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AVIATION SECTOR ANALYSIS JUNE 2021 EDITION

Introduction

Business Models

Revenue Streams

Cost Drivers

Covid-19 Impact

Impact of Global Factors

Introduction Started with an air mail of just 6 miles and 6500 mails between Allahabad and Naini in 1911. Indian airplane story is no more than a roller coaster story with first airline in 1932, Tata air services now called as Air India. The sector shifted from private to government in 1953 and then again shifted to private in 1994. The major boom in the airline sector came in early 2000’s due to the entry of low-cost airlines like SpiceJet, Indigo, Air Asia, etc. These airlines now hold the major share in the massive airline market in India with indigo holding major chunk of the pie. Now with the seventh largest aviation market in the world Serving more than 350M customers. Passenger traffic growing at a CAGR of 11.3% Contribution of 84billion dollars in the country’s GDP, providing millions of jobs directly and indirectly. The sector plays an important role in the development of infrastructure and tourism sector for the country. Recent Union Budget announced for financial year 2021-22 provided several incentives for the sector. Tax holidays at IFSC at GIFT city, Gujrat for the capital gains incomes of the airport leasing and financing companies. For the promotion of aatmanirbharta, custom duties have been reduced to 0% from 25%, which shall improve the domestic manufacturing of airline equipment in the country. The government is trying to achieve the goal of building 100 new airports through PPP model. Other important announcement in the Krishi Udaan scheme to boost the agriculture and allied sector, development of health system capabilities at entry points of airports under Atma Nirbhar Swasth Bharat Yojna, etc.

Aircraft Movements in India ( in Lacs)

Business Models There are generally five main airline business models which are employed by majority of the airlines around the world. There are different hybrid models that can stem from combining two or more models, each one with its unique intricacies. However, the broader framework, however, remains aligned to one of these 5 models.

Legacy airlines/ Full Service Network Carriers These airlines generally have a large fleet, which is quite diversified as they also tend to operate multiple routes including long haul, short haul and regional flights. Because of their long experience in the aviation business, legacy airlines are generally expected to be reliable, have good customer service, be predictable with lesser timetable changes and flight cancellations and have a decent service quality.

Low cost airlines As the name suggests, low cost airlines primarily focus on reducing costs to the bare minimum and maintaining these low fares as their biggest selling point. The low-cost business model works on the assumption that the low price sells itself due to perceived price sensitivity of an average customer. As all airlines need to comply with basic airline regulations such as maintenance, low cost airlines cannot save costs on such regulatory requirements. Therefore, most of the cost savings come from other business areas and services. Some potential savings are driven by limited in-flight services, reserved seating services, limited baggage etc. Cost savings can further be driven by certain conscious business decisions such as a monotype fleets (single aircraft models throughout the fleet), highly disciplined and controlled maintenance contracts and lastly, point to point flights to increase efficiencies through the learning curve.

Charter Airlines Charter airline business models generally rely on partnerships with travel agencies for the transport of passengers to a given location throughout a year. Post agreement, it becomes the travel agency’s responsibility to fill the aircraft with passengers. Some of the biggest advantages of this model come from significant reductions in advertising costs, secured cash flows from long term agreements and low-cost customer service. The biggest roadblock for charter carriers is to enter into contracts with tour operators. Since supply can often exceed demand in this model, there is limited growth potential as a standalone business model.

Regional Airlines Regional airline business models tend to focus on transporting people from smaller, regional airports to larger hubs. Their core service area tends to focus on increasing accessibility of aviation transport. The primary streams of income for a regional airline include ticketing income, long term hauling agreements and franchise income where regional airlines feed passengers to larger airlines. Moreover, these airlines generally encounter slightly lesser operating costs due to a smaller fleet, lower maintenance costs and lower booking and ticketing costs.

Cargo Airlines Cargo airline business models are mostly self-explanatory. These airlines transport goods for forwarders or big shipping companies. Because there are no passengers involved, there are hardly any costs associated with the transport of people. However, they primarily rely on major contracts with forwarding and shipping companies and such contracts require a very high level of service. Thus, cargo airlines sometimes have higher service costs to ensure reliability of service quality.

