assigned to airlines already operating in that airport. SAC’s proposal alters current regulations by taking into account operational efficiency as a principal determinant for slot allocation at Congonhas airport, as well as domestic market (main cities) and regional market share as complementary factors. Neither ANAC’s nor SAC’s proposal had been approved as of the date of this document. See “Item 3. Key Information—D. Risk Factors—Changes to Brazilian rules regarding slots distribution, fare restrictions and fees associated with civil aviation may adversely affect our business and results of operations.”

Airport Infrastructure

INFRAERO, a state-controlled corporation, is in charge of managing, operating and controlling federal airports, including control towers and airport safety operations.

Smaller, regional airports may belong to states or municipalities within Brazil and, in such cases, are often managed by local governmental entities.  At most important Brazilian airports, INFRAERO performs safety and security activities, including passenger and baggage screening, cargo security measures and airport security.

The use of areas within federal airports, such as hangars and check-in counters, is subject to a concession by INFRAERO.  If there is more than one applicant for the use of a specific airport area, INFRAERO may conduct a public bidding process for the granting of the concession.

We have renewable concessions with terms varying from one to five years from INFRAERO to use and operate all of our facilities at each of the major airports that we serve.  Our concession agreements for our terminals’ passenger service facilities, which include check-in counters and ticket offices, operations support areas and baggage service offices, contain provisions for periodic adjustments of the lease rates and the extension of the concession term.

Of the 63 Brazilian airports managed by INFRAERO at the end of 2012, approximately 30 were receiving infrastructure investments and upgrades.  The airport upgrade plan does not require contributions or investments by the Brazilian airlines and is not expected to be accompanied by increases in landing fees or passenger taxes on air travel.

Until 2010, landing and navigation fees charged in Brazilian airports were similar in all airports independent of whether they were busy or not. In 2011, the Brazilian government increased landing and navigation fees at the busiest airports as compared to less busy airports and at peak hours.

In August 2011, the Brazilian government privatized the new Natal airport, which will have its construction completed and further operation by the winners of the privatization auction. In February 2012, the Brazilian government privatized the Guarulhos, Brasília and Campinas international airports, which will be operated by the winners of the privatization auction for periods of 20 to 30 years;

The airports auctioned were:

Source: SAC

These airports represented approximately 30% of total Brazilian passengers transported in 2012, including domestic and international traffic, according to ANAC.

In December 2012, the Brazilian government announced its intention to privatize the Galeão (in Rio de Janeiro) and Confins (Belo Horizonte) airports by September 2013, and other airports are also expected to be privatized in the near future.

Concession for Air Transportation Services

According to the Brazilian Federal Constitution, the Brazilian government is responsible for public services related to airspace as well as airport infrastructure, and may provide these services directly or through third parties under concessions or authorizations.  According to the Brazilian Aeronautical Code and regulations issued by CONAC, the application for a concession to operate regular air transportation services is subject to a license granted by ANAC to operate an airline and to explore regular air transportation services.  The applicant is required by ANAC to have met certain economic, financial, technical, operational and administrative requirements in order to be granted such license.  Additionally, a concession applicant must be an entity incorporated in Brazil, duly registered with the Brazilian Aeronautical Registry (Registro Aeronáutico Brasileiro), or RAB, must have a valid airline operating certificate (Certificado de Homologação de Empresa de Transporte Aéreo), or CHETA, and must also comply with certain ownership restrictions.  See “—Restrictions to the Ownership of Shares Issued by Concessionaires of Air Transportation Services.”  The ANAC has the authority to revoke a concession for failure by the airline to comply with the terms of the Brazilian Aeronautical Code, the complementary laws and regulations and the terms of the concession agreement.

Our concession was granted on January 2, 2001 by the High Command of Aeronautics of the Ministry of Defense.  The concession agreement can be terminated if, among other things, we fail to meet specified service levels, cease operations or declare bankruptcy.

The Brazilian Aeronautical Code and the regulations issued by CONAC and ANAC do not expressly provide for public bidding processes and currently it is not necessary to conduct public bidding processes prior to granting of concessions for the operation of air transportation services.  Due to the intense growth of the civil aviation sector, this rule may be changed by the government, in order to allow more competition or to achieve other political purposes.

Import of Aircraft into Brazil

The import of civil or commercial aircraft into Brazil is subject to prior certification of the aircraft by ANAC.  Import authorizations usually follow the general procedures for import of goods into Brazil, after which the importer must request the registration of the aircraft with the RAB.

Registration of Aircraft

The registration of aircraft in Brazil is governed by the Brazilian Aeronautical Code, under which no aircraft is allowed to fly in Brazilian airspace, or land in or take off from Brazilian territory, without having been properly registered.  In order to be registered and continue to be registered in Brazil, an aircraft must have a certificate of registration (certificado de matrícula) and a certificate of airworthiness (certificado de aeronavegabilidade), both of which are issued by the RAB after technical inspection of the aircraft by ANAC.  A certificate of registration attributes Brazilian nationality to the aircraft and is evidence of its enrollment with the competent aviation authority.  A certificate of airworthiness is generally valid for six years from the date of ANAC’s inspection and authorizes the aircraft to fly in Brazilian airspace, subject to continuing compliance with certain technical requirements and conditions.  The registration of any aircraft may be cancelled if it is found that the aircraft is not in compliance with the requirements for registration and, in particular, if the aircraft has failed to comply with any applicable safety requirements specified by ANAC or the Brazilian Aeronautical Code.

All information relating to the contractual status of an aircraft, including purchase and sale agreements, operating leases and mortgages, must be filed with the RAB in order to provide the public with an updated record of any amendments made to the aircraft certificate of registration.

