INTRODUCTION

Aviation sector in India has been transformed from an over regulated and under managed sector to a more open, liberal and investment friendly sector since 2004.Entry of low cost carriers, higher house hold incomes, strong economic growth, increased FDI inflows, surging tourist inflow, increased cargo movement, sustained business growth and supporting government policies are the major drivers for the growth of aviation sector in India. Forecasts by AAI for the next 5 years have projected a sustainable growth rate of 16% for international and 20% for domestic aviation sector. Recognizing the exponential growth of air traffic in India, the Ministry of Civil Aviation has been following a very liberal policy in the exchange of capacity entitlements / traffic rights. Domestic airlines have been allowed to fly overseas, forge partnerships with foreign carriers while foreign carriers in turn have been interlining with domestic airlines to access secondary destinations. The government has also tried to ensure an environment conducive for growth of all stakeholders associated with Indian aviation segment. With the rise in the number of airlines, growing passenger segment and route expansion, there is however a need for Indian airport to have their infrastructure in place, which unfortunately at present is the weakest link in the chain. Greenfi eld and modernisation projects are being developed on PPP model to develop facilities conforming to international standards and to encourage the domestic operators to shift base, so as to decongest major airports. To monitor the quality of services rendered by various airports and their tariff, an independent regulator, Airport Economic Regulatory Authority (AERA), is proposed to be appointed. To ensure competitive practices in ground handling services, the government has proposed adoption of a new ground handling policy from January 2009. Global and domestic aircraft manufacturers are upbeat on the aircraft demands from India. Non scheduled services have also steadily picked up and are growing at a CAGR of 19% primarily driven by a sustained growth in the economy and facilitated by the need of Indian corporate captains to invest in more productive hours everyday. In addition, total cargo traffic of all airports has increased from 10% during 2006-07 to 14% in 2007-08, recording a CAGR of 13% for last six years. With the growth in the passenger and aircraft traffic in India, there has also been a significant focus on requirement of maintenance, repair and overhaul (MRO) facilities. The Indian MRO market is growing at about 15% annually. However, on the manpower front, currently there is a shortage of qualifi ed pilots and other technical staff including Aircraft Maintenance Engineers and Air Traffi c Controllers. While there are a lot of new avenues in aerospace services in the coming decades, the constraints associated need to be addressed to enable the smooth growth of the sector. Some of the issues faced by the sector include mounting losses of the airlines, rising aviation fuel prices, congestion at airports, shortage of qualified pilots and technical manpower, upgradation of security, land acquisition, high taxation, high airport charges etc. There is a need to study the causes of the issues and address the same thereby paving an unobstructed growth path for the various opportunities.

HISTORY OF INDIAN AVIATION SECTOR

Pre1993: Aviation was traditionally viewed as an elite activity, and one in which socialist governments could not be seen to allocate resources. The two government airlines Air India and Indian Airlines (domestic and shorthaul international) were the only Indian carriers. Both carriers operated with relatively old aircraft and inefficient work practices, from airports which were functional at best. There was no focus on developing traffic and the market grew at uninspiring single digit rates. 19931995: The first steps in domestic aviation deregulation were taken allowing private airline entry, first as air taxis and then as scheduled operators. However, the government was still focused on protecting the stateowned carriers, and a slew of undercapitalised and underprepared startups entered and then mostly exited the market. Only Jet Airways and Air Sahara survived beyond the initial couple of years. 19952003: After the failure of the deregulation experiment, the industry fell into dormancy. No new carriers entered the market and Air India and Indian Airlines continued to be starved of capital. Despite the fact that the broader economy performed well during this period, aviation continued to show limited growth. Aviation was largely untouched by the economic reform agenda of the governments in power as there was little strategic direction for the sector. 20032006: This was a period of unprecedented change. With the arrival of Ministers of Civil Aviation on both sides of parliament that recognised the importance of aviation for the development of business, trade and tourism, and who had a vision for delivering a vibrant and modern sector, the industry saw dramatic reforms across the aviation value chain. Developments included: Domestic open skies policy which saw market entry by several carriers. The arrival of the low cost airline model in India with the launch of Air Deccan, and subsequently SpiceJet, IndiGo and Go Air. Announcement of the airport modernisation plan, including the privatisation of Delhi and Mumbai, upgradation of 35 nonmetros and encouragement of Greenfield development. Placement of orders for 111 new aircraft for Air India and Indian Airlines. Liberalisation of the international sector with some private carriers permitted to operate overseas. Greater access for foreign carriers and opening up of international routes for nonmetro airports. Increased foreign direct investment caps in certain sectors of the industry.

Traffic started to accelerate at double digit rates, both domestic and international, levels never before seen in India, highlighting a latent demand for travel.

