Seminar on Financial Issues Plaguing the Airlines

International Foundation for Aviation And Development (India Chapter) Regd. Office: 602, Asha Deep Apartments, 9, Hailey Road, New Delhi-110 001 Telefax: +91.11.23736732, Mobile +91.9818519235 Email: Website:

Seminar on Financial Issues Plaguing the Airline Industry Thursday, December 3, 2009 at India International Centre, New Delhi

Introduction

Today’s topic is on the financial issues plaguing the airline industry; issues which are very critical to the industry. Airports have a buffer in their financials, because the number of landings remains more or less the same, while the airlines are forced to maintain their schedules and fly, even if their load is less. So the airline industry has a major problem.

There are three types of airlines: legacy carriers, full service carriers and the newly emerging low cost or low fare carriers. It is within these parameters that the airline industry is going through a serious problem. The International Air Transport Association (IATA) has declared that the results for 2009 will be extremely poor.

So how do we go forward and what do we do? We have two people who will speak to us today. The first person is Mr. Kapil Kaul. Almost everyone present has heard of him; he represents the Centre for Asia Pacific Aviation (CAPA); and the second is Mr. Sudesh Punani a former Finance Director of Air India. He will talk about Air India in particular. Just this morning the Economic Times carried an article on how Air India would be revived and go public in 2013. With these few words, may I request Kapil to speak? After that we can display some statistics on the international situation of the airline industry and discuss that. This will be followed by a talk by Mr. Punani.

State of Airline Finances

Mr. Kapil Kaul: Speaker for the Session

Good morning ladies and gentlemen. I am not going to make a formal presentation today. I intend to give a high-level analysis of what is happening in the airline industry, particularly with regard to the financial issues, which are rather precarious. My belief is that the next three to six months would be very critical from a financial perspective for at least the top three players.

Before I give you an Indian perspective, I would like to share some thoughts on the global overview and what is happening in the global aviation business, particularly the global airline business – what its structural outcome would be in the next three to six months or possibly a year. We must admit when we talk about airlines, globally or traditionally, that they have never been money-making businesses. If you look at the statistics for last 65 years, the average rate of return for airlines is not more than 2.5 per cent. Not a single airline has ever made money, and more importantly, even in the most profitable of times, during growth periods, it does not recover the costs incurred.

There are various reasons why the airline industry has never been a money-making business. This is primarily because of structural issues, the main one being overcapacity, which increases market fragmentation. The second is excessive and negative government regulation at a global level, when we talk about bilateral issues and other aspects.

My own assessment is that the biggest issue that airlines face globally is that they are always plagued by overcapacity. These are government airlines, and I am not referring to a particular airline here. It could be Alitalia, or any other government-controlled airline in any part of the world. These airlines don’t have to worry about balance sheets, and they are in business because of state funding and easier access to finance. They continue to add capacity, with the result that structurally we have always had overcapacity. It is not that the industry can’t make money and can’t give decent returns. It is just that due to overcapacity, they have never been able to attain the kind of returns that global airline businesses could give.

If you look at the last 12-18 months, you will observe that traffic has been significantly low. Yields and revenues are down. We appear to be more concerned about traffic declining and a slowdown in the economy. What is of greater concern is the reduction in revenue. This is perhaps the biggest challenge that the global industry faces right now. The situation at the global level is such that the first items on airlines’ agendas are to boost liquidity, raise cash and strengthen balance sheets. In the last five to six months airlines globally have raised about four to five billion dollars. Lufthansa is the only investment grade airline in Europe to have raised money. Other airlines that raised money include British Airways, SAS, etc. In fact, most of the global carriers raised money and the main reason was to boost liquidity, because no one knows how much cash is needed in the downturn.

No one knows how serious this downturn will be. So when the IATA CEO says that airlines were in the ICU for 12-18 months; that is a fact. When there is a revenue shortfall of 80 billion dollars which is expected this year; when there are cumulative losses are over 27 billion dollars over two years; when traffic is down; when yields are reduced to 12-15 per cent at the global level; and when passenger growth has declined by about 10 per cent; clearly there is a massive problem.

In Asia particularly, where the business models are of a higher premium, such as Singapore Airlines and Cathay Pacific, the downward impact on traffic especially in the premium class is about 25-30 per cent. Freight traffic, which is a very critical driver for airline route economics has declined by 25-30 per cent. So globally, the industry is in a very precarious situation.

