No Frills, No Profit

In Spicejet's operations centre at its office in Gurgaon, company director and part-owner Ajay Singh is showing off the airline's impressive on-time performance. Pointing at a board full of numbers, he queries a nearby employee and tells this correspondent: "Only one delay today, and that too because of air traffic control (ATC) issues."

But while SpiceJet, and the three other budget carriers in India, Air Deccan, Indigo and GoAir, improve their on-time performance, their financial performance leaves a lot to be desired. Singh, in whose airline Tata Sons investment arm, Ewart, recently acquired a 10 per cent stake, laughs when he says: "No-one is making money, it is a bloodbath, but at least we are losing less money than the others and even make a marginal operating profit." SpiceJet, which has a fleet of 11 aircraft currently, expects to have 17 by year-end.

Another airline that has definitely not slowed down its growth plans is Indigo Airlines. Promoted by the Delhi-based travel services firm Interglobe, Indigo burst onto the scene with a huge 100-aircraft order at the Paris Air Show in 2005. So far, nine aircraft have been delivered and Bruce Ashby, CEO of the airline, expects six more by the end of the year. "By 2008, we should have a fleet of 23 aircraft." However, ask him if he is making money, and he shrugs: "This is not a business where you can expect to make money for the first 18-24 months. In the current environment in India, with infrastructural issues, that time frame might get slightly extended." However, Ashby did point out that Indigo hopes to turn the corner soon.

So what's the problem? "Customers only care about the lowest fare, there is little price elasticity for fares on a particular sector," says Jeh Wadia, MD, GoAir. "And the health of the industry is being compromised by things like sales tax on aviation turbine fuel (ATF). Over 42 per cent of my costs today are on ATF; if the government brought ATF under value-added tax (VAT), we would start making a profit overnight."

GoAir recently reduced its fleet from seven aircraft to five and the number of stations it serves from 13 to 11. While some in the industry see this as a sign of weakness, Wadia strongly quashes these rumours. "Our plans were always to bring in additional capacity every winter, because in winter we can bring in aircraft that are being underutilised in Europe at low-lease costs for the peak season in India." Wadia adds that GoAir expects delivery of its first brand-new aircraft from Airbus later this year

That said, Ashby and Singh both believe that a good customer experience can allow airlines to charge a certain premium. "SpiceJet is rarely the cheapest airline on a particular sector," Singh points out, while Ashby says: "In this industry, it is all about getting the job done with no hassles; if you do that time after time, the word spreads, and it gives us the ability to charge a slight premium."

Samyukth Sridharan, Principal Sales and Marketing Officer, Air Deccan, believes that fares will start climbing, "We believe that the low-cost industry has seen a bottoming out in costs and we will see prices begin to rise over the next 12-18 months." Air Deccan plans to increase ancillary revenues to 25 per cent of the company's topline within the next four years. "That will allow us to fiddle with fares," adds Sridharan.

However, while GoAir, Indigo and SpiceJet work on the tried and tested single-aircraft type, low-cost model, Air Deccan utilises its ATR aircraft on smaller sectors, prompting one rival to quip that the airline was "trying to be a jack of all trades", Sridharan, however, has confidence in the model. "We believe the ATRs give us access to smaller airports and the latent market in tier-II towns

The low-cost bunch has now also to contend with higher interest rates, which will result in a shrinkage in disposable incomes among the middle class. "There might be a short-term impact, but people will still travel in the long term", Wadia says. Sridharan is more forthright, "The alternative is to spend hours and even days on a train or bus."

Robey Lal, Country Manager, India, International Air Transport Association (IATA), believes that India remains a bright spot for the global aviation industry. "Policy decisions to liberalise markets have stimulated an enormous market. Consequently, India ranks amongst the top six fastest growing markets in the world." However, Lal adds: "In domestic markets, we see more scope for movement." Gautam Roy, aviation analyst, Edelweiss Capital, believes that pricing power will only come back if capacity is reduced. "I believe there needs to be a degree of common-sense consolidation in the industry. Even though planes are travelling full, the seats are being sold at unprofitable prices right now."

A few airlines share that view. "In the current environment there is space in India for (just) a couple of budget carriers," Ashby points out. "I think there is a market for two full-service and two budget carriers, plus the government airlines and maybe a couple of niche carriers, so I fully expect some consolidation," Singh adds. Any guesses on who will still be in business this time next year?

Jet, Sahara, go

The Air Sahara acquisition will strain the balance sheet of Jet Airways but its international operations should drive earnings.

The stock market is not flattered with the deal Jet Airways, India’s number 1 private airline, has finally struck with competitor Air Sahara. But the Jet stock has not been hammered the way some analysts were predicting when talks of the deal going through first emerged on April 10.

The stock, which lost 5.57 per cent on April 11 on reports that the deal value would be closer to what Jet Airways had offered to acquire Air Sahara when it first bid for the company a year-and-a-half ago, gained 3.24 per cent when the final announcement was made on Thursday. The stock ended the week at Rs 629.90.

