Aviation India: Just taking off. :: Kotak Sec

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Aviation
India
Just taking off. Our research belies investor fears that the aviation sector cycle has
already played out. Evidence on the ground suggests the sector is in the early stages of
an up-cycle. The rise in stock prices over the past year notwithstanding, we believe our
covered stocks are likely to see ~50% upside over the next year given (1) favorable
demand-supply dynamics, (2) rising capacity which would be deployed profitably and
(3) robust cash flows. We reiterate our BUY call on Spicejet and Jet Airways with target
prices of Rs120 and Rs1,220, respectively.




37% of the industry capacity still burning cash
As of 2QFY11, 37% of the total airline capacity in the domestic segment in India was burning cash.
Kingfisher alone lost Rs3 bn in cash in 2QFY11 (Exhibit 1). Our estimates suggest that NACIL
(National Aviation Company of India Ltd) would also have lost cash in 2QFY11 as its cost (per
ASKM) is higher than that of Kingfisher.

None of the companies have announced significant capacity addition plans
With the exception of Spicejet and Indigo, none of the other airlines have announced significant
capacity addition. We estimate both these carriers will add 8-10 aircraft in FY2011E. The only
significant capacity addition announced that is not in our estimates is the recent deal for 30 Q-
400s (Bombardier) by Spicejet. Fifteen of these would be delivered in 13 months starting June ’11
whereas the company has an option on the remaining 15 aircraft—it will take a final decision on
these depending on market conditions. These aircraft would be connecting Tier-2 and Tier-3 cities
with Tier-1 cities. Effectively, these would not compete in ~60% of the aviation market in India
which is composed of only flights between Tier-1 cities.

ROEs on incremental investments don’t justify significant capacity additions
According to our estimates, the ROE which an airline would make on equity investment in a new
plane, assuming the yields and the cost structure is as per our FY2011E numbers of Spicejet and
Jet, is 8.6% and 4.7% for LCC and FSC, respectively (Exhibit 2). We note that the yield required to
generate a reasonable ROE of 15-16% is 10% higher than the average yield per RPKM that we
have assumed for Spicejet and Jet, assuming the costs remain at levels estimated in FY2011E.
We note that leasing is even more expensive than an outright buy transaction. The leasing rates
vary from 11-13% p.a. of value of the aircraft whereas an outright buy transaction would cost
around 10.5% p.a. including depreciation.

1HFY11—demand beats estimates; supply falls short
As of 1HFY11, capacity of the industry (seats/month in millions) has grown by only 8% which is
much less than our estimates of growth of 11.5% for FY2011E. On the other hand, growth in the
number of passengers for 1HFY11 has been 17.4% yoy vs 14.7% growth (yoy) that we are
estimating for FY2011E (Exhibit 3).

Key risks
(1) Fuel represents ~35% of the total costs for Indian airlines. A large increase in fuel costs
would be difficult to pass on and would hit profitability; (2) Expenses in USD account for ~65% of
the total costs. Significant depreciation of the Rupee in view of high current account deficit (at
3.6% of GDP for FY2011E) could significantly inflate the costs; (3) Any move by the government
to impose price controls would have an adverse impact.