Differentiating Man From The Boys

This blog is on Aviation sector and Interglobe Aviation Limited (Indigo) as in investment opportunity. This blog will cover the entire understanding of Aviation sector, its business relationships with lessors and all the other variables to the story.

Disclaimer: This blog is not a recommendation to buy / hold / sell any stock. This blog is mainly for information and educational purpose only. The intention to share write ups on this blog is to create a repository of ideas so that investors / visitors on the website / blog can have a look at various frameworks & approaches. Please read the detailed disclaimer at the bottom of the post.

Glossary:

Lets take a look at the terminology used in this industry.

ASK = Available seats * Km traveled by the aircraft

RPK = ASK * PLF

Types of Aircrafts:

Aircraft's are broadly categorized in 4 bodies:

World fleet:

Lets have a look at the world fleet and its composition. 

Narrow body aircrafts comprise of ~58% of the total fleet. If we look at Indian fleet size, it is small pond in a large ocean. In fact some US airlines have a higher number of fleet than the total Indian fleet.

In last month, out of the 27,884 aircraft ~ 16,500 are just parked i.e. almost 60% of the total fleet. This situation might bring some permanent closures of airlines.

Retirements:

The average age life of an aircraft can range between 15-20 years. With technology development, the new age aircraft claims to have a life span of 25-30 years.

Out of the 27,800 world fleet ~20% of the fleet >15 years old. Aircraft in this age band can face elevated risk of retirement. Currently, the prices of wide body aircraft's have contracted by 10-15% while narrow bodies have remained flat.

At present, the long haul travel is under stress since international flights are not in operation. We may see the wide body aircraft's >15 years retiring if the stress continues longer and thus tightening the supply.

Passenger trips & GDP:

While US, France and Germany stand high in trips per year per person, India stands on the lower end of 0.1 trip per person. India being a highly populated country ~133 crore, still lies very low on per capita trips.

This clearly signifies that India is an under penetrated market and has an opportunistic growth in front of it. In the medium term, once the crisis is over, the demand outlook looks strong  largely driven by low penetration, growing working class and expansion of middle class.

MRO Industry:

MRO stands for Maintenance, Repairs and Overhauls.

Usually, MRO is done with OEM's outside India because there is no MRO center in India. However, in the recent Aatma Nirbhar Bharat theme, FM has announced that they are planning to indigenise an MRO centre. This would aid the airlines, by not sending the crafts out of the country and further not incurring expense in foreign currency.

Now, lets have a look at the Indian aviation sector.

Indian Aviation

About:

Below mentioned are some of the facts about the Indian Aviation sector:

• Airline traffic is one of the fastest growing (~14% CAGR in the last decade)
• The growth is structurally driven on account of low penetration and rising affordability (mainly middle class)
• Airport infrastructure will increase connectivity and hence traffic
• Freeing up of air space (announced by FM) will reduce the fuel cost
• Short haul (mainly non -metro) competes with rail and road
• Up to 49% FDI is allowed in this sector
• Most of the flying comes from the corporate/business sector
• High operating leverage on account of high fixed cost
• Relationships with OEM's and lessors plays a vital role in this game
• Asset (aircraft) prices are not volatile except for deep down cycle events like 9/11, GFC, Covid 19 etc.

Problems faced by the sector:

As we all know the sector faces a primary issue of liquidity and negative net worth, which further leads to inability to raise liquidity in times like Covid. Few other problems are listed below:

1. High competition
2. Low brand loyalty (commodity)
3. Ineffective split between FSC (full service carriers) and LCC (low cost carriers) business
4. Inefficient capital allocation
5. Change in technology adds to cost
6. Unpredictability and usually ill-advised government intervention
7. Taxation of jet fuels
8. Difficult infrastructure constraints

Growth in the Indian Aviation:

          

The domestic passenger traffic has grown at ~14% CAGR over 10 years and international traffic has grown at 8.24% CAGR during the same period. If you compare it with any other commodity, it has grown the fastest.

