INDIAN AVIATION INDUSTRY

Through turbulent times, FDI relaxation alone not a game changer Fver
Summary
The Indian Aviation Industry has been going through a turbulent phase over the past several years facing multiple headwinds high oil prices and limited pricing power contributed by industry wide over capacity and periods of subdued demand growth. Over the near term the challenges facing the airline operators are related to high debt burden and liquidity constraints - most operators need significant equity infusion to effect a meaningful improvement in balance sheet. Improved financial profile would also allow these players to focus on steps to improve long term viability and brand building through differentiated customer service. Over the long term the operators need to focus on improving cost structure, through rationalization at all levels including mix of fleet and routes, aimed at cost efficiency. At the industry level, long term viability also requires return of pricing power through better alignment of capacity to the underlying demand growth. While in the beginning of 2008-09, the sector was impacted by sharp rise in crude oil prices, it was the decline in passenger traffic growth which led to severe underperformance during H2, 2008-09 to H1 2009-10. The operating environment improved for a brief period in 2010-11 on back of recovery in passenger traffic, industry-wide capacity discipline and relatively stable fuel prices. However, elevated fuel prices over the last three quarters coupled with intense competition and unfavorable foreign exchange environment has again deteriorated the financial performance of airlines. During this period, while the passenger traffic growth has been steady (averaging 14% in 9m 2011-12), intense competition has impacted yields and forced airlines back into losses in an inflated cost base scenario. To address the concerns surrounding the operating viability of Indian carriers, the Government on its part has recently initiated a series of measures including (a) proposal to allow foreign carriers to make strategic investments (up to 49% stake) in Indian Carriers (b) proposal to allow airlines to directly import ATF (c) lifting the freeze on international expansions of private airlines and (d) financial assistance to the national carrier. However, these steps alone may not be adequate to address the fundamental problems affecting the industry. While the domestic airlines have not been able to attract foreign investors (up to 49% FDI is allowed, though foreign airlines are currently not allowed any stake), foreign airlines may be interested in taking strategic stakes due to their deeper business understanding, longer investment horizons and overall longer term commitment towards the global aviation industry. Healthy passenger traffic growth on account of favorable demographics, rising disposable incomes and low air travel penetration could attract long-term strategic investments in the sector. However, in our opinion, there are two key challenges: i) aviation economics is currently not favorable in India resulting in weak financial performance of airlines and ii) Internationally, too airlines are going through period of stress which could possibly dissuade their investment plans in newer markets. Besides, foreign carriers already enjoy significant market share of profitable international routes and have wide access to Indian market through code-sharing arrangements with domestic players. Given these considerations, we believe, foreign airlines are likely to be more cautious in their investment decisions and strategies are likely to be long drawn rather than focused on short-term valuations. On the proposal to allow import of ATF, we feel that the duty differential between sales tax (averaging around 22-26% for domestic fuel uplifts) being currently paid by airlines on domestic routes and import duty (8.5%10.0%) is an attractive proposition for airlines. However the challenges in importing, storing and transporting jet fuel will be a considerable roadblock for airlines due to OMCs monopoly on infrastructure at most Indian airports. From the working capital standpoint too, airlines will need to deploy significant amount of resources in sourcing fuel which may not be easy given the stretched balance sheets and tight liquidity profile of most airlines.

MARCH 2012

ICRA RATING FEATURE

Contacts
An j a n G h o s h +91 22 3047 0006 aghosh@icraindia.com

Analysts
Subrata Ray +91 22 3047 0027 subrata@icraindia.com Shamsher Dewan +91 124 4545 328 shamsherd@icraindia.com Si d d h a r t h Sh a h +91 22 3047 0018 siddharth.shah@icraindia.com

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Indian Aviation Industry Evolution & Recent Updates [1/2]

