IndiGo, SpiceJet get wings to fly higher

Demand growth, pricing discipline favouring airlines; sustained oil prices above $60-level can play spoilsport: Analysts

The prospects for listed aviation companies remain strong, driven by robust demand, moderate capacity additions and cost-cutting efforts. 

While a sharp rise in aviation turbine fuel (ATF) cost has played a spoilsport, airlines have been able to pass it on, thus maintaining their profitability in the first half of FY18. 

Rating agency ICRA said the industry’s ability to mitigate the 8.7-per cent increase in fuel costs came on the back of a lower competitive intensity resulting in an improvement in higher per unit profitability and better financial performance in FY18. 

Given the overall scenario, analysts said there were gains to be made in InterGlobe Aviation (IndiGo) and SpiceJet, despite their outperformance in last one year, but investors need to keep a tab on oil prices.

Demand strong, capacities lag

A key trigger for the sector is robust demand, which is in high teens for three-and-half years now. Growth in November was just under 17 per cent, while passenger load factor (PLF; which indicates paid seats per flight) hit a record level of 89.2 per cent. While festival or holiday demand and addition of routes pushed up passenger growth in November, overall demand is expected to grow on lower penetration, improved infrastructure and regional connectivity.

At a time demand is strong, capacity additions have lagged. Capacity addition in November was up 10 per cent versus demand growth of 17 per cent. Technical glitches in the new Airbus A320neo aircraft and delays in new deliveries, coupled with an increasing focus on international routes, have meant muted capacity additions. Scaling down their capacity addition estimates, analysts expect PLFs to increase by about 100 basis points year-on-year to 85 per cent in FY18.

ATF costs key

Source: Analyst reports

The key moving part is crude oil prices, given that ATF accounts for about 40 per cent of the overall cost of airlines. While crude oil prices are hovering around $65 a barrel because of production cuts, geopolitical tensions and short-term supply constraints, analysts expect this to move towards $55-60 per barrel due to higher supply of shale and the unlikelihood of member countries sticking to production cuts. The World Bank estimates crude oil to average at $56 a barrel in 2018 compared to $53 in 2017. In a report last month, JP Morgan indicated that better industry demand-supply should result in higher load factors and better ability across the industry to maintain profitability without compromising demand even with oil near $60 a barrel. Unless crude oil prices rise sharply and stay high, the continuing trend of debt reduction on the back of improving operational performance and lower ATF prices over the last few years should continue for domestic airlines. Aggregate industry debt, according to ICRA, is expected to decline to Rs 62,000-63,000 crore by FY18-end from Rs 71,000 crore three years ago. 

Data compiled by BS Research Bureau

While low fare airlines structure their operations to keep costs to a minimum, even full service airlines such as Jet Airways have now chalked out plans to cut costs and debt. Recently, Jet said it would cut its unit costs, excluding fuel, by 12-15 per cent, which translates to cost savings of Rs 2,300 crore by 2020. Improving cash flow is then expected to be used to pay down its debt of Rs 8,000 crore. 

Aviation stocks to pick

Most brokerages are positive on the prospects of IndiGo on higher capacity additions, change in aircraft acquisition policy and improving yields (revenue per passenger mile). Garima Mishra of Kotak Securities says outright purchase of aircraft will de-risk IndiGo from the rupee depreciation, offering higher tax shield on accelerated depreciation and will bring down the overall cost of ownership. A significant trigger for the stock is better pricing discipline. Given that its unit costs are 20 per cent lower than SpiceJet, this might lead to lesser price competition, and therefore yield stable margins. While IndiGo had issues on the capacity addition front, any improvement on deliveries will boost its network and market share. 

SpiceJet continues to have the highest load factors among domestic airlines, with November load factor at 95.5 per cent. PLF has been over 90 per cent for each of the last 31 months. This, coupled with a bit of pricing power, has helped SpiceJet report strong revenue growth of 29.6 per cent for the September quarter.  Analysts at SBICAP Research expect the company to report revenue growth of 19-22 per cent over the next two years, with earnings growth mirroring traffic growth of 16-18 per cent over the medium term.

Most analysts are positive on Jet’s plans to reduce it’s per unit costs, which are 26-53 per cent higher than SpiceJet and IndiGo. However, its leverage at 6.4 times net debt to operating profit is still high and its cash flows could fall short of debt repayments, said analysts at IDFC Securities. Investors should await significant reduction in debt and costs before taking an exposure to the stock.