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Flying into air pockets and multiple headwinds

Rajan D. Kamat | Updated on February 10, 2013

Leasing of aircraft has been an inextricable part of aviation business.

Industry players will have to find their equilibrium while focusing on yield rather than load factor.They have to come up with a more tactical response to the ‘low-cost vs. full-fare carrier’ debate.

Government-owned airlines dominated Indian aviation industry until the mid-1990s, when the country adopted an open-sky policy allowing air-taxi operators to fly on charter and non-charter basis for cargo and passenger traffic. This paved the way for ending the monopoly of Indian Airlines and Air India. By 1995, several private airlines entered the fray and accounted for more than 10 per cent of domestic air traffic.

Indian aviation industry has undergone a transformation over the past 15 years. Between 2000 and 2010, the sector grew nearly 160 per cent in traffic terms, and India now ranks among the top-10 civil aviation markets. Government-owned Air India Ltd is still the big daddy and under its wings are the erstwhile operations of Air India, Air India Express, Indian Airlines and its subsidiary Alliance Air.

Over 50 per cent of the market is now shared between Jet Airways — the carrier which made a complete difference to the Indian traveller, and Indigo — the recent challenger to Jet’s numero uno position. During calendar year 2012, however, traffic dipped with domestic airlines carrying 588 lakh passengers, compared with 607 lakh in 2011.

Regulatory framework

The Ministry of Civil Aviation, responsible for formulating national policies and the development and regulation of the civil aviation sector, exercises administrative control over organisations such as the Directorate General of Civil Aviation (DGCA), Bureau of Civil Aviation Security (BCAS) and Airports Authority of India (AAI) apart from the public sector units operating in this domain.

Besides regulations for aircraft and air safety, DGCA impacts the civil aviation business through administration of route dispersal guidelines, preference in traffic rights and slot allocations.

Business and Accounting

Writing on accounting for Indian aviation industry during these tough times, one is reminded of a remark by Virgin Airlines founder Richard Branson. In his blog ‘Learning from mistakes’, he commented that if you want to be a millionaire, start with a billion dollars and launch a new airline.

While profitability of aviation industry has been a challenge worldwide, in India the main constraints include high price of aviation turbine fuel (ATF), airport infrastructure, lack of international-standard maintenance and repair organisation (MRO), and trained crew.

The ‘competitive rivalry’ that the management consultant Michael Porter famously spoke about is much evident in civil aviation industry.

Fare reduction in a bid to maintain the seat factor (percentage of seats sold on a sector) often disrupts margins. Just this month, Spice Jet offered one million tickets at Rs 2,013 anywhere in India and the DGCA had to intervene to ensure that competitors did not succumb to the pressure.

The risk in such a proposition is that regular flyers would take advantage of the scheme rather than poaching flyers from competition. This, inevitably, perpetrates the unhealthy syndrome of high seat-factor with low yield. This has been the bane of aviation players over the last few years, raising concerns over the viability of certain players.

The fundamental assumption of ‘going concern’ is that the balance sheet is drawn on the basis that there is no requirement to dispose of the assets or liquidate liabilities except as envisaged in the entity’s normal business plan.

This call is taken over a period of twelve months from the balance sheet date. This, in the current situation, dovetails into impairment considerations.

The comforting factor is that over 90 per cent of the non-current assets of an airline typically has a dollar-denominated market value, and with a depreciating rupee the rupee-denominated ‘value in exchange’ provides a high threshold to cover the carrying value. However, to decide if the news is good enough, one has to understand the dollar-rupee exchange implications on the income statement.

‘Code sharing’ is one practice that evolved from the collaborative approach that airlines adopted towards passenger traffic. Parties to the arrangement can book passengers on a counterparty’s sectors, so that they can offer travellers a through-and-through ticket. Although still relevant, it was crucial when Web booking through travel portals was not in vogue.

Collections from tickets booked remain in ‘forward sales’ until pulled in as revenue to the income statement when actually flown, and provide a source of working capital.

Another peculiarity of airline revenue recognition is ‘stale tickets’ revenue, which is based on past trend and the ticketing terms. Revenue may be impacted positively if it is dollar denominated — that is, for an airline that flies international sectors. However, considering the dollar denominated costs of operating ‘wide body aircraft’ on these sectors, this can often be a zero sum game for an Indian airline.

Leasing of aircraft has been an inextricable part of the business model, and there are players whose fleet comprises almost entirely of aircraft on operating leases rather than finance leases. Finance leases imply that the fleet and finance liability is recognised on the balance sheet as non-current assets and borrowings, respectively.

Rupee depreciation has meant that currency loss has been added to the carrying value of the fleet of Indian players pursuant to the relaxation in Indian GAAP arising from para 46/46A of Accounting Standard 11, as distinguished from International Financial Reporting Standards. The padded up value has to be depreciated over the balance life.

Operating leases (dry leases) emerged as a significant alternative, perhaps by compulsion rather than choice. The compulsion is triggered by the balance sheet leverage often cornering the players into “sale and leaseback” deals, where aircraft are sometimes sold at a profit and leased back.

Informed analysts are wary of such profit, as it might not in substance meet the test stipulated in the lease accounting standard —which requires such ‘profit’ to be spread over the operating rentals and recognised over the lease period as reduced rentals. Given the significance of rentals to the income statement in this industry, it is normal to talk of EBITDAR rather than EBITDA.

‘Frequent flyer’ points are a common feature intended to reward loyalty. The accumulated points can be redeemed for tickets.

While the accounting under IFRS will depend on the exact terms of redemption allowed, in India the practice has been to allow redemption without cannibalising revenue — that is, when the flight is not fully booked. The extra cost of carrying the passenger free of charge is accrued as a provision under AS-29, after factoring the lapsed ‘miles’ based on past trend.

Government response

Sometime around May 2011, the Ministry of Corporate Affairs referred a possible ‘cartelisation’ plea against private carriers to the Competition Commission of India. This came about after fares were hiked in the wake of the Air India strike.

The Commission rightly concluded that the hike in fares was a market-driven response of the ‘dynamic pricing’ followed in the industry, rather than anti-competitive practices. The picture of bleeding airlines against the backdrop of increasing traffic clearly confirms this is a case of an opportunity turned into a crisis — albeit, to the benefit of consumers.

This crisis, in turn, later compelled DGCA to focus on the financial surveillance of industry players from the perspective of air safety compliance. This process dealt a blow to Kingfisher Airlines, with the ‘King of good times’ biting dust.

It is interesting to note that regulatory concern on pricing made the DGCA set up a fare monitoring cell a couple of years ago. A complex intervention of business and regulatory issues indeed! Industry players will have to find their equilibrium while focusing on yield rather than load factor and with a more tactical response to the ‘low cost carrier (LCC) versus full fare carriers’ debate.

A study was commissioned at the behest of regulators to address key issues such as

ensuring competitive neutrality between private carriers and the national carrier; incentive-based route programme; and market-based tools for slot distribution.

Responses to these are being evolved, and could significantly impact the competitive landscape.

Recently, foreign direct investment, or FDI, rules were modified to allow foreign airlines up to 49 per cent stake in Indian carriers. The conditions are

the domestic carrier is registered in, and has its principal place of business within India;

the chairman and at least two-thirds of the directors are citizens of India;

the substantial ownership and effective control are vested in Indian nationals; and

all foreign nationals associated with the Indian company as a result of the investment will have to undergo security clearance.

It is expected that the FDI relaxation will enable inherently viable players to recapitalise and up their game with the superior management strengths that strategic alliances can bring to the table.

Rajan D. Kamat is Partner, Deloitte Haskins and Sells

Published on February 10, 2013

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