India’s aircraft orders to exceed 1,000 with Jet Airways’ imminent order; infrastructure a problem

After decades of inaction, India is on the way to becoming a regional force

For India, the elastic has at last snapped into place as rapid economic growth and more liberal governance encourages airlines to expand into the vacuum they had left until very recently.

Most of the action for the time being is in domestic and regional short haul operations. Whether this rush of new orders can be absorbed - and whether the infrastructure, including human resources, can support this level of growth is another issue.

Meanwhile the atmosphere is positive and, importantly, the competence of management is growing, led by the highly successful LCC IndiGo.

Ratio of Aircraft on order to Aircraft in service in the 20 largest markets, by current fleet

Source: CAPA Fleets Database, CAPA Research.

Note: Ratio for India assumes additional 100 aircraft orders each for Jet Airways and Vistara. Without these, the ratio would decline to 1.8 but would remain the highest.

1. Jet Airways, the oldest private airline is renewing

Jet Airways' existing order for 75 737 MAX aircraft, which are scheduled for delivery between 2018 and 2023, will mostly be used for replacement. At present, half of its narrowbody fleet is aged 9 years or older.

At the same time, the new order for 100 aircraft is intended for expansion. The carrier also has five A330s and 10 787-900s on order, although it continues to defer deliveries. Nevertheless, a large widebody order will be necessary in the near term, both for replacement and expansion.

Average age of Jet Airways fleet by aircraft model

Source: CAPA Fleets Database.

2. Vistara, the youngest, is growing

Vistara, India's youngest full service airline, currently has a fleet of 14 A320s - the most recent of which is a neo variant, with a further six neos on order. The airline plans to induct widebodies once it becomes eligible to operate international services upon reaching a domestic fleet size of 20 aircraft. Vistara's first international route is expected to launch from the Winter Schedule 2018/19.

For its 50 narrowbody and 50 widebody order, Vistara is expected to opt either for a combination of A320s and A350s, or 737s and 777s.

The airline is reportedly interested in the 777X, but with the first deliveries of the type not expected until 2020, and given current fuel prices, Vistara may alternatively consider the 777-300ER.

Taking widebodies, including 787s, on short term lease from Singapore Airlines - a 49% shareholder in Vistara - is also a possibility.

India's airlines aircraft in service and on order (assuming new Jet Airways and Vistara orders)

Source: CAPA Fleets Database, CAPA Research.

3. IndiGo's aggressive and unprecedented growth creates a strategic compulsion for others to expand

IndiGo has the largest in-service fleet in India, at 135 aircraft, and the largest order book of any airline in the world, at 458 aircraft. Its fleet could expand by up to 46 aircraft during this financial year - a net addition of almost one aircraft a week.

Other airlines are responding by accelerating their own expansion in order to hold on to market share and to prevent IndiGo from securing a dominant position with over 50% of the market. As of May-2017, its share had already crossed 41%.

Despite IndiGo's market-leading performance to date, this scorching pace will undoubtedly test the capabilities of its management team, increasing the risk of a negative impact on the airline's profitability and operational performance.

And to add to the complexity of its operations, IndiGo recently surprised the market by announcing plans to diverge from its single aircraft type model and launch a regional operating division.

In May-2017 the airline announced an order for 50 ATR-72s, which is likely to be expanded further in the near term. However, in terms of regional equipment orders in the market this simply replaces the 50 Embraer jets that were on order to Air Costa, until that airline suspended operations earlier this year due to financial difficulties. Air Costa's operating certificate was revoked in Jun-2017.

As per CAPA's earlier research reports, we do not rule out the possibility of IndiGo ordering A330neos to launch long haul low cost services.

Unprecedented expansion places immense pressure on the aviation system; the industry may be be underestimating the challenges ahead

Of the expected 1123 aircraft on order, more than 700 are scheduled for delivery within the next decade and 400 within the next five years. This excludes orders yet to be placed and equipment to be taken on lease.

India might experience the entry of 1-2 new large startups in addition to the incumbent airlines, including Qatar Airways' proposed venture.

Aircraft induction on this scale will require massive infrastructure development, skilled resources, and aircraft financing at a pace that has not been seen before in India.

Despite stronger than expected yields since Jan-2017, overcapacity will reduce profits and increase losses in FY2018

Since demonetisation took place in Nov-2016, the market has defied expectations of a slowdown in demand for air travel. Instead, traffic growth has remained robust and yields have been surprisingly strong for the past five months, firming by 6-8% year-on-year in Apr-May-2017.

But despite the strength of the Indian economy, the market will not be able to soak up all of the additional supply without stimulatory pricing. Excess capacity will place downward pressure on yields, pushing airlines towards lower profits and increased losses.

Financial results in 4Q17 and for the full year FY2017 were lower than most operators expected

However, these results were in line with CAPA's profit forecast in Dec-2016. With deteriorating financials, rising oversupply and higher competitive risks, raising strategic and retail capital may start to become challenging.

In FY2016, at an industry level, India's airlines posted the lowest losses in a decade. But this may prove to be a high water mark. Losses increased from INR5.7 billion to an estimated IN20.9 billion in FY2017. CAPA projects that airline financials will deteriorate further to a loss of INR25-30 billion in FY2018.

These market conditions and the associated risks may subdue investor interest in Indian airlines - strategic, institutional and retail - and by FY2018 the window may close for airlines to raise capital.

