The Current State of Indian Aviation

www.braviacapital.com Hong Kong • New York • London • Istanbul • Delhi

The Current State of Indian Aviation

What Indian airlines need to do to get back in the black

September 2012

Abstract This paper examines the current aviation market in India. We have attempted to outline the key challenges facing the Indian aviation sector. This is done by an overview of the Low Cost Carrier (LCC) model and compared to India’s LCC model to highlight structural differences. An overview of the Full Service Aviation (FSA) model is compared to India’s FSA model. With this background of the Indian aviation market in perspective, the steps necessary to bring the Indian airlines back into profitability are suggested.


The Current Environment In 1994, India’s Air Corporation Act of 1953 was repealed giving private airlines the opportunity to schedule serviced flights. Following this repeal, a host of new airlines have sprung up to meet India’s need for air travel.

Source data: Worldbank

India still remains significantly underpenetrated in the civil aviation sector: at present there are only 0.52 departures per 1,000 people in India and less than 2% of Indians travel by air each year. However, this creates a huge opportunity as India has 1.2 billion people and a rising and upwardly mobile middle class.

Source: Centre for Aviation and Indian DGCA

Domestic passenger traffic crossed the 60.7 million mark at the end of 20111. Domestic passenger growth year-on-year was 17.2%, in-line with the year-to-year increase expected from a rapidly growing emerging economy with a relatively small passenger base. India’s domestic passenger growth is estimated to increase by roughly 15% per year out through 2020. This growth rate, if sustained, would put domestic air travel at over 210 million domestic passengers per year by 2020. Despite these favorable demographics, the Indian carriers have failed to translate the demand for air travel into profits. For the year ended March 2012, 5 out of the 6 major airlines in India were loss making. This paper examines the root causes for the profitability shortfall, and lays out the groundwork to understand

1 Centre for Aviation

where India’s aviation market is heading. We are proposing a discussion as to what needs to be accomplished to put the Indian airlines back into the black. Challenges in the Indian Market

In spite of the robust demand for air travel, the following factors have driven the airlines into losses:

1) Inability of the Indian airlines to achieve cost parity with their global peers;

2) Imbalance between the supply and demand for aircraft in India;

3) Lack of differentiation within the domestic carriers leading to intense competition;

4) Management decisions not to implement standard risk management practices;

5) Price wars among the various players including India’s flag carrier; and

6) High levels of leverage of the carriers. 1) It is important that the Indian airlines achieve cost parity with the rest of the world to ensure the viability of the industry. The higher costs from taxes and infrastructure bottlenecks have not been able to be passed along to customers, leading to an erosion of the Airline’s balance sheets, which in turn raises the operating costs of running their business. For example, aviation fuel tax (AFT) is a major concern for the airlines. The Indian airlines pay almost 60%2 more for fuel than their counterparts in international markets.

Aviation fuel has several layers of tax. The first layer is the refinery transfer price to buy the fuel. The refiner gets an import parity add-on, which was originally designed to ensure the oil companies earned at least a specified amount. The oil marketing companies then add another layer of costs known as the ‘marking add-on’. Next, the Indian Government applies levies on the fuel and the local states then apply a state sales tax on the fuel. The Indian states set their own sales tax rates, which range between 4% and 30%. The average sales tax is between 22% and 26%. The net result is a huge fuel expense burden for the airlines operating in India.

2 centreforaviation.com


Source: Frost & Sullivan

Infrastructure bottlenecks also create additional costs for the airlines. For example, the re-built Mumbai airport was engineered to handle a normal annual passenger load of 29 million passengers per year. According to the Airport Authority of India, the total number of passengers handled for the 2011-12 year was 30.75 million and this is set to increase meaningfully going forward. The capacity overload becomes particularly acute during peak travel times, i.e. morning and evening rush hour. In addition to the physical constraints of the airport there are personnel constraints in the aviation industry. India requires 2,200 qualified air traffic controllers and currently only has 1,7003. Since customers consider an airline’s punctuality metric when choosing carriers, the airlines have been modifying the scheduled block hours. The times reported are often longer than the Directorate General of Civil Aviation’s standardized block flight times. This creates havoc for the air traffic controllers, who then find that aircraft are requesting to land outside the predicted slots. These types of inefficiencies often exasperate delays. The DGCA’s enforcement of standardized block times has been most pronounced on congested airport routes, such as routes serving Mumbai. As many as 45 flights across all airlines had to rework their schedule times to Mumbai airport4. Jet Airways needed to reschedule 20 flights and Kingfisher needed to reschedule 14 flights. GoAir and Indigo had to reschedule 7 and 4 flights respectively.

