CAPA’s Indian Aviation Outlook FY14: Wanted: transparent policy framework to support ambitious plans

To order the full 320 page CAPA India Aviation Outlook Report FY2013/14 click here or contact Binit Somaia on bs@centreforaviation.com

Major policy decisions, with good intentions, are frequently implemented in an ad hoc manner on the basis of limited consultation, without consideration for the overall structural dynamics of the industry and without sufficient clarity on the detail. And at times there has been hesitation which has led to steps being re-traced. This has ultimately led to political controversies, disillusioned investors and industry losses.

The 2013/14 financial year has started in this vein. CAPA strongly welcomed the long overdue decision to allow foreign airline investment, which has the potential to be game-changing for Indian aviation. But the manner of its execution has left a lot to be desired. From confusion about whether the policy applied only to incumbent carriers or start-ups as well, to the controversy about the allocation of bilateral entitlements, the end result sends the wrong signal to prospective investors. Such major decisions have been taken in the absence of a policy framework and without the institutional capabilities to assess and understand their implications. CAPA expects many new decisions to be announced in the next few weeks although most of them may not be implemented during this financial year.

India has made no serious attempt to address the industry's core structural challenges, particularly the fiscal and cost environment, which is particularly hostile at present as a result of stubbornly high fuel prices compounded by a sharp depreciation of the Rupee and a punitive ad valorem sales tax. In spite of this, we expect modest growth of 4-6% to return to the domestic market in FY14, while international traffic could expand at 10-12%.

Domestic Outlook FY2014: Passenger numbers expected to pass 60 million again

Domestic traffic is expected to expand by 4-6% in FY2014, with most of the growth to occur in the second half of the year. Starting from Q3 the traditional festival and holiday traffic is expected to be supplemented by increased passenger movements driven by state elections in November, and then by general elections some time prior to May 2014.

AirAsia's likely entry in the second half of this financial year could also provide some further growth although the airline will still be relatively small even by the end of the forecast period. These factors could potentially push growth above 6% subject to market conditions from Q3 onwards. We expect that by the end of FY14 domestic traffic will match or slightly exceed the previous high water mark of just over 60 million annual domestic passengers reported in FY12.

India Domestic and International Passenger Numbers FY03 to FY14 (projected)

Source: CAPA, Airports Authority of India

International Outlook FY2014: Buoyant traffic could grow at 10-12%

International traffic growth is expected to be more buoyant than domestic and could grow by 10-12% as Indian carriers expand and as more bilateral entitlements are expected to be granted to foreign carriers. As is the case for domestic traffic, the second half of the year is expected to account for the majority of the growth. Capacity expansion during the year ahead is likely to be around 10%, largely driven by LCCs.

Jet is already profitable on international operations and is expected to further strengthen its performance in the coming year as a result of its increasing cooperation with Etihad. IndiGo and SpiceJet are both modestly in the black on overseas routes.

However Air India continues to incur huge losses on international services due to poor alignment between its fleet structure and route network, and weak commercial capability, particularly in offshore markets. As a result international operations account for 80% of its losses. The 787s will help but the structural issues run deep and this will impact the carrier's overall turnaround prospects.

Private airlines are expecting profits of USD250-300+ million in FY2014 - while Air India loses USD750-800 million

CAPA estimates that India's private airlines could post combined profits of USD250-300 million or more in FY14 with a projected breakdown as follows, based on CAPA Research estimates:

• GoAir: USD8-10 million profit;
• IndiGo: USD100-120 million profit;
• Jet Airways: USD125+ million profit;
• SpiceJet: USD25-30 million profit.

Jet's return to profitability is largely being driven by a significant reduction in interest costs as a result of a USD600 million reduction in high interest Rupee debt and access to lower interest rates through offshore financing options that have become available in light of the Etihad investment. In addition the carrier is expected to see an increase in net earnings from further strengthening of its international operations although the real benefits will be seen from FY15 SpiceJet's and GoAir's profitability is subject to them being able to control their losses during the weaker second and fourth quarters which have let them down in the past.

In the case of SpiceJet, now that it is a relatively large airline, these swings between strong and weak quarters can have a major impact on financials as the losses in low season are so large.