Exhibit 1: Industry Evolution Year Major Milestones < 1953 1953 1986 1994 1995 1997 2001 2003 2005 2007 2010 2011 2012 Nine Airlines existed including Indian Airlines & Air India Nationalization of all private airlines through Air Corporations Act; Private players permitted to operate as air taxi operators Air Corporation act repealed; Private players can operate schedule services Jet, Sahara, Modiluft, Damania, East West granted scheduled carrier status 4 out of 6 operators shut down; Jet & Sahara continue Aviation Turbine Fuel (ATF) prices decontrolled Air Deccan starts operations as Indias first LCC Kingfisher, SpiceJet, Indigo, Go Air, Paramount start operations Industry consolidates; Jet acquired Sahara; Kingfisher acquired Air Deccan SpiceJet starts international operations Indigo starts international operations, Kingfisher exits LCC segment Government allows direct ATF imports, FDI proposal for allowing foreign carriers to pick up to 49% stake under consideration

Historically, the Indian aviation sector has been a laggard relative to its growth potential due to excessive regulations and taxations, government ownership of airlines and resulting high cost of air travel. However, this has changed rapidly over the last decade with the sector showing explosive growth supported by structural reforms, airport modernizations, entry of private airlines, adoption of low fare - no frills models and improvement in service standards. Like elsewhere in the world, air travel is been transformed into a mode of mass transportation and is gradually shedding its elitist image.

Strong passenger traffic growth aided by buoyant economy, favorable demographics, rising disposable incomes and low penetration levels
India aviation industry promises huge growth potential due to large and growing middle class population, favorable demographics, rapid economic growth, higher disposable incomes, rising aspirations of the middle class, and overall low penetration levels (less than 3%). The industry has grown at a 16% CAGR in passenger traffic terms over the past decade. With advent of LCCs and resultant decline in yields, passenger traffic growth which averaged 13% in the first half has increased substantially to 19% CAGR during 2006-2011. Despite strong growth, air travel penetration in India remains among the lowest in the world. In fact, air travel penetration in India is less than half of that in China where people take 0.2 trips per person per year; indicating strong long term growth potential. A comparative statistic in United States, the worlds largest domestic aviation market stands at 2 trips per person per year. We expect passenger demand to remain stable and grow between 12-15% in the medium term, assuming a no major weakness in GDP growth going forward.

Source: ICRA Research Exhibit 2: FDI Regulations FDI Limits Airports - Greenfield Projects - Existing projects Air Transport Services - Scheduled Air Transport Services* - Non-scheduled Air Transport Service - Helicopter Services / Seaplane services requiring DGCA approval Other Services Ground Handling Services subject to sectoral regulations and security clearance Maintenance and Repair organizations; flying and technical training institutions 49% (NRIs 100%) 74% 100% 74% (NRIs 100%) 100% Automatic Automatic up to 49% FIPB 49% to 74% Automatic Automatic up to 49% FIPB 49% to 74% Automatic Automatic 100% 100% Approvals Automatic Automatic up to 74% FIPB - beyond 74%

However domestic airlines operate under high cost environment; intense competition has constrained yields; aggressive fleet expansions have impacted profitability and capital structures
Despite reforms, the domestic aviation sector continues to operate under high cost environment due to high taxes on Aviation Turbine Fuel (ATF), high airport charges, significant congestion at major airports, dearth of experienced commercial pilots, inflexible labor laws and overall higher cost of capital. While most of these factors are not under direct control of airline operators, the problems have compounded due to industry-wide capacity additions, much in excess of actual demand. Intense competitive pressure from Low cost carriers (focusing on maximizing load factors) and national carrier (looking to regain lost market share) have constrained yields from rising in-sync with the elevated cost base. Besides, aggressive fleet expansions (LCCs have added aircrafts mainly on long-term operating leases; FSCs have purchased aircrafts debt financed, most often backed by guarantees from the US EXIM Bank or Europes ECA) to leverage upon the anticipated robust growth and to support international operations have significantly impacted the capital structure and weakened the credit profile of most domestic airlines.

