Nitin AgrawalMoneycontrol Research
With domestic passenger traffic crossing the 10-million mark for the first time in a month of May 2017 and passenger load factor touching a new high of 88.9 percent, Indian carriers look set to fly high. The aviation industry, though highly competitive, is experiencing a sweet spot thanks to benign fuel prices and an increase in passenger traffic driven by middle-class affluence. In this environment, we believe that the players having excellent networks and performance along with sound financials are well placed.
Interglobe Aviation, better known as IndiGo, the market leader in the domestic skies, is now aiming big with its announced intent of acquiring Air-India’s international operations, along with Air-India Express. Is it being too ambitious, or is the cherry-picking of parts of the national carrier a well-considered strategy that will generate value in the long run?
Industry Tailwinds
India’s domestic traffic registered a growth of 20 percent compounded over FY14-17, gaining market from the railways where rail upper class passenger traffic registered a meagre growth and rail non-suburban passenger traffic witnessed a decline.
The industry is building additional capacity and has placed orders for as many as 829 aircraft (current fleet size is 498). As per a report from IDFC, 251 additional aircraft will be added to the fleet by FY20, translating into a capacity increase, as measured by ASKM (Available Seat Kilometers), of 15 percent compounded over FY17-20. This additional capacity is expected to serve a 17 percent increase in passenger traffic.
The industry has witnessed load factor growing from 78.8 percent in FY15 to 81.7 percent in FY17. Load factor is estimated to be stable at around 80 percent with additional capacity and passenger growth.
The paradigm shift in the industry came from the decline in fuel prices -- from above USD 100 per barrel to the current levels close to USD 45 per barrel. As fuel alone contributes around 30-35 percent of the total cost of an airline, declining prices have led many airlines to turn profitable after recording losses for years.
IndiGo: Dominates the Indian Sky
IndiGo dominates the Indian skies with 40 percent market share; if international traffic is thrown in, its market share is still a healthy 34.9 percent. Its passenger traffic registered a significant growth of close to 28 percent compounded over FY12-17, as against industry growth of about 10 percent on the back of its no-frill products at competitive prices, its reach and on-time performance.
Cost Optimization
IndiGo is navigating well in skies on the back of its operational efficiency. The company has focused on reducing every component that appears in its cost structure. IndiGo’s per unit cost is lower compared to other players in the industry, as shown in the table below. Even when oil prices were ruling very high, the company was consistently able to make profit. Now, with low prices, earnings are poised for takeoff.
Efficient Sweating of Assets
The company also has a young fleet (average age of five years), which gives it a better fuel efficiency. Use of single aircraft and class configuration also help it to reduce training costs. Additionally, the company has been able to utilise its assets much better than its peers: Its aircraft utilisation stands at 12.7 hours per day (SpiceJet: 10 hours per day).
(EBITDAR is Earnings before Interest, Tax, Debt, Amortization and aircraft and engine Rentals, an important metric to value airline carriers)
Asset-light model
The company has a very strong balance sheet, thanks to its asset-light model. It has a fleet of around 131 aircraft out of which 114 (87 percent) are on operating lease, reducing capital requirements. On the back of low capital requirement, the company has been able to generate a very high free cash flow yield, which stands at 11.8 based on FY17 numbers, up from 2.5 in FY15.
On the capacity front, IndiGo has 411 aircraft on order and is expected to reach a fleet size of 200 aircraft by FY19, representing a growth of 24 percent compounded over FY17-19. The higher capacity is expected to serve various new routes and support growth in passengers.
Air India – the New Feather in the Cap?
As far as reach is concerned, the management wishes to capture share in the long-haul international market and believes that there are untapped international opportunities. This is where a potential acquisition of parts of Air-India comes in. Air India’s international operations have a 44.1 percent market share among Indian carriers, and Air-India Express offers Indigo an opportunity to expand its low-cost franchise.
Acquisition of Air-India’s international operations would give IndiGo immediate access to the various restricted and closed foreign markets, strengthen its reach and give it access to highly coveted slots at foreign airports.
The management, which is adept at running the low-cost model successfully in India, is confident of tackling the challenges that come with the deal including absorbing huge debt, a different type of fleet and potential labour union problems, to name a few. It also believes that, without this deal, it would take many years to establish its footprint in the international market.
We did some back-of-the-envelope calculations and found that IndiGo is expected to face stress on both its balance sheet (debt burden of Rs 242 billion) and income statement with the acquisition of Air-India’s international and Express operations. However, we believe that margin will reach close to IndiGo’s pre-acquisition average level by FY20E.
In spite of industry challenges, IndiGo has performed well in the past. The stock trades at a trailing multiple of around 7.7 times EV/ EBITDAR, 5.1 times projected FY20 (without Air India) and 5.5 times FY20 (with Air India). We have high comfort on the business and the valuation and we would advise investors to build positions gradually for the long haul especially if there is short-term turbulences on account of a possible Air-India acquisition.
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