Restrictions on the Ownership of Shares Issued by Concessionaires of Air Transportation Services

According to the Brazilian Aeronautical Code, in order to be eligible for a concession for operation of regular services, the entity operating the concession must have at least 80% of its voting stock held directly or indirectly by Brazilian citizens and must have certain management positions entrusted to Brazilian citizens.  The Brazilian Aeronautical Code also imposes certain restrictions on the transfer of capital stock of concessionaires of air transportation services, such as VRG, including the following:

·         the voting shares have to be nominative and non-voting shares cannot be converted into voting shares;

·         prior approval of the Brazilian aviation authorities is required for any transfer of shares, regardless of the nationality of the investor, which results in the change of the company’s corporate control, causes the assignee to hold more than 10% of the company’s capital stock or represents more than 2% of the company’s capital stock;

·         the airline must file with ANAC, in the first month of each semester, a detailed shareholder chart including a list of shareholders, as well as a list of all share transfers effected in the preceding semester; and

·         based on its review of the airline’s shareholder chart, ANAC has the authority to subject any further transfer of shares to its prior approval.

The Registrant holds substantially all of the shares of VRG, which are public concessionaires of air transportation services in Brazil.  Under the Brazilian Aeronautical Code, the restrictions on the transfer of shares described above apply only to companies that hold concessions to provide regular air transportation services.  Therefore, the restrictions do not apply to the Registrant.

Environmental Regulation

Brazilian airlines are subject to various federal, state and municipal laws and regulations relating to the protection of the environment, including the disposal of materials and chemical substances and aircraft noise.  These laws and regulations are enforced by various governmental authorities.  The non-compliance with such laws and regulations may subject the violator to administrative and criminal sanctions, in addition to the obligation to repair or to pay damages caused to the environment and third parties.  As far as civil liabilities are concerned, Brazilian environmental laws adopt the strict and joint liability regime.  In this regard we may be liable for violations by third parties hired to dispose of our waste. Moreover, pursuant to Brazilian environmental laws and regulations, the piercing of the corporate veil of a company may occur in order to ensure enough financial resources to the recovery of damages caused against the environment.

We adopted several Environmental Management System (EMS) procedures with our suppliers and use technical audits to enforce compliance.  We exercise caution, and may reject goods and services from companies that do not meet our environmental protection parameters unless confirmation of compliance is received.

We are monitoring and analyzing the developments regarding amendments to Kyoto protocol and emissions regulations in the United States and Europe and may in the future be obliged to acquire carbon credits for the operation of our business.  No legislation on this matter has yet been enacted in Brazil.

Pending Legislation

The Brazilian congress is currently discussing a draft bill that would replace the current Brazilian Aeronautical Code (Código Brasileiro de Aeronáutica).  In general, this draft bill deals with matters related to civil aviation, including airport concessions, consumer protection, limitation of airlines’ civil liability, compulsory insurance, fines and the increase of limits to foreign ownership in voting stock of Brazilian airlines from 20% to 49% or higher.  This draft bill is still under discussion in the House of Representatives and, if approved, must be submitted for approval to the Federal Senate, before being sent for presidential approval. If the Brazilian civil aviation framework changes in the future, or ANAC implements increased restrictions, our growth plans and our business and results of operations could be adversely affected.

Aircraft Financing by Export Credit Agencies

In 2010, the Ex-Im Bank agreed on a common approach with European export-credit agencies on offering export credits for commercial aircraft.  Among other things, the new ASU sets forth minimum guarantee premium rates applicable to aircraft to be delivered on or after January 1, 2013, or under firm contracts entered into after December 31, 2010 and also changes the maximum amount that may be financed. 

In light of our current credit ratings and the introduction of the ASU, we expect our minimum guarantee premium rate applicable to aircraft delivered on or after January 1, 2013 will increase substantially from a previous rate of 4%. The Ex-Im Bank has not yet informed us if it will guarantee this increased amount to be financed, which could cause us to have to seek other more expensive financing alternatives or use our own cash resources to finance the additional amount.

Aircraft Repossession

The Cape Town treaty is an international treaty intended to standardize transactions involving movable property. The treaty creates international standards for registration of ownership, security interests (liens), leases and conditional sales contracts, and various legal remedies for default in financing agreements, including repossession and the effect of particular states’ bankruptcy laws. As of February 2012, the convention had been ratified by 50 countries, including Brazil.

C.      Organizational Structure

The Registrant is a holding company, which owns directly or indirectly shares of six subsidiaries:  (i) VRG, which also owns (ii) Webjet, (iii) Smiles, and three offshore finance subsidiaries, (iv) Gol Finance Cayman and (v) GAC Inc., which owns (iv) Sky Finance II.  VRG is the Registrant’s operating subsidiary, under which we conduct our business. Gol Finance, GAC Inc. and Sky Finance II are off-shore companies established for the purpose of facilitating cross-border general and aircraft financing transactions.

D.      Property, Plant and Equipment

Our primary corporate offices are located in two buildings in São Paulo.  Our commercial, operations, technology, finance and administrative staff is based primarily at our headquarters.  We have concessions to use other airport buildings and hangars throughout Brazil, including a part of a hangar at Congonhas airport where we perform aircraft maintenance.  As of December 31, 2012, we have 45 Boeing 737s classified as finance lease aircraft. We own a state-of-the-art Aircraft Maintenance Center in Confins, in the State of Minas Gerais.  The certification of our aircraft maintenance center authorizes airframe maintenance services for Boeing 737-300s and Boeing Next Generation 737-700 and 800s.  We have three hangars at our Aircraft Maintenance Center, with a capacity to perform maintenance on six aircraft simultaneously and painting services on one additional aircraft.  We also have room to build more hangars in the future if needed.  With our system of phased maintenance for our Boeing NG 737-700 and 737-800 aircraft fleet, we are able to perform maintenance work every day without sacrificing aircraft revenue time, and schedule preventive maintenance with more regularity and around the utilization of our aircraft, which further dilutes fixed costs.  We use the new facility for airframe heavy checks, line maintenance, aircraft painting and aircraft interior refurbishment.  See also “Item 4—Business Overview—Aircraft” and note 17 to our financial statements as of and for the year ended December 31, 2012.

ITEM 4A.     Unresolved Staff Comments

None.

ITEM 5.       Operating and Financial Review and Prospects

You should read this discussion in conjunction with our consolidated financial statements and the related notes and the other financial information included elsewhere in this annual report.

