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Indian carrier 1QFY2013 performance indicates sustainable recovery will be challenging

24-Aug-2012

In the CAPA India Aviation Outlook 2012/13, we projected that India’s airlines would post a combined loss of USD1.3-1.4 billion for the 12 months ending 31-Mar-2013. However, these losses were expected to be accounted for by two carriers, Air India (USD1.3 billion loss) and Kingfisher Airlines (USD220-260 million loss). The remaining four private carriers combined – Go Air, IndiGo, Jet Airways/JetLite and SpiceJet – were expected to post a modest profit of approximately INR11 billion (USD200 million profit).

Based on 1QFY2013 performance and the expected direction of the market over the next three quarters the major update to the CAPA India forecast is that Air India’s losses could ultimately be closer to USD1 billion, an improvement of USD300 million over the earlier projection. The uncertainty regarding the scale of Kingfisher’s operations means that any outlook for the carrier’s financials is very difficult to estimate, and its full-year loss could be higher than expected. However, the other four private carriers remain on track to achieve a USD200 million profit for the full year.

In the first quarter ended 30-Jun-2012 those four private carriers are estimated by CAPA India to have achieved a profit of approximately USD40 million, with a breakdown as follows (it should be noted that the results for IndiGo and Go Air are CAPA India estimates as these two carriers are not listed and do not publish their financials):

  • IndiGo: INR1.06 billion (USD18.9 million) – CAPA India estimate;
  • SpiceJet: INR560 million (USD10 million);
  • Go Air: INR300 million (USD5.4 million) – CAPA India estimate;
  • Jet Airways: INR240 million (USD4.3 million);
  • JetLite: INR117 million (USD2.1 million);

However, sale-and-leaseback revenue and other non-operating income have strongly contributed to the return to profitability at all of the above carriers, especially Jet Airways. SpiceJet was profitable at the net level, however, the carrier did have a large and unexplained increase of INR440 million in other operating income which contributed to the net profitability.

IndiGo also had significant sale-and-leaseback and other non-operating income, however, the airline is still estimated to be profitable at the underlying level without these contributions. The fact that the result is below CAPA India’s expectations reflects the cost challenges in the market.

Other income could not be confirmed for Go Air but the airline is believed to be profitable without such contributions.

If Air India has a chance it is now, but it needs a board and management that can seize the initiative

Air India’s domestic gross revenue per passenger increased by 46% in 1Q resulting in topline growth of USD80 million, despite the impact of the pilotsstrike. Based on CAPA India estimates, Air India’s average gross passenger revenue was the highest in the industry at INR5655. As a result, domestic operations showed significant improvement and may have ended the quarter with a small surplus at the operating level, although CAPA India estimates a net loss of INR3-4 billion (USD53.6-71.4 million).

Air India estimated 1Q gross revenue: FY2013 v FY2012

 

1QFY2012

1QFY2013

Y-o-Y change

Domestic

INR9.2 billion

INR13.4 billion

45.7%

International

INR15.8 billion

INR16.1 billion

1.9%

Total

INR25.0 billion

INR29.5 billion

18.0%

For the first time in several years, Air India’s domestic performance is headed in a positive direction which could become a trigger for an overall turnaround if the situation is capitalised. The national carrier needs to take advantage of the current domestic market conditions to focus on its restructuring by further reducing its cost base, improving productivity and solving its outstanding HR issues.

If Air India has an outside chance at achieving a successful turnaround, the time is now, but it needs a board and management that can seize the initiative. With no significant capacity induction expected in the overall domestic market, the carrier should be in a position to maintain its improved yields and load factors. Meanwhile, the financial restructuring plan that has been approved by the Government should result in a significant reduction in overall interest costs thereby reducing losses at the net level.

However, CAPA India is concerned that Air India may not have the capacity to fully leverage the demand in the market, as it has less than 55 domestic aircraft (of which only around 45 are dedicated purely to domestic), which is inadequate for a sustainable turnaround.