However, the overall industry result is expected remain in the red, dragged down by a projected USD750-800 million loss at Air India. These projections have been developed on the expectation:

• that oil prices will remain stubbornly high with average Brent Crude rates for the year assumed to be USD100-110/barrel;
• that the Rupee is not expected to provide any cushion with average rates for the year projected to remain in the range of INR54-55 to the US Dollar;
• and that pricing discipline will be maintained - since Jan-13 the industry appears to have lost the discipline that was present during the previous nine months. If the sector was to experience an extended period of discounting similar to that seen in Q4FY13, and as we are seeing again in Q2FY14, profitability would deteriorate well below the projected levels. During low seasons there appears to be an absence of price rationality.

Key issues for the sector in this financial year include:

USD1.3 billion in foreign airline investment is imminent

Indian carriers are expected to see an infusion of USD1.3 billion (possibly higher as a result of financial assistance other than equity) in the next few months as a result of foreign airline investment transactions. This estimate of funds includes USD700-750 million of investment in equity in up to three Indian airlines, including Jet Airways, and a further USD550-600 million in additional financial assistance such as access to foreign exchange loans at lower interest rates and sale-and-leaseback income from assets such as aircraft and airport slots.

The estimated total financial package on offer to Jet Airways for example is around USD900 million, consisting of:

• USD379 million in equity in the airline;
• USD150 million in equity in Jet's frequent flyer programme;
• USD70 million from the sale-and-leaseback of three pairs of Heathrow airport slots;
• USD300 million debt financing.

However, the industry continues to be afflicted by losses, a huge debt burden and the need for massive capital requirements to fund forward business plans. Set against a backdrop of key structural challenges in the sector, particularly in relation to a high tax and high cost environment with increasing regulatory intervention, this may subdue investor interest. Nevertheless we expect two more foreign airline investment deals this year in cases where there is a clear strategic benefit.

Foreign airlines will be watching with the interest the outcome of the Jet Airways-Etihad deal which has recently become embroiled in controversy and which will impact investor sentiment about other potential transactions. Key points include:

• The expansion of the India-Abu Dhabi bilateral agreement coincided with the announcement of the Jet-Etihad partnership which has resulted in major political challenges (and potentially legal challenges) and has made the approval process for the deal more complex.
• The original Shareholders' Agreement has been questioned by the Securities & Exchange Board of India (SEBI) and the Foreign Investment Promotion Board. Objections raised relate to concerns that the agreement granted almost de facto control to Etihad for a 24% stake.
• Revisions have already been made to the Shareholders' Agreement and further watering down is expected as a result of further agencies such as the Central Vigilance Commission and the tax authorities taking interest in the case. The final agreement may be quite different from the intent in the original document and as a result Etihad may seek a revised valuation.
• Despite these challenges we expect that the transaction will eventually be concluded by Aug-13. However, any future deals will be subject to increased scrutiny, and in particular the critical strategic issues of management control and market access will come under sharper focus. This is likely to be the case for both unlisted as well as listed airlines.
• If the deal does not proceed, this will be a particularly negative outcome for Jet Airways which has been completely focused on this transaction and has developed its new business plan around it.

Bilateral agreement amendments will need to allow up to 200,000 additional seats by 2015

Aside from the recent expansion of the India-Abu Dhabi bilateral agreement, India is estimated to be faced with requests from foreign governments for an additional 175,000-200,000 weekly seat entitlements over the next 2-3 years. Most of the requests are from Middle East markets such as the UAE (Emirates, flyDubai, Air Arabia), Qatar (Qatar Airways) and Turkey (Turkish Airlines), as well as Hong Kong and Singapore.

The emirates of the UAE currently have entitlements of over 90,000 weekly seats which will increase to approximately 130,000 in a phased manner over the next three years as a result of the new India-Abu Dhabi agreement. However the UAE (primarily Dubai and Shrajah) is expected to seek an additional 45,000-70,000 weekly seats by 2016. Importantly the UAE has been able to negotiate the largest number of points of call in India. CAPA expects that the Indian government will continue to liberalise bilaterals in the coming months unless it faces legal challenges in light of the India-Abu Dhabi agreement.

Airline Start-ups: AirAsia India is likely to start up this year

AirAsia India is likely to receive its security clearances and No Objection Certificate in the next few weeks, which will enable it to apply for an Air Operator's Certificate to launch the airline. We expect that the airline could commence services by late October 2013.

