CAPA India Outlook 2012/13: Critical uncertainty prevails. Possible Air India shutdown

- Serious cost challenges

- continued dithering over foreign ownership

- government leadership needed more than ever

The full 100 page CAPA India Aviation Outlook 2012/13 offers the most detailed insight into the direction of the sector at this critical juncture. To order your copy, please download the order above left, or contact Binit Somaia on bs@centreforaviation.com or +61 2 9241 3200. Special discounts are available for CAPA Members and for advance purchases.

CAPA expects domestic capacity growth of 7-8% in FY2012/13

12 months ago CAPA's forecast for Indian domestic traffic in FY2011/12 was for growth of 17%, the actual outcome was 15.1%, with the lower growth accounted for by the downsizing by Kingfisher towards the end of the financial year.

In FY2012/13 Indian carriers are expected to add approximately 24 aircraft during the year, which includes eight Q400s to be inducted by SpiceJet. This corresponds to the equivalent of 20 narrowbody aircraft on domestic routes. CAPA estimates this which would result in capacity growth of 7-8% in a best case scenario. This projection does not take into account the possibility of exceptional events such as a scenario involving further capacity reduction by Kingfisher Airlines or where Air India's operations are severely impacted by industrial action.

CAPA projects domestic traffic growth of 8-10% in FY2012/13

CAPA estimates that domestic passenger traffic will grow by 8-10% in FY12/13 and more likely towards the lower end of the range. Much will depend upon the impact of oil prices and other input costs on airfares. Upside growth is limited by the fact that capacity expansion will be measured, and with load factors already quite strong there is limited opportunity to grow traffic through higher occupancies.

India's airlines expected to post a combined loss of USD1.3-1.4 billion

In the 12 months ending 31-Mar-2013, Air India is once again expected to be the worst performer in the industry and to report a loss of INR70 billion (USD1.3 billion). Kingfisher Airlines is projected to lose INR12-14 billion (USD220-260 million). However, the remaining four private carriers combined could post a modest profit of approximately INR11 billion (USD200 million).

These estimates are based on assumptions for the whole year of an average Brent Crude price of USD120-125/barrel, and an exchange rate of INR51-52 to the USD. Similarly, due to the current and trade account deficits, weak capital inflows and safe haven flows to the US dollar as a result of the EU debt crisis, there exists the prospect that the Rupee could depreciate to as low as INR60 in the absence of Reserve Bank of India intervention. Aside from other US-dollar denominated costs, this will serve to further compound the impact of high oil prices. However, in our base case we assume that the Rupee remains in an INR54-56 range for the next three to six months and appreciates by 8-10% thereafter, averaging out at INR51-52. The volatility of the exchange rate is a key concern for the year ahead.

Jet Airways to be primary beneficiary of market dynamics

Although the troubles facing Air India and Kingfisher Airlines have been positive for all of the other carriers, Jet Airways has been, and will continue to be, the largest beneficiary. Kingfisher's dramatic contraction from 66 to 16 operational aircraft, of which half are regional ATR aircraft, has left the domestic business market open for Jet Airways. Similarly, the temporary industrial action on Air India's long-haul international routes has driven North American and UK traffic to Jet Airways.

The reduction in capacity arising from reduced flying by Air India and Kingfisher has already resulted in quite substantial increases in yield of 10-12% in 4QFY2012, and an estimated 12-15% in the current quarter, 1QFY2013. All other things being equal, this should have resulted in an increase in CAPA's profit outlook for the private carriers, however, the yield improvements are negated by the extremely challenging cost environment and supply side constraints.

Significant cost challenges, especially sustained high fuel and a weak Rupee

India's carriers will face a deteriorating cost environment in FY2012/13 on a number of fronts. These include:

1. Fuel prices: A high, and more importantly sustained high, oil price environment. There remains a possibility that oil prices could rise substantially with effect from Jul-2012 should the European Union proceed with plans to introduce an embargo on oil supplies from Iran;
2. Weak currency: Further depreciation of the Rupee, which has already fallen more than 20% in the last 12 months, thereby pushing up the price of dollar-denominated costs such as fuel, aircraft leases, maintenance and offshore interest obligations;
3. Airport charges: The regulator has already approved a 334% increase in charges at Delhi Airport, with Mumbai expected to be allowed to raise fees by an even higher amount of up to 500%. Combing these additional levies is likely to have the impact of increasing Delhi-Mumbai airfares by 15-20% which will have a negative impact on traffic. Increased airport charges are expected to be progressively introduced at other airports such as Chennai and Kolkata to fund the modernisation programmes;
4. Service tax: The extension of the service tax regime on economy class airfares from a fixed amount to an ad valorem percentage will increase the absolute level of the impost on most sectors.