* Note: Foreign airlines are currently not allowed to participate directly or indirectly in the equity of an Air Transport Undertakings engaged in operating Scheduled, Non-Scheduled and Chartered airlines. Source: Department of Industrial Policy and Promotion (DIPP), ICRA Research

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Indian Aviation Industry Evolution & Recent Updates [2/2]

Exhibit 3: Growing LCC Market Share
100% 80% 60% 40% 20% 0% 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 FSC (%) LCC (%) 99% 95%

Low-cost model now dominating the skies; viability remains to be seen

Internationally the LCC model came into existence when the US Congress passed the Airline Deregulation Act in 1978 easing the entry of new companies into the business and giving them freedom to set their own fares and choose routes (Prior to this routes and fares were fixed by a Government Agency). This was followed by entry of carriers like Southwest, which pioneered the LCC concept. Majority (~60-65%) of an airline cost are dependent on external factors, which cant be managed by an LCC. This includes the fuel cost (~40%), maintenance cost (~12%) and ownership cost (~12-15%). LCCs try to achieve a cost advantage in other ways by avoiding the in-flight services, operating from secondary airports, selling tickets through the internet, higher number of seats in the aircraft, inventory reduction through use of similar aircraft and lower employees per aircraft. The Indian aviation sector was exposed to intense competition with the advent of a low-cost airline Air Deccan back in 2003. The success of Air Deccan spurred the entry of other LCCs like SpiceJet, Indigo, Go Air and subsequently low fare offerings from Jet airways and Kingfisher airlines. As a result, the sector which was completely dominated by full-service airlines till a decade ago is now dominated by low-cost airlines. However, longer term viability of LCCs models in India remains to be seen (Kingfisher exited the segment recently) as airport charges are same for FSCs and LCCs in India. Besides, the fuel costs forms a larger proportion of overall costs as compared to international standards due to higher central and state government levies (viability of direct ATF imports remains to be seen due to lack of supporting infrastructure) and high congestion at major airports (half an hour hovering at major airport could increase fuel costs by Rs.60,000 to Rs. 115,000 depending on aircraft, besides impacting aircraft utilizations). These constraint can be resolved only if there significant improvement in infrastructure such that LCCs could operate on secondary airports.
Exhibit 7: LCC Strategies Categories Single model of aircraft Operate on secondary airport Point to Point Model Single class configuration No In-flight services Fewer employees per aircraft E-Ticketing Remarks Reduces maintenance and inventory cost. Lower charges, lower turnaround time due to less congestion. Improves aircraft utilization by reducing waiting time at airports. More seats per flight so spread costs over a larger base. Helps to keep the costs and hence the fares low. Reduces employee cost and leads to higher employee productivity. The traditional method of ticketing costs around US$ 4.5 per passenger whereas the cost of an e-ticket comes to US$ 1 which helps reduce selling expenses. Primarily on-board sales. Provides alternate source of revenues helps to reduce break-even PLF.

1%

5%

29%

34%

46%

48%

63%

69%

71%

66%

54%

52%

37%

31%

Exhibit 4: ATF Price Trends (Mumbai, Rs/KLitre)

80,000 70,000 60,000 50,000 40,000 30,000 20,000 Apr-09 Apr-10 Apr-11 Jan-09 Jan-10 Jan-11 Oct-09 Oct-10 Oct-11 Jan-12 Jul-09 Jul-10 Jul-11

Exhibit 5: Rupee Depreciation (INR/USD)

54 52 50 48 46 44 42 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12

Exhibit 6: ATF Tax Structure in India

Particulars Excise Duty Average Sales Tax Levies by states Margins of Oil Marketing Companies Tax Rates 8% ~23-24% ~15-18%

Source: Company Filings, Bloomberg, ICRA Research

Ancillary Revenues

Source: Company Filings, ICRA Research

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Indian Aviation Industry Operating Performance [1/2]

Exhibit 8: Domestic Airlines - Operating Matrix Revenues Domestic Revenues International Revenues Other Operating Income Sub-Lease of Aircrafts Cargo, Auxiliary Revenues etc. Non-Operating Income Aircraft Sale & Lease back Domestic revenues are largely INR denominated; Robust pax traffic growth, but yields out of sync with cost structures due to intense competition, government support to national carrier and customer preference for LCC models Airlines with international operations generate part of revenues in foreign currency; foreign carriers dominate in the longer haulage and premium service offerings Earnings from aircraft sub-leases (dry or wet) are mostly in $ terms, helps rationalize capacities Low contributions from cargo and auxiliary revenue due to their modest adoption level With capacity constraints at global aircraft manufacturers & rising commodity prices, market value of successful aircraft models often exceed book values making sale and lease back (conversion of Financial Lease to Operating Lease) an attractive option to book non-operating incomes, generate free cash flows and deleverage the balance sheet