200607: During this period, traffic continued to accelerate further, to levels approaching 40% in 2007. However it was at this stage that the realities hit home although traffic was buoyant, yields were being slashed through overcapacity and fragmentation of the industry, and costs were increasing because of the poor state of airport infrastructure and a shortage of human resources. The bullish fleet orders placed by Indian carriers saw capacity being introduced at the rate of 6 to 6.5 aircraft a month, whereas the actual growth in demand was closer to 3 aircraft equivalents. Aside from the mismatch between supply and demand, the rate of growth was simply too great for the industry to handle from a management and capital perspective. In a fragmented market, with multiple startups chasing market share, lossleader pricing was widespread and Air Deccan in particular was responsible for setting fares well below cost as it fought to retain its first mover market share. The rapid increase in capacity at a time when the airport modernisation program was yet to deliver upgraded infrastructure, meant that airports and airways were highly congested, increasing airline operating costs. With the inadequate surface access and airport (and airways) infrastructure, airlines were unable to secure a significant competitive edge over other means of travel, thereby excluding huge parts of the stilluntapped leisure market.

In a period of global boom, demand for skilled personnel such as pilots and engineers also outstripped supply leading to a sharp escalation in wages, and in some cases grounding of aircraft due a shortage of staf. Balance sheets were stretched as a result of the aggressive fleet induction programs, combined with the mounting operational losses. 200809: The fragility of the sector which had overextended itself by growing at rates that it could not manage, in an environment that was not conducive to efficient operations was exposed during the fuel price spike of mid2008 when oil reached close to US$150/barrel. In India, this situation was exacerbated by the taxation structure which increases the costs of fuel by up to 60% vis a vis international

benchmarks. As costs spiralled upwards, carriers were forced to raise fares, and with a simultaneous slowdown in the Indian economy, there was resulting decline in traffic of around 1012% yearonyear. 200910 : After the dramatic changes of the last five years, we are starting to see the emergence of a more favourable environment: Indias GDP growth slowed from over 9% in 2007/08 to 6.1% in 2008/09. However, given the contraction globally, this was a relatively a good result. The economy appears to be recovering earlier than expected, with GDP growth of 7.9% in the last quarter, ahead of expectations. The World Bank projects annual growth of 8.0% per annum from 2011 to 2014. Domestic traffic is also showing a return to growth. After 12 consecutive months of yearonyear declines in domestic traffic, July 2009 saw a return to positive territory, which has continued since then. This is partly due to the impact of a lower base resulting from last years decline, however discussions with the industry indicate a discernible increase in demand as business and consumer confidence increases, although yields continue to remain depressed.

2010 ONWARDS: The operating environment is improving, with airports and airspace gradually being upgraded, and ground access being developed, which will not only enhance the passenger experience, but should allow airlines to achieve faster turnarounds and higher aircraft utilisation.

Passenger traffic to double in the next five years

Our analysis indicates that the performance of aviation stocks is correlated to traffic growth and earnings momentum. The domestic passenger traffic has witnessed a 14.7% CAGR in FY01-11 to 54 mn and the international traffic has grown at a 13.4% CAGR to 13.4 mn passengers in the same period. The growth rate is higher in the last five years led by government initiatives, better infrastructure and the emergence of LCCs all of which have helped domestic passenger traffic grow at 16.5% CAGR in FY06-11 while international passenger traffic has seen a 15.5% CAGR in the same period. The passenger traffic (PAX) in India has grown by 18% in FY11 and 15% in FY10. We expect Indias passenger traffic to nearly double in the next five years from 67 mn passengers in FY11 to 123 mn passengers (domestic - 99 mn and international - 19.3 mn) in FY15E assuming a 16.5% CAGR in domestic traffic and 15.5% CAGR in international traffic.

Infrastructure- Improvement visible but long way to go

The governments infrastructure facilities in support of aviation are clearly visible with the opening of the new terminal in New Delhi. Moreover, the other measures include the Green field airports in Hyderabad, Bengaluru and New Delhi and the on-going upgradation of terminals in Mumbai. The improved infrastructure facilities and modernization of technology have enabled faster turnaround of aircrafts and improved the flying experience for passengers. The no of airports have increased 6% in FY06-10 to 116 (domestic 1% and international 21%) while the flights per day have risen by 90% (domestic 101% and international 51%). The operational efficiency has enabled PAX handled per day witness a 115% growth in the same period (domestic 142% and international 54%) highlighting the improvement in turnaround of aircrafts, higher take-offs and better load factors.

