Airlines: Caught in rough weather

Anand Kalyanaraman | Updated on January 12, 2018

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Investors can bail out of airline stocks, given their high valuation and likelihood of the companies’ earnings staying weak.

A year is a long time in Indian aviation. From stellar in 2015-16 to slack in 2016-17, the sector’s financial performance justifies its well-earned reputation for fickleness.

All the three listed carriers — IndiGo Airlines, SpiceJet and Jet Airways — took a knock on the bottom-line last year, national carrier Air India’s financial position deteriorated further and two fledgling regional airlines — Air Pegasus and Air Costa — shut shop.

In contrast to the 52 per cent growth in 2015-16, market leader Indigo Airlines’ profit shrank 16 per cent in 2016-17. Low-cost peer SpiceJet’s profit fell 4 per cent in 2016-17 while full-service carrier Jet Airways took the worst hit, with a 67 per cent profit crash; both these airlines had swung from loss to profit the year before.

All this turbulence is despite air traffic continuing to grow at a rapid pace. India is among the fastest growing aviation markets globally; overall domestic passenger growth was nearly 22 per cent in 2016-17, with IndiGo and SpiceJet leading the way.

High cost, low fares

The paradox of divergence in passenger growth and profit growth is primarily due to two old bugbears — high costs, especially fuel, and low airfares due to intense competition.

After plummeting to below $30 a barrel in the March 2016 quarter, crude oil steadily inched upwards in 2016-17. Aided by output cut deals among OPEC and major non-OPEC producers, crude oil crossed the $50 a barrel mark in the December 2016 quarter and inched towards $60 levels.

This led to aviation turbine fuel (ATF), the major expense of airlines in India, getting costlier. From about ₹39,000 a kilolitre in March 2016, ATF price in Delhi rose almost 40 per cent to ₹54,000 a kilolitre in March 2017. As a percentage of sales, the listed airlines spent 2-5 percentage points more on fuel in 2016-17 than in 2015-16.

Other costs, including employee expenses, rose sharply too. But airlines, rather than hiking ticket prices to compensate for higher costs, took cuts. Intense competition in the domestic skies and fare wars saw IndiGo’s yield (average fares) dip more than 10 per cent in 2016-17, while that of Jet Airways and SpiceJet fell 3 per cent and 2 per cent.

The cut-throat price competition in the Indian skies was accentuated by the significant fleet addition under way in the sector.

As per rating agency ICRA, the Indian aviation industry added sizeable capacity during 2016-2017, reflected in the 19.6 per cent year-on-year growth in domestic available seat kilometres (ASKM).

Airline seats are a perishable commodity and carriers often choose to discount fares, sometimes even below cost, rather than flying seats empty. IndiGo Airlines, which is adding aggressively to its fleet and added the maximum capacity among domestic airlines last year, also took the sharpest cut in its yields.

The pricing problem got compounded by demonetisation during the December 2016 quarter, with airlines slashing fares to offset the impact of the high-value note ban on passenger traffic. The industry had added capacity and indulged in price battles to woo passengers the earlier year (2015-16) too, but the key difference then was the cushion to profit from low costs.

When costs started heading North in 2016-17, airlines found themselves unable to raise ticket prices and rather offered cheaper tickets. The upshot: despite high passenger numbers, airlines’ revenue growth lagged costs, and profit became the casualty.

Stock prices swing

The market, slave to earnings, had raised a toast to airline stocks in 2015-16. When ATF was at its nadir in January-February 2016, airline stocks were touching their zenith. The SpiceJet stock had quintupled and Jet Airways had tripled over two years while IndiGo had nearly doubled from its already pricey listing in November 2015.

But last year, with the earnings slipping, punishment came swift and severe. From their peaks in early 2016 until mid-February 2017, the airline stocks were marked down 30-50 per cent. But these stocks have rallied sharply since then, despite March 2017 quarter results being quite weak with sharp profit declines.