Cost Structure Fuel Cost Employee Cost Aircraft Maintenance Expenses Landing, Navigation & Airport Charges Other Expenses Selling & Distribution Expenses General & Administrative Expenses EBITDAR

ATF costs contributes 30-45% of overall operating costs for Full Service Carriers (FSCs) & 40-55% for Low cost carriers (LCCs) Domestic ATF prices are linked to fluctuation in crude oil prices and movement in INR vs. $ High central and state levies translates into a 60-70% higher ATF prices in India over the global average Significant congestion at major domestic airports increases fuel costs considerably

Given the fact that Indian airlines have been in aggressive expansion phase, dearth of experienced pilots require airlines to employee foreign pilots which command higher salaries and are often paid in foreign currency

Aircraft Lease Rental Depreciation Interest Expense PBT Source: ICRA Research

Most airlines follow an operating lease model for large part of their capacity; Lease rentals are also denominated in foreign currency thereby exposed to fluctuation in forex movement; Depreciation costs mainly for owned aircrafts (Financial Lease) Significant rise in interest expenses due to deterioration in the capital structure, cash losses and increased working capital requirements besides overall rise in interest rates

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Indian Aviation Industry Operating Performance [2/2]

Exhibit 9: Domestic Airlines - Gross Sales Growth (%, YoY)
40.0% 30.0% 20.0% 10.0% 3% 0.0% -10.0% -20.0% -30.0% Mar-09 31% 19% 34% 21% 20% 20%

The domestic airlines industry is facing significant operating (slowing growth, rising fuel costs) and non-operating (interest costs, rupee depreciation) challenges as evident in the quarterly performance trends of listed airline companies.
9%

13%

-3% -17% Jun-09 -25% Sep-09 Sep-10 Mar-10 Mar-11 Dec-09 Dec-10 Sep-11 Jun-10 Jun-11 Dec-11

Sales Growth: After a strong rebound in 2010, the pax growth has been moderating over the last few quarters due to moderating economic growth and weak industrial activity. Besides, severe competitive pressure from domestic LCC players (rapidly gaining market share) and Air India (trying to maintain market share) have resulted in price wars (at times below cost pricing), lowered yields and moderated sales growth for the airlines. Even on international routes, the yields have remained weak due to weaker economic conditions and severe competition from global airlines. Rising ATF Prices & Steep Rupee Depreciation: The airlines industry had been severely impacted by the significant increase in ATF prices (up 57% in last 18 months) as Indian Carriers do not hedge fuel prices and have exhibited limited ability to charge fuel surcharges due to irrational and undisciplined pricing dictated by competition rather than costs / demand. Besides, the steep rupee depreciation (~18.7% depreciation in CY11, although partly reversed through 7.3% YTD appreciation in CY12) acts double whammy as apart from fuel costs, substantial portion of other operating costs like lease rentals, maintenance, expat salaries and a portion of sales commissions are USD-linked or USDdenominated. Profit Margins: With combined impact of 1) moderating pax growth 2) lower yields due to excessive competitive 3) rising ATF prices 4) steep rupee depreciation and 5) rising debt levels and interest costs, the profitability margins of the airlines industry have been severely impacted. As per Centre for Asia Pacific Aviation (CAPA), Indian carriers could be posting staggering losses of $2.5 billion (~Rs 12,500 crore) in 2011-12, worse than the losses of 2008-09 when traffic was declining and crude oil prices spiked to $150 per barrel. Overall, the industry has been marred by cost inefficiencies and is bearing the brunt of aggressive price cuts, rising costs, expensive jet fuel, a weaker rupee, high interest payments and hence mounting losses. The government support required to bailout the loss making Air India has increased substantially; while the leading private players like Kingfisher Airlines, Jet Airways and SpiceJet are making significant losses. With Banks unwilling to enhance their exposure to the industry, recast their loans or pick up equity stakes without viable business plans, industry needs to come out with strong equity infusion plans. Hence, the government is mulling allowing foreign carriers to pick strategic stakes in domestic airlines to help them stay afloat in these difficult times, besides bringing global expertise and best industry practices over the medium term.

