Testing Times: Aviation industry faces higher risks and losses

Aviation industry faces higher risks and losses

Kapil Kaul, Director and CEO, South Asia, CAPA India

The Indian aviation industry is facing headwinds in the form of higher costs and lower yields. The environment for the aviation industry has become extremely challenging in the past six months, precipitated by an increase in oil prices to $80 per barrel and the depreciation of the rupee to over Rs 70 per dollar. But with India’s GDP expected to grow by around 7.5 per cent in 2018-19 (GDP in the first quarter was 8.2 per cent) and with passenger traffic likely to increase by around 17 per cent (domestic traffic at 18-20 per cent and international traffic at 10-12 per cent), we do not see this as a downward cycle at this stage.

The airline industry will need to adjust to a new normal of higher costs and excess capacity. This may take time. Until then, industry losses are likely to increase. With airlines offering low fares, the demand for travel will be stimulated. As a result, according to estimates by the Centre for Asia Pacific Aviation (CAPA), domestic traffic is expected to grow at 18-20 per cent this year, and international traffic at 10-12 per cent.

The airline industry

For airline operators, the resultant increase in costs has been exacerbated by a significant downward pressure on yields. This is due to the rapid increase in capacity as carriers take delivery of new aircraft at an unprecedented rate. Traffic, however, continues to be stimulated by the lower fares on offer, delivering larger losses on domestic year-on-year growth of around 20 per cent. In the near term, the pressure on the airline industry is expected to continue with the oil prices expected to remain at $75-$80 per barrel and exchange rate at Rs 70-Rs 72.

With the exception of IndiGo, none of the airlines have the balance sheet to comfortably withstand the damaging combination of higher unit costs and lower yields. Full-service carriers (FSCs) are feeling the pressure acutely and could lose $1.75 billion-$2 billion in 2018-19. This is not only because of their uncompetitive cost base for domestic operations, where yields have come under intense pressure, but also the lack of profitability on international services. Ever since the days that Kingfisher used to operate, CAPA has regularly stated that the market cannot support three FSCs.

Low-cost carriers (LCCs) are somewhat less vulnerable due to the cash generated from their relatively higher volumes of advance sales, and the incentives on sale and leaseback transactions. The three leading LCCs are significantly better placed, but a full-year loss cannot be ruled out for them at this stage. Despite their relatively stronger position and having posted very positive results in 2017-18, the three largest LCCs are also feeling the impact of the challenges in the operating environment. Although CAPA estimates that their full-year results are likely to range between break-even and modest profitability, at this stage even a full-year loss remains possible (excluding compensation from original equipment manufacturers and other income).

Aircraft induction continues at an unprecedented rate. Around 55-60 narrow bodies are scheduled for delivery over the remaining seven months of this financial year, along with 31 regional turboprops. IndiGo is leading this aggressive expansion and is expected to reach a fleet size of 220 aircraft by March 2018, subject to there not being any delays due to engine issues for their A320neo deliveries.

Airlines have completely lost the pricing power as a result of the rapid capacity addition. This is evident from the significant decline in yields since April 2018, and especially in July and August. During this period, fares were even lower than CAPA’s earlier estimates. Looking ahead, fares below $50 are widely available for travel between Delhi and Mumbai over the coming days, even on FSCs.

Industry consolidation is likely to occur. In January 2018, CAPA India had projected that industry consolidation would occur over the next couple of years. This process is likely to accelerate should oil prices exceed $80 per barrel or if the exchange rate continues to weaken. Long haul low-cost services may be deferred. The adverse environment is likely to result in Indian LCCs deferring plans to launch long-haul services with wide body equipment. Even plans for long-haul narrow body operations could be rationalised. India’s airlines have a near-term requirement to raise over $3 billion in capital. Based on our estimates as at the end of the first quarter of 2019, FSCs would require around $2.6 billion and LCCs approximately $400 million.

Airport infrastructure

Airports have continued to report exceptional growth with Indian airports handling 309 million passengers in 2017-18, up 16.5 per cent over the previous year. In the first quarter of 2018-19, traffic was up by 17.1 per cent, and a similar or possibly even a slightly higher rate is expected for the full year. This would mean that India’s airport system will handle over 50 million incremental passengers this year, which is more than that handled together by all the Indian airports in 2003-04. While this growth in traffic is impressive, airports have been unable to build capacity as fast as it is being utilised.

Both the Airports Authority of India (AAI) and public-private partnership operators are investing in additional infrastructure. However, it will take at least two to three years for this impact to become visible. Until then, challenges will be experienced, particularly at metro airports. A shortage of slots and parking bays, particularly during peak hours, is increasing costs. Airlines are burning more fuel due to congestion in the air and on the ground. And network efficiency is being impacted because airlines are forced to operate flights at sub-optimal times and spread their operations to smaller airports due to slot constraints.

Airport-related constraints have been an issue for some time but were not so keenly felt when the operating environment was more benign. Now that fuel and currency issues have become a core concern, airport capacity issues are adding to the challenge. Enhancing the efficiency of existing airport assets will help deliver incremental capacity faster and in a more cost-effective manner than constructing new infrastructure, and this should be a priority.

Current challenges in the sector may impact capital raising by airport operators. The two largest private airport operators in the country, GMR and GVK, are both seeking to raise capital. However, the increase in airline-viability (or consolidation) risks may impact their plans. Land acquisition issues continue to hold up greenfield second airports at Navi Mumbai and Jewar (serving Delhi and the national capital region). Now that financial closure has been achieved for Navi Mumbai, the project is expected to be fast tracked.

Key recommendations

Although there are a number of structural issues in the industry that need to be addressed over time, some critical steps that the government can take in the near term to assist the industry during this challenging period are:

  • Ensuring that aviation turbine fuel is included under GST to reduce the overall tax burden on the sector. If a consensus cannot be reached, the central government may need to explore ways to compensate the states for the projected loss of tax revenue. Not only will this significantly reduce the operating expenses of Indian carriers, but it will also improve investor confidence and facilitate capital mobilisation.
  • Recognising that airport infrastructure constraints are adding to the challenges of the sector is critical. Most of the largest airports in the country will reach saturation at the very time that the airlines are taking peak deliveries of aircraft. This will require measures to be taken by the AAI both as the air navigation services provider for all of India’s airspace and as the largest airport operator.
  • Adopting a more proactive approach towards understanding the fiscal position of Indian airlines. This is to ensure that they have sufficient cash to be able to withstand cyclical downturns. This could include introducing regulations on liquidity as is the case in some markets. w

This article has been extracted from the executive summary of the report, “CAPA India Mid-Year Aviation Outlook 2018-19”