Further, if you look at the diagram below, India does not have even 5% of the market share inspite of being the 2nd largest in population and 7th largest country in the world.

The above only shows how under penetrated the aviation segment is in India and the potential it has to grow.

Further, the international space of outbound and inbound traffic from India is majorly driven by foreign airlines. Indian airlines are looking forward to venture out in this space.

Indian Fleet:

 

Majority of the Indian fleet is driven on narrow bodies. Indigo dominates the Indian skies with 262 flights and as on 30.06.2020 it has 274 flights. The size of the fleet declined in 2019 because Jet Airways went bust in Jun 19.

Market Share in Passenger Traffic:

Indigo dominates the passenger traffic with more than 50% share with its efficient fleet, LCC model and above all efficient management. It started with 1 flight in 2005 and is now the market leader.

Fleet composition:

The above is a broad categorization of the fleet operated by all the airlines. Out of them, only Indigo operates same family aircrafts (i.e. say 320 series), while the others have a combination of aircraft resulting in increase of training cost to adapt to different technology.

Sector Pax Load Factor (PLF):

The increase in PLF is on an increasing base, middle class penetration, competitiveness in pricing of the fares as all the airlines match rates, the moment one drops the prices others have to. Presently, say ~60% PLF is required for the air craft to deliver a positive contribution.

Existing Airports and Upcoming:

We expect that by FY 40 we might have around 190-200 operating airports.

Distribution of India's International Passenger Traffic:

If we look at the distribution of the traffic, majority of the traffic can be traveled by short haul flights i.e. LCC's. India having maximum of its fleet under the segment can find an opportunistic growth in this segment. ~40% of the international travel market is covered by Indian fleet.

Further, most of the traffic is towards non leisure destinations. Thus, we believe that Indian airlines will be looking at the international space to occupy more share.

Having looked at the Indian aviation sector now lets have a look at " Man among the boys".

Interglobe Aviation (Indigo)

Key Personnel:

Before we start with Indigo it is imperative for us to know the faces behind the success of Indigo.

Rahul Bhatia (RB) - Promoter:

He holds a degree in electrical engineering from the University of Waterloo in Ontario, Canada. He was instrumental in the formation of Interglobe Enterprise in 1989 with its flagship business of air transport management. He has more than 25 years of experience in travel Industry and has led  the development of  many new business initiative of the Company, including the travel and aviation business.

Rakesh Gangwal (RG) - Promoter:

He holds a degree in in Mechanical Engineering from the Indian Institute of Technology Kanpur in 1975, and an MBA degree from the Wharton School of the University of Pennsylvania with a Major in Finance. He has more than 30 years of experience in the aviation industry.

He had been a financial analyst in the product development group of Ford Motor Co and a production and planning engineer with Philips India Ltd. In 1984, he joined United Airline as manager, strategic planning. He held a series of positions at United Airlines and left with  Senior Vice president post. His association with the airline industry began in September, 1980, when as an associate of Booz Allen & Hamilton, Inc, he worked closely with United Airlines. Prior to joining US Airways (CEO), he served as executive vice president for Air France, beginning in November 1994. After leaving US airways as the CEO he then joined Worldspan Technologies, Inc.

About Indigo:

• Indigo dominates the Indian aviation with a market share of ~50%. 
• It has been able to expand profitability owing to its low-cost operation, which are ~15% cheaper than the next best player.
• Its cost are the lowest among prominent global LCC’s.
• Indigo has made considerable profits in last few years. 
• Despite a hostile market, Indigo has grown rapidly over the past decade
• ~55% of the expenditure is in USD. Hence, rupee depreciation impacts the profitability drastically.
• Only airline with strong liquidity and balance sheet in this segment.
• Serves 86 destinations including 24 International destinations.
• International travel is only 25% of its flying

Indigo Operations:

