Airline Industry Analysis

Submitted in Partial Fulfillment of the requirements of the courseInvestment ManagementProject toProf. K.N. BadhaniOn30th August 2014

ByGROUP 6 SECTION BDasi Prithvi Tej PGP13019Binita Kumari PGP13081Rakesh Krishna V PGP13108Shital Kumar PGP13118Rohith Votarikari PGP13129Post Graduate Diploma in ManagementIIM Kashipur

MACROECONOMIC ANALYSISMacro-economic factors affecting the Airlines Industry are: Recovery in the global economy As global economy is expected to recover after 2014, growth of passenger traffic is expected because of increase in foreign tourists as well as NRIs. As Indian airlines is concentrating more on short haul routes as well as heavy traffic destinations such as Middle east and Europe, it is expected to grow significantly and become more affordable. Proposed development of tourist circuits like Sarnath-Gaya-Varanasi Buddhist Cicuit and five other tourist circuits will help to boost airline traffic in longer run. Electronic Travel Authorization (e-Visa) at nine airports It will give a push to foreign arrivals and boost airline traffic over the long term. Investment in Airport Infrastructure Investment of close to Rs 310 Billion is expected to flow into airport infrastructure between 2013-2014 to 2017-2018. It will boost the airlines industry and improve the airport facilities. Grant of flying rights to oversees destination An increase in flying rights between New Delhi and Abu Dhabi to 36000 seats per week has been granted, similar grants to high traffic international routes such as Middle East and Europe will improve the air passenger traffic significantly. High ATF costs, no control over the volatility Aviation Turbine Fuel(ATF) prices are driven by the volatility in demand-supply of global crude oil. Rising fuel costs forces to increase price of ticket which eventually leads in the decline in airline traffic. Higher sales tax in India In India, ATF prices are more because of higher sales tax ranging from 4 to 30 per cent because of which fuel cost escalate leading to operational inefficiencies. Facing Inflation in operating costs, no comparable hike in prices aircraft and other technical costs, employee costs, landing and parking charges at airports have risen sharply, but prices are not increasing in a commensurate manner leading to low RKPM and rising expense per ASKM for airline companies. Increase in price leads to decrease in air traffic. Besides that, airline companies have been regularly giving heavy discounts to attract customers and fill their capacity; any such discount without the actual increment in passenger traffic will lead to further narrowing the operating margin. Government allows FDI by Foreign carriers in Domestic Airlines for the operators, FDI will provide the much needed funding for highly leveraged carriers, while for consumers, opening airlines to foreign players will ensure worlds best practices in terms of better flying experience and improved technology and safety systems. However, lack of required infrastructure and the depreciating rupee, will create hurdles to have any material impact on ATF costs. Exchange Rate operating costs for airline companies include ATF costs, aircraft lease rental costs, staff costs, selling costs, and administrative costs etc., close to 70 percent of these costs are linked with US Dollar. Hence, fluctuations in exchange rate directly impact the operating costs of the companies. Acutely sensitive to global factors like wars, economic instability and environmental regulations - the industry thrives on the growth in disposable incomes of consumers; any economic downturn hit it badly. War or terrorism has direct impact on this industry as can be seen from the decline in air traffic after 9/11. Recent accidents of international airlines have also impacted the air traffic.

INDUSTRY ANALYSISEvolution of the industry and present competitive landscape

2002-03: Moderately competitive landscapeIn 2002-03, competition in the domestic airlines industry was low with 2 players dominating the industry: Jet Airways and Indian airlines group (Air India, Alliance Air & Indian Airlines) together had 88 per cent market share. Sahara airlines also operated at this time and had a smaller share of the overall domestic market. The players did not undercut each other on ticket prices to grab market share and concentrated on profitability.2006-07: Competition intensifies: Low-fare carriers forayed into the industry, beginning with the launch of Air Deccan in 2003-04. Subsequently, three more - Spice Jet, Go Air and Indigo - began operations between 2005-06 and 2006-07. Two full-service carriers - Kingfisher and Paramount - also entered the market in 2005-06. Thus, the number of carriers in the domestic airlines industry trebled from 3 in 2002-03 to 9 in 2006-07. LFCs offered tickets at much lower prices as compared to FSCs and hence, managed to capture 42 per cent of the domestic market share in 2006-07.

