Analysis: India’s airlines face a crushing liquidity crunch

As the country deals with a drastic slowdown in consumption, 5 percent GDP growth for the quarter, a falling rupee and minimal capex spending by corporates, India’s airline industry is also facing liquidity challenges. Lending to airlines is severely constrained and the failure of Jet Airways continues to haunt lenders. For banks with an exposure of more than Rs 8,500 crore to Jet Airways, the likelihood of a suitor diminishes each day. Even the most optimistic assessments indicate that they will only be able to recover a miniscule portion of amounts lent. The fact that this is a large airline failure which comes just seven years after Kingfisher airlines where the default is to the tune of Rs 9041 crore only exacerbates the situation. The consequence: banks are negative on the airline sector. Liquidity issues abound.

Currently, there are six airlines in operation with three being profitable on a net basis. The profitability fluctuates wildly and the overall industry balance sheet (with the exception of Indigo) remains weak. Even for the LCCs, take away the non-operational income and the cash-flow situation is not quite representative of healthy margins. While some airlines tout gross profit figures or EBITDA earnings, these simply don’t count as they assume that the financing costs don’t matter. As legendary investor Warren Buffett put it, “people who use EBITDA are either trying to con you or they’re conning themselves”.

While the demise of Jet Airways has certainly helped with pricing power for existing airlines, this comes during a time where demand is slowing. The seven-month period of January-July 2019 saw domestic traffic growing by only 3.15 percent which was a four-year low. The single-digit growth numbers will likely continue for the rest of the year. When viewed in conjunction with compressed margins and rising costs – it is a situation that makes for thin debt-service coverage and thus the reluctance of bankers to lend.

If that wasn’t bad enough, the banking industry itself faces liquidity issues. Banks, for the most part, are undercapitalised. And undercapitalised banks have the tendency to make bad loans as the leverage levels are already high and recognising non-performing assets (NPAs) means that the bank loses all capital on such loans. Where there are enough bad loans on a bank’s balance sheet – it engages in a practice of lending to already distressed companies in the hopes they will get better and thereby repay the capital to the bank. However in doing this there is the unintended consequence: banks extending credit to weakest airlines at a cost of borrowing that may be lower than that extended to the strongest airlines. The lending which is ideally to be used towards recapitalisation ends up being used by airlines for continuing operations and not growth. Consequently, weak airlines are kept afloat impacting industry pricing power, capacity utilisation and borrowing rates. The recapitalisation of weaker airlines never occurs.

In an irony of sorts banks are avoiding this situation by asking for collateral such as personal guarantees or first charge on assets or simply not lending to airlines. Not lending is the safer option as it involves zero risk and the current narrative of airlines as an extremely risky proposition is prevalent and strengthened. And to be fair, it’s not just the banks. There are a host of factors to blame.

On the airline side, in addition to the macro-economic factors, the asset-light models have led to balance sheets that offer very little by way of collateral. Structures such as first-charge on cash-flows have now been shown to be ineffective. Other esoteric structures like foreign currency escrows also require strong operational numbers, a well-thought-out plan and a balance-sheet focused management. That for Indian airlines is lacking as a whole. Above all these complex sophisticated structures call for a certain degree of risk-taking coupled with a measured bet on the sector’s outlook. It is a call few are willing to take.

The liquidity situation will hit hard. Airlines, after all, require large amounts of capital for day-to-day operations. These include bank guarantees, lines of credit of working capital loans. These are increasingly constrained. Yet, airlines are at the apex of the aviation and tourism value chain and fuel the entire aviation economy so the impact flows through to other parts of the economy.

Undercapitalised airlines pose a challenge as cutting off credit to the airline means a significant impact to the “aviation economy.” Some airlines may continue to add capacity just for the cash-flows from financing, while others may be forced to dispose capacity for the very same reason. Some will engage in pricing below cost towards cash-flows forcing the rest of the industry to follow. And consequentially the proverbial downward spiral.

To alleviate this situation, policymakers may have to think of ways of reducing cost for the airlines while also looking at avenues to boost lending to the sector. There are several policy interventions that are possible but it remains to be seen if these will be proactively taken.

Overall, the liquidity situation is likely to cause turbulence for airlines in the months to come.

Satyendra Pandey is the former head of strategy at a fast-growing airline. Previously, he was with the Centre for Aviation (CAPA) where he led the advisory and research teams. Satyendra has been involved in restructuring, scaling and turnarounds.

Read his columns here.