India's airline industry is expected to post a combined operating loss of USD two billion for the 12 months ending March 31, 2009. The financial performance of Indian carriers has been repeatedly battered since 2005 by deep discounting, the fuel price spike, slowing demand and depreciation of the Indian rupee. With red ink accumulating over the last three-four years to over USD three billion, the industry is in desperate need of restructuring. The problem: too many airlines, too few airports and passengers. India's airline sector appears headed for another round of consolidation in 2009, as carriers seek to return the industry to profitability after a turbulent couple of years. Earlier attempts have not been particularly successful. But this appears to be the only option.
But, as airlines the world over have frequently found, mergers can bring along with them large amounts of baggage. These often outweigh the more obvious - or more apparent - benefits.
The current situation
The immediate problem is that the airline market is highly fragmented, with too few routes to fly. And the train market has not yet taken to the air. Nine carriers are battling for a share of the market, operating largely similar route networks and offering limited differentiation in the customer proposition.Indian domestic market share in February 2009
To address the overcapacity in the market, Indian carriers recently attempted to stimulate demand with promotional pricing. In January 2009 carriers cut fares by up to 50 per cent across much of their inventory.
But with concentration on major inter-city (metro) routes, the mass leisure market has not yet been tempted to fly. The result was a marginal increase in traffic, but a dramatic decline in yields and consequently revenue for the month of January 2009. Passenger loads for LCCs reportedly showed some improvements in February 2009. However as up to 40 per cent of these seats were sold during the promotional period, yields remained under pressure. The results for March 2009 are expected to show further weakening.
Demand is proving to be relatively unresponsive to price stimulation - at least at a level that is viable. This appears to be because the large discretionary market is still absent. In these circumstances, the only other solution is to reduce capacity. And the most effective way to achieve this is likely to involve consolidation through acquisition or market exit.Consolidation round one: Disappointing results
This is not the first time Indian aviation has witnessed restructuring of the market in recent years. The earlier phase of consolidation took place in 2007 with the acquisition of Air Sahara by Jet Airways, followed by Kingfisher Airlines taking a controlling stake and subsequently merging with Air Deccan, and the decision to merge Air India and Indian Airlines.
For Jet Airways and Kingfisher, the key driver of their decisions to acquire Air Sahara and Air Deccan, was to establish market leadership in order to be able to influence the direction of the industry and achieve pricing power.
Other anticipated benefits included network expansion, access to scarce airport slots and infrastructure, and costs savings through scale economies. At that time, the market was reporting growth of 25 per cent year-on-year and the acquisition strategy appealed to investors. But this consolidation, aimed at creating a more viable business model, took place against the background of an industry that was beginning to exhibit the first signs of distress.
- The bullish fleet orders placed by Indian carriers saw capacity being introduced at the rate of six to 6.5 aircraft a month, whereas the actual growth in demand was closer to three aircraft equivalents;
- Aside from the mismatch between supply and demand, the rate of growth was simply too great for the industry to handle from a management and capital perspective.
- In a fragmented market, with multiple start-ups chasing market share, loss-leader pricing was widespread and Air Deccan in particular was responsible for setting fares well below cost as it fought to retain its first mover market share;
- The rapid increase in capacity at a time when the airport modernisation programme was yet to deliver upgraded infrastructure, meant that airports and airways were highly congested, increasing airline operating costs;
- With the inadequate surface access and airport (and airways) infrastructure, airlines were unable to secure a significant competitive edge over other means of travel, thereby excluding huge parts of the still-untapped leisure market;
- In a period of global boom, demand for skilled personnel such as pilots and engineers also outstripped supply leading to a sharp escalation in wages, and in some cases grounding of aircraft due a shortage of staff;
- Balance sheets were stretched as a result of the aggressive fleet induction programmes, combined with the mounting operational losses.
These early signs of growing pains were largely ignored and airlines continued to pursue aggressive but unachievable growth strategies. The flaws in this approach were exposed by the astronomical fuel prices in 2008 which created an impossible operating environment, not only for Indian airlines, but for the entire global industry.Jet Airways-Air Sahara: A strategic mistake
The acquisition of Air Sahara by Jet Airways was arguably the carrier's first major strategic error (as CAPA observed at the time). Allowing Sahara to exit from the market would have resulted in a market correction that would have been to the benefit of all players. Jet incurred a high acquisition price and has been funding operating losses ever since. The process of integration has been difficult and costly and continues to negatively impact Jet Airways. It is reported that Jet Airways has yet to settle the full purchase price for the carrier, reflecting the state of its financial situation.