Exhibit 10: Domestic Airlines Fuel Costs (% of Gross Sales)

60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Sep-09 Sep-10 Dec-09 Dec-10 Sep-11 -26% Sep-10 Dec-09 Mar-10 Dec-10 Mar-11 Sep-11 Jun-10 Jun-11 Dec-11 Jun-09 Jun-10 Jun-11 Mar-09 Mar-10 Mar-11 Dec-11 -9% 29% 32% 40% 33% 44% 35% 36% 36% 47% 52% 50%

34%

Exhibit 11: Domestic Airlines Reported PAT (% of Gross Sales)

0.0% -5.0% -10.0% -15.0% -20.0% -25.0% -30.0% Mar-09 Jun-09 -26% Sep-09 -14% -11% -4% -11% -3% -1% -4% -10% -7%

ATF Import: [Heading]

Indian Aviation IndustryAirlines Operating Performance [2/2] Note: Aggregate Data for Listed
Source: Capitaline, ICRA Research

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Indian Aviation Industry: Proposed FDI Relaxations [1/2]

Exhibit 12: Factors that support investments in Indian Aviation Sector Strong growth prospects Passenger traffic growth has grown at a CAGR of 16% in India over the past 10 years Relative underpenetrated market Penetration of air travel at <3% is significantly below benchmarks in other markets An opportunity to create India as an hub An opportunity for foreign airlines to create India as their hub for international traffic between Europe and South East Asia; Additionally offer better connectivity within India with international destinations An opportunity to create India as an MRO centre Foreign airlines could also look at leveraging on Indias low-cost arbitrage by setting up MRO facilities in India Low Valuations Market valuation of listed airlines in India has suffered due to poor performance Exhibit 13: Factors that are not in favor of investments Aviation economics are not favorable in India Higher taxes on ATF and airport charges continue to be key headwinds for the sector; besides higher cost base, airlines in India are also mandatorily required to fly on certain unviable routes Inadequate Infrastructure Development of airport infrastructure has not kept pace with demand, thereby resulting in delays and higher costs for airlines Poor financial health of most airlines Intense competition, sharp fluctuation in ATF prices and high debt burden continue to weigh on the financial performance of Indian airlines; foreign exchange fluctuation and lack of adequate hedging mechanism (for fuel) have added to the woes Highly competitive & Price Sensitive traveler base

FDI in Aviation: Feasibility and Impact Analysis for various stakeholders

FDI Proposal: The Civil Aviation Ministry is expected to soon circulate a proposal before the union cabinet to consider allowing up to 49% equity investment by foreign carriers in domestic airlines. In case of listed airlines, if the proposal does not get a waiver from SEBIs Takeover Code, foreign carriers may have to first make an open offer of 26% stake to public shareholders and later acquire up to 23% stake (from promoters or fresh equity), such that their stake remains within the 49 % cap. Indian Carriers: The FDI proposal, if approved, would certainly be an important milestone in the aviation sector and may provide much-needed relief to the domestic aviation industry reeling under the pressure of mounting losses and rising debt burden. Besides, the move will help bring global expertise and best industry practices over the medium term. Foreign Carriers: It will not just provide entry into one of the fastest growing aviation market globally but also an opportunity to establish India as their hub for connections between US/Europe and South-East Asian countries. While full-service airlines could help them further consolidate their market position on international routes (and improve connectivity within India), acquisition of lowcost airlines could help them compete in a market where travelers are highly price sensitive. Consumers: New players could enter the market as they could now have a strategic foreign player with deep pockets to support the airline in difficult times. Besides, it would provide more flexibility in international travels when one travels through the same airline domestically as well as internationally. Overall, this could increase competition, offer more alternatives, reduce tariffs and improve customer service standards over the medium term. However, the Global Airline industry is itself currently going through a tough phase (Bloomberg World Airline index down 22%, Asia-Pacific Airline index down 25% in last one year), due to below trend economic growth across advanced economies and high crude oil prices ($100-125/Barrel). Besides, aviation economics currently remain unfavorable in India due to intense competition, mandatory route dispersal guidelines, higher taxes on ATF, airport related charges and inadequate airport infrastructure. For example, airlines like Air Asia (citing high infrastructure costs) & American Airlines (parent facing financial stress) have recently withdrawn from India. Lastly, foreign carriers already enjoy significant market share of profitable international routes and have wide domestic access through code sharing agreements. Given these considerations, we believe, attracting investments from foreign airlines may not be easy.