We appear to be excited with the thought that we have reached the bottom of the cycle. But that is not the concern. The concern is what we should do to earn the shortfall of revenue which is about 80 billion dollars today that the industry faces. That is the strategic, key concern for the industry over the next 6-12 months.

Our view is that there is a lag of about one to two years for traffic and yield recovery to happen. So you will not see the industry picking up globally by 2010. It may occur in 2011 or 2012. Having said that, if the recovery does take place in 2011-12 the key message for 2010 would be that the airlines need to survive. Airlines are only looking at survival in 2010 which means that the large airlines of the world will continue to raise capital and look for avenues to boost liquidity. They would continue to make attempts to ensure that they have cash in the balance sheet to be able to survive this downturn.

The other aspect which is the biggest concern is freight. An analysis was done by CAPA globally that showed that the downturn in freight was as important as the downturn in the premium markets. Losses from the freight market in the last two to three years have been roughly four to five billion dollars.

In fact, we are now seeing a restocking of inventories after tremendous reductions in stocks, across the world especially in North America. So when you look at the global picture before we come to India, the concerns are that it is still 12-18 months before we see recovery. Recovery would not be of the type we saw two to three years ago. One of the most important factors that will have a major and fundamental impact on how aviation business will perform globally is that the consumer has been changing during the past 12-18 months. And this is not only in India; the consumer is changing globally.

In my view, the consumer change would be more permanent and this current problem is cyclical in nature. The airline industry globally has cyclical issues but will now have more structural outcomes. One of the structural outcomes could be reviewing whether the business models of premium carriers with first class cabins and excessive business class cabins is the way forward. Are you going to re-look at how aircrafts will be configured in the future? Are you investigating how business models will be operated in the next few years? These are a few things that will be looked at during the next 12-18 months from a global perspective.

India has been a very strange market, primarily from the perspective that before 2004 we were a very under-managed, extremely closed and over-regulated market. This was to such an extent that to get our bilaterals before 2004, we needed a group of lobbyists. People were compelled to do various things to get bilaterals before 2004. And certainly from the summer of 2004 to the summer of 2009, the bilateral frequencies have risen from 711 per week to 1315 per week, which is roughly about a 90 per cent increase in bilateral entitlements. It also got compensated from the fact that traffic grew from 14 million to 27 million passengers but we saw the end game changing. While five years ago the complaint was that if you wanted to visit India from October, to December, you could not get seats. Today the problem is that we have given excessive bilaterals, and it occurred over a span of five years. The end game has actually changed from one extreme to the other.

However, from the perspective of a domestic market, if it is reviewed from 1995-96, once the earlier set of airlines closed down, India actually gave commercial licenses to start new airlines. It is under the 2004-2009 regime that genuine deregulation in the domestic skies was truly introduced, low cost airlines were encouraged and they were operating at the international level. It was not possible to conceive that Jet Airways could become almost as large as Air India in the international market in a span of three years. It was difficult to imagine that Kingfisher Airlines, which has just started, could fly international.

It is clear that over the last five years India has moved from one extreme to the other. But during this movement, we are once again faced with the same structural problems that the global industry faces, primarily in terms of overcapacity, of increased market fragmentation, and to some extent now, the uncertainty in regulatory framework.

When we look at the current situation within India, we come straight to the financial issues affecting the business which is a result of overcapacity, increased market fragmentation and the kind of deregulation that we have seen. The big three today are Kingfisher Airlines, Jet Airways and Air India. They have a debt burden of about 10 billion dollars which is equivalent to one per cent of our GDP. Our assessment is that if the fleet aircraft programmes of all the three companies materialize over the next two to three years, the debt burden on aircraft purchases will be about 12-15 billion dollars, at least 12 billion dollars in the next three years. Air India has to acquire 60 more planes, Jet Airways has 45 planes in all and 20 options, and Kingfisher Airlines has about 30-40 planes. The combined cumulative investment is about 10 billion US dollars.

If we talk about operational losses, not including sales, leasebacks and other items that are reflected in the balance sheet; just the operational losses would be around Rs.25000 crores for 2004 to 2009-10. So if you look at the big three, they have 10 billion dollars as the current debt burden. The expected a debt burden because of aircraft acquisitions which to some extent cannot be deferred, is at least 12 billion dollars. Operational losses for the entire industry, including damages for the current year, are to the tune of Rs.25,000-26,000 crores.