A.      Operating Results

Revenues

We derive our revenues primarily from transporting passengers on our aircraft.  In 2012, 88% of our revenues were derived from passenger fares, and the remaining 12% of our revenues were derived from ancillary revenues principally from our cargo business, which utilizes available cargo space on our passenger flights.  Nearly all of our passenger revenue and cargo revenue is denominated in reais.  Passenger revenue, including revenue from our Smiles loyalty program, is recognized either when transportation is provided or when the ticket expires unused.  Cargo revenue is recognized when transportation is provided.  Other ancillary revenue consists primarily of ticket change fees, excess baggage charges, interest on installment sales and other services.  Passenger revenues are based upon our capacity, load factor and yield.  Our capacity is measured in terms of available seat kilometers, which represents the number of seats we make available on our aircraft multiplied by the number of kilometers the seats are flown.  Load factor, or the percentage of our capacity that is actually used by paying customers, is calculated by dividing revenue passenger kilometers by available seat kilometers.  Yield is the average amount that one passenger pays to fly one kilometer.

The following table demonstrates our main operating performance indicators in 2011 and 2012:

Our revenues are net of certain taxes, including state-value added taxes, Imposto sobre Circulação de Mercadorias e Serviços, or ICMS; federal social contribution taxes, including Programa de Integração Social, or PIS; and the Contribuição Social para o Financiamento da Seguridade Social, or COFINS.  ICMS does not apply to passenger revenues.  The average rate of ICMS on cargo revenues varies by state from 4% to 12%.  As a general rule, PIS and COFINS combined are imposed at rates of 3.65% of passenger revenues.

We generate most of our revenue from ticket sales through our website, and we have one of the largest e-commerce platforms in Brazil.

ANAC and the aviation authorities of the other countries in which we operate may influence our ability to generate revenues.  In Brazil, ANAC approves the concession of slots, entry of new companies, launch of new routes, increases in route frequencies and lease or acquisition of new aircraft.  Our ability to grow and increase revenues is dependent on receiving approval for new routes, increased frequencies and additional aircraft from ANAC.

Operating Expenses

We seek to lower our operating expenses by operating a standardized fleet with a single-class of service, having one of the newest fleets in the industry, utilizing our aircraft efficiently, using and encouraging low-cost ticket sales and distribution processes. The main components of operating expenses include those related to aircraft fuel, aircraft rent, aircraft maintenance, sales and marketing, and salaries, wages and benefits provided to employees, including provisions for our profit sharing plan.

Our aircraft fuel expenses are higher than those of low-cost airlines in the United States and Europe because the Brazilian infrastructure to produce, transport and store fuel is expensive and underdeveloped, especially in the north and northeast regions of the country.  In addition, taxes applicable on the sale of jet fuel are high and are passed along to us.  Our aircraft fuel expenses are variable and fluctuate based on global oil prices.  Since global oil prices are U.S. dollar-based, our aircraft fuel costs are also linked to fluctuations in the exchange rate of the real  versus the U.S. dollar.  In 2012, fuel expenses represented 41.5% of our total operating expenses, as compared to 39.3% in 2011.  In 2008, the price of West Texas Intermediate crude oil, a benchmark widely used for crude oil prices that is measured in barrels and quoted in U.S. dollars, varied significantly, reaching an all-time high of US$145 in March 2008 and decreasing to US$44.60 per barrel at the end of 2008.  At year-end 2009, the price per barrel was US$79.36 and increased to US$91.40 at the end of 2010. At year end 2011 the price per barrel was US$98.83 and at year end 2012 the price per barrel was US$91.82.  We currently enter into short-term arrangements to hedge against increases in oil prices and foreign exchange fluctuations.

Our aircraft rent expenses are in U.S. dollars and have increased in line with the expansion of our operations.  We use short-term arrangements to hedge against exchange rate exposure related to our lease payment obligations.  In addition, leases for seven of our aircraft are subject to floating-rate payment obligations that are based on fluctuations in international interest rates.  We currently have hedging policies in place to manage our interest rate exposure.

Our maintenance, material and repair expenses consist of light (line) and scheduled heavy (structural) maintenance of our aircraft.  Line maintenance and repair expenses are charged to operating expenses as incurred.  Structural maintenance for aircraft leased under finance leases is capitalized and amortized over the life of the maintenance cycle.  Once the maintenance is performed, accrual does not commence again until the maintenance status is reduced below the return condition.  Since the average age of our operating fleet was 7.2 years for 125 Boeing 737-700/800 aircraft at December 31, 2012, and most of the parts on our aircraft are under multi-year warranties, our aircraft have required a low level of maintenance and therefore we have incurred low maintenance expenses.  Our aircraft are covered by warranties that have an average term of 48 months for products and parts and 12 years for structural components.  The warranties on the aircraft we received in 2012 under our firm purchase order with Boeing will start expiring in 2016.  Thus, with regard to the accounting for aircraft maintenance and repair costs, our current and past results of operations may not be indicative of future results.  Our Aircraft Maintenance Center in Confins, in the State of Minas Gerais is certificated for the maintenance services for Boeing 737-300s and Boeing Next Generation 737-700 and 800s.  We currently use the new facility for airframe heavy checks, line maintenance, aircraft painting and aircraft interior refurbishment.  We believe that we have an advantage compared to industry peers in maintenance, materials and repairs expenses due to the use of Boeing 737 Next Generation aircraft that allows for phased maintenance as described in this annual report, and due to the internalization of our maintenance.  We believe that this advantage will remain in the future.

Our sales and marketing expenses include commissions paid to travel agents, fees paid for our own and third-party reservation systems and agents, fees paid to credit card companies and advertising.  Our distribution costs are lower than those of other airlines in Brazil on a per available seat kilometer basis because a higher proportion of our customers purchase tickets from us directly through our website instead of through traditional distribution channels, such as ticket offices, and we have comparatively fewer sales made through higher cost global distribution systems.  We generated 88.8% of our consolidated sales through our website and API systems in the year ended December 31, 2012 and 88.5% in 2011, including internet sales through travel agents.  For these reasons, we believe that we have an advantage compared to industry peers in sales and marketing expenses and expect this advantage will remain in the future.