3 CAPA Centre for Aviation 4 times of India (April 23rd, 2011)

Other short haul routes such as the Chennai – Bangalore route also had a wide range of block times, by as much as 44%5 ,as shown in the table above. According to officials, of the 7,255 flights operated at the Mumbai airport in June a total of 1,162 were delayed6. The leading cause of delay was airport congestion. This suggests that the real on-time punctuality metric for the Mumbai airport was around 84%. The infrastructure bottlenecks translate into higher costs for the airlines.

In addition to these regulatory and structural constraints, India also has one of the highest borrowing costs globally. According to IMF data, the cost of borrowing in India was approximately 12%7. Since investors demand a risk premium to compensate them for the added risks of investing in the aviation business, so the real cost of capital is even higher. Adding additional layers of inefficiencies and taxes on top of these costs creates a challenging environment for the Indian businesses. 2) The number of aircraft in India competing for passengers has continued to outpace the rate of new passengers.


The chart above shows the demand for aircraft, as measured by the revenue per passenger kilometer, has grown rapidly in India; however, the supply, as measured by the available seat kilometer, has grown faster than demand. Additionally, over the last decade the load factors for all domestic airline companies have remained below industry normal load factors of 80% or higher.

5 economic times (November 14, 2011) 6 dnaindia.com (August 13th 2012) 7 Assumes 5 year tenor



The break-even load factor is the percent of seats that need to be filled at the airline yield rate to break-even. When we look at Jet Airways, we can see their break-even rate is at or above 80%, while their actual seat factor is consistently below this needed hurdle rate. The airlines have not allowed the demand for air travel to catch up before adding new aircraft to their fleet; this in turn causes them to drop fares to increase load factors, causing the competition to do the same in an ongoing negative spiral. 3) The lack of differentiation between the domestic carriers has forced them to compete on price. Following on from the point above, the airlines have shown that they are willing to price fares below their breakeven rate, compounding losses for the sector.

Source Spice Jet 2010 and 2011 AR

The above chart shows that the percentage of Indian travel classified as low cost has continued to increase from 1% in 2004 to an amazing 70% and growing as of 2011. Price competition has accelerated as the legacy carriers and new airlines in the industry have rushed to embrace the low cost carrier model. Hence, there are multiple airlines competing on price that have no cost advantage in this space. 4) Management has not implemented standard risk practices in the airline industry. In 2007 the Federal Reserve Bank of India removed its ban on fuel hedging,

yet airlines have not started hedging their fuel exposure in a meaningful way. Fuel costs are often the airlines largest cost at 40 - 50% of operating costs and are notoriously unpredictable. Since Indian airlines have not embraced hedging as a way to mitigate risk, they expose themselves to swings in commodity and foreign exchange prices, over which they have no control. By embracing prudent risk management the airlines could structure their balance sheet to protect owners equity from the vagaries of the market. The hedged balance sheet removes the basis risk caused by currency exposures and fuel costs. It is important to point out that most airplane leases are payable in a foreign currency and that fuel costs are typically payable in U.S. dollars. This means that the weakening Rupee increases operating costs. The current practice of the major Indian airlines is to leave these risks unhedged.

Source: Google.Finance

The chart above shows that the U.S. dollar has continued to strengthen against the Rupee over the prior year.

Source: indexmundi

Simultaneously we can see that the (ATF) fuel price has continued to increase from the 2009 (relative) lows. Hence, both risks have been allowed to eat away the industry profits; weakening the airlines financial position.