2007-08: Extremely competitive landscape: With competition rising rapidly, the new entrants and incumbent players rapidly expanded their fleet, in a bid to capture market share. The share of LFCs rose to 47 per cent in 2007-08 from 42 per cent in 2006-07. However, this expansion heavily eroded players profitability. Costs incurred by airlines on ATF, manpower etc, rose sharply, but companies were unable to hike fares due to intense competition. This led to pressure on realizations, and profit margins of most airlines slid into the red. The industry's combined losses amounted to Rs. 49 billion in 2007-08. The capital structure of most airlines deteriorated, while some carriers faced a liquidity crunch and had to raise further debt to meet capital expenditure requirements.The consolidation phase: Steadily increasing losses eroded the net-worth of airline companies, forcing financially. The consolidation phase weak companies to sell out or merge with stronger companies. This led to consolidation in the industry, wherein JetLite (Air Sahara) was acquired by Jet Airways, while Kingfisher bought Air Deccan. The government decided to merge Indian Airlines with Air India to form a new entity, National Aviation Company of India Limited (NACIL). The move was taken due to the steadily mounting losses of Air India and Indian Airlines. As a result of such consolidation, the market share of the top three players NACIL, Jet Airways group and Kingfisher airlines rose to around 70 per cent at the end of 2008-09.2009-10: Growing market share of LFCs: LFCs such as Go Air, Indigo and SpiceJet continued to gain market share by expanding their fleet. As a result, the share of the top three players (Jet Airways, Kingfisher and NACIL) dropped to around 60 per cent in 2009-10. To sustain and expand their market share, Jet Airways and Kingfisher introduced low-fare operations under the Jet Konnect and Kingfisher Red brands, respectively. Jet Airways converted two-thirds of its seating capacity to Jet Konnect by the end of the second half of 2009-10. Consequently, more airlines shifted to the LFC model from the FSC model.2010-11: PLFs touch record highs: Entry of LFCs, higher household income, strong economic growth, surging tourist inflow, increased air cargo movement, sustained business growth and supportive government policies were major drivers for the growth in the domestic aviation industry in 2010-11. During the year, PLFs reached record highs due to limited fleet addition and strong demand from business and leisure travellers. Few efficient airlines with better operating cost structure and financials turned profitable. The market share of the top three players (Jet Airways+ Jetlite , Kingfisher and Indigo) in the industry was about 61 per cent in 2010-11. PLFs increased to 77 per cent in 2010-11 from 72 per cent in 2009-10.2012-13: Pricing Discipline post kingfisher exit: The period saw a marked decrease in passenger traffic due to ongoing economic slowdown and high air fares. Kingfisher exited domestic operations beginning in the 3rd quarter on account of its financial woes, leading to about 13 per cent of total domestic capacity going out of market. The remaining 6 players namely Indigo, Air India, Jet Airways, Jetlite, Spicejet and Go air registered marginally better PLFs of 77 per cent and higher realizations post kingfisher's exit. Indigo, Jet Group (Jet airways+ Jet Lite) and Spicejet together captured close to 73 per cent of the domestic market.2013-14: Deals and Discounts: The year saw discounting on ticket prices during the peak seasons too. Overall, the both international and domestic realizations declined during the year. Also, Abu Dhabi based Etihad Airways bought 24 per cent minority stake in Jet Airways for Rs 20.6 billion during the year. As a part of the deal, Jet also sold three of its flying slots at London's Heathrow Airport for a sum of USD 70 million to Etihad.The entry of AirAsia India, a three-way venture between the Malaysia-based low-cost airline, the Tata Group and investment firm Telestra Tradeplace, in June 2014 is expected to further increase pricing competition among existing LFCs. Another joint venture between Tata Group and Singapore Airlines awaits operating permit which will further intensify the competition in the industry.

Player wise RPKM

Porter Five Forces:

Profitability:

Capital-intensive: The airlines industry is capital-intensive, with high fixed costs for aircraft acquisition, leasing and maintenance. The cost of maintaining aircrafts and complying with aviation safety norms are high. Additional costs incurred on training pilots, technical support staff and crew members are fixed as well. Moreover, the airlines industry has had to contend with higher security and insurance charges since the September 11, 2001 terror attacks in the US.