Jet currently flies 44 domestic and 6 international operations and has one of the youngest fleets globally boasting of an average age of less than five years. Apart from the domestic routes, Jet now flies to destinations like London, Singapore, Bangkok and Kuala Lumpur. The airline commands a 25 per cent market share in the domesic market.

While Jet claims that the deal comes 40 per cent cheaper than its earlier aborted attempt, there are hidden numbers which make the deal more expensive. Eitherway, analysts are divided on the stock.

Those bullish are relying on Jet’s flourishing international operations and a more benign domestic climate to accelerate its earnings. The bears on the contrary fear that the Sahara buy-out will strain Jet’s balance sheet unnecessarily.

Even though Sahara’s 27 aircraft, parking bays, staff and other infrastructure apart from its ready eight per cent market-share will be a definite plus, the benefits do not seem to be commensurate with the price Jet is paying for it, they feel.

A leading foreign broking firm put a sell on the stock with a target price of Rs 390. But two other firms, which have been positive on the counter since January this year, reaffirmed their bullish stance with a target price of over Rs 720.

Apart from the Rs 500 crore that Jet paid as upfront payment for the aborted merger attempt, the company would pay Rs 400 crore by April 20 and another Rs 550 crore through four equated annual instalments between 2008-2011. One good part of the deal is that the staggered payment eases the cash flow burden somewhat and reduces the acquisition price going by the net present value of Rs 1250 crore.

The total cost to Jet Airways for control of the Air Sahara however comes to Rs 1950 crore considering the money Jet had spent on Sahara before the deal was called off in June last year and certain other liabilities.

The valuation seems high for a company whose losses have soared and market share halved since the first aborted merger attempt in January 2006. If the stock market has still forgiven the company for this, it is because analysts were expecting a dead loss of Rs 700 crore for Jet Airways considering the litigation would have worked against Jet in all probability.

With intense competition from Low Cost Carriers and price undercutting becoming the order of the day, Sahara’s financials have only worsened since January 2006.

According to reliable sources, Air Sahara incurred a loss of Rs 300 crore on a revenue base of around Rs 1800 crore with accumulated losses totalling to Rs 700 crore. Jet has also seen its realisations fall in the past year and is estimated to close FY07 with a loss of Rs 120 crore.

“Though the current indicated deal size is lower than the amount Jet was ready to pay for Air Sahara, when the deal was first announced, since then the overall competitive environment hasn’t improved. As on December 2006, Jet Airways and Air Sahara both reported running in losses and lost a significant market share after the deal was announced. At the current valuations, we believe the merger would strain the profitability and balance sheet of Jet Airways in the near to medium term, before the merger can fully realize the benefits arising out of the synergies” says Surbhi Chawla, Research Analyst, Angel Broking.

Already, Jet Airways financials look streched with a debt-equity ratio of more than 2. In all the company will need to raise in excess of Rs 5000 crore in order to fund the acquisition and avail of export credit to pay for the aircrafts it proposes to buy for its international operations over the next couple of years.

The company plans to add 20 wide-body aircrafts for its international fleet expansion. All this only means that the need for additional capital would entail equity dilution creating an overhang on the stock.

But there are a few critical positives as well. Given the acute shortage of trained airline staff especially pilots, Jet gets a ready pool of experienced staff from Sahara. Besides, access to Sahara’s parking bays will come in handy as it increases its international fleet.

“The synergies that we see from the merger of two entities will arise from the commonality of fleet (B-737), reduction in spares, maintenance cost, infrastructure facilities,” adds Chawla of Angel Broking.

Critical to the financial performance of Jet would be how the domestic environment pans out. For now the reality is that most domestic airlines are adding to their existing fleet and increasing capacity. Unless the fleet addition slows and price competition eases, domestic yields may continue to be under pressure. But there are analysts who feel that the worst may be over.

According to Nikhil Vora, research analyst, SSKI, fears of price wars, low load factors and oversupply seem to be a thing of the past. He estimates that gross yields which were hovering under Rs 6.0 till 2006 are expected to improve to Rs 6.6 (FY08E) and Rs 6.8 (FY09E). Average load factors are also expected to improve from 69 per cent to 74 per cent in FY09 even as the aviation industry growth at 20-25 per cent per annum, the domestic air travel is expected to touch 60 mn passengers by FY09.

Much would depend on how Jet utilises Sahara. The talk doing the rounds is that Jet would convert Sahara into a LCC and it would remain focussed on business travellers as a premium carrier. This should help Jet hold up both realisations and market share. Eventually, Jet should be able to extend its higher level of operational efficiency to Sahara and turn it around within the next eighteen months.

The biggest plus is that the acquisition of Sahara strengthens Jet Airways’ international operations as Sahara has permit to operate in Gulf market and operations could commence in early 2008. International operations enjoy higher realisation, load factor and better margins.

And in just a few months since launch Jet has been able to achieve yields and load factor comparable to that of global peers like British Airways and Singapore Airlines. The commencement of India-US operations later this year and the Gulf route through Sahara will further boost business and margins.

“Profitability in the business will be driven by rapidly surging international operations,” says Vora who has put an Outperformer on the stock. He estimates that international revenues will help Jet double its total revenues over the next couple of years.