5) The participants in the industry, including India’s flag carrier, are engaging in a price war. Many of the private carriers boast better performance metrics, and have expanded rapidly at the expense of Air India. In an attempt to regain market share, some of the players, including Air India, have often aggressively priced tickets below their breakeven rates. Air India has relied on the fact that it is a subsidiary of the Indian Government to restructure obligations on more favorable terms, and for further equity infusions by the Indian Government. The propping up of Air India, at the expense of the Indian taxpayer, enables Air India to continue its predatory pricing initiative. The net result of the Government backstop is the destabilization of the Indian airline industry, and a loss of confidence by potential investors. The market share amongst the Indian carriers remains fragmented, and continues to realign amongst the players. The long-term secular growth of aviation in India should allow a handful of players to grow and thrive.

Source: (DGCA) Directorate General of Civil Aviation The most recent market share report from the Directorate General of Civil Aviation shows that IndiGo has 27%, Jet Airways has 20%, and both Air India and Spicejet have 18% on domestic routes. Kingfisher has accelerated their flight cuts and reduced capacity to deal with challenges on their balance sheet. Hence Kingfisher has dropped from first place last year down to last place at only 3% in the rankings. Kingfisher has been particularly hard hit. Kingfisher had expanded rapidly after a merger with Air Deccan (a low cost airline) in 2007, followed by an expansion in their aircraft order book of A380’s. As India’s aviation woes began to accelerate, Kingfisher took on a heavy debt load, which essentially funded losses incurred while gaining market share. 6) The Indian airlines tend to have a high level of financial leverage. The financial leverage appears, both on and off their balance sheets. The use of the sale and leaseback method for acquiring planes is common globally, but Indian airlines have generally followed this

route without regard to a sensible structuring of the capital stack. A sale and leaseback is the selling of an aircraft to a third party who then leases the plane back to the company. The leasing company earns a return for taking the market risk of the aircraft as well as providing the leasing service to the company. This method is perfectly prudent when the goal of the airline is to maintain their financial flexibility, or manage other risks associated with heavy capital investments. For example, in Jet Airway’s fourth quarter 2012 earning results conference call, KG Vishwanath pointed out that Jet Airways was planning on selling 10 -12 airplanes in 2013; the sale would be structured as a sale leaseback to try to raise USD $200 million. Management’s reasoning for selling these assets into the sale and leaseback structure was to pay down expensive Indian debt. However given their Auditors statement that Jet Airways did not have the ability to raise cash, it is possible that the temptation for management to use these proceeds for operating needs will likely happen. Given the dire losses being taken in the Indian aviation industry it is important to scrutinize if the airlines are turning to the sale and leaseback method as an earnings/loss smoothing mechanism at the shareholders expense8. Next we will summarize the success factors implemented by low cost carriers worldwide; this will give an overview of how low cost carriers create a competitive advantage. Understanding these success factors will create a baseline to then turn our attention to analyzing the Indian low cost carriers.

The Low Cost Carrier Model The low cost carrier model pioneered by Southwest Airlines has been successfully copied around the world. This year, Southwest celebrated their 40th anniversary, and reported their 39th consecutive annual profit; giving strong support to the claim that the LCC model can work.

8 Bangaloraviation


According to Air Transport World, Ryanair was the most profitable low cost carrier as of July 2011. IndiGo Airlines was the only Indian airline to claim a spot on the ranking. The champions of the low cost model have slight regional variations on a standard playbook, which is as follows:

1) Have a uniform fleet of aircraft to drive cost efficiencies;

2) Point-to-point system instead of a hub and spoke model to increase aircraft utilization rates;

3) Reduce costs by utilizing second tier airports; 4) Integrate online bookings and drive down their

(POS) point of sales costs; 5) Have best in class customer service metrics;

and 6) Maintain a lean and nimble organization.