\Source: ICRA Research

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Indian Aviation Industry: Proposed FDI Relaxations [2/2]

Exhibit 14: Significant Erosion in Market Capitalizations (Rs Crore)
8,000 6,000 4,000 2,000 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12

Foreign carriers already enjoy significant share of international traffic; domestic access through code sharing agreements
As per DGCA data, foreign carriers already enjoy ~65% market share in international traffic and hence ~27% of total passenger traffic (Domestic + International). For Jet Airways, due to longer haulage (~4.6 hrs avg block hours in international routes as compared to ~1.6 hrs avg block hours in domestic routes), revenue per passenger carried on international route has been 2.5x to 3.0x revenue per passenger carried on do mestic route. We expect this ratio to be higher on an industry wide basis as foreign carriers dominate longer haulage routes, full service offerings and business traffic as compared to shorter haulage, low fare offerings & VFR (visiting friends and relatives) traffic prominence of Indian carriers. As a result, we estimate that the foreign carriers have already garnered 42-48% of total airline revenues (inbound, outbound & within India). Besides, the stark difference between Jet Airways domestic and International EBITDAR margins indicates that the foreign airlines could be already enjoying majority of the industry profits, with the domestic carriers left with price conscious no-frills pax traffic, less viable routes and hence saddled with high operating losses. Besides, due to number of code sharing agreements, foreign carriers can offer enhanced connectivity into Indian cities without acquiring stakes in Indian carriers.

Jet Airways

Kingfisher Airlines

SpiceJet

Exhibit 15: Foreign Carriers Pax market shares in International Routes (FY10 Data) British Airways Thai Airways Cathay Pacific Jet Airways Air India 2,000,000 4,000,000 6,000,000 3.0% 3.1% 3.3% 3.6% 4.1% 4.3% 10.8% 12.5% 21.4% 8,000,000

Dilutions at Current market capitalizations unlikely to solve issues of staggering debt levels and mounting losses
Besides, since the airlines stocks have corrected significantly over the last two years, fresh equity infusions are current market capitalizations (although 50-100% higher YTD) could lead to considerable stake dilution for the existing promoters who have built these businesses over the years. Besides, the amount of fresh equity that could be raised at current market prices would not be a game-changer considering the staggering debt levels and quarterly losses posted by the airline industry (auditors have already raised concerns over the rapid depletion of networth for all listed airline companies). Exhibit 17: Promoter Stake dilution incase in fresh equity infusion Jet Airways Kingfisher Total Debt Outstanding FY11 (Rs Cr) Current Market Capitalization (Rs Cr) Current Promoter holding (%) Fresh Equity infusion for 49% stake* Mcap Post Equity infusion 15,210 2,767 80% 2,658 5,425 41% 7,057 1,150 59% 1,104 2,254 30%

Exhibit 16: Jet Airways Domestic vs. International Operations 30.00% 20.00% 10.00% 0.00% -10.00% Q4 FY10 Q1 Q2 Q3 Q4 Q1 Q2 Q3 FY11 FY11 FY11 FY11 FY12 FY12 FY12 Jet Airways : EBITDAR Margins - Domestic (%, LHS) Jet Airways : EBITDAR Margin - International (%, LHS) Jet Airways : Rev per pax (International/Domestic) 26% 22% 23% 19% 26% 13% 26% 23% 3.00 2.50 2.00 1.50 1.00 0.50 -

16% 3% 11% 7%

14% -9% 8% 2%

SpiceJet 86 1,066 39% 1,024 2,090 20%

Total 22,353 4,982

4,787 9769

Promoter holding post infusion *Assuming Equity infusion @ current share price that has already run-up considerably in anticipation (Jet up 87% YTD, SpiceJet up 43% YTD) Source: ICRA Research