Air India could face a temporary shutdown due to massive HR issues

The flag carrier which continues to flounder, operating an unviable business model that is kept alive by the generosity of India's tax payers, is expected to enter a defining period. The merger between Air India and Indian Airlines is defined by the fact that the most critical issue, namely that of the integration of human resources has been ineptly handled and almost willfully ignored, with nobody within the airline senior management or at the level of the government having taken responsibility.

This has been a constant source of tension within employee ranks and after years of neglect a committee was established in 2011 under Justice Dharmadhikari to look into staff grievances. The committee submitted its report to the Ministry of Civil Aviation in early 2012. In the absence of any strategy of its own to deal with the issues at hand, the Government is left with virtually no option but to implement the report's recommendations.

Although the proposed actions have not yet been made public, CAPA expects that the outcomes will meet with a mixed response from the unions and industrial action is likely. The Government appears to be preparing to adopt a firm stance, limiting discussions with the unions and it may not shy away from a watershed moment in the next two to three months after the report is accepted by the Government, which could include a temporary shutdown of the airline.

But a key concern is the fact that at this critical juncture the management at Air India could be set for change at the most senior levels, including the position of chairman and managing director. The new team could be faced with a highly charged and complex situation. Similarly, the board has not been strengthened following a couple of high profile non-executive departures last year, while there will be new appointments in a number of senior government roles as well.

All of this further compounds the fact that there is nobody taking ownership of the turnaround of Air India, which in itself is unrealistic and unachievable without resolution of the personnel issues. For the last two years CAPA has strongly advocated that Air India should be placed in special administration, similar to that adopted for Satyam, if any meaningful progress is to be achieved.

Kingfisher Airlines' revival completely dependent on foreign airline investment being permitted

Facing severe financial difficulties, Kingfisher has deliberately downsized over the last six months to conserve cash and has now declined to become India's smallest domestic airline by market share. CAPA estimates that Kingfisher has a funding requirement of close to USD1 billion, of which USD500-600 million is needed immediately and a further USD300-400 million in the next fiscal year.

The airline is surviving on the basis of bare minimum infusions by the promoter, while it seeks external investors. So far there is no known serious interest and the longer it takes the more difficult it will become to turn the airline around. The most likely suitor for Kingfisher is thought to be a strategic foreign airline investor. Current regulations prohibit investment by foreign airlines although a proposal to permit 49% is currently under consideration. Kingfisher appears to be holding on in anticipation of the restriction being lifted, however, the timing of such a development remains uncertain.

Expectations for a positive decision on foreign airlines raised, dashed and then delayed

In Jan-2012 the Ministry of Civil Aviation gave its strongest support to date for a proposal to permit foreign airline investment of up to 49%. This was supported by a Group of Ministers meeting the following month, which agreed to submit a note to Cabinet in favour of the move. It was presented as virtually a fait accompli. But subsequently it became apparent that there was some resistance at the Cabinet level and the decision has already been deferred a couple of times and may be delayed further. There does remain a slim chance that it may be approved shortly after the close of the current parliamentary session at the end of May-2012, but publicly raising and then dashing expectations of an imminent change in regulations is a poor way to play with the industry. The Government should instead have consulted privately and more widely with key stakeholders to understand the possible reaction and the possibility of moving ahead.

However, if the restriction is lifted, SpiceJet, Go Air and Kingfisher are the most likely candidates to seek foreign airline investors with SpiceJet arguable the most attractive of the three. The longer that approval is delayed the more damaging it will be for Kingfisher.