1) The low cost carriers have a uniform fleet of aircraft. The carrier is able to squeeze cost efficiencies and operational efficiencies by developing domain expertise with one aircraft. The uniform fleet ensures that pilots can be easily rotated. The Maintenance costs can be cut down because there are fewer heads needed to support multiple aircraft. The LCC is also better able to negotiate with the manufacturer on airplane costs and peripheral services. 2) By utilizing a point-to-point system instead of the traditional hub and spoke model, the low cost carriers are able to achieve better utilization from their planes. The LCC is able to avoid extra costs associated with handling baggage to other planes and costly delays when the hub and spoke model gets backed up. By focusing on the point-to-point system, the carrier has better control of when planes can depart and arrive; leading to better punctuality metrics.

3) The low cost carriers utilize second tier airports to drive down costs. Utilizing a second tier airport brings significant savings and efficiencies. The LCC is able to avoid the high costs of securing a gate, which would be charged at a tier one airport. A tier two airport has less traffic, which results in a quicker turn around time. Because fuel costs are often the airlines largest cost; reducing fuel burn leads to significant savings. Busy airports can result in aircraft circling the airport while waiting for a landing slot to open. Busy airports also tend to have excessive taxiing time on the tarmac, eating up fuel. 4) The low cost carriers reduce the point-of-sales costs by utilizing online bookings. The LCC’s have invested in information technology to squeeze costs out of issuing tickets.

Source: Ryanair Annual Report

5) The top LCC’s pay particular attention to their customer service metrics, so that they are the choice carrier for their customers. By looking at Ryanair’s scorecard, it shows that they strive to measurably improve their customer performance metrics, such as punctuality and customer responsiveness. 6) The low cost carriers maintain a lean and nimble organization. Additionally, the successful LCC’s have high employee productivity. Each of these cost savings is additive, and when combined creates a competitive advantage for the LCC’s. The lower operating costs means that the companies can still earn adequate returns on invested capital, even at very compressed ticket prices. Given the LCCs ability to successfully generate profit around the world, as well as to spur demand for air travel by making it more affordable, this raises the question, what are the Indian airlines doing wrong? To answer these questions, we first compare the Indian LCC carriers to their international peer group.


India’s Low Cost Carrier Market

Source: CapitalIQ (Jet Airways, and Spicejet,. Top LLCs Ryanair, Southwest Airlines, and AirAsia)

When we compare the Indian LCC airlines to the largest foreign LCCs, we can see a dramatic difference in the volatility of their core earnings power (i.e EBIT margins). By benchmarking against the LCC standard playbook we can break out where the Indian LCC’s are falling short.

* Kingfisher Red is no longer in service Looking at India’s LCC’s by fleet, we can see that they in fact do practice building on a unified fleet to squeeze cost efficiencies. All of the Indian LCC’s, including the now out of service Kingfisher Red, have sound practices for uniform fleet management, as shown in the table above. India still remains underdeveloped in infrastructure. One of the areas where the lack of infrastructure investment shows up is in the lack of airports. The top five airports account for approximately 65%9 of all Indian air traffic.

9 DGCA

The lack of infrastructure has a direct impact on the Indian airlines ability to implement the success factors of the LCC playbook. Although the low cost carriers do utilize the point-to-point model instead of the hub and spoke method, the benefits of better aircraft utilization are not fully realized. The Indian airlines are forced to use tier 1 airports, as they do not have any alternatives. When these tier 1 airports get congested, the utilization of the planes decreases impacting performance metrics and driving up costs. The ability to utilize second tier airports is simply not available. The result of utilizing the same infrastructure means the ability to differentiate their offering becomes blurred. The customers of the LCC’s end up paying for services, which they don’t need, such as waiting lounges and other amenities. The LCC’s also end up paying for expensive gates at the airport, driving up the total cost of the service. The busy airports result in excessive fuel burn - both waiting to ground and to depart. With all of the airlines utilizing the same infrastructure, the ability for an airline to create a competitive advantage through better performance metrics such as on-time service or price differentiation becomes compromised. The lack of airports is one of the significant factors leading to intense price competition for the Indian airlines. The global LCC’s have lean and nimble organizations, and have highly efficient staff. The global LCC’s are then able to pay their staff above average wages; reducing poaching and industry turnover. Poaching of talent is a major challenge for the Indian airlines. The excessive churn of staff and rotation of the limited talent pool drives up costs for the airlines, without any corresponding efficiency gains.