Similarly, the carrier has only 20-25 aircraft available for international services, of which the core aircraft type, the Boeing 777 has not been appropriately deployed with respect to route selection. Hence the induction of the 787 will be critical if Air India is to establish a competitive product and network. However, the staggered delivery schedule through to 2014 may not be fast enough.

Without an appropriate fleet to support it, Air India’s business plan is almost irrelevant. Subject to a strong performance in FY2013 CAPA India believes that the carrier may need to consider augmenting its capacity.

These recent positive developments should be used as an opportunity to remotivate employees, particularly as resolution of human resource issues remains the most significant structural challenge for the airline. The upcoming retirement of 13 executive directors will deplete management strength at this critical time and Air India should use this development to renew its capabilities by inducting experienced industry professionals with specialist domain knowledge to add value and competitiveness to its turnaround plan. Serious attention must be given to providing Air India with the necessary framework – including an effective board and senior management – to maximise the prospects of achieving a successful turnaround. It should be noted though that even with a focused approach this could take 3-5 years.

However, the pilots’ strike proved very costly to the carrier’s reputation and virtually sealed the decision by Star Alliance not to proceed with its membership.

Based on its 1Q performance and subject to sorting out issues with the pilots to allow international operations to recover, a robust result in 3Q and 4Q which is possible, could see Air India’s projected full-year loss for FY2013 decline from USD1.3 billion to just under USD1 billion.

Jet fails to leverage weaknesses at full service competitors

Jet Airways continues to face a strategic challenge with respect to its low-cost strategy which remains ill-defined, despite the fact that the Jet Konnect subsidiary accounts for the majority of the airline’s domestic capacity. The confusion is highlighted by the fact that certain aircraft operate as full service in one direction and then return under a low-cost designation. Meanwhile, progress on the rationalisation of JetLite and JetKonnect under a single brand is progressing slowly.

Jet’s revenue growth was surprisingly modest given that the airline was presented with a potentially invaluable opportunity to exploit the difficulties faced by both of its full service competitors. Air India’s international operations were crippled by a pilots strike that last almost two months and which may require a further two months to resume full service, while Kingfisher has downsized dramatically, operating less than 25% of its fleet size of this time last year.

Despite the troubles at Kingfisher, its key competitor in the corporate market, Jet Airways achieved only a modest 8.9% year-on-year increase in gross revenue per passenger in Q1FY2013. International average gross fares grew slightly more at 11.8%, but again this was below expectations given that Air India, the largest international operator in the Indian market was crippled by industrial action for much of the quarter. That Jet Airways has been unable to leverage this situation to deliver far greater improvements to revenue and its bottom line indicates a serious structural weakness.

CAPA India is of the opinion that insufficient attention is being given to managing costs. In the hostile environment that prevails sustained profitability will be difficult without a major restructuring of controllable non-fuel costs. Jet Airways needs to focus on three key elements in order to create a viable operation:

  1. Introduce strategic clarity and greater definition with respect to its low cost subsidiaries;
  2. Control and rationalise its non-fuel costs, and:
  3. Focus on generating ancillary revenues. This is an area which the airline is starting to take some clear steps towards and which serve it positively.

IndiGo on track for record profit but high costs and international service may impact results

IndiGo continues to be the lead performer in the market, however, the elevated cost environment in the domestic market has also resulted in a downward impact on its 1Q performance. And with international services still in their first year, the losses associated with establishing these new routes have also brought down its numbers. The impact of international services could be greater than expected and hence IndiGo’s net profit for 1Q may be less than the INR1.06 billion estimated by CAPA India. Nevertheless, the carrier could be on track to record its highest annual profit to date, subject to the performance of its international operations and the direction of the overall cost environment. Strong results in 3Q and 4Q will be critical to achieve a record profit for the year.