Rising affordability

Air fares have remained more or less stagnant over the last 5 years (Jet airways: Mumbai-Delhi airfare). This has been mainly due to the entry of LCCs and their quest to capture a higher market share. In the same period, per capita income has increased by 85% to `66487 from `35844 in FY06-11. This has made air travel more affordable, with the average ticket price as a percentage of per capita income declining to 7 2% in FY11 from 13.5% in FY06.

MAJOR INDIAN AIRLINES

The airline landscape in India has been transformed in recent years. In 2003 there were just 4 carriers Air India, Indian Airlines, Jet Airways and Air Sahara all operating full service models. And private carriers in those days were limited to operating domestic routes only. Today, there are effectively 7 airlines operating 11 different brands. Air India + Air India Express Jet Airways + Jet Konnect + JetLite Kingfisher Airlines + Kingfisher Red IndiGo SpiceJet Go Air Paramount On the domestic front, the 3 large airline groups Air India, Jet Airways (+ JetLite) and Kingfisher Airlines command a 67% market share.

I. Air India
The history of Air India is the History of Indian Aviation. It is one of the oldest and the largest airline of India. Air-India was founded by J.R.D. Tata in July 1912 as Tata Airlines. Founded as a small, private, domestic carrier in 1932, Air-India is now owned by government. It operates only on International routes and has negligible presence in the domestic traffic.

II. Indian Airlines:

Indian and Air India were born with nationalization of Air Transport in 1953 by way of Air Corporation Act, 1953. Indian Airlines emerged as a merger of 8 domestic carriers. It caters mainly to domestic routes and in some nearest nations. The two national carriers have enjoyed sole monopoly in the air transport segment over a long period of time as private carriers were debarred from entering the segment under the Air Corporation Act, 1953. The private players like Jet, Sahara and others were made to enter the segment only after the New Economic Policy, 1991 came into existence. Another major turning point has come in the history of the Air Industry when Air India was granted permission from the GOI (Government of India) to merge with Indian Airlines, the two national carriers of India. This Mega Merger marked the first marriage in the Indian skies which was followed by other mergers. The name of the new airline remained Air India, since it is known worldwide.

III. Jet Airways:

In May 1974 Jetair (Private) Limited was founded. In 1991, as part of the ongoing diversification programme of his business activities, Naresh Goyal (founder of Jet Airways) took advantage of the opening of the Indian economy and the enunciation of the Open Skies Policy by the GOI, to set up the company for the operation of scheduled air services on domestic sectors in India. It started its International Operations in the year 2004 and carries more than 7 million passengers per annum. In May 2007, Jet Airways took 100% stake in Air Sahara.

IV. Air Sahara:

Like Jet, Sahara also began its operations in the year 1993 after the domestic Air Market was opened by the GOI in 1990s. It is owned by the diversified Sahara India Parivar group. Now Air Sahara is being taken over by Jet Airways and it is being renamed as Jet Lite. Jet has intensions of converting Air Sahara in sync with LCC model to reach every segment of air travelers.

V. Air Deccan:
Indias first budget carrier arrived in the Air Industry in the year 2003. It is headed by Captain Gopinath, Air Deccan redefined the accessibility to the Indian Skies with new model and concept in the aviation sector. It injected competitive spirits into the system and gave common man wings by reducing airfares which matched the first Class Railway Fares. The third wedding in skies was marked when Vijay Mallya of Kingfisher Airlines picked up 26 % stake in Air Deccan. Air Deccan is the Nano of the Airline sector; what Tata - Nano plans to do to the automobile industry (converting two wheelers into four wheelers) Air Deccan has done to Aviation industry (shifting people from rail travel to travel by air). Presently, there is a new segment of travelers; the leisure customers. Yet another segment is introduced and that is the first time travelers. Air Deccan introduced the concept of dynamic pricing which means selling at a higher price during high season (tourist season) and selling cheap during the off-seasons. Therefore, everyday the price would change depending upon the kind of competition and also the load factor. Also it introduced various schemes and prgrammes.

VI. Kingfisher:
The King Fisher initiated its operations in May, 2005. It is a major Indian luxury airline operating an extensive network to 34 destinations, with plans for regional and long-haul international services. Kingfisher Airlines, through one of its holding company UB holdings Ltd has acquired 26% stake in the budget airline Air Deccan.

VII. GoAir:
GoAir is an Indian low-cost airline based in Mumbai. It was established in June 2004, the airline started its operations in October 2005 with a fleet of 20 leased Airbus A320 aircraft.

VIII. Indigo:
IndiGo Airlines commenced its operations in 2006 and went on to swiftly establish itself as one of the premier budget airlines in the country. IndiGo Airways soon added IndiGo flights and destinations to its network. The unimpeachable services and timely performances of IndiGo flights added to the popularity of the airline.