The LCC Indian airlines have done a reasonable job implementing online ticketing systems. The Indian LCC airlines with primary operations in the domestic market have been compelled to engage in a price war with other airlines seeking higher market share. The rational manager would implement alterative courses of action and avoid a head on price war, however this was not the course of action pursued by the Indian airlines. A rational course of action would be to rationalize routes to avoid ruinous pricing. The airlines could have considered wet leasing aircraft of any excess capacity to earn positive cash flow on the planes, and to implement plans to compete where they can develop an advantage. Whilst a few airlines have started to embrace the idea of wet leasing their aircraft during the off season, the number of planes on wet leases is still very small. The pricing of tickets below the LCC’s break-even point is a primary reason for the airlines earning negative returns.

Source: Center for Aviation To begin to put the Indian Airlines in perspective, it is helpful to look at the load factors for the various carriers. We can see that IndiGo has the highest load factors of the all the carriers. IndiGo is a private LCC. We also can see that Kingfisher had the highest load factors of the full service carriers, and had load factors that were above many of the low cost carriers.

Source http://www.centreforaviation.com/ and CapitalIQ

To see India’s higher overall cost structure compared to the global market we can look at the Cost per ASK10. Higher costs will lead to under investment in the Indian airlines. The second detrimental effect of India’s higher cost structure is that outside competitors will continue to grow, and eventually will come into India to grow market share against weakened local players. The graph above shows that JetLite has a cost per ASK in 2011 of USD 7.19 cents. SpiceJet had a cost per ASK of USD 5.59 cents. In comparison a regional competitor, AirAsia has a cost of USD 3.96 cents per ASK and continues to grow rapidly in the region. For the LCCs that are competing domestically, we now have a clear understanding why it is difficult for them to develop a competitive advantage. For clarity, let’s define competitive advantage for a LCC. The LCC has a competitive advantage when the airline can earn above average rates of return while offering the lowest fare in the market and providing the best in class service and meeting industry metrics important to LCC customers. The second area where the Indian LCC’s compete is on the cross border (i.e. international) flights. According to the DGCA, foreign carriers currently have 65% of the international traffic in India. The reason foreign carriers have such a high percentage of business in India is due to laws enacted to protect Air India. A domestic airline requires five years of domestic operations and must have at least twenty aircraft in operations before they can apply for approval to carry passengers on international routes. Additionally Air India has had the right of first refusal on all international routes, to the detriment of other Indian private carriers. This unlevel playing field has allowed Air India to carry passengers on the most high margin international routes. The Indian Government has enacted bilateral air traffic entitlements with other countries. A bilateral agreement grants airlines reciprocal flying rights from the respective country. The foreign competitors through the use of code share agreements are able to cover routes throughout India. The international players primary competition has been Air India; therefore, the foreign competitors have gained significant market share on these routes. As the domestic Indian players begin to pass their five years of operations we expect the competition on international routes to increase. For example, in April GoAir was in talks with the Government to get its international license. The ability to offer international flights translates into an increase in utilization of their fleet by approximately 5 extra hours a day.

10 ASK is available seat kilometer


Departures on international flights have tended to be inconvenient for the Indian traveler due to curfews imposed by the foreign airports. “Of the 30 busiest airports (passenger numbers above 30 million p.a.) 18 are in North America and only 4 have curfews. The 6 in Europe all have curfews. Of the remaining 6 – all of which are in Asia – only 2 have curfews”11 The impact of the developed market curfew is that there is a disproportional amount of landing and departures into the night in India, leading to criticisms that the west has pushed their noise pollution problems onto the developing markets. If the Indian airports also implement restrictions, on evening landings for international flights, there could be a negative impact for the utilization on these aircraft. Next, we summarize the full service factors that customers are willing to pay a premium for. We show how the full service airlines create value. Then we turn our attention to understanding the outlook for full service carriers in India.