• Low cost carrier

            -    Simple service offerings

            -    Short-haul; point to point route structure

            -    High aircraft utilisation

            -    Lower employee cost

• Buyer of first hand aircraft

• Fleet profiling

            -    Single aisle

            -    Young fleet

• Efficient management; On time performance 

• Non-metro slots

• High cash on the balance sheet

• Fleet = 274

            -    Owned – 29

            -    Operating Lease – 245

Indigo's fleet plan - A secret sauce:

RG's strong connects with OEM's and lessors has played the game for Indigo well. Further, his experience with aviation industry helped him develop the below mentioned formula:

• Place bulk orders:

Placing bulk orders helps achieving higher discounts and attain high incentives. Discounts go upto 40%. Since Indigo places such a big order, Airbus (only collates all the machinery from other OEM's and brings together the aircraft) can further negotiate prices with other OEM's like Pratt & Witney, etc.

• Keeps average age low:

Indigo generally keeps an aircraft for about 4-5 years and then send it back to the lessor. Keeping average age low not only keeps the maintenance expense under check but also improves customer satisfaction (enjoy a ride in a new aircraft)

• Use of single type of aircraft (A320 family):

Single type of aircraft generally have the same infrastructure hence, rationalise training and maintenance cost. Many airlines have a combination of aircraft and all have different operating system which increases the training cost. Indigo has A320 & A321 family aircraft where the operating mechanism is the same.

• Less than 10% fleet is owned:

Liquidity is imperative to the aviation business. Having an owned fleet leads to a heavy outflow of cash and this in turn makes the airlines less viable.

• Sale and lease back (SLB):

Indigo has maximum of its fleet on SLB. SLB generates $8-10 mn per aircraft (upward sloping asset price curve). Induction of new aircraft creates this liquidity. Will be explained in the later part of the blog.

• Works on long term relationship with all the suppliers which helps in favorable 

• Keeps route concentration high

Fleet Addition – Creating a History:

In the aviation industry there is no such thing as timing, since the asset prices don't fluctuate meaningfully. With such magnitude of the order, Indigo is in a position to negotiate better. These orders have been by far the biggest orders globally from a single airline given to Airbus. Furthermore, it was the anchor customer for A320 Neo's. Indigo has further negotiated the order with other OEM's to get favorable prices.

Deliveries of Aircraft:

• Induction of A320 Neo’s will not only replace the old A320 CEO’s, but also lower the fuel burn (15% lower when compared to the conventional CEO engines)
• Pending order book is ~410 aircrafts
• All the new aircrafts are not allocated towards growth but are also allocated towards replacement of old aircrafts. (aircraft >6 years)
• Most of the new deliveries will happen on SLB model
• A321 XLRs is long range with lower loads (non stop itineraries) 

Being Young:

Indigo has a fleet target age of ~4 years. The spike in age of the fleet was due to the delay in the induction of A320 Neo’s on account of the issues in the P&W Engines which further lead to induction of second hand aircraft too during that period that come in with a high maintenance cost.

A young fleet results in lower maintenance costs for an airline, while keeping the risks of technological obsolescence nil. From the above diagram we can see that deliveries of  Neo's have started and A320 Ceo's which will be naturally retired shall be replaced with the induction. This will further lead to reduction in fuel cost.

Currently at ~6 years (46% of the existing fleet is over 6 years and 15% are older than 10 years) vs ~3.7 years during IPO in 2015.

Having understood how the procurement process of IndiGo is it is clear that induction of aircrafts not only reduces maintenance cost but also generates cash flow in the form of capital gains which adds to liquidity.

RASK, CASK AND Yield:

• RASK is a function of PLF and Yield (fare)
• CASK has been growing in the last three years on account of delay in induction of A320 Neo and compulsive second hand buying.
• FY19 was the first year of reported loss on account of increase in CASK. The CASK was increased because of Jet Airways exit. The Govt had ordered all the airlines to fill the slots of Jet Airways with added capacity. Now because Indigo's induction was delayed it had to procure aircrafts from the second hand market which lead to an increase in the maintenance cost.
• International RASK is usually lower than domestic RASK, though margin profiling is the same.