Jet Airways' bottom line has been further impacted by an aggressive international expansion which stretched the carrier's resources and damaged investor confidence.Jet Airways share price: March 2005 to March 9, 2009
The airline has since been forced to cut a number of existing routes and halt new services as it consolidates its overseas network. To address the overcapacity in its long-haul fleet, Jet Airways recently leased a number of wide-body aircraft to Gulf Air and Oman Air.Air India-Indian Merger: Nice idea, poor execution
The merger between Air India and Indian Airlines made perfect sense on paper for over a decade. Their complementary networks, common ownership and need to generate greater efficiencies all pointed to the benefits of a merged entity. As it was, the merger coincided with a flurry of increased domestic and international competition, placing great pressure on management.
Successful implementation required robust guidance and a capable execution team to handle such a complex undertaking. Instead, the process moved ahead without first strengthening the management and organisation structure. More attention was devoted to discussion around non-core issues such as long term fleet acquisitions and establishing subsidiaries for ground handling and maintenance, than to addressing the state of the flying business.
Air India has continued to see its domestic market share decline.Air India market share: January 2004 to January 2009
The situation was compounded by the cultural chasm between Air India and Indian Airlines, leading to an increase in internal politics, a potentially messy situation in an entity with 35,000 employees. A bloated workforce, unproductive work practices and political impediments to shedding staff made the creation of a viable business model extremely challenging.
Against this background, Air India's accession to the Star Alliance looks increasingly difficult. Technology integration between the two carriers and with Star, which is critical to membership, appears to be 18-24 months away. If Star Alliance begins to lose patience in its quest to induct an Indian member, this may create an opportunity for Jet Airways.
The situation calls for a depth of leadership across the organisation which still does not exist. This is reflected in the financial results, with an expected loss for the 12 months ending 31 March 2009, significantly higher than USD 500 million. There appears to be no clear business plan to revive the carrier and effecting a turnaround now appears to be a Herculean task. The new government, which will be elected in May 2009, will be faced with some tough decisions about Air India's future.Kingfisher Airlines-Deccan: Not as easy as it sounded
The Kingfisher Airlines acquisition of Air Deccan is another case of underestimating the challenges of merging two carriers. It is a venture that has proved to be costly. Removing Air Deccan as an independent operator took out the airline that was most responsible for the irrational fares in the market place and, to this extent, it restored some pricing discipline which advantaged the entire industry.
However, integrating such different carriers (one, a classic low cost airline and the other a five-star carrier), has proven to be extremely difficult. The huge combined network and distinct in-flight products of the two carriers, has created duplication and confusion about the brand. This has been damaging to Kingfisher, with repercussions for its financial performance. The combined entity today has a large network and diverse operations that are proving to be hard to manage.More consolidation now around the corner?
Where did this consolidation leave Indian aviation? Air Sahara, which should ideally have been left to fail and exit, continues to create problems for Jet Airways. The Air India merger has been a non-starter because of a lack of leadership, while Kingfisher is still digesting Air Deccan.
So, even after this first round, the industry is still faced with over-capacity, especially in the full service category where passenger load factors remain below 65 per cent. In India's high cost/low fare environment; it is simply not a sustainable strategy to keep flying with one in three seats empty.Indian domestic passenger load factor in January 2009
The full service model, particularly the operation of a premium class, has limited demand beyond the six major metros. For the major operators, this implies that recalibration of the in-flight product offer in line with this should be pursued. And, despite the fact that carriers have reduced overall domestic capacity by around 10.9 per cent over the last ten months, there is now a need to reduce available seats by a further seven- ten per cent, the equivalent of grounding around 20 aircraft.Domestic capacity change by carrier February 2009 v May 2009
Demand Outlook 2009: Weak traffic growth ahead1. 2008/2009 - last quarter to cap difficult year
Domestic traffic for the 12 months ending March 31, 2009 may show a decline of ten-12 per cent year-on-year as the final quarter has seen demand remain soft. The promotional pricing announced in January 2009 had minimal impact on loads and only served to dramatically reduce yields and profitability. Although load factors did show improvements in February 2009, particularly for LCCs, with SpiceJet and IndiGo reporting figures of 76-80 per cent, yields were poor as up to 40 per cent of traffic was booked in January 2009 under the promotional pricing schemes. The results for March 2009 are likely to see a reversal, with lower load factors and sharper year-on-year declines in traffic.Indian domestic passenger numbers and growth: March 2008 to February 2009
The slowdown in Q4 has been felt across all segments of travel: corporate, leisure and Visiting Friends and Relatives (VFR). Financial performance is being further challenged by the continued depreciation of the Indian Rupee, which is driving up costs. Losses for this final quarter are expected to be significantly higher than Q3.2. 2009/2010 - weak first half, but improvement thereafter
CAPA expects demand in the first half of 2009/10 to remain quite weak, however if oil prices stay below USD 50, airline losses will be significantly reduced as yields for both Full Service Carriers (FSC) and LCCs are strong. The capacity cuts of approximately 15 per cent in 2008, and deferral of new aircraft deliveries will also start to deliver benefits in 2009/2010. Demand is expected to rebound from Q3 after the next government has been formed and as the economic recovery takes hold. Traffic for 2009/2010 may return to 2007/2008 levels.3. Most international markets remain solid
International traffic, especially to West and South Asia, remains strong, and modest growth is expected in 2009/10, particularly in the last two quarters. Premium traffic however has been declining and is likely to seriously impact Indian carriers such as Jet Airways, Kingfisher Airlines and Air India.
