Aviation in a tough industry. Globally we have seen time & again that the industry is prone to bankruptcy. A significant amount of capital expenditure is required upfront & then there are very high fixed costs. This means that unless we get a high degree of customer stickiness, it becomes very difficult to make a profit. This is a factor we’ve seen play out in India where a lot of airlines have gone bankrupt despite the fact that there is tremendous growth in traffic & the projected growth is also very high. As a result, there’re a lot of airlines investing in growing capacity because they want to cater to this growing market. As they invest in growing capacity they also have to ensure that the capacity gets utilized. That builds a pressure on the airlines to keep pricing at a level where more customers join the band of flyers. This has been a big pain for Indian airlines despite the huge growth margins. India has the lowest airfares in the world[i]. Because the airfares are so low, the airlines are unable to make profits while operating. It is often said that oil is a big factor in aviation but oil has been volatile for over 6 years now. Despite that, the global aviation industry has returned a profit consistently for the last 10 years. It is expected that the industry will hit a profit of $ 36B in 2019[ii]. Looking just at the APAC, the profitability is expected to be $ 10B[iii]. These numbers show that airlines have been on a positive growth trajectory for the last 10 years.
Despite this backdrop, the Jet fallout did happen. The airline industry in India is suffering from very high ATF prices. The tax imposed by the central & state governments on ATF in India make it a very expensive fuel in comparison to their international peers. Further, ATF is not a part of the GST. Hence, airlines are unable to take the set-off of the GST that they pay. Also, there’re a lot of congestions are airports which adds to the operating costs of airlines. Apart from the infrastructure issues, there’s a pursuit for growth & market share resulting in lack of discipline in pricing.
In a distressed situation, the first question asked during valuation is the possibility of a turnaround, i.e. the steps to be taken to make sure that the airline can operate at margins that are remunerative. There has been a history of turnarounds in the airline industry globally as well as in India. Spicejet was almost grounded about 5 years ago & today is one of the best aviation stocks in the world[iv]. Any incoming investor looks at the possibility of a turnaround when they are evaluating a distressed business & try to figure out what is the best they can do with the business. They would always put a higher degree of risk in to the future cashflows of the company because they’re not sure whether they’ll be able to achieve those projected cashflows. One of the most valued assets for any airline is parking slots, which guides an airline’s ability to land at a certain airport. Jet’s parking slots are only available to it till June. If the airline is not revived till then the slots will be up for auction and then the airline will have no value left. Another factor the investors will look at is the flexibility of the lenders in taking a haircut. The equity value of a business is the total value of the business minus the total debt of the business. If the value of the business is less than the value of the debt, then theoretically there is no value to equity. Then an investor would not bother coming in. The only reason an investor would come in is if the lenders are willing to bring their value down to a reasonable number.
From a lender’s perspective, it’s important for them to maximize their recovery. In order to maximize recovery, tough questions need to be faced. If they invest some more money one may argue that it is putting good money after bad. Another argument is that by making a relatively small investment, the lenders may be able to recover a significantly higher sum later. When this starts to play out, the lenders need to have a lot of comfort with the new investor and their business plan. If the lenders have that confidence, things may work out for the airlines.
It remains to be seen if any new investor will perceive value in the airline. However, as the age old adage goes, at the right price, everything is a good asset.
[i] https://www.telegraph.co.uk/travel/news/revealed-cheapest-countries-for-flights/
[ii] https://www.travelagentcentral.com/running-your-business/stats-airline-profits-to-hit-35-5-billion-next-year
[iii] https://www.iata.org/pressroom/pr/Pages/2018-12-12-01.aspx
[iv] https://www.livemint.com/Companies/T2BOBSwziSYSnEDPMJ2xEM/The-SpiceJet-turnaround-story-and-how-it-became-worlds-best.html
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