A further 1-2 cross-border joint ventures involving foreign LCCs could be announced in the next 12 months.

The 5 Year/20 Aircraft rule has been a failure and is likely to be abbreviated

The current regulation requiring Indian carriers to have completed 5 years of domestic operations and have a fleet size of 20 aircraft before being permitted to launch international services has served only to discriminate against Indian carriers since the same requirement does not apply to foreign airlines flying into the country. We expect that at the very least the 5 year and 20 aircraft thresholds will be revised downwards in the next few weeks to less than 2 years and 10 aircraft, and we would not be surprised if the rule is abolished entirely in due course.

Among the incumbents, GoAir would be the beneficiary of a rule change as it is the only airline which does not currently qualify. However, the second beneficiary would be AirAsia India which has made no secret of its desire to operate international services from India.

The removal of the restriction would also pave the way for the launch of an Indian long haul LCC in the next two years, with AirAsia being a possible candidate.

The A380 Operating ban will be lifted this year

With the Indian government seemingly comfortable with granting additional traffic rights to certain markets, the restrictions on A380 operations relative to a 747-800 (which would be permitted under most bilateral agreement) because of a concern about excess capacity becomes difficult to defend. As a result we expect this ban to be lifted and a number of bilateral agreements will be updated to permit the aircraft. Emirates and Lufthansa are likely to introduce the A380 on services to India from the Winter 2013/14 schedule.

Jet Airways' aggressive fleet orders, with SpiceJet also in negotiations

Although not officially announced, Jet Airways has reportedly signed an order for 50 737 MAX aircraft. Meanwhile discussions with Airbus for an A320neo order for Jet Konnect are expected to conclude shortly, possibly after the deal with Etihad is approved and formalised.

SpiceJet is currently in negotiations with both Boeing and Airbus for 30-40 narrow body aircraft of the re-engined MAX and neo types and a decision is expected shortly. SpiceJet's current narrow body fleet is all Boeing however there is a possibility, which is under consideration, of the carrier switching manufacturers and transitioning to A320s and eventually A320neos.

Air India's intention to lease 19 A320s and 11 turboprops has been pending for the last two years, and these plans are unlikely to be finalised.

Indian Carrier Fleets and Aircraft Orders as at 31-May-13

Source: CAPA Fleet Database. Note: Air India includes Alliance Air regional operations.

Air India's challenge is insurmountable, as billions of dollars are squandered, with no strategy

Despite the best intentions of Air India's management and recent improvements in performance, the carrier has an almost insurmountable challenge, especially in an environment which is set to become increasingly competitive with a strengthened Jet Airways, rapid liberalisation of bilaterals and new market entrants such as AirAsia.

In this scenario the government will be faced with having to drip feed billions of dollars over the next few years to finance deficits with no meaningful improvement in the carrier's situation. Meanwhile Air India itself will be politically hamstrung with regard to taking the difficult restructuring decisions required to develop a competitive cost base.

As a result Air India has no future under continued government control which should bring privatisation back on to the agenda, with a possible decision on the divestment schedule in 2014 triggered by the impact of foreign airline investment transactions. In the meantime the carrier requires a new turnaround plan and financial restructuring programme that takes into account the changes in the market since the last plan was prepared two years ago.

A viable and long-term solution for Air India is imperative not only for the airline itself but for the industry at large because as long as it struggles under government ownership it will continue to drive distortions in policy.

Kingfisher Airlines' hopes of returning to the skies are remote

Since the airline suspended operations in Oct-12 the promoters have continued to express their intention to re-launch the airline, and we understand that discussions with prospective investors remain in progress even till today.

However, given the state of the company's finances and operations after such an extended grounding, a resumption of services is highly unlikely.

Regulatory Intervention on commercial issues continues to bamboozle the market

As CAPA had earlier highlighted, the announcement by the DGCA in late April 2013 that unbundling of fares would be permitted was not the reform it was made out to be.

There was never any specific restriction in the Civil Aviation Regulations; however the practice of charging for preferred seating or baggage for example had been "discouraged" by email communication from the Ministry. And just as informally some airlines had found innovative ways to get around the issue.