IX. Spicejet:
SpiceJet, a rebirth of ModiLuft marked its entry in service by offering fares priced at Rs.99 for the first 99 days since its inception in 2005. The carrier is giving tough competition to Railways.

Evolution of domestic aviation industry

Duopoly (FY03-05): The industry was dominated by two major players, NACIL and Jet Airways with more than 90% market share. It also saw the entry of the first Indian low-cost carrier (LCC), Air Deccan, launched in FY04. Entry of new players (FY05-07): Three more LCCs (SpiceJet, Indigo and Go Air) and two more FSCs (Kingfisher Airlines and Paramount Airways), entered the industry. Consequently, the number of players increased from three in FY03 to nine in FY07. Intense competition (FY07-08): This period was marked by the beginning of intense competition in a bid to capture market share, with rapid fleet expansions by both new and incumbent players. This resulted in a sharp drop in profitability and the deterioration of balance-sheets. By the end of FY08 the top-three players market share dropped to 69% and the share of LCCs increased to 31%.

Consolidation phase (FY08-11): The subsequent significant erosion in net worth resulted in merger/acquisition of the financially weak companies with the stronger ones and the halting of fleet additions. Jet Airways acquired Air Sahara (now Jet-Lite), Kingfisher acquired Air Deccan, and Indian Airlines merged with Air India to form NACIL. However, the market share of LCCs increased to 45%, by FY11. In the next five years, we expect LCCs to gain control of more than half of the domestic aviation market because of LCCs relatively faster fleet addition; compared to FSCs. FSCs are increasing focus on serving tier-II and tier-III cities through their LCC arms. The relatively fast growth in leisure travel (compared with business travel), is more advantageous for LCCs due to the cost consciousness of the Indian consumer.

CASE STUDIES OF JET AIRWAYS,SPICEJET AND KINFISHER AIRLINES

Jet Airways
Focus on international segment key driver for profitability Jet started its international operations in FY05 and since then has seen a stark improvement in its financials and operations. The International division has seen a successful turnaround from being loss making until FY08 (EBITDA level). It turned EBITDA positive in FY09, EBIT positive in FY10 and PBT positive in FY11. With a 3.5 times increase in market share in last five years (10% in FY06 to 36% in FY11). Jet Airways is currently the second largest international operator in India. The companys international business accounts for 46% of its consolidated passenger revenues in FY11 and 57% of its consolidated ASKM. With a strong presence in the international business the company has been able to aid growth of the domestic traffic as well due to synergies like a) the international passengers acting as a ready customer base to its domestic segment, b) creating a diversified passenger traffic leading to demand throughout the year, and c) stability of its business model. Improving domestic business Due to the strong brand image, operational synergies and flexible business model, the domestic business of Jet Airways has witnessed a sharp improvement in operations. The company plans to add 17 Boeing 737-800 to its existing fleet over the next one and a half year, to increase its domestic capacity and capture a greater share of the demand supply mismatch present in the domestic aviation industry in India. Merger of JetLite and Jet Konnect to boost LCC segment growth The company has also successfully managed to improve JetLites operational efficiency over the years with a rise in block hours despite the reduction in ASKM which has helped improve efficiencies and reduce costs. Jet plans to merge its two LCCs JetLite and Jet Konnect and operate under the brand name of the latter. Presence in domestic as well as international market The domestic passenger traffic has witnessed a 16.5% CAGR in FY06-FY11 to 54 mn trips. We assume similar growth trend in the future considering a) rising GDP over the next five years with a 2.2x

multiplier effect, b) improving infrastructure with new airports and expansion of existing airports, and c) rising per capita income in India and comparatively lower rise in ticket prices hence improving the affordability of Indian travelers. With a 16.5% CAGR in FY11-FY15E we expect the domestic passenger traffic to grow to 99 mn trips.

Synergies of International travel The average ticket costs on international routes are nearly 20% higher than on domestic routes, for the same distance travelled, due to the lack of severe competition, leading to pricing power for international route operators. Moreover, Fuel cost, which accounts for 40-45% of revenue, is 25-30% cheaper on international soil (due to low government taxes) which leads to higher margins. To add to this, the international business reduces the cyclicality in demand as the lean season in India of July-Oct ends up being a strong season for the international markets and a lean season for the international market of AprJuly is a strong demand season for domestic travel. Such synergies have ensured that the profitability of international operations remains significantly higher than domestic business. The EBITDAR margins too for the international business in FY11 were 24% as compared to 15% in the domestic business.