The Full Service Carrier Model A common mantra is that when low cost carriers come into a market that they take share away from the full service carriers. This is generally true; however, it is important to understand how full service carriers create value, and why they are here for the long haul. After the realignment period when the ratio of FSC/LCC normalize, the full service carriers that execute well in meeting customers needs can earn appropriate rates of return for investors and prosper. According to PWC’s 2012 experience radar, a survey of air travelers in the United States, customers were surveyed to determine what services they valued in air travel to what they were also willing to pay for these services.

11 International Civil Aviation Organization EPA paper

PWC summarized their findings into a grid. Services that were profitable to the Airlines and highly valued by the customers were labeled as “Aces”. Alternatively, Low valued and low profitably services were labels as “Folds”. The two remaining areas, “Table Stakes” and “Wild Cards”, were areas of lighter competitive advantage.

For both the leisure traveler and business traveler the area that stood out where customers were willing to pay a premium was for comfortable seating. Customers were willing to pay a premium and fly with the full service provider’s that met this criterion. For example, it was found that the average leisure traveler was willing to pay approximately 18% more for extended legroom. Both the leisure and business traveler highly valued on-time arrivals. However here it was interesting to note that this desire was not easily transferable into additional profitability for the airline. On average the business travelers were willing to pay 14% more and leisure travelers who were willing to pay approximately 2% more. Out of the approximately 600 people surveyed, both leisure and business travelers preferred purchasing a bundled package (i.e included luggage costs, and food, etc) to a-la-carte options. The average traveler was willing to pay a 9% premium for a bundled ticket. By creating the right point of sale environment the full service airlines have the chance to create a positive impression of the airline, and increase their cross sell products in a way that leads to customer loyalty and profitability for the airline. According to the PWC study, two out of three business travelers preferred fully refundable to non-refundable fares. The average business traveler was willing to pay an 18% premium for the fully refundable fare. It was also found that 8 out of 10 leisure travelers valued pro-active rebooking of flights when there were cancelations or delays. Full service providers are ideally situated to offer these services to meet customer needs. The successful full service carriers have a lean cost structure and can charge appropriately for the additional services added. The full service airlines with a bloated cost structure have needed to look critically at their


expenses, and in some cases have had to be restructured, to bring their costs back into alignment. The full service carriers meet specific needs that are not met by the low cost carriers. The management teams of the Indian carriers need to have a detailed understanding of their Aces and their Folds; based on understanding the needs in their local markets. The full service carriers who are able to provide these services and charge appropriately for them will continue to grow and prosper. We will now turn our attention to the outlook for India’s full service carriers.

India’s Full Service Carrier Model The Indian full service carriers have struggled to earn adequate returns. As mentioned previously, India’s legacy rules meant until recently only full service carriers dominated India’s aviation market. Once the regulations were amended the low cost carriers were able to take root in India.

Source: CapitalIQ (Indian Airlines, Jet Airways, and Kingfisher. Top full service carriers: Lufthansa, United Continental, Delta Airlines, and Air-Franc KLM.

Both India’s full service carriers and the representative basket of global full service carriers were hard hit heading into and through the global financial crisis. However, unlike the Indian FSC’s the global players have been able to respond and restore their core earning power to pre-crisis levels. The Indian full service carriers have had a hard time adapting to the changing landscape. Many of the Indian FSC’s have chosen to open a version of an LCC rather than to focus in on refining their FSC models. One of the downsides with a FSC running their own in house LCC is the risk of becoming a middle of the road player, which has higher average operating costs on the LCC side, and a substandard service-to-price on the full service side, leading to other competitors gaining an advantage.