Salaries, wages and benefits paid to our employees include annual cost of living adjustments and provisions made for our profit sharing plan.  We have no seniority-related increases in these costs due to our salary structure.  We believe that we have an advantage compared to industry peers in salaries, wages and benefits expenses due to generally lower labor costs in Brazil as compared to other countries. In addition, recently, the government reduced the airlines payroll tax effective as of 2013. We believe that these advantages will continue to exist in the future.

Aircraft and traffic servicing expenses include ground handling and the cost of airport facilities.  Other operating expenses consist of general and administrative expenses, purchased services, equipment rentals, passenger refreshments, communication costs, supplies and professional fees.

Webjet

On November 23, 2012, we began the process of winding up Webjet’s activities and the consequent discontinuation of its brand. The first step adopted was to cease all Webjet flights. Webjet’s passengers were absorbed by us and we became responsible for all air transport and associated services for these passengers. We estimate the return of all 13 Webjet’s Boeing 737-300 aircraft under operating lease agreements by the end of 2013. As a result, we recognized additional costs of approximately R$140 million in the fourth quarter of 2012 in connection with Webjet’s wind up. However, we expect that these measures will improve operational efficiency as of 2013.

Brazilian Economic Environment

As a company with most of its operations currently in Brazil, we are affected by general economic conditions in the country.  While our growth since 2001 has been primarily driven by our expansion into new markets and increased flight frequencies, we have also been affected by macroeconomic conditions in Brazil.  In 2012, we shrank 3.8% in terms of revenue passenger kilometers in the domestic market (considering Webjet pro-forma data for 2011).  This decrease was primarily due to a 5.4% domestic capacity reduction in the same period in response to Brazil’s economic slowdown in 2012 and to a new industry-wide cost structure in place since 2011, caused by higher fuel costs, new exchange rate levels and additional airport fees.  We believe the rate of growth in Brazil is important in determining our future growth capacity and our results of operations.

Our results of operations are materially affected by currency fluctuations.  The vast majority of our revenues are denominated in reais  (with a small portion of our revenues from our international flights being denominated in other currencies), but a significant part of our operating expenses are either payable in or affected by the U.S. dollar, such as our aircraft operating lease payments, related maintenance reserves and deposits, and jet fuel expenses.  Based on a statistical analysis of our first eight years of operations, we believe that our revenues are highly correlated with the real/U.S. dollar exchange rate and jet fuel prices because real  fluctuations and increases in jet fuel prices are generally incorporated into the fare structures of Brazilian airlines.  In 2012, 54% of our operating expenses (including aircraft fuel) are denominated in, or linked to, U.S. dollars and therefore vary with the real/U.S. dollar exchange rate.  We believe that our foreign exchange and fuel hedging programs partially protect us against short-term swings in the real/U.S. dollar exchange rate and jet fuel prices.  Overall, we believe that the combination of our revenue stream, with its correlation to movements in the real/U.S. dollar exchange rate, and short-term hedges on the U.S. dollar-linked portion of our expenses, will mitigate the adverse effect on our operating expenses of abrupt movements in the real/ U.S. dollar exchange rate.

Inflation has also had, and may continue to have, effects on our financial condition and results of operations.  In 2012, 79% of our operating expenses (excluding aircraft fuel) were denominated in reais, and the suppliers and service providers of these expense items generally attempt to increase their prices to reflect Brazilian inflation.

The following table shows data for real GDP growth, inflation, interest rates, the U.S. dollar exchange rate and crude oil prices for and as of the periods indicated.

_________

Sources:  Fundação Getúlio Vargas, the Central Bank and Bloomberg

(1)   Inflation (IGP-M) is the general market price index measured by the Fundação Getúlio Vargas.

(2)   Inflation (IPCA) is a broad consumer price index measured by the Instituto Brasileiro de Geografia e Estatística.

(3)   The CDI rate is average of inter-bank overnight rates in Brazil (accumulated for period-end month, annualized).

(4)   Three-month U.S. dollar LIBOR rate as of the last date of the period.  The LIBOR rate is the London inter-bank offer rate.

(5)   Represents the average of the exchange rates on the last day of each month during the period.

Critical Accounting Policies

The preparation of our consolidated financial statements in conformity with IFRS requires our management to adopt accounting policies and make estimates and judgments to develop amounts reported in our consolidated financial statements and related notes.  We strive to maintain a process to review the application of our accounting policies and to evaluate the appropriateness of the estimates that are required to prepare our consolidated financial statements.  We believe that our estimates and judgments are reasonable; however, actual results and the timing of recognition of such amounts could differ from those estimates.  In addition, estimates routinely require adjustment based on changing circumstances and the receipt of new or better information.

Critical accounting policies and estimates are those that are reflective of significant judgments and uncertainties, and potentially result in materially different outcomes under different assumptions and conditions.  For a discussion of these and other accounting policies, see Note 2 to our consolidated financial statements.

Property,  Plant and Equipment.  Property, plant and equipment, including rotable parts, are recorded at cost and are depreciated to estimated residual values over their estimated useful lives using the straight-line method.  Each component of property, plant and equipment that has a cost that is significant in relation to the overall cost of the item is depreciated separately.  Aircraft and engine spares acquired on the introduction or expansion of a fleet, as well as rotable spares purchased separately, are carried as fixed assets and generally depreciated in line with the fleet to which they relate.  Pre-delivery deposits refer to prepayments made based on the agreements entered into with Boeing Company for the purchase of Boeing 737-800 Next Generation aircraft and includes interest and finance charges incurred during the manufacture of aircraft and the leasehold improvements.