Freedoms of Airline Industry The First Freedom: Freedom to overfly a foreign country (A) from a home country en-route to another (B) without landing Also called the transit freedom Granted by almost all the countries- except for Russia which offers transit freedom to few airlines only

The Second Freedom: To land in a foreign country for technical and refueling purposes only for purposes other than carrying passengers Include refueling, maintenance, or emergencies

Home Country

Home country

The Third Freedom: Carry traffic from a home country to another country for commercial purposes

Home country

The Fourth Freedom: Pick up traffic from another country to a home country for commercial purposes

Home country

The Third and the Fourth Freedoms are the basis for commercial services, since these allow the rights to carry passengers, mail, and freight in a country. They are generally reciprocal agreements where countries allow airlines start commercial services in the other country simultaneously The Fifth Freedom: Freedom to carry traffic between two foreign countries Allows airlines to carry passengers from a home country to another intermediate country, pick passengers in the intermediary country and then fly onward to a third-country

Home country

The Sixth Freedom: “Unofficial” freedom to carry traffic between two foreign countries Via the airline’s home country by combining the third and fourth freedoms Refers to the right to carry passengers between two countries through an airport in the home country With the creation of airport hubs, this freedom has now become more common, for example London and Amsterdam in Europe or Dubai in the Middle East

The Seventh Freedom: Base aircraft in a foreign country for use on international services Essentially establishes a foreign hub for the airline The right to operate passenger services between two countries outside the home country Though similar to the Fifth freedom, this freedom has the additional benefit of allowing a foreign base which is not covered in the Fifth freedom The Eighth Freedom: Freedom to carry traffic between two domestic points in a foreign country on a flight that has either originated or is destined for the airline’s home country Also called “cabotage” privileges Right to move passengers on a route from a home country to a destination country using more than one stop in the same country Passengers may be loaded and unloaded on both the stops

The Ninth Freedom: Freedom to carry traffic between two domestic points in a foreign country Though very similar to the Eighth freedom, this does not have the restriction of origin or destination being the airline’s home country Also referred to as a “full cabotage” or “open-skies” privilege Involves the right of an airline from a home country to carry passengers in a different country

Home Country

Home Country A

Major Issues with Freedom: Independent of trade agreements Means, two countries may have a free trade agreement implying liberalization of commercial transactions and allow investments from the other country Their respective air carriers could still have restrictive air freedoms under the Air service agreements between the same two countries

Competitive Landscape India’s airline market is infamous for cutthroat competition and losses, having an irrational competitor in the form of state-backed Air India While other airlines have struggled, IndiGo has been the stand-out performer in terms of profitable growth

Airlines Operators in India

Indigo

Spicejet

Air India

Go Air

Vistara

Market Share

53.9%

13%

10.2%

8.9%

6.3%

Load Factor*

66.3%

78%

66.9%

66.3%

66.8%

Passenger Ferried (in millions) (Dec 2020)

5.39

0.95

0.75

0.65

0.46

Brand Logo

Load Factor: Measures the percentage of available seating capacity that has been filled with passengers. A high load factor indicates the airline has sold most of the available seats

Trends in Industry Number of Passenger (In crores)

Cargos Handled (In lac tonnes)

High load factors driving revenues

Rising Passenger Demand

Figure showing Ancillary Revenues

Increasing Cargo Volumes

Source: Statistica

Improving Ancillary Revenues

Improving operational metrics

Boost from higher capacity addition – Capacity addition which can be measured with Available Seat miles (ASM) has been growing rapidly

Value Added Services

Commission Based Services

Source: https://www.routesonline.com/

Rise of Low Cost Carriers and Ultra low Cost Carriers

Personalized User Based Services

Revenue Streams

Source - https://www.oliverwyman.com

Capacity Opportunities for revenue production Also revenue reduction if not increased as per the trends and growth in the industry Increasing capacity by network and value carriers added most to their revenue after the financial crisis in 2008 Load Factor Percentage of available seating capacity which is filled with the passengers Airlines generally have low profit margins so they should have high load factor to stay profitable Yield and load factor balance is important indicator of how efficiently the airline is using its resources Ancillary Revenue and others Onboard sales Excess baggage fees Ticket change charges Other miscellaneous charges In 2019, Revenue from this source amounted to 109.5 billion dollars