The price sensitive nature of the Indian traveler means that the Indian FSC need to understand how to define their target customers. It is important that the carriers understand the needs and behaviors of their customers so that they can optimize their services offered. For example, customers in India who fly LCC often book more than four weeks in advance. Customers who traveled by a FSC often booked within a week of departure. The Indian FSC need to continue to refine their offerings to meet customers needs by offering the right product at the right price point. The demand for the FSC will grow as more and more Indians fly each year. The largest challenge for the full service providers and legacy carriers is to bring their costs under control, so that pricing for incremental add-ons meets customer expectations. In the next section we provide a road map to restore India’s aviation industry back into profitability. The Future of India’s airlines

Source: Finance.Google

The immediate concern for the troubled airlines is how to shore up their balance sheets. Currently only IndiGo is profitable out of the major Indian airlines, while Spicejet has reported a 1st quarter June 2012 profit of US $ 10 million, after a US $ 120 million annual loss as of year end March 2011. The airline Company’s woes have been reflected in their listed stock prices. The chart above shows that, between November 2010 and August 2012 that, the stock price of Kingfisher has dropped by approximately 90%, and Spicejet has dropped by approximately 62%. Given the grave state of affairs of many of the airlines, drastic action is required to create significant improvements in the industry. We now lay out these factors, when/if implemented will have the needed impact of turning the Indian aviation industry around:

1) The Indian Government needs to remove its ban on foreign direct investment by airline


companies and lift the ceiling on the percentage of investment allowed;

2) A regulatory body needs to be established that addresses predatory pricing and product dumping. The regulatory body needs to address the basic supply and demand imbalance;

3) Taxation of the airlines as well as airline costs (e.g. ATF) needs to be brought in line with global industry norms;

4) Aggressive expansion in airport construction needs to be initiated;

5) Airlines need to differentiate themselves by product offering;

6) Managers need to create the right score cards for success, such as return on invested capital and not market share; and

7) The Indian Government needs to create a fair and level playing field for the airlines to compete.

The Indian Government is reassessing its (FDI) foreign direct investment limits by foreign airlines. Currently there is a 49% cap on FDI for non-airline investors, and a ban on any investment by a FDI airline. The psychology of misjudgment suggests that investors become more risk adverse in a bear market, and more risk tolerant in a bull market.

Souce: CapitalIQ (MSCI ACWI IMI and MSCI Global IMI/Airline (Industry)

The chart above shows that the global airline index has underperformed the recovery seen in the equities market. This means that investors without domain experience in aviation will likely shy away from making such investments. Concurrently foreign airlines, that can best understand the risks, are being prevented from coming in to shore up the company’s balance sheet. The secondary impact, if the Indian Government were to allow FDI from the aviation sector, is that this would bring with it a seasoned talent pool; which could assist in profitably rebuilding the airlines. India is severely lacking in experienced personnel in the aviation sector. The industry is lobbying for a predatory pricing commission to be put in place. This step may be needed to stabilize the industry, and to provide confidence to potential investors.

India’s market participants and Government agencies need to address the tax structure that is heavily penalizing the airline industry. The Government has made several recent moves, which suggests they understand the severity of the situation; however, there is strong incentives for the local states to countermove and nullify the Governments initiatives. For example, SpiceJet has announced that the Director General of Foreign Trade has approved their request to import aviation turbine fuel. By allowing the airlines to directly import fuel this tax can be removed; leading to a substantial savings to the airlines. This move would be a significant step in moving the airlines toward cost parity. However, there is a concern that the states will simply respond by enacting an entry tax as is customary on crude oil imports by some of the states. The second issue, is that the airlines do not have the infrastructure in place to store and handle the AFT, and this would require an investment by the airlines using capital they don’t have. Therefore the above policy is simply a band-aid fix to a fundamentally flawed policy, i.e. allowing the states to tax what is essentially an inter-state or national product/commerce. The lack of Airports is a serious bottleneck in India, and causes excessive costs to the airlines. There is no FDI limit on greenfield airports; the Government should encourage public private partnerships to build airports that meet world standards. In theory this policy exists, but it generally takes in excess of a decade to launch a new airport or sometimes to even rebuild or extend an existing one. Building airports in India faces several obstacles. Acquiring land can be difficult because the last person (land owner) to holdout can gain a windfall profit on their land. This leads to projects being abandoned due to the inability to acquire land in a timely manner. Additionally, significant red tape can also reduce the attractiveness of potential investments. An additional challenge with airports is to integrate the airport to the city through public transportation such as adequate roads and rail. For the airports, several proposals have been put forward to ease the congestion at the major hubs, such as creating an airport solely to handle cargo and thereby freeing up much needed air space or building secondary airports near the metros to meet the demand. This is a flawed fix and in reality, little has been done to address the lack of airports to keep up with air traffic demand. The airlines in India need to develop strategies to differentiate themselves from their competitors to ensure the companies earn adequate returns. As an example, AirAsia has had great success leveraging social media, and designing their websites, which make the Malaysian airline a destination site for finding events such as concerts and for buying products. Given the close average age groups between the tech savvy