Improving domestic business and merger of Jetlite and Jet Konnect Due to the strong brand image of Jet Airways, operational synergies, a flexible and unique business model, and a strong growth in passenger traffic, the domestic business of Jet Airways has witnessed a sharp improvement in operations. The improvement in operations is clearly highlighted by the rise in PLF to 75.1% in FY11 as compared to 71.6% in FY10 even as the ASKM rose by 17.5% in FY11. Even in Q2FY12 the domestic business has seen load factors rise to 72.1% from 71.4% in Q2FY11 as the ASKM grew by 7% Y-o-Y. In fact the yields have also seen a rise in the current fiscal with revenue/RPKM rising by 10% in Q1FY12 and 1% Q2FY12.

The company also plans to add 17 Boeing 737-800 to its existing fleet over the next one and a half year, a move that should help to increase its domestic capacity and capture a greater share of the demand supply mismatch present in the domestic aviation industry in India.

Balance sheet concerns overdone

India's airlines are reeling under a US$20 bn debt load and struggling to make profits. The debt picture of Kingfisher is already making waves with a current debt of ~`89 bn. Investors are thus concerned with the high debt of Jet which stands at ~`133 bn. However, Jets debt consists of ~`76 bn of long-term debt related to aircraft acquisition which accounts for 57% of the total debt. Moreover, the company has managed to lower its debt even in the past. Jets debt surged to `166 bn in FY09 after witnessing a severe cash-flow crunch during the downturn FY08-09. However the company was able to reduce the debt by `30 bn over the next two years due to a series of initiatives which included a) Sale and leaseback of aircraft: Jet recognized `4.9 bn on sale and lease back of aircraft in FY08-09 which reduced its cash crunch burden. b) Refinancing of high-cost debt: Jet refinanced its long-term debt related to aircraft acquisition of `90 bn (66% of total). The company also refinanced `25 bn of its remaining ~`47 bn loan in to dollar terms at a significantly lower interest rate of 6.5% (compared to 12 5% in the case of rupee loans). This resulted in savings of interest outflow. c) Monetising Bandra-Kurla Complex (BKC) land: Jet signed a preliminary agreement with Godrej properties to jointly develop its BKC land. The deal entailed a) an upfront payment of `5 bn (`3.6 bn for debt repayment and `1.4 bn for cost already incurred), b) development of 1.6 mn sq ft (msf) of office space, with complete ownership of 0.25 msf given to the company, and c) a 50:50 share of the profits from the land developed

Key Risks
Fuel costs beyond airlines control Aviation turbine fuel (ATF) prices account for 40-45% of an airlines total revenues. A sharp increase in the ATF prices have dented margins and led to losses across the industry. Any further price rise could result in a significant net loss and hence erosion of net worth for the company. Change in landing and navigation charge regulations Currently, aircraft with less than 80 seat capacity are exempt from airport landing and navigation charges. Jet Airways has 20 ATR aircraft, with a seat configuration below 80. As these aircraft qualify for exemptions, any change in these policies could lead to higher taxes and so affect future earnings. Yields stagnating Any sharp increase in competitive intensity (in times of low passenger traffic or excess expansion by airlines) could adversely affect the load factors and passenger yields, reducing margins Rates and currency fluctuations A stronger dollar may affect Jets profitability, as a large part of the companys costs are dollar denominated, like lease rentals, ATF cost and maintenance costs. In addition, a major portion of their debt is dollar denominated; hence, a stronger dollar could hit earnings. Downturn in the economy Any downturn in the economy could lead to relatively low passenger traffic growth, which could have a negative impact on load factors, and could eventually have a negative impact on profitability. External factors There are many external factors which can affect profitability, which include bad weather conditions, terrorist activities, country and state policies and others.

SpiceJet
Macro factors in favour of SpiceJet We believe the current trends emerging in the Indian Aviation industry are in favour of LCCs. With the comparatively low leverage and fleet expansion plans we expect the company to capitalize on the growth opportunities in the industry in the coming years. The company has constantly increased its fleet and hence seen a multi-fold increase in market share from FY05 (4.4%) to FY11 (13.5%) and 15% till date. Consequently, we believe SpiceJet is one of the best bets in the industry and offers a very favourable riskreward ratio.

Domestic Passenger traffic to witness 16.5% CAGR in FY11-FY15E The domestic passenger traffic has witnessed a 16.5% CAGR over FY06-FY11 to 54 mn trips. We assume similar growth trend in the future considering a) rising GDP over the next 5 years with a 2.2x multiplier effect, b) improving infrastructure with new airports and expansion of existing airports, and c) rising per capita income in India and comparatively lower rise in ticket prices hence improving the affordability of Indian travelers. With a 16.5% CAGR in FY11-FY15E, we expect the domestic passenger traffic to grow to 99 mn visits.

