Flying High

After facing headwinds in the past few quarters due to slowdown, the aviation industry is seeing a revival with demand growing faster than supply. But will this enable the industry to continue generating superior returns in future? Rajesh Naidu finds out

NDIA’S aviation sector has come a full circle. After the opening up of the industry and the phase of growth, competition and consolidation, airlines, which have racked up losses, are now seeing a revival with demand growing faster than supply. Strong economic growth, range-bound fuel prices and the return of pricing power signal an uptrend for the industry.
The fortunes of the aviation industry are linked closely to the state of the economy. And with growth being more or less broadbased, business as well as leisure travels are expected to pick up further, a far cry from the scenario a few months ago when several airlines had piled up huge losses and in some cases payment defaults.
What would be weighing high on investors’ mind are the prospects for the industry and whether airlines would be able to sustain profits. Can airlines still create value for its investors? The ET Intelligence Group did a reality check on the industry and found out that the answers were reassuring.
COPING WITH CONSTRAINTS
Airline companies have learnt the hard way, the lessons to optimise profits during the past five years. The huge investment that the industry attracted, thanks to the India growth story, led to excess capacity, which resulted in a price war. During the five year period — FY04-FY08 — the industry players faced consistent losses or profits, which were erratic and generated mainly in the form of nonbusiness income. This was followed by the financial meltdown.
In this situation, it was natural to see a shake-out. Over the past two years, Jet Airways acquired Air Sahara, while Kingfisher took over Air Deccan. The government went on to merge Air India and Indian Airlines. A few other insignificant players faded out of the scene. However, this process of consolidation did not have a deep impact apart from an increase in market share, as both the topline and bottomline of airlines continued to stagnate.
Airlines companies — especially the fullservice carriers — also realised that in order to boost their topline, it was crucial to focus on two areas. First, apply the brakes on capacity addition and secondly giving primacy to a low-cost carrier (LCC) service to create a hybrid business model.
LCC IN VOGUE
LCC has now become an integral part of the business model of Indian airlines. It is a key positive for airlines’ future, as the industry remains highly cyclical. The cheaper ticket price of an LCC ensures a better passenger load factor and in turn a good topline for many airlines. Among the cost-conscious Indian travellers, an LCC player, such as SpiceJet, Go Air and IndiGo would remain the first preference. Most often, it is only when they fail to obtain a seat in a no-frills airline, do they opt for full-service carriers. Realising this, purely full-service carriers, such as Jet Airways and Kingfisher Airlines, also started LCC services. Jet Airways launched JetLite and Jet Konnect services, while Kingfisher Airlines kicked off its service — Kingfisher Red. These initiatives that work on low costs have helped enhance their revenues and earnings tremendously. A rapid adoption of the LCC model has enabled Jet Airways to report consistent profits during the past three consecutive quarters. In contrast, Kingfisher, which was late in adopting this, continues to report losses and now has a negative net worth.
On the sidelines, pure LCC players, such as SpiceJet, IndiGo and GoAir, continue to thrive with the three of them commanding close to 34% of the market share today. In fact, SpiceJet was the first among the three listed players to bounce back after the slowdown and post a net profit for FY10. A rising debt burden and interest outgo have weighed down these full-service carriers. In FY10 alone, both Jet Airways and Kingfisher Airways paid almost 1,100 crore each towards interest costs, while carrying a pile of debt several times their equity base. As a result, such players chose to adopt a leaseback model to acquire new aircraft without adding to the debt burden. Take for instance, Jet Airways. The company now has 60% owned and 40% leased aircraft. It has dryleased three long-haul Boeing 777-300ERs to Thai Airways and THY Turkish Airlines.
HOW THE THINGS HAVE CHANGED
With growth back on the fast track and passenger traffic growing, there is not much of a change which is expected on the supply side. During the first nine months of 2010, the airlines passenger growth stood at a strong 20% according to the latest data published by the DGCA. This has greatly improved the load factor of the industry. From an average of 65% two years ago, the load factor has risen to 80%. And considering the upcoming holiday season, this is likely to improve even further. Better occupancy is also helping airline players increase their ticket tariffs, or revenues per passenger per kilometre. The improvement in sentiment has prompted Jet Airways to convert 60% of its flights to fullservice mode. Crude oil prices, that had wreaked havoc on the industry couple of years ago due to high volatility, have remained range-bound over the past one year. This has helped the three listed players to a large extent. The benign situation is expected to continue for the next 12-15 months, thanks to high inventories and spare production capacity in OPEC countries.
The buoyancy in the stock markets will also encourage some of the debt-laden airlines to raise funds through equity offerings. There have been media reports on QIP of Jet Airways, which, if it completes, could help it reduce its debt burden, bring down its interest outgo and improve balance sheet. There are no further capacity additions planned for the next few months as companies, such as Jet Airways and Air India, have deferred some of their earlier orders for new aircraft. At present, there are around 380 aircraft in the industry and analysts estimate if the continuing passenger growth continues within 15to 18%, around 150 aircraft can be accommodated over next five years.
VALUATIONS
On the valuation front, Jet Airways India is, at present, trading at an EV/EBIDTA of around 12 times on a trailing basis. Based on expected numbers for the FY11, the multiple will improve to around 8.5-9. The flexibility in its business model — when demand weakens it pushes its LCC services JetLite and Jet Konnect and leveraging its full-service carrier when demand improves — will be a key advantage. Investors could hold onto the company’s stock as of now.
SpiceJet, on the other hand, is trading at an EV/EBIDTA of around 12 times. The company’s successful LCC business model and a better balance sheet justify the premium. The challenges before Kingfisher appear daunting at present and apart from just the improvement in operational environment, a debt restructuring or equity infusion appear inevitable to get the company fully on track.
WHAT’S NEXT…
The coming two quarters would be good for all airlines companies considering the fact that the December and the March quarters are holiday seasons. This will ensure their yields grow and capacity utilisation improves. This will be reflected in improving numbers in their quarterly financial results and makes the industry attractive for investors. Another LCC IndiGo Airlines is also contemplating approaching capital markets for fund raising. While the industry has also been lobbying with the government to allow foreign airlines to pick up minority stake in domestic airlines, any development on these matters also will be positive news for the industry.

With inputs from Ramkrishna Kashelkar