Consolidation starts to become inevitable

This outcome is inevitable in the next 1-2 years as financial challenges and competitive dynamics recur. A repeat of the conditions seen after the euphoric growth during 2004-2008 is possible - although conditions have changed greatly since then.

Excess capacity threatens to make the weaker operators particularly vulnerable, provoking a high likelihood of consolidation. Deferral and cancellation of some of the headline aircraft order numbers are also likely.

Pilot resources are greatly stretched

In this rapid growth environment, poaching of pilots is becoming a serious challenge The regulator is likely to increase the notice period for pilots to exit from six to 12 months. CAPA views this as a major barrier to growth.

With its insatiable demand for crew to support its rapidly expanding fleet, and having its strong financial reserves to be able to fund a hold pool of pilots, IndiGo is leading the way in poaching crew. IndiGo could require 500-600 additional pilots in FY2018, creating a shortage across the industry.

The alternative, relying on expatriate commanders to address the shortage, creates a potential industrial relations challenge. The strategy of employing expatriate captains on higher salaries than locals is not only an expensive solution, it is also creating resentment among Indian pilots and could evolve into a more serious industrial relations issue. Alternatively, agreeing to the Indian pilots' demand for pay parity would further increase unit costs.

However, there does not appear to be any near term solution to addressing the supply side constraints. Little is being done institutionally to prepare for this high growth future.

Airport infrastructure challenges remain

CAPA has earlier highlighted that airport infrastructure challenges could constrain growth, leading to sub-optimal operations and network economics, and the situation is become more acute.

Parking bays and runway slots will become increasingly scarce over the next few years, especially at metro airports. Signs of congestion are already emerging at Mumbai, Chennai and Delhi.

The situation will deteriorate further unless airports are able to construct 400 parking bays and enhance airside capacity within five years. Otherwise airlines will face challenges in implementing their base and network plans.

Safety risks due to the regulator being overstretched

Institutional strengthening of the DGCA hs become a national interest issue. India's regulator, the DGCA, will struggle to provide adequate regulatory oversight for the projected size of the market. India is already under-resourced and short of expertise to meet current requirements - let alone future growth.

The increase in airport incidents in the past 12 months is of concern. In addition, the regulator will be stretched by the entry of new operators and first of type equipment as a result of the launch of the Regional Connectivity Scheme.

CAPA has long maintained that the projected industry growth rates will heighten safety risks due to the regulator being overstretched. Institutional strengthening of the DGCA is a national interest issue.

If oversight capabilities are left unaddressed, another FAA downgrade to Category 2 is not out of the question. That would have major repercussions for Indian airline growth.

Large aircraft orders driven by expectations of sale-and-leaseback profits, but may exceed the financing available

Indian airlines are planning to finance most of the aircraft orders through sale-and-leaseback transactions. By placing large orders they are able to achieve a lower purchase price from the manufacturers and a higher profit on selling the aircraft to a lessor, generating valuable cash for working capital.

They have seen how effective this strategy has been for IndiGo, and intend to follow suit.

Whether there is sufficient lessor interest to finance all of these aircraft, including pre-delivery payments, and what impact the volumes will have on sale-and-leaseback margins, is yet to be seen. Airlines that are banking on profits on the sale of aircraft may find that they are unable to raise as much cash as projected.

However, the outlook for macro-economic conditions remains favourable

CAPA India is South Asia's leading specialist aviation advisory and research practice and has the region's largest on-the ground team of consultants and analysts dedicated to covering the sector. Over the last 14 years we have built up a portfolio of more than 125 major advisory and research engagements in South Asia for airlines, airports, investors and suppliers. For more information on how we can support your business in the Indian market contact Director South Asia, Binit Somaia on bs@centreforaviation.com

Despite the challenges described, there many positive conditions as well.

India's economy looks well positioned to continue to grow at 7-8% per annum over the next few years, which are also expected to be characterised by political stability. And fuel prices are expected to remain benign, with the exchange rate in the region of INR65-70.

The Indian government appears willing to consider privatisation - a far-reaching and highly positive reform.

In such a highly competitive and challenging environment, Air India cannot continue to be funded by taxpayers to fight private capital. The national carrier has already absorbed USD3.75 billion of equity from the government with no end to the need for subsidies in sight.

Subsidising Air India to the tune of hundreds of millions of dollars a year is neither sustainable nor desirable for a government which has so many other pressing economic and social priorities. Furthermore, the government's role as a major operator in the aviation sector through its ownership of Air India and the Airports Authority of India will continue to be a negative influence on policy outcomes.

Air India's small operating profit in FY2016 was viewed in some quarters as a sign that the national carrier had turned around. While there have been some improvements in its operating and commercial performance, the company does not yet have a viable business model or a clear long term direction. And it remains hamstrung by massive debts.

Air India's plans to pursue aggressive expansion, taking delivery of 70-80 narrowbodies, widebodies and regional aircraft over the next few years without addressing the underlying organisational and balance sheet weakness, will lead the airline into a structural mess.

Air India's new strategy should be to deleverage its balance sheet significantly before a business case for privatisation is considered. Measures that could be taken to support an effective restructuring of the airlines include: hiving off Air India Express and pursuing a partial sale of its LCC subsidiary; selling its 50% stake in AISATS; divesting its ground handling subsidiary Air India Air Transport Services Limited; and inducting an investor in Air India Engineering.

The proceeds from these divestments, combined with the sale of real estate holdings, would help in significantly reducing non-aircraft related debts.