Below is a the allocation of slots of Jet Airways:

Airport Slot Allocation:

• Domestic: Airlines have to submit their choice of slots they want, and then negotiations happen between Govt, DGCA, Airports and Airlines.

• International:

            -    Smaller Airport: Direct negotiations between airlines & airports

            -    Larger Busy Airports: Through IATA.

• For any slot to remain with the airline, airline needs to utilize the slot  80% of the time

• Lesser utilization leads to lesser other revenues to the airport, like:

            -    Landing charges

            -    Parking charges

            -    Other airport services, etc.

• Domestic slots cannot be sold (Govt. reallocates); but internationally, slots have a value and are sold off.

• In times of stress (the vacancy created by Jet), you tend to get allocated more slots because it “needs” to be utilised, else airports will start bleeding

• Slots in non metro are less and hence competitive

Routes + Slot is the Key:

• The differentiating factor of Indigo to Spice (second after Indigo) is of adding more frequencies / capacity on existing routes till the market achieves maturity.
• The other differentiation between the route network is Indigo’s selection of routes, characterised by:

            -    Population in excess of 1 Mn

            -    Potential to service other key cities

            -    The route being a good fit with existing network

            -    The attractiveness of alternate modes of transport for the route (such as rail)

            -    The success of the route for competitors

ASK, RPK and PLF:

The progress of any airlines is looked upon by the increase in ASK. Indigo's ASKs have been growing at ~26% CAGR. Indigo increases its PLF by concentrating more flights on the same routes.

RPK's have also seen growth on account of increase in load factors.

Indigo's flying mechanism is highly efficient. Indigo aircraft travel up to 11 hours a day and the turn around time is very less. Even while traveling to international destinations it tries to get the aircraft back on the Indian grounds to save on the high parking charges which are also foreign currency driven.

 

Generally, Indigo has to fly at ~60% PLF to become contribution positive.

Cargo’s – Birth of a New Pillar:

Cargo traffic carried by scheduled aircrafts over the years

• The domestic cargo traffic registered a growth of 8.3% (CAGR) over the period from 2008-09 to 2018-19 while International cargo traffic grew at 5.3% (CAGR) during the same period
• Indigo has been looking into expanding its cargo business too.
• Indigo has currently converted 10 of its passenger aircraft to cargo flights
• Penetration into the international business will also increase the cargo business.

The above is just an estimate on where do we see the growth of ancillary revenue. 

Cost Sheet:

Deprecation has increased to 11% because of “Right To Use” classification as per new AS which added 9%.

Fuel - 37% of the cost sheet:

Airlines use ATF (Aviation turbine fuel) to fly.

The above graph shows how increase in fuel prices impact the profitability. 

Further,

• ATF is subject to 11% excise + state VAT.
• ATF is sourced domestically, majorly from IOCL. The prices of fuel are negotiated / contracted with IOCL to avoid sudden price volatility.
• Indigo does not hedge its fuel cost; neither any peer does.
• Since prices are negotiated /contracted it brings in more visibility.
• Changes in fuel prices are reflected with a lag of 20-30 days.
• Fuel costs may or may not be passed on; scenario specific.
• Induction of NEO’s & retirement of CEO’s will reduce the fuel burn.
• Low fuel prices have brought down break even load factor to 50%.

The above graph shows the movement of ATF prices over the years. Even though the fuel cost is low at the moment, airlines cannot take full advantage of the same as they are not operating at 100% capacity.

Lease Rentals ~35% of the cost sheet:

Before we look into lease rentals we need to first understand how the SLB model operates.