Fuel costs & higher sales tax:Fuel costs, the largest cost component for airlines, are beyond carriers' control and considerably impact their operating margins. Aviation turbine fuel (ATF) prices are driven by the volatility in demand-supply of global crude oil. Rising fuel costs would force carriers to increase ticket prices. Increase in ticket prices can lead to dip in demand and subsequently, decline in passenger load factors (PLFs) of the carriers.

ATF prices in India are expensive as compared to the rest of the world, owing to high local sales taxes which ranges from 4-30 per cent. Consequently, airlines' fuel costs escalate, leading to operational inefficiencies.Congestion: Congestion affects the turnaround time of aircrafts and reduces average aircraft utilisation rates. This leads to wastage of fuel and inefficient use of aircrafts by airline companies. Congestion can also cause inconvenience to passengers, as delays in flight take-offs will unsettle their time schedules.Aggressive price strategy: Carriers often employ aggressive pricing strategies in order to capture higher market share and sell tickets at below breakeven levels. This strategy reduces average yields and increases competition, leading to losses for the entire industry as others will be forced to follow suit and bring down their fares as well.Inflating costs and deflating revenues: For airlines globally, aircraft and other technical equipment costs, employee costs, landing and parking charges at airports have risen significantly, with ticket prices not increasing in a commensurate manner.

This has led to low revenues per passenger kilometre (RPKM) and rising expense per available seats per kilometre (ASKM) for airline companies. Also, domestic airline companies are unable to pass on increased costs because of severe competition in the industry.EBITDAR AND EBITDA margin

Longer recessions, shorter recoveries: New airline carriers enter the industry during periods of high economic growth. These forays lead to a price war among players, resulting in considerable losses for the whole industry. The price war continues until weaker players move out of the industry or merge with financially strong companies.Strong influence of external factors: The airlines industry is acutely sensitive to external events such as wars, economic instability, government policies and environmental regulations. The industry's PLFs declined significantly following events such as the 9/11 terror attacks in the US and the outbreak of the SARS syndrome in South-East Asia. The industry thrives on growth in disposable incomes of consumers and the economic downturn seen since 2008 has impacted the overall profit margins of the industry on the whole.Technical AnalysisThe term technical analysis is a complicated sounding name for a very basic approach to investing. Simply put, technical analysis is the study of prices, with charts being the primary tool. The roots of modern-day technical analysis stem from the Dow Theory developed around 1900 by Charles Dow. Stemming either directly or indirectly from the Dow Theory, these roots include such principles as the trending nature of prices, prices discounting all known information, confirmation and divergence, volume mirroring changes in price, and support/resistance. And of course, the widely followed Dow Jones Industrial Average is a direct offspring of the Dow Theory. Here we mostly used Support/Resistance, MACD, SMAVG (50), SMAVG (100), and SMAVG (200).Bar chartsA bar chart displays a security's open (if available), high, low, and closing prices. Bar charts are the most popular type of security chart. As illustrated in the bar chart in below figure, the top of each vertical bar represents the highest price that the security traded during the period, and the bottom of the bar represents the lowest price that it traded. A closing tick is displayed on the right side of the bar to designate the last price that the security traded. If opening prices are available, they are signified by a tick on the left side of the bar.

Moving AveragesMoving averages are one of the oldest and most popular technical analysis tools. A moving average is the average price of a security at a given time. When calculating a moving average, you specify the time span to calculate the average price (e.g., 25 days). A simple moving average is calculated by adding the security's prices for the most recent n time periods and then dividing by n. For example, adding the closing prices of a security for most recent 25 days and then dividing by 25. The result is the security's average price over the last 25 days. This calculation is done for each period in the chart. Note that a moving average cannot be calculated until you have n time periods of data. For example, you cannot display a 25-day moving average until the 25th day in a chart.

The classic interpretation of a moving average is to use it to observe changes in prices. Investors typically buy when a security's price rises above its moving average and sell when the price falls below its moving average.

