India’s aviation growth story has all the perfect ingredients working in sync — a growing middle-class forecast to hit 300 million+, economic growth averaging 7 percent+ per annum, expanding urbanisation, improving infrastructure and favourable demographics. Indeed, consensus forecasts estimate that India will be the third largest aviation market by 2030. Yet, in such a market where two large established airlines are up for sale, investor interest has been limited at best.
From a valuation perspective, on first glance, there are several aspects that would lend themselves towards increased earnings and a profitable exit for an investor. But a closer examination of the valuation drivers gives a very different picture. These are:
Large aircraft orders also carry an inherent risk
India’s airlines have been on a buying spree. The commercial fleet of 645 aircraft is set to double within the next ten years and the ratio of aircraft in order to aircraft in service is about 1.7 which is the highest globally. These aircraft orders assume that the market will continue to grow and that more and more travellers will take to the sky. But layer in the ability to finance these aircraft, the ability to induct the aircraft and the ability to dispose of these aircraft and one gets a very different picture.
Inadequate provisioning leads to limited debt capacity
Private capital requires the ability to take on additional debt. Not only for an optimal capital structure but also towards better returns. The most recent example is that of
Jet Airways. With debt levels that high, the question remains were they not provisioned for and what gearing range was used (if any).
Similarly, with airlines inducting large quantities of aircraft financed via sale-and-leasebacks this again brings up the question of provisioning. Specifically, in the last few years, the trend has been to provide for supplementary lease rentals via non-fund measures. This helps conserve cash-outflow in the near term but as the aircraft go on their 6 yearly checks there will be a large hit to the cash-outflows. The question is: have these been provisioned for?
Not all airlines have addressed cyclicality of cash flows
In India, Q1 and Q3 are periods where demand is high (consequently stronger cash-flows) and Q2 and Q4 are traditionally weak periods. Capacity adjustments can help address negative cash flow risk for these periods. Currently, these adjustments are only via scheduling C-checks during weak quarters and/or balancing seasonal demand patterns. Idling assets is not quite an option and fixed costs remain the same. Giving rise to unstable EBITDAs. With the voluminous aircraft orders, the capacity adjustments may not be possible to the same degree in the future. There are tactical interventions to address cyclicality of cash-flows but very few airlines are proactively thinking and implementing such measures. Cyclicality carries cost and if not addressed can impact the earnings potential considerably.
Certain liability structures are impractical
The challenges faced by airlines have highlighted the need for a closer examination of liability structures. For instance, certain structures call for “first lien on cash-flow.” While extremely attractive on paper, this is impractical by its very nature. In most cases, a payable towards financing cannot take precedence over operational payables as it essentially means the grounding of the airline.
Similarly, a high net-worth promoter or entity backing the airline is inconsequential if the liability structure does not ultimately force the funding.
Management inertia and attrition are both signals
There is a focus on the exodus of management which often signals challenges and/or a confused strategy. Indeed for Indian airlines and a market where aviation talent is hard to come by, and where leading an airline requires
unique capabilities management, attrition is a very negative signal. However, equally important is management inertia. As that too points to the fact that the organization may not be adapting to the changing market dynamics and trends. Stand-alone metrics such as OTP and load factor are inconsequential
On-time performance (OTP) and load factor are both key metrics for airlines. While the former is indicative of the efficiency and reliability of the schedule, the latter indicates how much of the capacity is being utilized. Yet stand-alone these metrics are meaningless. Give an airline operations head enough spare aircraft or generously lower your asset utilization and one can immediately improve OTP. Similarly, empower the sales teams to lower prices and dole out incentives and one can achieve any load factor target. The metrics have to be seen in conjunction with others. OTP must be seen in conjunction with asset utilization. Load factors must be seen in conjunction with yield. Stand-alone these metrics are inconsequential.
For slots, bilaterals and parking rights – value accrues from usage, not from grant
There has been much talk of how certain airlines will be lucrative for investors due to holdings of slots, bilaterals and parking rights across the airport in India and globally. Yet, the contradiction is that for any airline holding these assets the value accrues from usage and not grant. A prime slot out of a constrained airport is of no use if the airline is unable to derive premium on that slot. Similarly, slots at international airports are not value-accretive if they don’t have a strong network and feed that is supporting flying in and out of the airport using that slot. Same is the case for bilateral rights and parking rights.
It’s worth repeating that for slots, bilaterals and parking rights value accrues from usage, not from grant.
investors have shied away from the market. But given the size and geopolitical positioning, investors will no doubt examine opportunities in Indian aviation. A second look at valuation drivers by Indian airlines may be just what is required.
Satyendra Pandey has held a variety of assignments in aviation. He is the ex. 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. Has also provided policy inputs and suggestions.