Source: DGCA, Company filings, ICRA Research

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Direct ATF Imports: Benefits and near term feasibility remain misty
In addition to the proposal on FDI, the empowered group of Minister has also recently approved the proposal for airlines to import Aviation Turbine Fuel (ATF) directly, a demand that the airlines have been lobbying for quite some time now. While the cabinet approval is yet come by, in our opinion, the impact of this development is likely to be a mixed bag. Although the taxation differential (between currently applicable sales tax rates and likely import duty) certainly suggest a large potential saving for airlines, the availability of infrastructure is likely to be a considerable roadblock. Given the monopoly of OMCs at major airports, airlines would have to resort to a fee-based structure for utilizing their infrastructure for fueling, storing and transporting ATF. At the same time, airlines will also have to engage a fair bit of working capital in sourcing imported ATF as against credit period available from OMCs. Given the current liquidity constraints, managing additional credit lines from banks is also likely to be a challenge for airlines and overall would reduce the potential savings being envisaged. At present, airlines buy ATF from OMCs which is priced on an import parity formula and is also subject to sales tax varying from 4%-30% depending upon states. Given the higher tax rates at major airports, airlines pay on an average 22-26% sales tax on ATF for domestic operations. With the option to import directly, the effective taxes on ATF would prima facie reduce as airlines will pay import duties and will be exempted from paying sales tax thus resulting in large savings for airlines. While the savings appear to be significant, there are various practical issues that airlines will have to sort out before they could start importing ATF directly. At most airports (barring the private ones), state-run OMCs own and operate the infrastructure for sourcing, fueling and storing aviation fuel. For sourcing fuel directly, airlines will have no other option but to utilize the existing infrastructure possibly on a fee-based structure with OMCs. In addition, airlines will also lose out on volume discounts (ranging between 4-5%) and credit period offered by OMCs and would need to pay in cash for direct imports, implying incremental funding requirement. There is also an additional worry that the states may implement an entry tax (as applicable on crude oil in some states) to offset the revenue loss from sales tax. Given these hurdles, the effective savings could be much lower than what is reflected from tax differential. In absolute terms, the impact will be higher on airlines with higher share of domestic operations like Indigo or SpiceJet.

International Routes: Freeze on international permissions to private carrier removed

In another major boost to private airlines (especially IndiGo and SpiceJet), the Civil Aviation Ministry has lifted the freeze on their overseas expansions. The government had imposed the freeze in Mar-2011 with the objective of protecting the financially strained Air India from more competition on foreign routes. However, lower utilizations of maximum permissible limits under the bilateral Air Service Agreements (ASAs) have prompted the move to allow eligible domestic airlines (with more than 5 years experience) expand their international operations. The move will benefit the private carriers (although may increase competition and losses for the national carrier) as international flights provide better margins owing to the availability of fuel at international rates, higher auxiliary revenue through in-flight sales and higher fleet utilization, as international operations could happen during the otherwise idle night hours.

Financial guarantees to the debt-ridden national carrier in securing funding at competitive rates
As per media reports, Group of ministers (GoM), headed by finance minister cleared the financial restructuring plan for Air India under which the national carrier will be allowed to raise Rs 7,400 crore through government- guaranteed bonds bearing a coupon rate of 8.5-9%. According to official data, Air India has outstanding loans and dues worth Rs 67,520 crore. Of this, Rs 21,200 crore represents working capital loans, Rs 22,000 crore long -term loans taken for fleet acquisition, Rs 4,600 crore dues to vendors and it carries an accumulated loss of Rs 20,320 crore. The ministerial group also decided to restructure the carriers Rs 21,200 crore working capital loans - Rs 7,400 crore shall be come from the bond issue, Rs 9,800 crore will be converted into long-term debt of 10 to 15 years and the balance Rs 4,000 crore will remain outside the restructuring exercise. While the financial guarantees may help it overcome near term headwinds, operation turnaround at ailing national carrier remains critical for overall health of the industry.