MACD

The MACD is calculated by subtracting a 26-day moving average of a security's price from a 12-day moving average of its price. The result is an indicator that oscillates above and below zero. When the MACD is above zero, it means the 12-day moving average is higher than the 26-day moving average. This is bullish as it shows that current expectations (i.e., the 12-day moving average) are more bullish than previous expectations (i.e., the 26-day average). This implies a bullish, or upward, shift in the supply/demand lines. When the MACD falls below zero, it means that the 12-day moving average is less than the 26-day moving average, implying a bearish shift in the supply/demand lines. A 9-day moving average of the MACD (not of the security's price) is usually plotted on top of the MACD indicator. This line is referred to as the "signal" line. The signal line anticipates the convergence of the two moving averages (i.e., the movement of the MACD toward the zero line). The MACD is the difference between two moving averages of price. When the shorter term moving average rises above the longer-term moving average (i.e., the MACD rises above zero), it means that investor expectations are becoming more bullish (i.e., there has been an upward shift in the supply/demand lines). By plotting a 9-day moving average of the MACD, we can see the changing of expectations (i.e., the shifting of the supply/demand lines) as they occur.

Company wise Technical AnalysisMACDGlobal Vectra

Currently MACD goes on decreasing that is moving from positive to negative side and it also running below the signal line, it shows the condition of bearish and to sell out the stock. Whereas, somewhere on February 14 and May 17 MACD moving from negative to positive and running above the signal line , it shows the condition of bullish and to buy.Jet Airways

Here on July 15 signal line cross over is negative, though the difference between MACD and signal line is very less, it shows the beginning of bear market and suggest to sell out the stock. Whereas, in September and April the difference between MACD and signal line is very high and positive, which shows a condition of bullish market and suggest to buy stock.Jagson Airlines

Here also showing a condition of bear market, because the MACD is moving from positive to negative and the gap between MACD and signal line is also negative, so it suggests to sell out the stock The arrow represents the upward and downward pressure on the stocks at specific period.Kingfisher Airline

Again it shows a condition of bearish market, because the gap between MACD and signal line is negative. In September the signal line cross over is very high and positive, so it shows a condition of bullish market. The arrow represents the upward and downward pressure on the stocks at specific period.

Spice jet Airways

Here also after June 15 the MACD continually goes on decreasing and showing negative signal line cross over, this indicates bearish market.

Support & ResistanceGlobal Vectra

Here prices are running somewhere around 50, which shows that there is no trend. Since past one year it doesnt come across the support zone i.e. oversold territory. Whereas, Somewhere during Feb, May and June, it was running under overbought territory i.e. resistance Zone.Jet Airways

Price are moving below 50 which means that stock losses are greater than gain. During April it was running under overbought zone, whereas for sometimes in December and February it was running under oversold zone.Jagson airline

Here Prices are running much lower than 50 which means that stock losses are much more greater than gain, it can be considered as bearish market and suggest to sell the stock.Kingfisher Airline

Here also price is moving much more below than 50 and showing a condition of bearish market which suggests selling out the stock. During February and March it was continuously running under oversold territory.

Spice Jet Airline

However prices are running below 50, but it started moving upwards with expecting to increase in prices over a period of time.

Company Valuations:

SpiceJetValuing Airlines industry is difficult as operating profits itself are negative. We have tried to value company Spicejet using discounted cash flow method FCFF and used following assumptions

Assumptions of Valuation: Currently Spicejet is in growth phase as we have observed it still makes significant amount of Capital expenditure and also expanding its fleet every year. Terminal growth for Spicejet is assumed after 10 years. High Growth phase for Spicejet is considered for coming 5 years after which transition period is considered from year 6 to year 10. Stable growth rate rate is assumed at 5% which would be on par with GDP rate. Instead of assuming overall growth rate in EBIT we have assumed component wise growth rates as EBIT is negative for SpiceJet. Beta in the stable growth phase will tend to one. WACC is equal to return on Capital in stable growth phase. Tax rate for the company is assumed to be zero due to previous years high net operating loss

Values considered in Valuation:Risk Free Rate8.50%

Indian Equity risk Premium7.00%

Beta1.83

Cost of Debt10%

Cost of Equity21.3%

Perpetual growth rate5%

Individual Component Growth Assumptions for coming 10 years:YearGrowth Rate in RevenueEBITDA/RevenueGrowth Rate in Capital SpendingGrowth Rate in DepreciationWorking Capital as % of Revenue