Exit of Kingfisher Red to benefit competitors like SpiceJet With the rising ATF prices and the lower yields due to competitive pressures, the aviation industry has been making losses. With a mounting debt of `7 bn, kingfisher Airlines decided to shut its LCC business (Kingfisher Red) as per the press conference held by the company on November 22, 2011. Kingfisher Red accounted for 75% of the companys total ASKM and commanded a market share of 19.8% until

Sep11. With the exit from the LCC business, we expect part of the capacity and market share to get distributed amongst the other LCC operators like Indigo, SpiceJet and GoAir with the first two being the biggest beneficiaries. Consequently we believe SpiceJet should see a stark improvement in its market share. This is clearly visible from the monthly market share data which shows the rising market share of SpiceJet from 13.6% in Aug11 to 16.3% in Jan12.

Strong operating structure

Reasons for a low cost structure and better operations are stated below: A. Lower sales and distribution costs Since the company uses a cheaper reservation system (Navitaire), the average cost per transaction is as low as US$0.50, compared to GDS system used by FSCs (Galileo), with an average transaction cost of ~US$3. B. Benefits of a single and younger fleet SpiceJet also uses a single and younger fleet type (Boeing 737s), hence enabling the company to gain benefits in the form of lower staff training costs, lower maintenance costs, and better bargaining power with vendors. C. Higher block-hours per aircraft Operating under the LCC model, SpiceJet is able to turn around its flight faster than its FSC counter parts (25 minutes against 40-45 minutes for FSCs). Consequently, the average block-hours per aircraft per day over the last four quarters were 11.1 hours. With the start of its international operations in Nov10, it saw a further improvement in utilisation of aircraft by deploying them on international routes in late-night or early-morning slots. Hence it saw a further rise in block hours. D. Higher Passenger load factors Given the increasing passenger traffic, slower capacity addition and a stronger demand for LCCs, SpiceJet has been able to post better passenger load factors (PLF) than Jet Airways and Kingfisher. E. Higher market share per aircraft Due to more block-hours and capacity per aircraft, the company has enjoyed the highest market share per aircraft for the last four years. Its market share per aircraft in FY11 stood at 0.4%, much higher than the industry average of 0.3%.

Healthy balance sheet

SpiceJet has one of the cleanest balance sheets in the industry with a debt of ~`4.4 bn following its FCCB conversion for fleet expansion. The healthy balance sheet gives it an edge over other players in terms of a) lower interest charges, b) expandable leverage to fund further expansion plans, and c) stronger ability to withstand economic slowdowns. Hence, we expect SpiceJet to outperform its peers with a healthy balance sheet and good growth momentum.

Teething issues visible but operations expected to improve The company saw Mr Maran entered as the promoter of the business in June10. Post the entry of Mr Maran the entire top management has seen a re-shuffle with a slew of exits like the AVP and CCO of the company. The rejig in its management has had its share of impact on the operations of the company with SpiceJet witnessing a decline in its block hours per aircraft and PLF in H1FY12 as compared to the previous few H1. Due to the lower operations the company witnessed a high non-fuel cost per ASKM in H1FY12 and a higher break-even seat load factor. Despite the fact that operational efficiencies had declined in H1FY12, the operations have seen a strong bounce back in Q3FY12. We believe the decline in H1FY12 was just teething issues and the company should emerge as a stronger player over the next few quarters with the entry of Bombardier into its fleet.

Key Risks
Fuel costs beyond airlines control Aviation turbine fuel (ATF) prices account for 40-45% of an airlines total revenue. A sharp increase in the ATF prices have dented margins and led to losses across the industry. Any further price rise could result in a significant net loss and hence erosion of net worth for the company. Change in landing and navigation charge regulations Currently, aircraft with less than 80 seat capacity are exempt from airport landing and navigation charges. SpiceJet is adding further Bombardier aircraft, with a 78-seat configuration, to its fleet, which qualify for these exemptions. Any change in these policies could lead to higher taxes and so affect future earnings. Yields stagnating Any sharp increase in competitive intensity (in times of low passenger traffic or excess expansion by airlines) could adversely affect the load factors and passenger yields, reducing margins Rates and currency fluctuations A stronger dollar may affect SpiceJets profitability, as a large part of the companys costs are dollar denominated, like lease rentals, ATF cost and maintenance costs. In addition, the debt for new aircraft is also in dollars; hence, a stronger dollar could hit earnings. Highly fixed-cost intensive The airline industry is highly fixed-cost intensive with lease rentals, maintenance and employee costs remaining fixed. Any reduction in passenger traffic can adversely affect the profitability. Downturn in the economy Any downturn in the economy could lead to relatively low passenger traffic growth, which could have a negative impact on load factors, and could eventually have a negative impact on profitability. External factors There are many external factors which can affect profitability, which include bad weather conditions, terrorist activities, country and state policies and others.