It is clear that the industry is in a very precarious situation. The extent of the financial baggage that these airlines are carrying, is such that the interest burden for Air India over the next three years is roughly about Rs.3000 crores per annum. For Kingfisher Airlines and Jet Airways, it would be about Rs.2000 crores plus. An interest burden of Rs.5000 crores per year makes the debts almost unserviceable.

On the other hand, the structure of the market is changing. The assessment is that the domestic market next year would be totally low cost. CAPA’s assessment is that next year it is possible that Jet Airways would exit from full service and that Kingfisher Airlines would put the remaining 16 per cent back into the LCC section. It is also very possible that Air India, which was planning to increase capacity by 30 per cent, would gradually downgrade and turn its domestic operations into an LCC one. Thus, along with the huge financial burden, particularly in terms of unserviceable debts, the structure of the market is changing and turning into a purely low cost service. If you look at the regional international space, where India has 70 per cent of the world’s population, flying time from India, to within the region is just five hours, which is the ideal bandwidth for a low cost airline. Hence it appears that the regional international markets are going to be driven by low cost services.

In a scenario, where there are huge financial losses, major debt burdens, considerable aircraft acquisitions to be financed, a change in the market structure to low fares, you have to review your business models to make them competitive and viable, and to ensure that you have a business which is ready for the purpose. And that’s the challenge for the big three Indian airlines.

If you look at airlines like Indigo Airlines, SpiceJet Airlines, Go Air, and the others, the one outstanding example is Indigo Airlines. A caveat needs to be put here, because one does not really know Indigo’s financial details, as it is a closely held company. However, going purely by our assessment and their filings with DGCA, the airline had a robust performance last year. It continues to deliver a healthy performance. Our assessment is that it will remain a profitable company on a sustained basis during the next fiscal. In comparison with the big three that have huge financial burdens we have one outstanding example in Indigo Airlines, which is a superior business case. It has an extremely disciplined management, no debt on their balance sheet, a cost structure which is competitive and high management capital.

While there is a shining example in Indigo Airlines, there are airlines like SpiceJet for that matter, which could be considered second to Indigo Airlines in a sense, and almost likely to deliver consistent profitability. It had problems that in the first and third quarters, it made some money, but that was diluted in the second and fourth quarters, because seasonal dips are sharper for SpiceJet, and the upswings don’t compensate for the dips. Thus its business format has a problem. However, our estimate is that Indigo Airlines and SpiceJet, particularly Indigo, appear to be outstanding examples.

As we enter the next year, we shall certainly see Kingfisher Red, Jet Connect and even Air India Express as the leading low cost airlines in India. Today, in 2009-10, Indigo Airlines is the leading low cost carrier. However, Jet Connect has already proved that after becoming a low cost carrier, it arrested the growth of these two airlines despite not having a competitive cost structure. Next year, with the franchise brand that Jet and Kingfisher have, it could well be that Jet Connect and Kingfisher Red would join Indigo Airways and SpiceJet to be viewed from a brand perspective and a size perspective.

Our assessment is also that airlines would look at consolidation on a particular basis. SpiceJet will be a pivot around which consolidation will occur next year. It is possible that there will be acquisitions and mergers. Jet Airways is seeking either an acquisition which could be a cashless one, or a merger in the domestic market. Hence, there will be strategic consolidations during the next three to six months and these will have an impact on how 2009-10 will shape up.

Returning to the airlines on the top of the list, today, in everyone’s mind is Air India’s restructuring, a most painful exercise that the airline is undergoing. If you look at the expenditure base of Rs.19,000 crores, and a revenue basket of Rs.12,000-14,000 crores, our assessment is that structurally, it is not a viable business model. When you look at a Rs.19,000 crore burden and a Rs.12,000 to 14,000 crores deficit, you have a concern as to how to ensure that the business model fits in with the revenue basket. If Air India has to create a revenue basket in line with its expenditure and maintain expenditure in line with the revenue basket, there is a need for a fundamental overhaul in the manner in which Air India has been run. It is perhaps preferable to create and start a totally new airline. We carried out an assessment for a major investor last week, some of which I will share with you.