Passenger Yield Average fare earned per passenger per mile (or kilometre ) Yield varies with demand and supply factors, market segments, seat classes etc. Airlines have adopted price discrimination and product differentiation strategies Cargo Initially cargo was said to be an add-on business but gradually it has turned to a dominant source of revenue In 2019, cargo airlines generated revenue of approximately 102.4 billion dollars worldwide During crisis cargo proved to be a good source of revenue for the industry Operating revenue per available seat mile (RASM) proves to be an effective way to compare airlines across varying business designs

Cost Drivers Labour Accounts for more than 35% of operating expenses in airlines Unit labour cost is increasing at a greater rate for value carriers as compared to network carries in US

Maintenance Cost It can range from 10%-15% of an air carrier budget Age of the aircraft is a major factor to determine the maintenance cost. In addition to this, equipment and facility cost, overheads, supply and logistics cost also contribute to it It was once quoted by Federal Aviation Administration that major air carriers outsourced on an average 64% of their maintenance expenses

Fuel Cost - 10%-12% of operating expenses in this industry Companies engage into programs for hedging fuel costs.

Other Cost Drivers Food Commissions Insurance Non-aircraft Rentals Advertising Landing Fees, etc.

Financial Distress The Indian aviation sector over the recent few years has shown a critical development possibility on various parameters like passenger traffic, freight traffic, aircraft movements and number of airports, among others. But the financial performance of most of the air carrier individually is not at all impressive. Every five years one airline in India is being grounded, most recent being Jet Airways which had to suspend its operations in April 2019 due to severe financial & monetary crunch Air transportation has become a very significant industry over time and it plays a vital role in global tourism and supply chain functionalities. This industry generates significant employment and contributes majorly to global economic growth.

However, it is also vulnerable to several intrinsic and extraneous risks. These risks include economic boom and bust cycles, volatility in exchange rates and oil prices, protectionism, infrastructure challenges, wars & political upheavals, among others. This industry is also vulnerable to various other events such as terrorist attack, weather conditions as well as natural disasters. All these issues lead to significant fluctuations in the profitability of air carrier or airline. In any unregulated market, the competition will significantly grow between the parties involved. The hallmark of this economic system is that some firms will inevitably fail. The more proficient firms will succeed, and the poorly managed will fail, allowing others to take their place. Consequently, cost effectiveness is critical. According to economic theory, an existing airline will be able to succeed as long as it is operated and managed efficiently; if it fails, a more proficient and efficiently run airline will replace it. Warren Buffett once referred the aviation industry as the death trap for investors

The Indian aviation sector which is highly competitive in nature has shown considerable growth prospects especially in the domestic segment in the past few years. India is the third largest domestic civil aviation market in the world and is expected to move to become third largest air passenger market by 2024. As the airline industry in India operates in a cut throat competition, the ability of different airline companies to increase prices is restricted to a great extent. More often than not prices are even discounted or reduced to attract the customers. But for maximizing profit, revenue maximization is also as necessary as reducing cost. Since profitability is considered to be critical for growth and survival of any industry, the companies belonging to the aviation sector have to pursue new strategies to maintain profit margins. In such a dynamic scenario, there is a very high propensity for financial distress for these companies which eventually lead to financial bankruptcies and even insolvencies.

Several cases of financial distress have been observed in the airline companies in India within the last decade 1. For example, Kingfisher airlines had to halt and discontinue its operation in 2012 due to their inability to pay off its liabilities. 2. Spice Jet grounded more than 2000 flights at the end of 2014 due to huge accumulated losses. It was bailed out only by additional funding from promoters. 3. Similarly, in 2016, Air Asia had to put its expansion and growth plan on hold due to a severe liquidity crunch. Air Pegasus became bankrupt in 2017. 4. In the same year, Air Carnival and Air Costa had to close down their operation. 5. In recent times, in 2019, Jet Airways operations are completely suspended due to financial crunch.

Fate of Industry According to Finance minister Nirmala Sitharaman in her Budget speech, the privatization of Air India will be completed in 2021-22 Apart from selling 100% stake in Air India and Air India Express, the government is also looking to offload its 50% share in Air India Services Pvt Ltd This was a sharp reversal from 2017, when the govt offered only 76% of the carrier and received no bidders Tata sons views Air India as its birth right Originally established the carrier in 1946 Market experts believe that if Tata acquires Air India, it will merge the flag carrier with Vistara

Impact Analysis Merger will create a large, premium carrier with significant scale, excellent routes and slots Tata sons may also combine AirAsia India and Air India Express Creating a single major low-cost carrier to compete domestically and feed international services at major hubs including Delhi and Mumbai In addition to consolidation, the elimination of an irrational player could bring a degree of fare rationality to the Indian market. A consolidated, reasonable Indian airline market could eventually become a profitable place to do business.