Traffic to Europe and North America is likely to remain weak as a result of the economic slowdown in those regions, and the excess capacity on UK/Europe routes is likely to start to hurt. A number of carriers such as Air France, Austrian Airlines British Airways, Finnair, SAS and Virgin Atlantic have announced frequency cuts. Inbound traffic has been further damaged as a result of the terrorist attacks in Mumbai in November 2008 which is likely to have a significant impact on Q4. Visitor arrivals declined 17.6 per cent and 10.5 per cent in January 2009 and February 2009 respectively.
However, Gulf carriers such as Emirates, Qatar Airways and Air Arabia continue to expand aggressively both in terms of frequencies and the number of cities served. For example, Emirates now operates 163 weekly services to India, including five daily flights to Mumbai. This reflects the advantageous location of the Middle East hubs to serve the strong Westbound traffic flows from India to the Gulf itself, Europe and North America. As other carriers consolidate or pull back, these airlines stand to gain market share and establish a very strong position for when markets recover from 2010 onwards.
Overall, 2009/2010 is expected to see the resumption of growth for both domestic and international traffic, particularly from Q3. However, much depends upon the direction of the economy, fuel prices and political/security stability. The regional security situation, especially the continuing tension between India and Pakistan will be a decisive factor.Airline Sector Outlook 2009: Access to capital the key1. Multiple challenges for Full Service Carriers as losses mount
The three large airline groups have amassed huge losses over the last three years, a massive burden on their operations. With demand expected to remain weak for at least the next two to three quarters at least, these carriers need to cut capacity, reduce costs and rationalise their networks in order to turn around in 2009/2010.
Pressure will continue on FSCs over the coming months and access to capital is key to ride out this difficult period. Amongst private carriers only Jet Airways has managed to raise over USD 500 million, through debt raising. Air India's request for capital infusion may be delayed by the general election. Kingfisher appears to be closer to securing funds but this is yet to be finalised. The airline industry may need cash cover of up to USD 1.5 billion till 2010 and the amount raised might not be enough.
The near break-even situation in December 2009 has given the airlines a temporary breathing space but the overall fiscal environment continues to be uncertain. Air India is unable to address its internal issues and the situation appears to be beyond redemption.
Lack of management depth and the divide between the Air India and Indian Airlines’ factions make matters worse. CAPA expects the continuing decline may affect its accession to the Star Alliance. Kingfisher urgently needs to induct a new management structure as its operations expand and become ever more complex.2. LCCs vulnerable
SpiceJet continues to be vulnerable as the new management is yet to take hold of the situation. However, the carrier has been increasing its fleet utilisation in recent months which should be reflected in an improved cost structure. The present cash position may last for another few months but the infusion of further capital will then become necessary.
IndiGo's losses are not known and may not be very different from SpiceJet’s, but it continues to deliver a robust operational performance. IndiGo's management team appears to be focused on their business plan and they are planning to take delivery of five aircraft this year. The performance of the new management team and the continuing support of its US investors will be crucial as IndiGo prepares for 2009/2010. Investor realignment may be on cards in 2009 as the US-based investor is reportedly seeking to exit.
Both carriers will require further capitalisation in the coming months, however they do have a chance of returning to profitability if fuel remains below USD 50 and a recovery in demand is seen from Q3 2009. In the LCC space, four carriers are operating very similar footprints. The next round of consolidation is therefore most likely to occur in the LCC sector, especially as the FSCs do not have the balance sheets to engage in further acquisitions.3. Consolidation
The next round of consolidation may be strategic in nature. SpiceJet, for example, has indicated that it would be interested in participating in such a development. The market and investors will support sensible consolidation which is designed to restore profitability rather than pursuing scale, and CAPA expects that activity will be seen on this front in H1 2009/2010.
Foreign airlines appear unlikely to be able to participate in any consolidation opportunities in the short term though, as they are barred from holding equity in Indian carriers. The government had shortly been expected to permit foreign carriers to take a shareholding of up to 25 per cent. However, with the dates for the general election having been announced, a major policy reform of this nature is unlikely. The new government, which will be formed in May 2009, is likely to take charge at a time when Indian aviation is re-shaping itself in preparation for its next phase.