SLB:

Below is a detailed explanation on how the SLB model works:

• At year 0, Indigo will typically place an order for an  aircraft (after getting a good discount) from the original manufacturer (Airbus) by paying a minimal pre-delivery payment (PDP) say ~20-30% of the aircraft base price and the same are paid over a period of 24 months to 6 months prior to delivery (average lead time for delivery is 2.5-3 years) - With this Indigo gets right to buy. Discount is earned mainly due to RG's connects with OEMs. Not all airlines can procure the same.
• This right to buy would then be sold to an aircraft leasing company (lessor), which will then lease the aircraft back to Indigo
• At the time of delivery, the aircraft’s price (market price) (asset prices are not very volatile) would be paid by the lessor to Airbus instead of Indigo. 
• Airbus will then pay the difference (i.e. price received from the lessor and negotiated price with Indigo) to Indigo – This is what they call as “incentives”
• This incentive is an upfront cash inflow
• Any new induction of aircraft under SLB creates this liquidity in form of incentives
• Estimated gains on an aircraft is $8-10 mn  per aircraft (company has undelivered order book of 400+ aircrafts)
• Orders with OEMs cannot be cancelled as they come with high penalty cost
• 245 out of 274 aircrafts are on operating lease
• Lately, Indigo has procured SLB for its owned aircraft in order to generate liquidity.

Lease rentals comprise of 4 elements:

1. Rentals (10% of cost sheet) – These expenses are fixed in nature. They are paid to the lessor for leasing the aircraft.
2. ~9%  of the cost sheet is lease rentals under depreciation due to adoption of Ind AS where in the lease have been capitalised.
3. Supplementary Rentals (SR) (8% of cost sheet)

• Generally, an aircraft requires engine shop visit after 4 years of use (depending on condition of aircraft)
• Annual accrual of rentals are made for heavy maintenance visits, engine overhaul and landing gear overhaul for aircraft taken on lease.
• Profit and Loss is debited with a provision every year with an estimate and similar amount of SBLC is issued (for guarantee). This SBLC is issued against the cash which is offered as security. This forms major part of restricted cash in the balance sheet.
• Further, if the aircraft is returned (to the lessor) prior to scheduled maintenance then the amount set aside for maintenance is given to the lessor.
• This expense is 80%-90% are variable in nature
• Now, since most of the aircraft are currently grounded, Indigo is  in talks with the lessors to freeze the supplementary rentals and better align these with its utilization for a period of 9 months or so. This will strengthen the liquidity position.

        4. Maintenance (2% of cost sheet)

• Day to Day maintenance – like replacement of tyres, etc.
• Retirement of old aircraft A320 CEO, will lead to reduction in maintenance expense
• A320 CEO’s will be retired naturally

        5. Engine rentals (~6% of the cost sheet)

• Incurred only for spare engines
• PW & CFM engines are kept as spare
• CFM engines will be inducted in August 20.

Below is the list of lessors of Indigo:

In times of crisis lessors become the king. They can make or break the game by providing deferrals in lease payment. Deferrals will add to liquidity and the airlines who get it, will become strong. Indigo. Hence, relationship with lessors is crucial. Avolon is the biggest lessor with 31 aircrafts.

Employee cost - 12% of cost sheet:

• Indigo has targeted to reduce employee cost by 30% in FY21.
• It has taken a series of steps to curb its expense:

            -    Extension of leave without pay

            -    Salary cuts in the range of 5–25%

            -    Permanent Layoffs

Cash & Bank:

Now, that we have looked upon the major side of expense lets bring the elephant in the room.

Generally, all the airlines operate on negative working capital.

Restricted cash comprises of:

• 80% is supplementary rentals in the form of SBLC’s (Stand By Letter of Credit)
• Balance are other bank guarantees to Govt, airports etc.

Below is the liquidity plan that Indigo has undertaken in order to survive the pandemic

• The above provisioning done for ~550 days i.e. 1.5 years of sustenance, based on present 30cr cash burn per day
• Other liquidity measures are also under way and the company shall announce the same as and when required

Further, Indigo is not only the strongest balance sheet / liquidity among the Indian airlines but also among global peers. The below graph is as on April 20.

The above graph clearly shows the strength of the company. Global peers have received stimulus from their respective Govt.'s which Indian airlines did not receive. But inspite of that Indigo has been standing strong.