countries, 26.8 for Malaysia and 25.1 for India, we see opportunities in this space for the Indian airlines to carve a niche. To ensure the long-term viability of the airlines, the managers will need to act rationally. The managers will need to re-orient their thinking from market share to return on invested capital as a primary metric of success. Having the manager implement the right score cards for success helps stabilize the industry, and provides the best returns for their shareholders. Managers should only add additional capacity when they can improve their break-even rates; this would allow the yields on their assets to improve to appropriate levels.


The chart above shows that there is a strong correlation between the demand for air travel and the growth in GDP. The rule of thumb is that air travel around the world has historically grown at about two times GDP. Management should use reasonable models to forecast demand for Indian travel, and allow this demand to catch up before adding additional capacity. Most of our recommendations above have been addressed at various times in various forums. However, we believe that the single most important issue facing the country is the basic mismatch in supply and demand. We believe that unless the supply of aircraft is controlled, the situation is unlikely to improve, although there might be some short-term realignment when an airline goes out of business and its market share gets reallocated to the survivors. We believe that if a government regulator takes over the function of central purchasing with the OEMs and then auctions off the orders to the airlines, this will go a long way to addressing issues such as focus on market share, predatory pricing, etc. Let us not forget that the Indian aviation industry is still in its infancy and not that dissimilar to a utility with rampant and

unrestricted growth in supply, while beneficial to the consumer, this will ultimately cause significant damage to industry participants. Implementing these changes would put the Indian airlines on the path to profitable growth. India’s rising middle class continues to grow, and the demand for air travel in India will flourish. This means that in spite of the short-term turbulence; the long-term outlook in India is favorable. The Government of India has been signaling that they understand the need to create a level playing field for the airlines, and the combined effort of Government and industry players is necessary to put the airlines back in the black. A final takeaway is that the changes proposed above also present an opportunity for a workout styled investment to be made in the Indian airlines. This investment thesis would require a three-pronged approach.

a) Acquiring the assets at attractive prices; b) Implementing a well defined company plan to

support the yield on assets; and c) Re-alignment of several of the industry dynamics,

as laid out in the industry road map presented above.

The majority of airlines assets are stressed, which present an opportunity to enter this market at the right entry point (i.e. acquiring asset at attractive prices). Recapitalizing and restructuring a company could significantly reduce financing costs to support returns. Additionally, it would be necessary to implement a well-conceived plan to ensure overall operating performance improves. Lastly, if/as several of the roadmap initiatives (pointed out above) are implemented, the company should be able to further improve returns. Such an investment strategy could lead to potential returns, which are quite satisfactory. Disclaimer The recipient hereof shall not disclose or furnish information from this document, in whole or in part, to any other person, firm or corporation, nor shall the recipient hereof reproduce such information, in whole or in part, in any manner without the prior written consent of Bravia Capital Hong Kong Limited (“Bravia”). Although obtained from sources believed to be reliable, Bravia has not verified the information contained herein, and Bravia makes no representation or warranty with respect to the accuracy or completeness of this information. Bravia expressly disclaims any and all liability for representations or warranties, expressed or implied, as to the fairness, accuracy, completeness or correctness of the information and opinions contained in this document. This document should not be deemed to be exclusive to any particular recipient.

Documents

The Current State of Indian Aviation