CAPA expects that the investors most seriously considering opportunities in India include the Gulf carriers such as Emirates, Etihad, Qatar Airways, although others such as International Airline Group are also believed to be actively watching the market. Removal of the restriction on foreign airlines could in fact open up a strategic partnership opportunity for Air India should the Government wish to pursue such an approach.

Jet Airways expected to place a massive fleet order for up to 100 narrowbody aircraft in 2012/13

As noted, Jet Airways has been the main beneficiary of the negative situation at Air India and Kingfisher. Despite the carrier's own weakness, it may decide to take advantage of the situation to expand both domestically and internationally as it had done in 1996 when a number of its competitors had closed down.

CAPA expects Jet Airways could place a large narrowbody order for over 100 aircraft in FY2012/13 to meet both replacement and growth requirements. The airline is understood to be actively evaluating the A320neo and it is also likely to lease up to 10 A330s to support the expansion of its European route network.

Airports Authority of India likely to lead greenfield airport development

The need for the construction of new airport infrastructure remains unabated if India is to achieve its long-term potential. However, questions are emerging about the most appropriate source of funding for the large scale capex required.

The public-private partnership model that has been adopted for the modernisation of Delhi, Mumbai, Bangalore and Hyderabad airports has resulted in dramatically improved infrastructure. But there is a growing political, industry and community backlash against the corresponding increase in charges that are being introduced in order to generate a return on capital for the private investors. This is compounded by the overall uncertainty about governance issues within the current administration.

As a result, further airport privatisation is likely to slow and the Airports Authority of India may once again become responsible for leading future greenfield development, especially at airports such as Chennai. The exception to this in the short term is that the second airport in Mumbai at Navi Mumbai, is likely to be a pursued on a public-private partnership basis.

Industry regulator remains stretched, increasing safety risks

The Directorate General of Civil Aviation (DGCA) continues to remain extremely resource constrained, with insufficient manpower and expertise, which in a growing market is increasing the risk profile. CAPA believes that resultant safety concerns could lead the US FAA to once again threaten, as it did in 2009, to downgrade India to a Category 2 nation. On that occasion, the DGCA secured the necessary budget to invest in the required manpower, however, there has been limited progress since then despite the fact that the sector has grown significantly. Plans to establish a unified and independent regulator in the form of an Indian Civil Aviation Authority are moving slowly. A change in leadership at the regulator is also a possibility.

Crisis in aviation sector calls for bold and pragmatic leadership by the Government of India

Due to its preoccupation with Air India, the Ministry of Civil Aviation has limited resources to focus broader industry issues. As a result, the policy and regulatory framework is weak and misaligned with the requirements of the industry. This has been clearly highlighted during the current crisis as the Government has been able to deliver little of substance to assist the sector.

The current Minister for Civil Aviation, who has been in the role for six months, has grasped and acknowledged the challenges facing the sector far better than his predecessor, and his statements demonstrate a focus on fundamental issues such as airline viability. However, to date there has been no substantive progress on developing a comprehensive and robust new civil aviation policy. And the pace is only likely to be interrupted further by upcoming changes in senior roles within the Ministry.

Ad hoc intervention may have been workable 10 years ago when the sector was a fraction of its current size but it is no longer acceptable for an industry that handles 160 million passengers p/a and in which its core constituents, the airlines, have a total debt burden of USD16-17 billion, which could increase to USD20 billion within the next 12-18 months. Airports have additional debt of USD2.5-3 billion while Indian banks and financial institutions have a massive exposure of USD9-10 billion to the aviation sector.

An industry of this scale and with such widespread economic multiplier enabling effects cannot be held hostage to inconsistent and unpredictable policy and regulation. However, the Ministry of Civil Aviation is hampered because many of the key fiscal and policy reforms that could actually have a positive impact on the industry are outside of its purview. Aviation requires bold and pragmatic leadership at this time of crisis, which means that key decisions need to be taken at the level of the Government of India and not just at the Ministry.

The full 80+ page CAPA India Aviation Outlook 2012/13 will provide the most detailed insight into the direction of the sector at this critical juncture. To order your copy, please download the order form top left, or contact Binit Somaia on bs@centreforaviation.com <mailto:bs@centreforaviation.com> or +61 2 9241 3200. Special discounts are available for CAPA Members and for advance purchases.