In the Berkshire Hathaway report to its shareholders, there was one comment on airline stocks from Warren Buffett that attracted a lot of attention. Buffett commented that “After a century of mistakes and bad operating performance, aviation stocks may be finally coming into their own”. Coming from an aviation sceptic like Warren Buffett, this was surely something surprising. His past scepticism was not entirely unfounded. The US alone has seen more than 100 aviation bankruptcies. However, Buffett feels that something very interesting was happening for aviation stocks due to much better economics of operation. So what does that mean for Indian aviation stocks?
While the US aviation market is substantially larger than the Indian aviation market, some of the lessons of the last 25 years of Indian aviation have been largely similar. For a young industry, Indian aviation has seen a lot of bankruptcies and sell-outs. East West Airlines, Damania Airways, NEPC, Paramount, ModiLuft Kingfisher, Gujarat Airways and many more were forced to shut shop along the way. Then there were the likes of Deccan Aviation and Sahara Airlines that got merged into bigger names. The Indian aviation sector has also been struggling due to intense competition, competitive pricing, vulnerability to oil prices and poor aviation infrastructure. So what exactly is changing that could make aviation sector attractive from an investment perspective. Actually there are 3 key factors…
A consolidated industry is finally settling down to business…
Over the last 20 years the Indian aviation industry was disrupted by a variety of names like Deccan Aviation, Kingfisher Airlines and later by Indigo. The process of attrition has resulted in 4 Indian aviation companies viz. Indigo, Jet Airways, Spice Jet and Air India accounting for over 80% of the Indian aviation market. This consolidation has ensured that the predatory pricing policies adopted by many aviation companies has ceased along the way. That has resulted in prices on most routes settling at a level that is not too expensive for the consumer but continues to be lucrative for the aviation company. This situation is almost similar to the American experience with the top 4 airline companies; Southwest, Delta, American and United cornering nearly 67% of the US aviation market. This consolidation has been positive for the US aviation industry and is likely to benefit the Indian aviation stocks too.
There is a growth / valuation mismatch that is emerging in aviation…
If one looks at the monthly aviation numbers, the growth is quite frenetic. For the month of February 2017, the number of passengers has grown by 26% on a YOY basis. This is the kind of annual growth that has not been witnessed by the aviation industry for a very long time. In terms of P/E valuations, most aviation stocks are quite attractive. Among the listed aviation stocks while Indigo quotes at a P/E of around 15, Jet Airways quotes at a P/E of around 8 while Spice Jet has a P/E of around 6. This P/E needs to be viewed in the light of the massive growth in aviation demand that is likely to be spurred by the expansion of airport infrastructure in India. Additionally, most of these aviation companies are currently enjoying impressive load factors (aviation equivalent of capacity utilization) of over 90%, which is the best bet for aviation stocks to be profitable. Effectively, Indian aviation stocks are offering an interesting combination of high growth potential, better realizations due to consolidation, control over costs and attractive P/E valuations.
Managing the tricky devil of ATF prices…
At the end of the day, the Indian aviation sector still remains a play on ATF prices. Over the last couple of years, the price of Brent Crude has fallen from $115/bbl to $50/bbl. This has also resulted in a sharp cut in the prices of Aviation Turbine Fuel (ATF). For most Indian airline companies, ATF accounts for 40-45% of the total cost of running their airlines and hence their profitability tends to be extremely sensitive to changes in ATF prices. With oil prices expected to remain in the broad range of $50-60/bbl for the full year as per estimates put out by OPEC and the IEA, the price of ATF is unlikely to pose a major threat to aviation companies. That means, aviation profit margins will be largely protected!
A recent boost for aviation companies also came from the expectation that the Delhi government may cut the tax on ATF from 25% to 1% to give a boost to flying in select sectors. Of course, the Delhi government will be cutting these ATF tax rates only on select routes and not on all routes. But that could be the big trigger. Today many non-metro routes become financial unviable due to high ATF tax rates. If the rates are cut for these routes, then it can give a major boost to demand from these sectors. And, if Delhi takes the lead then a lot of other states will be inclined to follow suit.
Are there are any risks to the Indian aviation story?
The combination of lower input costs, stabilized yields and higher growth is now a reality for the Indian aviation segment. However, there are two risks that cannot be wished away. Firstly, the Indian aviation industry is still dependent on ATF prices for 40% of its costs. Any sudden global spike in oil prices due to supply disruptions can distort the price of ATF substantially. That could drastically change the economics of Indian airline companies. Secondly, most of the Indian aviation companies are still highly leveraged. Air India alone has a debt of Rs.45,000 crore. Both Jet Airways and Spice Jet are heavily in debt and their interest coverage ratios are still fairly weak at this point of time.
The aviation story, is, surely emerging as the big story from an investment perspective. It is surely emerging as a major play on the India retail demand story. In fact, aviation could be one of the big proxies for the spurt in spending and consumer demand in India. Whether it really translates into investment returns is something only time will tell!
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