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Annexure 1: Key operating indicators and valuations for the Global Airline Industry
Company Name M cap EV Sales CY/FY Current ($ Bn) FSC Carriers Delta Airlines Deutsche Lufthansa Air France-KLM Air China Ltd Singapore Airlines All Nippon Airways Cathay Pacific Airways China Southern Airlines China Eastern Airlines Qantas Airways Korean Airlines Malaysian Airline Thai Airways Garuda Indonesia Asiana Airlines Air New Zealand Jet Airways Kingfisher Airlines LCC Carriers Ryan Air Southwest Airlines Air Asia Cebu Air Tiger Airways SpiceJet 8.1 6.3 3.3 0.9 0.5 0.2 8.8 6.9 5.1 1.1 0.8 0.2 1.1 4.1 --0.5 0.6 0.0 0.2 --0.0 0.0 41.4 17.6 --30.3 18.5 17 3 --23 -63 121 26 10 10 10 53 98 21 9 8 9 84.1 80.9 80.0 85.0 85.8 82.5 6 15 --6 7 2.7 4.8 --1.8 2.6 13.1 11.4 11.1 9.6 --12.8 8.3 9.2 8.0 78.0 -7.3 3.7 8.2 6.2 --7.1 3.3 7.2 5.0 16.3 -1.9 0.9 1.9 1.7 2.4 -7.1 5.0 6.2 5.3 --7.9 6.3 1.7 12.2 10.2 7.7 7.7 7.0 6.3 4.1 3.6 1.5 1.8 1.5 1.3 0.8 0.6 0.2 18.0 --23.6 7.1 15.8 -14.7 15.2 7.6 14.6 3.0 5.8 1.9 -1.3 3.1 1.7 8.4 --6.7 2.8 8.2 -6.3 6.1 6.7 10.7 --2.2 4.8 1.5 3.2 1.4 0.4 --1.1 0.1 0.1 -0.6 0.5 0.0 (0.3) --0.1 0.0 (0.0) (0.0) (0.2) 18.8 --40.3 31.6 22.5 -32.2 31.4 19.8 ---21.8 -12.8 27.0 13.0 ---37 8 5 -31 60 4 -11 --15 -5 -5 -235 236 251 132 108 87 116 140 119 133 -51 -26 37 32 40 16 193 187 202 106 85 58 97 111 93 107 -39 -18 28 27 31 13 82.1 79.3 80.7 80.0 78.5 67.5 83.4 79.2 78.0 80.1 -75.4 -71.7 76.4 83.4 78.6 81.0 16 --10 9 0 -10 10 11 ---8 -11 9 9 3.7 --2.8 3.1 3.6 -2.6 2.7 3.0 ---2.7 -2.8 2.9 3.1 4.2 20.8 -6.8 27.2 30.4 14.5 5.8 5.3 13.1 8.8 -14.4 14.8 6.9 15.0 --3.5 9.1 -7.7 19.5 17.2 10.6 6.9 6.1 8.6 8.4 85.0 10.6 8.6 5.5 8.0 --3.9 2.8 8.1 7.5 4.2 5.9 7.1 6.4 7.4 3.9 8.3 16.2 5.9 7.9 6.7 3.4 88.2 -3.9 2.4 5.1 7.2 3.8 5.3 5.9 6.1 6.8 3.2 7.4 7.2 5.3 6.0 5.7 2.8 10.2 -7.4 0.6 0.3 1.1 1.0 1.2 1.0 0.9 1.2 0.6 1.2 2.4 0.8 1.8 1.2 0.6 4.0 -2.4 2.2 1.5 3.4 6.9 4.4 5.6 2.1 1.9 2.4 2.2 17.2 2.1 -2.9 2.6 --Current ($ Bn) 2011 ($ Bn) Net Profits CY/FY 2011 ($ Bn) EBITDAR CY/FY 2011 (%) RoE CY/FY 2011 (%) ASKMs CY/FY 2011 In Bn RPKMs CY/FY 2011 In Bn PLF CY/FY 2011 (%) Yield CY/FY 2011 $ FC/ ASKM CY/FY 2011 $ P/E Ratio CY/FY 2012e x CY/FY 2013e x EV /EBITDA CY/FY 2012e x CY/FY 2013e x P /BV CY/FY 2012e x P /CF CY/FY 2012e X

Source: Bloomberg, ICRA Research; projected estimates Bloomberg Consensus estimates

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