One area which the airline needs to apply some focus on is ensuring consistency of service levels as it continues to expand. The pressure of rapid growth is beginning to impact the customer experience at some key stations, although IndiGo’s overall customer satisfaction is still highly rated.

Kingfisher Airlines, moving closer to an operational shutdown

Kingfisher’s 1Q loss is in line with expectations. As the carrier continues to operate with minimal cashflows, its services are subject to occasional disruption due to labour issues arising from delays in the payment of salaries. Operating a ‘holding schedule’ with just a fraction of the fleet means that it is almost impossible to generate the necessary revenue (which totalled only INR3 billion/USD53.6 million in 1QFY2013 for example) to meet the huge fixed costs and interest burden on its debt. Kingfisher is able to continue as a result of daily infusions of funding by the promoter, however, with mounting losses the situation is unsustainable. In 1Q the promoters invested USD133.9 million, but this barely allows the airline to survive.

A viable turnaround is unrealistic without a significant recapitalisation of the airline. A financial investor is more likely to consider a stake in the airline alongside a strategic investor such as a foreign airline, but with no signs of an imminent change in the regulations to permit foreign airline investment, a successful turnaround becomes increasingly challenging as time passes. Without an investment of approximately USD600 million in the next 30-60 days, and access to a further USD400 million over the next 12-18 months to fully-fund its business plan, Kingfisher faces the prospect of an operational shutdown, possibly temporarily, to allow it to restructure and reorganise. The promoters and the banks will need to make a clear decision and take appropriate action on the future of the airline. A restructuring of the company will require the banks to take a significant haircut.   

Go Air, the surprise package

Go Air, the smallest Indian carrier by fleet size (although Kingfisher has a lower domestic market share due to its curtailed operations) is the surprise package, performing better than most of its larger competitors. The carrier is maintaining stable operations with a high level of customer satisfaction and has achieved the highest gross fares in the market (INR5100-5200) amongst the LCCs, aided by the fact that it operates several routes on which it faces limited competition.

A focused network with a small fleet, judicious route selection and an overall upward tide in terms of yields has provided Go Air with a creditable result given the operating environment. However, the carrier needs to reduce its debt levels which CAPA India estimates to be around INR9 billion, which would help to improve its bottom line.

SpiceJet performance weighed down by regional and international operations

SpiceJet’s financial performance continues to be impacted at a net level by its regional Q400 operations which commenced in Sep-2011 and as a result are still in the development stage and are yet to turn profitable. The carrier’s decision to launch its newest international route to Dubai in the summer months when point-to-point traffic is at its lowest is also likely to weigh down its Q2 results, and could have been better timed. However, some of the international operations will increase the utilisation of the existing fleet help build a more competitive cost base which is a step in the right direction. 

Foreign airline investment continues to be delayed

There appears to be broad consensus across the concerned ministries for allowing up to 49% investment by foreign airlines in Indian carriers. However, a formal decision has been repeatedly delayed due to objections from certain coalition partners and by strong lobbying, despite all carriers openly declaring support for the reform. Ultimately, this reflects poorly on the ability of the Ministry of Civil Aviation to implement key policy initiatives which are of importance to the sector, with the ground handling policy being another example.

Nevertheless, CAPA India expects that foreign airline investment will be approved in due course. As a result of this reform, the two airlines which are the most likely candidates for investment are GoAir and SpiceJet. Kingfisher’s prospects for recovery are highly contingent upon foreign airline investment being approved.

Direct import of aviation turbine fuel unlikely to materialise in practice

The highly punitive fiscal regime in India – particularly in relation to aviation turbine fuel (ATF) – is the primary problem for the aviation sector. The cost of ATF in India is almost 60% higher than international benchmarks. Combined with a high base price, fuel now represents 40-50% of a carrier’s operating costs. As the graph below depicts, without the sales tax on ATF (which averages 24%), India’s carriers would have reported a combined net profit in 1Q on domestic operations.