Kingfisher Airlines
Debt reduction a must for survival but uncertainty over quantum and time remains The acquisition of Air Deccan in FY08, economic slowdown in FY09, fuel surge due to the middle East crisis in FY11, and recurring net losses, have led to a mounting debt of `70.5 bn in FY11 from `9.3 bn in FY08. The high debt resulted in an interest outflow of `11 bn and `13 bn in FY10 and FY11 respectively. Considering the huge interest outflow and surge in debt, KFA has decided to restructure its debt by selling a 25% stake sale to banks. However, the debt portion remains high as the company is looking to a) convert part of its loans into equity, b) propose a preferential issue to investors, c) change the lease agreement terms, and d) selling property; in order to slash its debt by more than half. High debt leading to arrays of problems Given the net losses and mounting debts KFA has been fighting for survival over the last six months now with the following issues cropping up: a) fleet reduction to 62 aircraft vs 66 in FY11 which should result in lower ASKMs, b) lower flight schedules due to non-payment of salaries to employees and OMCs, c) freezing of accounts by IT department due to unpaid TDS, and d) inclusion with One-World put on hold along with the exclusion from IATA and the tie-up with British Airways coming to a stop. All these factors should significantly impact revenues and profitability going forward if the company manages to sustain. With the lease of the older aircrafts expiring we expect the ASKM to decline further. Exit from LCC segment to harm operations KFA has been saddled with losses since inception led by a) the long break-even period in the industry, b) acquisition of Air Deccan which led to a slower turnaround, c) global slowdown in economy which impacted air traffic, and d) Middle-East crisis leading to a surge in crude prices. All these factors have led to the accumulated losses of KFA exceeding `60 bn since its inception. To add to the woes, the high debt and interest outflow has been a major burden on the cash flows and led to erosion of net worth. Break-even seat load factor to improve We agree with the management that the cost differential between the LCC and FSC model in India is not high as is explained by the cost/ASKM (ex-fuel) for Jet Airways and JetLite. This is also reflected by the fact that unlike other countries, we use the same airports and infrastructure facilities for LCCs and FSCs. Considering the marginal cost differential and the high ATF taxes it is more difficult for players to sustain margins and we believe FSCs are better placed in an event of a downturn due to the higher yields. We hence believe, the higher yields should result in reduction in the break-even seat load factor for the airline. ASKM to reduce significantly with seat configuration Kingfisher Red accounted for 75% of the companys total ASKM in FY11. With the exit of KFA from its LCC model, we expect the company to re-configure seats in the economy class. The move to exit will also result in KFA adding first class seats to its Airbus aircraft. Since the company operates 35 airbus (total fleet 62), the average seat capacity should reduce thereby leading to lower ASKMs for the company.

Market share to decline

Given the fact that the growth in LCCs is much better than FSCs we believe KFA would miss out on the growing pie and this would result in a loss of market share in the long term though yields should see an improvement.

High debt leading to arrays of problems

Given the net losses and mounting debts KFA has been fighting for survival over the last six months now with the following issues cropping up: a) fleet reduction to 62 aircraft vs 66 in FY11 which should result in lower ASKMs, b) lower flight schedules due to non-payment of salaries to employees, c) cash and carry basis for fuel by OMCs to pressurise cash flows, d) freezing of accounts by IT department due to unpaid TDS, e) inclusion with One-World put on hold, and f) the exclusion from IATA and the tie-up with British Airways coming to a stop. All these factors should significantly impact revenues and profitability going forward if the company manages to sustain. With the lease of the older aircrafts expiring we expect the ASKM to decline further.