Sentiment has revived in recent months primarily due to two factors: the dip in global oil price and a stronger rupee that should moderate the cost of ATF. IndiGo had indicated improvement in average fares in February and March — the airline’s dip in yield in the March quarter was lower than in earlier quarters.

Airline stocks also seem to have benefited from the fact that the June quarter is traditionally a strong one for airlines.

That said, weak earnings over the past year and the rally over the past few months have turned airline stocks pricey. The IndiGo stock now trades at about 23 times its trailing 12-month earnings, compared with the average 18 times since listing. The Jet Airways stock quotes close to 13 times earnings, nearly double the average 6 times it has traded at in the past three years.

Similarly, the SpiceJet stock, at about 16 times earnings currently, is pricier than its average of about 10 times in the past three years. Investors can bail out of these stocks, given their high valuation and likelihood of the companies’ earnings staying weak.

Cost benefit uncertain

One, the cost benefits from recent favourable oil and rupee movements cannot be taken for granted, given their unpredictability. The most recent price dip in crude oil over the past week is due to the geopolitical developments in West Asia.

The stand-off between five Gulf nations (including Saudi Arabia) and Qatar has raised fears that the oil output cut deal among OPEC and non-OPEC countries could be undermined. While that’s a risk, several oil producers, including US shale producers, could find it unviable to operate at levels below $45 a barrel. The resulting supply squeeze will likely put a floor on oil price.

Oil, now about $47 a barrel, could move in the $45 to $60 range in the medium term. The rupee too, about 64 to a dollar currently, could keep swinging between 60 and 70 as it has in the past few years.

Capacity overhang

Importantly, even if costs stay subdued, the ability of airlines in India to adopt rational pricing and rake in benefits seems doubtful. Low yields that contributed much of the pain last year are likely to continue and could get worse, notwithstanding recent improvement in February and March.

That’s primarily because most airlines are on a capacity expansion spree. This will add to competitive intensity and keep fares subdued.

ICRA says that, at present, the industry has sizeable order backlog of new aircraft, which is 1.78 times the current fleet size of the industry. It expects about 17-20 per cent growth in industry capacity (available seat kilometres) during 2017-18 due to fleet addition by majority of the incumbents as well as new entrants, predominantly led by market leader Indigo.

Aviation consultancy CAPA estimates that India’s order book will soon reach 1,080 aircraft, the third largest in the world after the US and China. India’s ratio of 2.2 aircraft on order for every aircraft in service would be the highest of any major aviation market, CAPA adds. Of the expected 1,080 aircraft on order, more than 700 are scheduled for delivery within the next decade and 400 within the next five years.

True, there is much untapped potential in the domestic aviation market that calls for fleet expansion. But seat supply growing faster than demand is a key risk. Especially given that passenger growth rate has been moderating — from over 23 per cent y-o-y in calendar 2016 to less than 18 per cent during January-April 2017. Growth moderation could continue with a higher passenger base and airport infrastructure constraints in big cities, at least in the near term.

IndiGo has grown its fleet rapidly over the past few years and currently commands more than 40 per cent share in the domestic market. Aggressive expansion by the market leader, in a way, forces other players to counter the threat of increased dominance with expansion plans of their own.

Most other airlines, including low-cost peers SpiceJet and GoAir, too, have lined up big fleet expansion plans. According to ICRA, IndiGo has the largest order book of (405 aircraft), followed by SpiceJet (205) and GoAir (144); this does not include expected capacity addition for the regional connectivity scheme. CAPA expects the full service carriers to also step on the gas. It expects both Jet Airways and Vistara to place additional orders of 100 aircraft each.

If new airlines such as Qatar Airways make an entry into the Indian market as reported, capacity growth could hasten. Seen in conjunction with moderating passenger growth, this could put further pressure on fares.

Also, rapid capacity addition could again pile up airlines’ debt levels and drag bottom-lines. Calibrated capacity expansion in sync with passenger demand, and pricing discipline will be key for the financial growth of airlines. That seems unlikely, though.