Under IAS 16 “Property, Plant and Equipment,” major engine overhauls including replacement spares and labor costs, are treated as a separate asset component with the cost capitalized and depreciated over the period to the next major overhaul.  All other replacement spares and costs relating to maintenance of fleet assets are charged to the income statement on consumption or as incurred.  Interest costs incurred and exchange variation on debts that fund progress payments on assets under construction, including pre-delivery deposits to acquire new aircraft, are capitalized and included as part of the cost of the assets through the earlier of the date of completion or aircraft delivery.  Exchange differences are capitalized to the extent that they are regarded as an adjustment to interest costs.

In estimating the lives and expected residual values of our aircraft, we have primarily relied upon actual experience with the same or similar types of aircraft and recommendations from Boeing, the manufacturer of our aircraft.  Aircraft estimated useful lives are based on the number of “cycles” flown (one-take-off and landing).  We have made a conversion of cycles into years based on both our historical and anticipated future utilization of the aircraft.  Subsequent revisions to these estimates, which can be significant, could be caused by changes to our maintenance program, changes in utilization of the aircraft (actual cycles during a given period of time), governmental regulations related to aging aircraft, and changing market prices of new and used aircraft of the same or similar types.  We evaluate estimates and assumptions each reporting period and, when warranted, adjust these estimates and assumptions.  These adjustments are accounted for on a prospective basis through depreciation and amortization expense, as required by IFRS. 

We evaluate annually whether there is an indication that our property, plant and equipment may be impaired.  Factors that would indicate potential impairment may include, but are not limited to, significant decreases in the market value of the long-lived asset(s), a significant change in the long-lived asset’s physical condition, and operating or cash flow losses associated with the use of the long-lived assets.  As of December 31, 2010, no impairment on property, plant and equipment assets was recognized. As of December 31, 2011, we recognized an amount of R$50.7 million of impairment of fixed assets, for  more details see note 17 to our financial statements. As of December 31, 2012, no impairment on property, plant and equipment assets was recognized.

Lease accounting.  Aircraft lease agreements are accounted for as either operating or capital leases (finance leases).  When the risks and benefits of the lease are transferred to us, as lessee, the lease is classified as a capital lease.  Capital leases are accounted for as an acquisition of the asset through a financing, with the aircraft recorded as a fixed asset and a corresponding liability recorded as a debt.  Capital leases are recorded based on the lesser of the fair value of the aircraft or the present value of the minimum lease payments, discounted at an implicit interest rate, when it is clearly identified in the lease agreement, or market interest rate.  The aircraft is depreciated through the lesser of its useful life or the lease term.  Interest expense is recognized through the effective interest rate method, based on the implicit interest rate of the lease.  Lease agreements that do not transfer the risks and benefits to us are classified as operating leases.  Operating lease payments are accounted for as a rent, and the lease expense is recognized when incurred through the straight line method.

Sale-lease back transactions that result in a subsequent operating lease have different accounting treatments depending on the fair value of the asset , the price and the cost of the sale.  If the fair value of the asset  is less than its carrying amount, the difference is immediately recognized as a loss.  When the sale gives rise to a gain it is recognized up to the fair value, with the excess deferred and amortized throughout the term of the lease.  When the sale results in a loss and the carrying amount is not greater than fair value, the loss is deferred if compensated by future lease payments.  If the carrying amount is greater than fair value it is written down to fair value, and if there is still a loss it is deferred if compensated by future lease payments.

Lease accounting is critical for us because it requires an extensive analysis of the lease agreements in order to classify and measure the transactions in our financial statements and significantly impacts our financial position and results of operations.  Changes in the terms of our outstanding lease agreements and the terms of future lease agreements may impact the accounting for the lease transactions and our future financial position and results of operations.

Goodwill and Intangible Assets.  We have allocated goodwill and intangible assets with indefinite lives acquired through business combinations for the purposes of impairment testing to a single cash-generating unit, the operating subsidiary VRG.  Goodwill is tested for impairment annually by comparing the carrying amount to the recoverable amount of the cash-generating unit level that has been measured on the basis of its value-in-use, by applying cash flow projections in the functional currency based on our approved business plan covering a five-year period followed by the long-term growth rate of 3.5%.  The pre-tax discount rate applied to the cash flow projections is 11.63%. Considerable judgment is necessary to evaluate the impact of operating and macroeconomic changes to estimate future cash flows and to measure the recoverable amount.  Assumptions in our impairment evaluations are consistent with internal projections and operating plans.  Airport operating rights acquired as part of the acquisition of VRG and Webjet were capitalized at fair value at that date and are not amortized.  Those rights are considered to have indefinite useful lives due to several factors and considerations, including requirements for necessary permits to operate within Brazil and limited slot availability in the most important airports in terms of traffic volume.  VRG tradenames were acquired as part of the VRG acquisition and were capitalized at fair value at that date.  The tradenames are considered to have an indefinite useful life (and are not amortized) due to several factors and considerations.  The carrying values of the airport operating rights and tradenames are reviewed for impairment at each reporting date and are subject to impairment testing when events or changes in circumstances indicate that carrying values may not be recoverable.  Costs related to the purchase or development of computer software that is separable from an item of related hardware is capitalized separately and amortized over a period not exceeding five years on a straight-line basis.  The carrying value of these intangibles is reviewed for impairment if events or changes in circumstances indicate the carrying value may not be recoverable.  We assess at each balance sheet date whether intangibles with indefinite useful lives are impaired using discounted cash flow analyses, which considers the creditworthiness of the issuer of the security, as further described in Note 18 to our financial statements. As of December 31, 2011 and 2010 no impairment on goodwill and other intangible assets was recognized. As of December 31, 2012 we recognized an impairment of R$56.8 million on VARIG tradename, we evaluated it under the new perspectives of its use and, therefore, the future economic benefit generated by it, as further described in Note 18 to our financial statements.