A. Fleet reduction to lead to lower capacity and hence lower revenues Given the severe cash crunch of the company and its inability to pay its leasing company, KFA has returned three of its wide-body Airbus 320s and 1 Airbus 330 aircraft. KFA has hence been forced to curtail its international operations to some destinations in Europe and Asia. In a move to curtail further losses, the beleaguered KFA would review all routes, especially the long-haul ones, and the nonprofitable ones would be shut down as per media reports. There are also reports suggesting that the airline had shut down flights to and from many stations and many flights from Kolkata had been suspended and taken off ticketing sites. B.Lower flight schedules due to staff strikes owing to non-payment of salaries to employees With the situation deteriorating over the last few months, plenty of ground staff have been laid off and pilots have been leaving to join competitors at their free will. In a move to restrict the exit of pilots the company has asked the pilots to compensate for six months of their salary. KFA also faced fresh trouble after its ground staff and technicians went on a strike at the Delhi airport on March 14, 2012. The strike by the airline employees was against the non-payment of salaries for the last three months who have not been paid their salaries since Dec11 owing to the freezing of bank account of the cash-stripped airlines. C. Cash and carry basis by OMCs to drain cash flows The airline also owes more than `2 bn to three oil companies - HPCL, IOC and BPCL in dues. The oil companies have stopped granting credit to Kingfisher for lifting jet fuel and put it on a cash-and-carry payment mode. The carrier has been stopped fuel supply twice earlier due to non-payment and delay in payments. The cash-strapped carrier also has unpaid dues to the operators of airports and other agencies, which have been putting pressure on it. KFA is also unable to pay the daily cash-and-carry amount to the Airports Authority of India (AAI) and has accumulated dues of `50 mn in the past week, as per government officials. But, with the civil aviation ministry making clear that it won't pull the plug on Kingfisher, AAI cannot take any action against the airline. D. Tie up with British Airways and inclusion with One-World put on hold With the growing concerns over KFAs sustainability, its code-share agreement with British Airways has been suspended. The two airlines had signed a code-share agreement for each other's flights across India, Sri Lanka, the UK and continental Europe in Sept10. The agreement allowed passengers to book their journeys on each other's Web sites, earn frequent flyer points on the code-share routes and gain access to each other's airport lounges. With this suspension, Kingfisher loses an important sales channel for their domestic network. Lenders have declared Kingfisher Airlines a substandard account and its entry into a global airline alliance Oneworld has been stalled for now because of its financial troubles. E. The exclusion from IATA and the tie-up with British Airways coming to a stop To add to the existing woes, The International Air Transport Association (IATA) has suspended KFA from its account settlement system due to non-payment of fees. The industry group's clearing house (ICH), settles accounts between the world's airlines, airlineassociated companies and travel agencies. As per IATA, KFA participation in the ICH would be reinstated only after it fulfils ICH requirements. Kingfisher said it could not settle the dues as its bank accounts have been deactivated by tax authorities, the same reason the company gave when it had to cancel most of its flights last month.

Higher ATF prices to impact cost structure ATF prices have seen a sharp surge over the last one year. Led by the Middle East crisis ATF prices have surged by 62% since Oct10. Post an improvement in the scenario as well, ATF prices have refused to decline and with the falling rupee and stubborn Brent crude prices, ATF prices have risen by 332% in CY11 and 13% in CY12. The cost structure of airlines, which operate on thin margins have hence gone for a toss given the fact that fuel costs account for over 50% of the total costs. With the surge, airlines across India are finding it difficult to break-even on an operational basis. This is visible in the cost structure where by the cost/ASKM (with fuel) has risen from `3.94 in Q3FY11 to `4.42 in Q3FY12. We expect a 6.1% CAGR in fuel costs in FY11-FY14E for Kingfisher despite a reduction in fleet.

Key Risks
Huge debt on books The company has a debt of ~`8 bn as of FY12E. This has resulted in a high interest outflow there by resulting in mounting losses and negative net worth for the company. Despite the company restructuring its debt and selling equity to banks, the debt remains high which severely hinders its growth prospects. The high debt is also a strain on cash flows of the company and a lingering cause of concern. Any further rise in debt as expected by us can further negatively impact the balance sheet of the company.

 Fuel costs beyond airlines control ATF prices account for 40-50% of an airlines total revenue. A sharp increase in the ATF prices have dented margins and led to losses across the industry. Any further price rise could result in a significant net loss and hence erosion of net worth for the company. Change in landing and navigation charge regulations Currently, aircraft with less than 80 seat capacity are exempt from airport landing and navigation charges. Kingfisher has ~25 ATRs with a 78-seat configuration, to its fleet, which qualify for these exemptions. Any change in these policies could lead to higher taxes and so affect future earnings. Yields stagnating Any sharp increase in competitive intensity (in times of low passenger traffic or excess expansion by airlines) could adversely affect the load factors and passenger yields, reducing margins Rates and currency fluctuations A stronger dollar may affect Kingfishers profitability, as a large part of the companys costs are dollar denominated, like lease rentals, ATF cost and maintenance costs while the revenue stream from the international business is close to 25%. Highly fixed-cost intensive The airline industry is highly fixed-cost intensive with lease rentals, maintenance and employee costs remaining fixed. Any reduction in passenger traffic can adversely affect the profitability. Downturn in the economy Any downturn in the economy could lead to relatively low passenger traffic growth, which could have a negative impact on load factors, and could eventually have a negative impact on profitability. External factors There are many external factors which can affect profitability, which include bad weather conditions, terrorist activities, country and state policies and others.