Impact of Global Factors The airline sector is notorious for its problems in preserving profit margins in the context of a variety of internal and external variables that continuously threaten to disrupt them. Airline decisionmakers need to continuously modify their tactics, from growing competition and customer demands to labor shortfalls and trade union strikes to variations in fuel prices, to identifying methods to cut expenses and boost income to stay above the ground

Labor shortage While current labor force continues to want a higher wage, many airlines, especially in terms of commercial pilots, struggle to attract talent. There has been a major scarcity. This is partly due to shifting demands which prevent young people from being trained as a pilot and a reduction in the desire of the professional path. Consequently, salaries are increasing, further cancellation means fewer flights available, particularly in smaller areas and regional airports, given that smaller airlines tend to be affected by understaffing. This means travelers either have to completely cancel their trip arrangements or locate more convenient choices

Fluctuating oil prices Naturally, oil serves as a major component of variable cost for companies operating under this industry. We are facing a worldwide crude oil collapse, While the government pressures exporting countries to lower prices, the producer pumps crude record amounts. Naturally, decreased oil prices would mean lower flying expenses. Geographically comparing, the impact of Oil prices will be more in European countries when compared to other parts of the world.

Competition Falling oil prices, increasing demand for consumer travel and more airlines with more routes and more options for discriminating passengers have contributed to robust global. However, as competition rises, airlines are obliged to take into account trade-off between customer experience compromises, flight pricing and other cost savings, compared to rival carriers' potential for consumers' loss. Increased rivalry over space at these terminals also means more take-off flight and airlines operating from world hubs. Airports have already become crowded, and more demand implies that they may charge higher charges on their gates for one spot. However, more flights and passengers can also result in further delays if there is no consequent gain in operational efficiency which reduces airline earnings. Competition comes also in the form of data-driven technology that is threatening to undermine the age-old infrastructure airlines continue to operate on. With the continuous development in the technology sector in the past decade or so, we wouldn’t be surprised if how airlines operate will change totally in the next decade.

Did Covid-19 clip the wings ? The COVID-19 pandemic had an immense impact on the Indian aviation sector in the year 2020 and all major airlines facing losses and challenging times laid off employees, sent them on leave without pay, or cut their salaries. As the pandemic started to spread across India, all scheduled domestic passenger flights and international flights were suspended from March 25 and March 23, respectively. Scheduled domestic flights were restarted in a restricted manner from May 25. Special international passenger flights were permitted by the government under “Vande Bharat Mission” since May and special air bubble agreements were made with around 24 selected countries since July. However, scheduled international flights remain suspended in India.

Impact on Employees To weather the pandemic induced storm, all airlines took severe cost cutting measures like pay cuts or firings in 2020 0%

In April, GoAir decided to send the majority of its employees on unpaid leaves

-10%

Vistara implemented a leave without pay program for its employees based on their seniority

-20%

-30%

Air India

Air Asia

Indigo

Spicejet

Losses Quantifying the loss in terms of customers it is estimated that just 50-60 million passengers (40-50 million domestic and less than 10 million international) would travel in 2020-21. This is a sharp decline from 201920 when approximately 205 million air passengers (140 million domestic and 65 million international) travelled in India. It was projected by CAPA India in October that the Indian aviation sector will lose a combined $6-6.5 billion in FY21, of which airlines will account for $4-4.5 billion. As a result, the government's long-standing plan to sell state owned Air India has been hit.

Recoveries The air cargo traffic in India has shown a faster recovery in 2020 as compared to the passenger traffic. This has given some much needed respite to the aviation industry. In FY2021, the total cargo volumes are expected to see a decline of 17-20% in FY2021 with substantially meaningful recovery in cargo volumes expected only in FY2022. Presently, the Indian airlines are operating in the domestic sector at around 80 per cent of their pre-COVID levels and the domestic services are only expected to reach the pre pandemic levels by March 2021.

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