India is forecast to be third largest aviation market globally by 2030. To capitalize on this growth airlines have placed voluminous aircraft orders. Leading the charge is IndiGo, India’s biggest airlines by fleet operated and passengers carried.
At Inception, IndiGo hit the ground — well, skies if you may — running with an order for 100 Airbus320 aircraft in 2005. It ordered another 180 planes in 2011. Then came an order for 250 more planes with options for another 100 in 2014.
And now it has
placed an order for another 300 A320s (including variants).
With the latest shopping trip, India’s airlines collectively have 1,200+ aircraft on order — more than double the existing Indian commercial aviation fleet. To absorb these orders, airlines continuously evaluate fleet strategy and methods of financing. Traditional sources have included commercial banks, export credit agencies and at times even the aircraft and engine manufacturers. Since 2005, as the market has grown by leaps and bounds, the fleet acquisition source that has emerged as a core element of fleet strategy is leasing.
Leasing remains a cornerstone for fleet strategy in the Indian skies
For airlines the largest capital cost is that of aircraft. It is a cost that has to be examined carefully and balanced against a host of factors including asset life, depreciation cover and technology transition – to name a few.
For Indian airlines, the challenges are compounded
given the unique nature of the market. Add to this, the fact that the Indian market is severely challenged on liquidity. Indeed several airline failures can be traced back to improper liquidity management. And with the ongoing banking situation, this has worsened.
Ergo, options that minimise cash burn are usually more attractive. Leasing is one such option. Leasing remains the dominant method for Indian airlines to acquire aircraft and of the current commercial aviation fleet more than 80 percent is leased. Compare this to the global average of around 41 percent.
In addition to cash-flow considerations, leasing traditionally is also driven by liquid credit markets, low interest rates, high competition and high demand. When these elements align, it makes for an attractive financing environment where airlines are able to have banks, lessors and even manufacturers compete and get extremely good financing offers. Within this, one model that has been successfully leveraged by IndiGo and inextricably linked to their strategy has emerged. Namely:
the sale and leaseback. The sale and leaseback (SLB) model
In a sale and leaseback model (SLB), an airline acquires the aircraft at an attractive price and sells the aircraft to a lessor — ideally at a profit — and leases it back for its own use. The SLBs are important as they are cash generative and also help the airline with fleet flexibility.
In addition, as the airline inducts new aircraft the operational costs — most notably the maintenance costs — remain competitive. Shorter fleet replacement cycles also enable the airline to induct new technology faster. The flip side is that airlines are left with asset light balance sheets, over time they end up paying more for the asset.
For SLB transactions to be profitable the aircraft cost (asset cost) has to be very competitive. Further, the liquidity on the aircraft needs to be strong. This in turn is driven by supply and demand and the ability of lessors to place the aircraft with a number of airlines during the life of the aircraft.
IndiGo leverages both these aspects as a core element of its fleet strategy. The massive order volumes enable it to acquire aircraft at very competitive costs (look at it this way: when customers buy in bulk, they are able to bargain for good prices).
IndiGo has another advantage here. Given the type of aircraft, namely the Airbus 320 (and variants) that it mostly operates, the airline finds itself with a highly liquid aircraft with more than 8,000 of the type being flown by airlines across the globe. Consequently, the placement markets are broad and lessors have had no hesitation in financing these aircraft. Add to that low interest rates, high competition and high demand and IndiGo finds itself in a sweet spot.
IndiGo is well-positioned to capitalise on SLB premiums
SLBs are also critical because when planned for and done diligently they can provide for an income stream. This income is the difference between the cost of the asset to the airline and the price at which it is sold to the lessor.
Yet, the process is not quite that simple as lease contracts have to be negotiated and often elements if not explicitly mentioned can have major repercussions. That is:
the construct of leasing contracts are as important as the financial terms.
For the SLB income stream to be a recurrent one, replacement cycles have to be short. IndiGo does this via the six-year lease terms. Additionally, the streams have to run well into the future. Again done via the voluminous orders. The income stream enables the airline to de-risk operational cash-flows, minimize working capital debt as well as strengthen the balance sheet.
Right from the start, IndiGo has understood and aligned itself towards leveraging financing and towards capitalising on SLB premiums. The cost of the asset and liquidity are already covered via volumes and type of aircraft.
What is IndiGo’s secret sauce?
The low-cost carrier strategy and cost discipline build on delivering fares that match consumer demand; the network structure and revenue mix (until now) have been geared towards market dominance and consequently stable EBITDAs; sourcing core talent has ensured that lease contracts are competitive; management stability (viewed over the 14 years since the airline’s launch) has enabled continuity and credibility; and a strong balance sheet and liquidity management have enabled it to minimise credit risk.
These factors cannot be overstated as players in the aircraft financing and leasing market continuously evaluate risk. This comprises of default risk, the airlines credit rating, EBITDA fluctuations, comfort with management, contract enforcement, a country’s acceptance of the Cape Town Convention (which provides remedies for default), and also precedence.
For a market such as India that has seen several airline failures and where
structural challenges continue, airline strategy essentially has to address inconsistencies seen and mitigate these issues. The centerpiece of airline strategy is built on the elements of costs, cash flow and capacity. Airlines that get this right are poised to succeed. IndiGo happens to be one such airline.
Starting with its 100 aircraft order in 2005, IndiGo leveraged the order stream and minimised risk by not only looking at the asset but also the financing structure of the sale and leaseback. The SLB at this point is integral to the airline’s success and inextricably linked to its strategy.
Satyendra Pandey has held a variety of assignments in aviation. He 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