Overall, analysts estimate that Jet could incur a loss close to Rs 170 crore in the current fiscal, as much as in FY07 (estimated). Estimated earnings for FY09, at roughly Rs 40 crore is half of what it would have been without the merger. Rise in crude prices also remains a key risk.

But with buoyant economy, driving demand for air travel up at 20 per cent per annum, and international operations on a par with the best in the world, Jet’s business looks a good story to buy. But one will have to wait patiently for gains to trickle in.

Jet-Sahara: Will it soar after take-off?

If uncertainty is a threat to stock valuations, then an amicable resolution to the Jet Airways-Air Sahara wrangle should mean fewer air pockets for the Jet Airways stock in the days ahead.

But in reality things may not work out quite so simply for investors in India's premier private sector airline. Even after the final value of the deal has been announced, there remain grey areas on the basis and actual quantum of the acquisition price. What is more, the changed dynamics of the aviation sector call for a fresh look at the benefits from this deal for Jet Airways.

Lower valuation

According to its stock exchange announcement, Jet Airways is shelling out Rs 1,450 crore (a part of it in staggered payments) for acquiring the entire equity capital of Air Sahara.

If this is the total sale consideration, it represents a hefty 34 per cent discount to the original acquisition price of Rs 2,217 crore agreed to by the two companies in January 2006.

Market estimates suggest that Jet Airways has bagged its rival at less than one time its annual sales, which certainly appears a moderate valuation, going by the yardstick usually applied in mergers and acquisitions.

However, the downward revision in the acquisition price does not automatically make Air Sahara a "bargain" for Jet Airways as the former's fortunes have also taken a turn for the worse. The past year has seen significant slippage in the market share and fortunes of the full-service carriers, with low-cost airlines making significant inroads into the domestic aviation market.

Air Sahara, with its weaker financials and aggressive pricing, appears to have borne the brunt of the competitive onslaught. Its market share, at the 12 per cent mark a couple of years ago, has slipped to 8 per cent today.

Moreover, aggressive pricing by the carrier to compete with low-cost competitors has diluted somewhat its image as a premium airline. Given the competitive intensity and the shortage of skilled staff, the airline's staff strength is also likely to be lower today than it was a year ago.

The loss of market share would in itself call for some revision in the buyout price for Air Sahara in relation to the original terms.

In addition, the viability of the low-cost model is now more firmly established than it was a year ago. Low-cost carriers such as Air Deccan are now on a better financial footing and control nearly a third of the market (from 25 per cent about a year ago).

With full-service carriers forced to offer a larger proportion of their seats at discounted fares, and gyrating ATF (aviation turbine fuel) prices putting pressure on profit margins, Jet's own profitability parameters have been dented in the past year.

It is precisely these factors that have led to a sharp decline in the stock market valuations for Jet Airways over this period. Between January 2006 (when the original buyout bid was made) and now, the market capitalisation of Jet Airways has shrunk from Rs 9,200 crore to Rs 5,400 crore — a 41 per cent drop.

This is despite the company's annual revenues rising 29 per cent over the past 12 months. If stock market prices were the benchmark for valuation, the value of Air Sahara deserves to be marked down by at least a similar degree.

Questions that remain

There are other unanswered questions relating to the acquisition price of Rs 1,450 crore. If this represents the value of equity alone, what is the status of the debt on Air Sahara's balance-sheet?

Under the original (January 2006) terms of the buyout, the liabilities of Air Sahara were not to be transferred to Jet Airways. Do these terms still hold good?

Second, Jet Airways is said to have infused some cash into Air Sahara to meet its operational expenses during its initial negotiations. How is this factored into the acquisition price?

Finally, Jet is also said to have allowed Air Sahara to retain a portion of its assets, such as the brand name and the helicopter fleet. What is the valuation of these assets?

In return for a lower price, Jet Airways also appears to have made a few compromises on the intangibles relating to the terms of the deal. Reports suggest that it has agreed to take over Air Sahara's fleet on as-is-where-is condition.

This means that Air Sahara's entire fleet of 27 planes will now accrue to Jet Airways. The latter's fleet that was slated to go up to 89 aircraft only by 2009 will now be scaled up almost immediately.

Jet has also decided to retain the entire staff of the acquired operations, as opposed to its earlier plan of absorbing only the pilots and technical staff.

These changes may have a crucial bearing on the time taken and the challenges involved in the integration of Air Sahara's operations with that of Jet Airways, a task difficult enough to begin with.

No doubt some of Air Sahara's assets — its fleet, landing and parking rights at key airports and experienced staff — can strengthen Jet's operations at a time when competition, both from low-cost carriers and Indian, is set to intensify. However, there are also weak spots in the former's operations.

Jet Airways has for long been admired by industry players for its efficiency — low turnaround time, cost-efficient operations, relatively young fleet and best-in-class service.

The challenge for the company would now lie in bringing Air Sahara's operations on a par with it on these parameters. Seen in this light, Jet Airways may only have won a battle in bagging Air Sahara at a "bargain" price. The war is yet to be fought.