International segment weakness

While the domestic skies seem cloudy, the international operations of airlines don’t offer respite, either. Jet Airways derives more than half its revenue and profit from international operations, aided by the tie-up with its strategic investor Etihad Airways. This segment did worse than the domestic business in 2016-17 with a sharper fall in operating profit and margins. Ditto in the case of IndiGo that gets about a tenth of revenue and profit from its international operations.

Overall passenger traffic growth on international routes from India (about 8 per cent in 2016-17) is much lower than in the domestic market. The segment also sees significant competition from international airlines (primarily from West Asia) that have about a two-third market share. The ongoing problems in West Asia, which accounts for much of the international traffic of Indian carriers, could queer the pitch further.

Will UDAN take off?

The government’s ambitious regional connectivity scheme UDAN (Ude Desh Ka Aam Nagrik) finally took off in late April with the Prime Minister flagging off the Shimla-Delhi, Kadapa-Hyderabad and Nanded-Hyderabad air routes.

UDAN seeks to link up scores of unserved and under-served airports in Tier-2 and Tier-3 cities with major cities and with each other. The plan is to subsidise air tickets, making it affordable for passengers in smaller centres to fly, and offer viability gap funding (subsidies) and incentives making it feasible for airlines to offer subsidised tickets.

For instance, half the tickets on one-hour flights under UDAN will have a fare cap of ₹2,500 and the remaining can be sold at market rates. The Central and State governments will subsidise airlines flying the UDAN routes. There will be concessions on fuel taxes, airport charges, etc and airlines will get three-year exclusivity on routes allocated in auctions.

UDAN is important not just because it can offer much-needed quick connectivity to the country’s interiors but also because it can provide a fillip to air traffic. Infrastructure constraints at airports in big cities could slow down the rapid passenger growth that Indian aviation has experienced the past few years. UDAN, if successful, can compensate and also provide feeder traffic to networks in big centres.

The first round of auctions, earlier this year, saw 128 routes being awarded to five operators — Alliance Air, Air Deccan, Air Odisha, Trujet and SpiceJet. The next round of auctions is expected shortly. The scheme got a boost last month when market leader IndiGo announced its plan to participate. With big players such as Alliance Air, SpiceJet and IndiGo throwing their hat into the ring, UDAN seems to be on a promising flightpath. But there are challenges and risks for the airlines — in terms of increased fleet maintenance costs and uncertain demand.

For the UDAN foray, IndiGo has signed a term sheet for 50 ATR turboprop aircraft worth $1.3 billion (about ₹8,500 crore) at list prices. Doing this, it is breaking away from one of the key tenets of low cost carriers — having a single fleet type. So far, the airline has been flying only the A320 (including the neo variant) aircraft. Operations with the smaller ATR aircraft are expected to commence by the end of calendar 2017.

IndiGo expects to have seven of these aircraft by March 2018 and 20 by December 2018. The airline plans a separate division to handle the turboprop operations. With a six-month window given to commence operations after winning the bid, IndiGo will likely participate in the upcoming auctions. While UDAN could be a growth opportunity, the fleet diversification could increase maintenance and manpower costs.

Also, if the selected regional routes do not deliver good traffic growth, the new aircraft could become a burden. SpiceJet also bears the risk of uncertain demand but has the advantage of already having the smaller Bombardier Q400 aircraft in its fleet that could be deployed for the UDAN routes.

It’s early days yet, but some concerns have emerged after the first round of auctions in March. Of the five airlines that won the bids, only two — Alliance Air and Trujet — have started operations so far. The others, including SpiceJet, have not yet revealed their plans; they have time only until September to start operations or their performance guarantees could be encashed. All necessary approvals have to be in place soon; this could be challenging. Also whether the governments pay out the viability gap funding in a timely manner needs to be seen.

Published on June 10, 2017

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