Business Combination. We have accounted for business combinations using the acquisition method. The cost of an acquisition is measured as the sum of the consideration transferred, based on the fair value on the acquisition date. Costs directly attributable to the acquisition are accounted for as expenses when incurred. The assets acquired and liabilities assumed were measured at fair value, classified and allocated according to the contractual terms, economic circumstances and relevant conditions on the acquisition date. Goodwill is measured as the excess of consideration transferred in relation to net assets acquired at fair value. If the consideration is lower than the fair value of net assets acquired, the difference should be recognized as a gain in the income statement. After initial recognition, goodwill is measured at cost less any accumulated impairment losses. On October 3, 2011, we acquired the total capital of Webjet, through our subsidiary VRG, for an adjusted price of R$43.4 million. This acquisition was accounted by the acquisition method in accordance with IFRS 3R and the gain on bargain purchase of R$88.4 million was recorded in our income statement for the year ended December 31, 2011 under other operating revenues (expenses), not taxable as it is related to a permanent difference, according to the Brazilian transition tax regime (Regime Tributário de Transição – RTT). On October 2, 2012, we completed the valuation of assets and liabilities acquired, including intangible assets, as well as the effect of deferred taxes and concluded that no further adjustments to the provisional allocation held on October 3, 2011 were needed. The gain on bargain purchase generated by the acquisition of Webjet is related to the recognition of the value of intangible assets not recorded on Webjet’s financial statements, represented by rights of use of slots in the Guarulhos and Santos Dumont airports, which are two of the busiest airports in Brazil, and which value is a consequence of the significant demand growth anticipated in the next few years and our expectation for recovery of operation profitability in these airports. In the context of winding up of Webjet’s operations, we have retained all of Webjet’s capacity in these airports.

Derivative Financial Instruments.  We account for derivative financial instruments in accordance with IAS 39.  In executing our risk management program, management uses a variety of financial instruments to protect against sharp changes in market prices and to mitigate the volatility of its expenditures related to these prices.  We do not hold or issue derivative financial instruments for speculative purposes.

Derivative financial instruments are initially recognized at fair value and subsequently the change in fair value is recorded in profit or loss, unless the derivative meets the strict criteria for cash flow hedge accounting.

For hedge accounting purposes, according to IAS 39, the hedge instrument is classified as a: (i) cash flow hedge when it protects against exposure to fluctuations in cash flows that are attributable to a particular risk associated with an asset or liability recognized regarding an operation that is highly likely to occur or to an exchange rate risk for an unrecognized firm commitment, and (ii) fair value hedge when it protects from the results of a change in the fair value of a recognized liability, or a part thereof, that could be attributed to exchange risk.

At the beginning of a hedge transaction, we designate and formally document the item covered by the hedge, as well as the objective of the hedge and the risk policy strategy.  Documentation includes identification of the hedge instrument, the item or transaction to be protected, the nature of the risk to be hedged and how the entity will determine the effectiveness of the hedge instrument in offsetting exposure to variations in the fair value of the item covered or the cash flows attributable to the risk covered.  The purpose is that such hedge instruments will be effective in offsetting the changes in fair value or cash flows and they are constantly appraised to determine if they really have been effective throughout the entire period for which they have been designated.

Amounts classified in equity are transferred to profit or loss each period in which the hedged transaction affects profit or loss.  If the hedged item is the cost of a non-financial asset, the amounts classified in equity are transferred to the initial carrying amount of the non-financial asset.

If the forecast transaction or the firm commitment is no longer expected to occur, amounts previously recognized in equity are transferred to profit or loss.  If the designation as a hedge is revoked, amounts previously recognized in equity are recognized in profit or loss.

We measure quarterly the effectiveness of the hedge instruments in offsetting changes in prices.  Derivative financial instruments are effective if they offset between 80% and 125% of the changes in price of the item for which the hedge has been contracted.  Any gain or loss resulting from changes in the fair value of the derivative financial instruments during the quarter in which they are not qualified for hedge accounting, as well as the ineffective portion of the instruments designated for hedge accounting are recognized as other finance income (expenses).

Aircraft maintenance and repair costs.  Our aircraft lease agreements specifically provide that we, as lessee, are responsible for maintenance of the leased aircraft and engines, and we must meet specified airframe and engine return conditions upon lease expiration.  Under certain of our existing lease agreements, we pay maintenance deposits to aircraft and engine lessors that are to be applied to future maintenance events.  These deposits are calculated based on a performance measure, such as flight hours or cycles, and are available for reimbursement to us upon the completion of the maintenance of the leased aircraft.  If there are sufficient funds on deposit to reimburse us for our maintenance costs, such funds are returned to us.  The maintenance deposits paid under our lease agreements do not transfer either the obligation to maintain the aircraft or the cost risk associated with the maintenance activities to the aircraft lessor.  In addition, we maintain the right to select any third-party maintenance provider or to perform such services in-house.  Therefore, we record these amounts as a deposit on our balance sheet and recognize maintenance expense when the underlying maintenance is performed, in accordance with our maintenance accounting policy.  Certain of our lease agreements provide that excess deposits at the end of the lease term are not refundable to us.  Such excess could occur if the amounts ultimately expended for the maintenance events were less than the amounts on deposit.  Any excess amounts held by the lessor or retained by the lessor upon the expiration of the lease, which are not expected to be significant, would be recognized as additional aircraft rental expense at the time it is no longer probable that such amounts will be used for maintenance for which they were deposited.  The amount of aircraft and engine maintenance deposits expected to be utilized in the next twelve months is classified in current assets.

We follow IAS 16 - "Property, Plant and Equipment", and perform the capitalization of the costs relating to engine overhauls. This practice establishes that costs on major maintenance (including replacement parts and labor) should be capitalized only when there is an extension of the estimated useful life of the engine. Such costs are capitalized and depreciated until the next stop for major maintenance. The expense recognized directly in the income statement refers to maintenance costs of other aircraft components or even maintenance of engines that do not extend their useful life.

During the quarter ended June 30, 2011 we changed the classification of maintenance deposits from a non-monetary to a monetary asset, as since 2011 transactions involving these assets occurred substantially through receipts of funds, according to renegotiations conducted with the lessors. These transactions are recognized as exchange variation expense.

In addition, we have agreements with some lessors to replace the deposits by letters of credit, enabling us to use these funds in other expenditures relating to our lease agreements.