Unfortunately, instead of ushering in a new environment where airlines could finally have the freedom to emulate global practice with respect to ancillaries, the government's indecisiveness about the extent of the regulatory easing has only created greater confusion. Within weeks of the initial announcement the government advised airlines that they could collect preferred seating fees on no more than 25% of the seats on an aircraft.

The DGCA also appears to be unsure as to what role it should play with respect to regulation of airfares, as it oscillates between concern for the consumer and for airline viability rather than leaving market forces to determine the outcome. In the last 12 months we have seen the DGCA intervene when fares were seen to be too high during the peak festival season, and then just a couple of months later it objected to discounting by airlines because it was felt that the fares were unsustainably low.

A recent plan reportedly under consideration would require airlines to disclose the number of seats sold in each fare bucket and for this data to be made public. Mandatory disclosure and publication of such commercially sensitive information would be an unprecedented example of excessive regulatory intervention. We hope that this is simply a case of media speculation and that the plan does not proceed further.

A new Civil Aviation Authority is still not operational

The establishment of the new Indian Civil Aviation Authority has been approved by Cabinet but is unlikely to be operational this financial year. Intended to provide a regulatory agency with greater flexibility and autonomy, it faces a fundamental challenge in that it will absorb a weak DGCA which has been starved of resources since 2009 and is struggling to meet its regulatory oversight objectives because of a lack of skilled resources and expertise.

Civil Aviation Policy: the draft is decades old and will remain a draft

The long-awaited comprehensive new civil aviation policy has remained in draft format for the better part of two decades

It is unlikely to be announced in a formal and structured manner in FY14.

There will be significant activity in the airports sector in the coming year

A significant recent development is the decision by the government to invite private international operators to bid for operations and management contracts for Chennai and Kolkata airports (and eventually 15 profitable airports over subsequent years), which are currently under the state-owned Airports Authority of India (AAI). This process is expected to be fast-tracked over the next two months. This is a major strategic decision and should only be taken in the context of a clear long term vision for the future of the AAI.

The RFQ for the proposed greenfield airport at Mopa in Goa is expected to be issued in Aug-13, while tenders for the much-delayed Navi Mumbai airport should follow in Q3.

The government has also announced plans to issue tenders for the construction of 50 low cost airports to improve regional connectivity and this process may be accelerated in the coming months. In recognition of the increasing shift of the market to low cost, CAPA expects that Delhi may become the first airport in India to open a dedicated LCC terminal within the next two years.

There is a requirement for USD1.2 billion of funding for the airport sector in this current fiscal year. The AAI is scheduled to issue USD200 million of tax-free bonds, while the private operators are considering raising capital either through IPOs or securing strategic investors. The final decision will depend upon market conditions.

Ground handling decision due from the Supreme Court in Sep-2013

The ground handling policy which the Indian government first wanted to introduce in 2007, and which would restrict carriers from self-handling, was legally challenged by the airlines arguing that they would face higher costs and a loss of control over critical customer service functions.

The matter has been in dispute for several years and while settlement talks are apparently on between the parties, the opportunity for an out-of-court settlement remains unlikely.

The Supreme Court has postponed the date to hand down a final decision until 3-Sep-2013. We expect consolidation in the sector in FY14 on both the passenger and cargo sides of the business.

MRO's tragic history of dithering and taxation drives jobs offshore

Despite the growing potential of the market, especially as the fleet ages, India continues to represent a challenging environment for 3rd party MROs, with high taxation, expensive infrastructure, a shortage of skills and strong competition from neighbouring markets such as Sri Lanka and the UAE.

This is brought into sharp focus when an India-based MRO reportedly plans to establish a facility in Dubai to service Indian clients. There are likely to be one or two acquisitions in the sector this year.

CAPA India Aviation Outlook Report 2013/14

This analysis is an extract from the 2013/14 edition of the annual CAPA India Aviation Outlook Report released on 22-Jul-13.

The coming year to Mar-2014 will be a defining period for the long-term prospects of the Indian aviation market. In this complex environment, having access to up-to-date research and insights into the direction of the market is critical for any business with exposure to Indian aviation. For more information about CAPA India's research reports click here or contact Binit Somaia on bs@centreforaviation.com

CAPA has a strong and established track record in accurately identifying key trends and developments in the Indian market. We operate India's leading dedicated aviation advisory and research practice offering unrivalled analysis and data across the value chain.