Impact of sales tax on ATF on 1Q domestic financial performance

Earlier this year the Government allowed all Indian carriers to directly import ATF, enabling them to avoid the sales tax on fuel. The Directorate General of Foreign Trade has granted approval for carriers to import the following volumes of ATF:

Airline

ATF Volume (kilolitres)

Value

Air India

100,000

INR5.0 billion / USD89.3 million

Go Air

200,000

INR12.0 billion / USD214.3 million

IndiGo

715,000

INR32.0 billion / USD571.4 million

Kingfisher

500,000

INR22.3 billion / USD398.2 million

SpiceJet

50,000

INR2.4 billion / USD42.9 million

This initiative did signal a positive intent by the Government to assist the industry, although in practice the associated infrastructure and logistical issues mean that airlines will struggle to generate any cost savings. Furthermore, airlines will require a letter of credit or significant cash balances to fund advance fuel purchases, which in the current financial circumstances is very challenging. SpiceJet is expected to import its first tranche in the next few months, however, for the reasons noted CAPA India believes that the industry is unlikely to benefit from this policy development.

Cost and regulatory challenges expected to remain

The fact that the combined performance of these carriers is the best in six quarters is a positive development after an extremely challenging period for Indian aviation. Strong yield improvements and capacity discipline are also encouraging as airlines focus on profitability above market share, with only low single-digit year-on-year increases in weekly seats offered in May-2012 and Jun-2012.

Also positive is the fact that despite sharp increases in fares of 15-20% traffic continued to post modest growth in April and only small declines in May and June. This suggests that the underlying market demand remains strong. However, the pressure of increased costs being transferred to passengers is starting to be felt as evidenced by the more significant 9.9% decline in traffic in Jul-12.

But despite the strength of the market, the results are below CAPA India’s expectations which indicates that the hostile cost environment – some of which management has limited control over, such as the cost of fuel and the depreciation of the rupee – continues to impact all carriers and there are few signs that carriers are successfully tackling this issue.

Domestic ATF prices: FY2012/13 vs FY2009/10

Brent crude prices are once again approaching USD120/barrel and the Indian rupee remains weak at close to INR56 to the USD – as a result of which the local rupee price of aviation turbine fuel is almost equivalent to the USD150/barrel spike that was achieved in 2008. Except that in this case the elevated levels are far more sustained.

CAPA India estimates that the rupee is close to the peak of its weakness, however, it is expected to remain above 55 in the near term. Both oil prices and the current will continue to have a major impact in FY2013.

Cost pressures will be further intensified towards the end of this year when increases in airport charges and passenger fees are announced for Mumbai, Chennai and Kolkata in 3Q. Ground handling charges are also rising. Continued policy and regulatory challenges add to the complexity of the environment. The cost structure is not compensated by fare levels despite the recent increases in yields and at present Indian carriers do not have a cost base to deliver sustainable profitability.

Too early to point to a sustainable recovery

The fact that for most carriers underlying profits remained modest at best after excluding sale-and-leaseback and other non-operating income – during a peak travel quarter which saw strong yield improvements – means that structural imbalances remain. As a result, CAPA India believes that significant improvements will be required in 3Q and 4Q financial performance to suggest that a sustainable recovery is underway. 

CAPA India expects that 3Q will be a robust quarter supported by increases in yield. The current monsoon quarter 2Q, which is traditionally weak, is showing some visible signs of demand weakening, however, this is offset by relatively firm yields for this time of year. 

CAPA India sees signs of improvement but due to concerns about the cost structure and the regulatory environment, structural imbalances remain and it is too early to call a sustainable recovery. Continued increases in the cost of travel could impact traffic growth. We maintain our outlook for 8-10% domestic traffic growth (with an expectation towards the lower end of the range) for now, but continue to monitor the situation and will review the forecast in our mid-year outlook in Sep-2012.


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