At the inception of the leases, our initial estimates of the maintenance expenses are equal to or in excess of the amounts required to be deposited.  This demonstrates it is probable the amounts will be utilized for the maintenance for which they are to be deposited and the likelihood of an impairment of the balance is remote.  There has been no impairment of our maintenance deposits.

A summary of activity in the Aircraft and Engine Maintenance Deposits is as follows:

Our fleet plan contemplates the replacement of some operating leases with finance lease agreements, in line with our plan to further standardize our fleet with Boeing Next Generation 737-700 and 737-800 aircraft.  Due to the performance advantages of Boeing Next Generation 737-700 and 737-800 aircraft, we believe these aircraft should sustain attractive market valuations over the next years.  We therefore intend to increase the number of finance leases.  In light of this trend, our maintenance deposit accounts should decrease in the near term, subject to significant potential variations, including the actual cost of maintenance, the timing of the maintenance, aircraft cycles and potential new maintenance requirements.

Revenue Recognition. Passenger revenue is recognized when transportation is provided.  Tickets sold but not yet used are recorded as advance ticket sales that represent primarily deferred revenue for tickets sold for future travel dates. We recognize a portion of advance ticket sales as revenue based on historical data relating to the percentage of tickets sold that are not going to be used prior to the expiration date (“breakage”). The balance of deferred revenue is then reviewed on a monthly basis based on actual tickets that have expired and adjusted when necessary.

Mileage Program. Since the acquisition of VRG, we operate a frequent flyer program (Smiles) that provides travel and other awards to members based on accumulated mileage credits.  The obligations assumed under the Smiles  program were valued at the acquisition date at estimated fair value that represents the estimated price the Company would pay to a third party to assume the obligation for miles expected to be redeemed under the Smiles  Program. The fair value of mileage credits, net of estimated non-use of miles (breakage) is determined by the weighted average according to (i) the average amount charged per seat by VRG to airlines that participate in the loyalty program divided by the average amount of miles required to issue a ticket using miles and (ii) the average sale price of miles sold to airlines that participate in the loyalty program Smiles. This fair value is updated every six months.

Share-Based Payments.  We measure the fair value of equity-settled transactions with employees at the grant date using the Black & Scholes valuation model.  The resulting amount, as adjusted for forfeitures is charged to income over the period in which the options vest.  At each balance sheet date before vesting, the cumulative expense is calculated; representing the extent to which the vesting period has expired and management’s best estimate of the number of equity instruments that will ultimately vest.  The change in cumulative expense since the previous balance sheet date is recognized in the income statement prospectively over the remaining vesting period of the instrument.

Provisions.  Provisions are recognized when we have a present obligation (legal or constructive) as a result of a past event, it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation and a reliable estimate can be made of the amount of the obligation.  Where we expect some or all of a provision to be reimbursed, for example under an insurance contract, the reimbursement is recognized as a separate asset when the reimbursement is virtually certain.  The expense relating to any provision is presented in profit or loss net of any reimbursement.  If the effect of the time value of money is material, provisions are discounted using a current pre-tax rate that reflects, where appropriate, the risks specific to the liability.  Where discounting is used, the increase in the provision due to the passage of time is recognized as a finance cost.

Aircraft and engines return provision: in aircraft operating leases, we are contractually required to return the equipment in a predefined level of operational capability, as a result we recognize a provision based on the aircraft return costs as set forth in the agreement. The aircraft’s return provisions costs are estimated based on expenditures incurred in aircraft reconfiguration (interior and exterior), license and technical certification, painting, and other costs, according to the return agreement. Engine return provisions are estimated based on an evaluation and minimum contractual conditions that the equipment should be returned to the lessor, considering not only the historical costs incurred, but also the equipment conditions at the time of the evaluation.

Onerous contracts provision: present obligations resulting from onerous contracts are recognized and measured as provisions. An onerous contract is entered into when unavoidable costs to meet the obligations assumed under the contract exceed the economic benefits that are expected to be received over the contract term. The provision for onerous contracts refers to losses on operating lease agreements of out-of-service aircraft. The provision corresponds to the net amount between the present value of the installments of the respective leases and the expected revenue from the use of such aircraft through operation or subleases, where applicable. The assumptions used are estimates and the settlement of these transactions may result in amounts significantly different from those recorded.

Insurance provision: we maintain insurance coverage in amounts we consider adequate to cover potential claims, in light of the nature of business, and in accordance with contractual and regulatory requirements.

Others provisions: are substantially related to lawsuits and are provisioned for losses considered probable in our judgment, related to labor, civil and tax matters. Tax lawsuits are presented under tax obligations.

Deferred taxes.  Deferred taxes are calculated based on tax losses, temporary differences arising on differences between tax bases and carrying amounts for financial reporting purposes of our assets and liabilities.

Even though unused tax losses and temporary differences have no expiration date in Brazil, deferred tax assets are recorded when there is evidence that future taxable profit will be available to use such tax credits.  We record our deferred tax assets based on projections for future taxable profits, which considers a number of assumptions for revenue increases, for operating costs such as jet fuel prices, leasing expenses and etc. Our business plan is revised annually in order to reevaluate the amounts to be recorded as deferred tax assets.

Deferred taxes is a critical accounting policy for us because it requires a number of assumptions and is based on our best estimate of our projections related to future taxable profit.  In addition, because the preparation of our business plan is subject to a variety of market conditions, the results of our operations may vary significantly from our projections and as such, the amounts recorded as deferred tax assets may be impacted significantly in the future.

In December, 31, 2012, tax credits arising from tax losses carryforwards and negative social contribution basis were valued based on the reasoned expected generation of future taxable income of the parent company and its subsidiaries, subject to legal limitations.