127%-6%-50%15%2%

225%-4%-50%15%2%

322%-3%-50%15%2%

420%-1%-20%15%2%

515%0%-20%10%2%

615%1%-10%10%2%

712%2%-10%10%2%

812%3%5%5%2%

98%4%5%5%2%

106%5%5%5%2%

EBIT Calculation with consideration of past Net operating Losses (NOL):YearRevenuesEBITDADepreciationEBITNOL at beginning of YearTaxesEBIT(1-T)

171128.6106-4267.716636960.7675-5228.484136-7443.610-5228.4841

288910.76325-3556.430531104.882625-4661.313155-12672.094140-4661.3132

3108471.1312-3254.1339351270.615019-4524.748954-17333.407290-4524.749

4130165.3574-1301.6535741461.207272-2762.860846-21858.156240-2762.8608

5149690.16101607.327999-1607.327999-24621.017090-1607.328

6172143.68521721.4368521768.060799-46.623947-26228.345090-46.623947

7192800.92743856.0185481944.8668781911.151669-26274.9690401911.15167

8215937.03876478.111162042.1102224436.000938-24363.8173704436.00094

9233212.00189328.480072144.2157337184.264337-19927.8164307184.26434

Terminal Year247204.721912360.236092251.4265210108.80957-12743.55209010108.8096

Expected free cash flows to the firm1-5228.484136-3922.235960.767510875.35221-19065.30385

2-4661.313155-1961.11751104.882625355.643053-5873.191083

3-4524.748954-980.558751270.615019391.2073583-4625.900043

4-2762.860846-784.4471461.207272433.8845247-2519.985099

5-1607.327999-627.55761607.327999390.4960722-1018.053672

6-46.623947-564.801841768.060799449.070483707.5645286

71911.151669-508.3216561944.866878413.14484442934.552047

84436.000938-533.73773882042.110222462.72222575481.651195

97184.264337-560.42462572144.215733345.49926198422.556183

1010108.80957-588.4458572251.42652279.854402111491.93583

Current Cost of Capital Calculation:Total Debt in 201318022

Market Capitalization12908

Debt to Capital0.582672048

Equity to Capital0.417327952

WACC14.72%

Cost of Capital calculation with changing D/EYear1 to 5678910

Beta1.831.61.51.31.11

cost of equity21.31%19.70%19.00%17.60%16.20%15.50%

Debt Ratio58.27%58.27%58.27%58.27%58.27%58.27%

cost of capital14.72%14.05%13.76%13.17%12.59%12.30%

Reinvestment rate in Stable Growth phase and Terminal value:Return on capital at perpetuity12.30%

Reinvestment rate in stable growth0.406504065

Terminal Value113299.2117

PV Calculation using FCFFYears012345678910

FCFF-19065.30385-5873.191083-4625.900043-2519.985099-1018.053672707.56452862934.552055481.65128422.55611491.94

Terminal FCFF113299.2

PV Calculation13251.6202434315.3026545363.3300356830.1374567920.254178936.1550189317.6055898669.5401106184.337111127.7

Final Share PricePV of Equity5530.271537

Outstanding Shares535

Market Value when valuation is done18.2

Value of each share10.33695614

RecommendationSell

Current price of SpiceJet is Rs. 12.80 so our Sell recommendation is correct.Relative ValuationsWe have used Price/Sales multiple to relatively value all the companies. The relative valuation results are as follows:CompanySalesShares outstandingSales/Shares outstandingSales MultipleRelative PriceMarket Price

Jet Airway176166.4113.591550.8970860.161299250.158148254.05

Jagson Airways20.1680.1612993.21

Kingfisher5013.828808.726.1997081810.1612991.000006732.9

Global Vectra3301.2614235.80428570.16129938.034995333.05

Spicejet 63042.33535117.83613080.16129919.0068518.2

Note: Couldnt find the Sales of Jagson Airlines for the year 2013-14

Relative valuation shows that JetAirways and Kingfisher are overvalued and Global Vectra and SpiceJet are undervalued in the industry when valued with Sales Multiple.

GlossaryASKM Available seats KilometreRPKM Revenue Passenger KilometrePLF Passenger Load FactorATF Aviation Turbine FuelLFC Low Fare CarriersDGCA Director General of Civil Aviation