No. 1 V/s No. 2:

This is just a broad comparison of SpiceJet and Indigo in terms of spread. The structure of Indigo is so smartly made. Since prices are driven like a commodity, it has put its entire focus on cost reduction. The main reason for its sustenance.

IndiGo’s Strengths – Domestic:

The above is just a comparison of the strongest balance sheet of the Indian airlines. It is vital to look at the cash balances and the networth of all the three companies. Indigo stands strong on its foot even today. 

Furthermore, the misery in the sector is a tale of its own:

• Air Asia can potentially exit
• Go Air is on cash and carry, and has had many senior management departures.
• Air India is up for sale
• Spicejet is also deep in debt with large negative net worth. 
• Vistara has a very different full service positioning and Indian consumers are price sensitive.

The weakness of the other airlines has become the strength of the market share of Indigo.

Can LCCs replicate their domestic success in outbound travel?

• 83% of traffic on international routes is also short haul and therefore can be catered by LCCs. (Indigo operates on short haul carriers).
• International traffic, largely dominated by foreign airlines, can be harnessed over a period of time.
• Exit of Jet Airways capacity (14% of the total international traffic) has given LCC’s an opportunity to increase their market share.
• Indigo has been trying to penetrate within the international space. It has recently even agreed to start code sharing with the Turkish Airlines.
• Indigo's cost structure is similar to that of APAC LCCs and should improve further with the introduction of A321 Neos.
• Non stop itineraries are required and implementation of those will lead to further gains.

The Bigger Picture:

• Industry consolidation – an opportunity to add capacity profitably
• The current pandemic situation has brought in survival issues
• It’s a game of liquidity -  Survival of the strongest balance sheet
• Most of the players are underwater and it is just a matter of time when we see some consolidation
• Indigo has seen an increase in its domestic share during the current pandemic
• With only 45% fleet operational, it has become very tough for the airlines to run
• With other airlines running fewer fleet than allowed, has in turn lead to increase in market share without any addition of fleet. Current market share of IndiGo is ~60%.

Current Operations:

The following measures have been taken:

• 60% of the total fleet is allowed to operate (announced in Sept 2020; prior to that it was 45%), IndiGo is flying currently at 60% PLF
• Though, on the Vande Bharat mission Indigo is running profitable charter planes and there is no band on the price regulation on the same.
• 10 Airplanes converted to Cargo freighter to explore scope of cargo opportunities.
• Price bands have been introduced by the Govt.

• Strict sanitization measures have been introduced.
• Air travel will be the most safest mode of travel during Covid 19.
• International travel has started on “bubble” basis
• As of today, only 60% of India's airspace is free for use. The GOI has announced to ease the restriction so that civilian flying becomes more efficient. 
• Manufacturers are allowing delivery deferrals
• Global airlines are receiving support from the Government, but Indian Airlines aren’t.

Recovery expected in FY22:

    

Financials:

Profit & Loss:

Balance Sheet:

Cash Flow Statement:

Valuations:

   

• FY22 will be the first year of normalized operations post Covid.
• EBITDAR can go back to ~15000 cr
• Debt is not substantially expected to grow
• It is a negative working capital industry
• Presently the stock is not dropping a lot, since it is fight between valuations and the sole bet in the sector
• Increase in market share is going to be sticky

IndiGo’s Stock Performance:

Summary:

To sum it all up we believe Indigo is a strong an in the aviation industry for the following reason:

• Last man standing - we saw the balance sheet of the peers
• Strongest balance sheet (even compared to global peers)
• High liquidity & ability to raise money
• Strong relationships with OEMs & lessors
• Ability to buy in bulk at favorable rates
• LCC wins
• Demand side is structural with high growth potential
• Supply side is not oversupplied; relatively tight
• Presence in an under penetrated market
• The stock should be attractive after some decent corrections from present levels
• Rule of Three favors Indigo

Thank You

Authored By Manali Gala

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Source of the data:

Some of the data used in this blog is created by Centra, while some data may have been fetched through various websites, content, files, brokerage house notes, etc. available freely on the social media.

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