Projected future taxable income on tax losses carryforwards and negative social contribution are prepared based on business plans reviewed annually and approved by our Board of Directors. Such projections reflect changes in the economic scenario, market changes and also decisions of the Administration, including the following assumptions: (i) in the long-term scenario we will keep the strategy adopted in 2012 of rationalization of domestic supply. Based on this strategy, we have observed an increase load factors in line with a flat yield ratio; (ii) we continue with our ancillary revenue growth plan, such as the sale of special seats and buy-on-board; (iii) concerning the costs, the main change was the new level of personnel expenditure reached in 2012. Layoffs that occurred during the year, became the basis of the projection for a more efficient operation, contributing to manage costs; and (iv) our plans include the arrival of new aircraft Boeing 737-MAX, announced in 2012. From 2018 the new aircraft will contribute to an even more efficient operation in terms of fuel consumption.

Results of Operations

Year 2012 Compared to Year 2011

In 2012, our total revenue passenger kilometers (RPK) increased by 5.6% as compared to 2011, mainly due to the consolidation of Webjet’s fleet and route network since the last quarter of 2011. On the other hand, Gol’s total RPK (including Webjet figures) decreased by 3.8% as compared to 2011, mainly due to the slowing of Brazil’s economy as measured by year-over-year GDP growth.

Demand in Brazil, as measured in revenue passenger kilometers (RPK), increased by 2.7% in 2012 when compared to 2011. International demand in revenue passenger kilometers was stable in the same period and capacity in Brazil, as measured by available seat kilometers (ASK), increased by 2.7%. These modest growth figures reflect a reduction of flights in our route network, an industry-wide response to new cost levels, sluggish Brazilian GDP growth and a changing focus towards route profitability. In the fourth quarter of 2012, domestic supply fell by 5.1% as compared to the same period in 2011. The fourth quarter, traditionally a period of increased travel, experienced its first decrease in supply since 2003. 

During the course of 2012, we concentrated on adapting our operations to the current macroeconomic scenario, becoming a more efficient airline by adjusting domestic capacity and focusing on established, profitable routes. In the second half of 2012, this strategy began to yield results, such as a 4.0 percentage points increase in load factor and a 6.0% increase in passenger revenue per available seat kilometer (PRASK) over second half of 2011 figures. Also in the second half of 2012, our pro-forma domestic supply fell by 6.5% as compared to the same period in 2011 (including Webjet’s 2011 figures), contributing to a 4.0 percentage points increase in the domestic load factor.

In 2012, our domestic supply decreased by 5.4% as compared to 2011 (including Webjet’s 2011 pro-forma figures). Domestic demand (considering Webjet’s figures for 2011) decreased by 3.8%, due to our strategy of increased route efficiency implemented during 2012. In the international market, our demand and capacity decreased by 2.6% and 5.0%, respectively, primarily due to the discontinuation of flights to Bogotá, Colombia, and the winding down of international charter flights using Boeing 767 aircraft, partially offset by new international routes to Santo Domingo (Dominican Republic), Miami and Orlando.

In the same period, our total demand and capacity (considering Webjet’s figures for 2011) experienced decreases of 3.7% and 5.4%, respectively, primarily in response to new industry cost levels and sluggish Brazilian GDP growth.

The table below presents certain data from our results of operations for the periods indicated:

Operating Revenue

Operating revenue increased by 7.5%, from R$7,539.3 million in 2011 to R$8,103.6 million in 2012:

Passenger operating revenues increased by 6.7% from R$6,713.0 million in 2011 to R$7,160.0 million in 2012. This variation was primarily due to the consolidation of Webjet’s net revenue in 2012, 1.8 percentage points increase in load factors and 1.0% increase in yields between the periods. Consolidated passenger revenue per ASK increased by 3.6% year-over-year.

Cargo and other revenue or “ancillary revenue” (cargo, flight booking, excess baggage, on board sales, etc.) increased by 14.2% from R$826.3 million in 2011 to R$943.6 million in 2012, accounting for 11.6% of net revenue in 2012, primarily due to: (i) the consolidation of Webjet’s ancillary revenue; (ii) the 17.5% increase in revenue from fees for flight rebooking, no-show, passenger services and ticket cancellations; (iii) the 27% increase in excess baggage revenue; and (iv) an increase of approximately 2% in cargo revenue, which accounted for approximately 4% of the Company’s total gross revenue. Consolidated ancillary revenue per ASK increased by 11.0% year-over-year.

On a unit basis, revenue per available seat kilometer (RASK) increased by 4.5% from R$15.0 cents in 2011 to R$15.6 cents in 2012.

Operating Expenses

Operating expenses increased 15.7% from R$7,783.8 million in 2011 to R$9,009.2 million in 2012, primarily due to: (i) the consolidation of Webjet’s operating expenses; (ii) additional expenses of R$140 million related to the winding up of Webjet’s activities recorded in the fourth quarter of 2012; (iii) impairment of R$56.8 million on VARIG tradename.; (iv) consistently high jet fuel prices during the course of 2012 (in reais approximately 18% greater than 2011); (v) a 17% average depreciation of the real  against the U.S. dollar; and (iv) increased landing and navigation assistance fees resulting from new fee calculation methodologies introduced by Infraero.

 The following table sets forth our total operating expenses for the periods indicated:

On a per unit basis, our operating expense per available seat kilometer (CASK) increased by 12.5% from R$15.45 cents in 2011 to R$17.38 cents in 2012, mainly due to R$124 million of additional provisions (see note 11 to our financial statements included elsewhere herein) and other additional expenses related to logistics and passenger re-accommodation due to the end of Webjet’s Operations (for a total of R$140 million), impairment of R$56.8 million on VARIG tradename, higher CASK from fuel, aircraft rent, landing fees, and depreciation and amortization. The increase in CASK was partially offset by the 2.9% growth in supply (ASK). Operating expenses per available seat kilometer excluding fuel (CASK Ex-fuel) increased 8.4% from R$9.38 cents in 2011 to R$10.16 cents in 2012, mainly due to the extra costs related to the winding up of Webjet’s activities, impairment on VARIG tradename, higher expenses with aircraft rent, landing fees, and depreciation and amortization.

The following table sets forth certain of our operating expenses per available seat kilometer as a percentage of total operating expenses, for the periods indicated.

The following table sets forth certain of our operating expenses per available seat kilometer for the periods indicated: