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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 Indias
LCC model to highlight structural differences. An overview of the Full Service Aviation (FSA) model is compared to
Indias 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.


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The Current Environment

In 1994, Indias 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repealed giving private airlines the opportunity to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 Indias 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 2011
1
. 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. Indias
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 Indias 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
Indias 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
Airlines 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
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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 1,700
3
.

Since customers consider an airlines 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 Aviations
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 DGCAs 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 airport
4
. 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 23
rd
, 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 delayed
6
.
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.


Source: Centre for Aviation and Indian DGCA

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 13
th
2012)
7
Assumes 5 year tenor
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Source: Centre for Aviation and Indian DGCA

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.

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5) The participants in the industry, including Indias
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 A380s. As Indias 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 Airways 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. Managements
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
expense
8
.

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 40
th
anniversary,
and reported their 39
th
consecutive annual profit; giving
strong support to the claim that the LCC model can work.


8
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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 LCCs have
invested in information technology to squeeze costs out
of issuing tickets.


Source: Ryanair Annual Report

5) The top LCCs pay particular attention to their
customer service metrics, so that they are the choice
carrier for their customers. By looking at Ryanairs
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 LCCs have
high employee productivity.

Each of these cost savings is additive, and when
combined creates a competitive advantage for the LCCs.
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.


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Indias 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 LCCs are falling short.


* Kingfisher Red is no longer in service

Looking at Indias LCCs by fleet, we can see that they in
fact do practice building on a unified fleet to squeeze
cost efficiencies. All of the Indian LCCs, 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 LCCs end up paying for
services, which they dont need, such as waiting lounges
and other amenities. The LCCs 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 LCCs have lean and nimble organizations,
and have highly efficient staff. The global LCCs 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.

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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 LCCs 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 Indias higher overall cost structure compared to
the global market we can look at the Cost per ASK
10
.
Higher costs will lead to under investment in the Indian
airlines. The second detrimental effect of Indias 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, lets 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 LCCs 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
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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 PWCs 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
providers 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
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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 Indias
full service carriers.


Indias Full Service Carrier Model

The Indian full service carriers have struggled to earn
adequate returns. As mentioned previously, Indias
legacy rules meant until recently only full service carriers
dominated Indias 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 Indias 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 FSCs 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
FSCs 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
Indias aviation industry back into profitability.


The Future of Indias 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 1
st
quarter June 2012 profit of US $ 10
million, after a US $ 120 million annual loss as of year
end March 2011. The airline Companys 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
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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 companys 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.

Indias 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
dont 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
www.braviacapital.com Hong Kong New York London Istanbul Delhi

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.


Source: Centre for Aviation and Indian DGCA

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. Indias 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.



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