The cost of flying high

In 2012, when the government-owned State Bank of India (SBI) rejected Kingfisher Airlines' application for a working capital loan of Rs 200 crore, the Vijay Mallya-owned airline was pushed into the turbulence zone.

After that, the full-service carrier nose-dived into a financial crisis that eventually led to its crash a few years later. It left behind the debris of over Rs 9,000 crore default, 7,000 unemployed people, unpaid dues to operational creditors and battered confidence in the Indian aviation story.

Even as experts were trying to figure out what had gone wrong with Kingfisher Airlines, budget carrier SpiceJet Ltd began floundering due to cash flow issues. It was on the brink of a crash when its original founder Ajay Singh appeared as a white knight and saved it. This was in 2015.

Now, as the full-service airline Jet Airways is trying to fiercely fight financial headwinds, a feeling of déjà vu has hit the aviation sector. A funding gap of Rs 8,500 crore stares at Naresh Goyal, the promoter of the struggling airline. At stake are around 20,000 jobs, repayment of aircraft debt, an over Rs7,000 crore bank loan default, unpaid dues to operational creditors and a host of other liabilities.

This time SBI has stepped in to bail out the airline but the troubles at Jet is already skidding the airline industry off the growth runway. With more than 80 aircraft, which is over 10% of the 640 planes in the domestic market, grounded due to problems at Jet and software fault in the new generation Boeing 737 Max, air passenger growth has slipped from high double-digit growth in 2018 to a single digit growth in 2019 so far.

Floundering Growth

The Directorate General of Civil Aviation (DGCA) data shows air travel demand grew at an average of 21% last year while it has grown at just 8% in the first two months of this year. As if this was not bad enough, IndiGo is facing a severe pilot shortage. All this could see several positive outlooks on the domestic airline industry going awry.

These recent air pockets in the airline sector have made everyone sit up and wonder once again what makes the industry so prune to frequent turbulence.

A senior executive, who has worked with the two budget airlines and spoke anonymously to DNA Money, pointed out that it was fundamentally the unviable cost structure of Indian airline that made it difficult for airlines, specifically full-service carriers, to operate profitably.

"There is not much hope for the (airline) industry until the cost structure fundamentally changes. The fault lies in only two things. One is that the cost of operation for Indian airlines is very high compared to its peers in other parts of the world. The second is that revenue is lower compared with counterparts across the globe," he said.

Elaborating on the cost structure, he said the operational cost of Indian carriers is around 30-35% higher than their global peers; "Our cost of operation shoots up mainly because of aviation turbine fuel (ATF), which is around 50% of the total cost. Jet fuel cost in India is 30-35% higher compared to Malaysia, Thailand Indonesia and others. This is primarily because of high taxes on ATF".

ATF has not been covered under Goods and Services Tax (GST). At present, it attracts an excise duty of 11%. Over this central levy, states charge different rates of value-added tax (VAT) that goes up to 30%. For instance, Tamil Nadu and Karnataka impose 29% and 28% VAT respectively on jet fuel while Maharashtra and Delhi levy a VAT of 25%. Several states like Odisha, Chhattisgarh and others have lower tax rates on ATF.

Other than ATF cost, various surcharges, user development fee (UDF) and steep navigational, landing and parking charges at airports make the cost structure of domestic airlines unviable.

Jitendra Bhargava, aviation author and former Air India official, believes the industry players have been overlooking the "reality of market dynamics" in their mad scramble for market share.

"For too long, the industry players have overlooked the obvious reality of our market dynamics –passengers being hugely price sensitive and high operational cost platform. In the mad scramble for garnering or retaining the market share, airlines have been selling seats below the cost of producing a seat," he said.

In such scenario, he said low-cost airlines were able to recover the cost at existing levels of fare but full services carriers struggled to remain airborne; "A study of fares will show that fares of full-service carriers viz Air India, Jet Airways and Vistara are only nominally above those of IndiGo, SpiceJet and Go Air. At times, they are even lower. Though airlines are aware of the suicidal path they are taking, no consensus exists amongst them to ensure economic viability," said Bhargava.

Bhargava expects the competition between the airlines to intensify with over 800 more aircraft expected to join the fleet. Airlines will take delivery of these aircraft in the coming years.

"All airlines are stimulating the market growth through low fares so that they can induct aircraft in coming years with high loads and retention of market share," he averred.

The airline expert said today's cost structure made it impossible for a full-service airline to compete with no-frills airlines in the price-sensitive domestic market.

The aviation writer said the recent fall in demand for air travel has been partially triggered by slow economic growth but a bigger factor was the higher level of fares due to a shortfall in capacity. He viewed this as positive for the airlines as it will help them improve yields.

Crude Factor

Airline businesses have also suffered because of higher crude prices and a weak rupee, which has made things tougher for them. Jet fuel prices moved higher at $80 per barrel in February, while the domestic currency had also depreciated last month before bouncing back firmly of late.

Since 70% of the airline costs is dollar-denominated, even a slight depreciation in the rupee hurts the cost structure of operators.

A CEO of a recently launched airline, who spoke off the record, told DNA Money the list of factors that dented the costs of domestic airlines was endless.

"70% of our costs are dollar denominated. The exchange rate has really hurt the industry. High jet fuel taxes have driven up our aviation fuel costs to the highest level in the world. This is on top of high Brent rates. High maintenance requirements due to the operating environment – high engine degradation, a high number of bird hits and airport closures and diversions, poor runway conditions, huge airspace congestion plus things like VIP movements and Republic Day shutdown of airports that cause delays and diversions. High airport costs where all costs are simply passed on to the airlines. High-security costs and archaic or inefficient security requirements. Shortage of captains resulting in expensive expats. The list goes on..," he said.

Against this backdrop of the intrinsically swollen operational cost of local airlines, any discounting by them disrupts cash flow and splashes the red on their books. This debilitates their ability to repay existing loans and raise more working capital to sustain their operations.

Bhargava said often heavy discounting due to overcapacity led to airlines operating below cost. Last few years had seen exactly that as airlines took deliveries of planes they had ordered. Such a strategy adversely impacts the profitability of airlines.

Financials Nose-dive

In the third quarter ended December, IndiGo reported a 75% slump in net profits, SpiceJet's net profits tumbled 77% and Jet posted a net loss of Rs732 crore. In its mid-year assessment of India's airline industry, the Sydney-based airline consultancy firm Centre for Asia Pacific Aviation (CAPA) estimates Indian airlines to collectively report a loss of $1.7 billion, lower from an earlier forecast of $1.9 billion, in FY19. Another factor that prompted the consultancy firm to cut its forecast of losses was the moderating crude prices.

For now, investors, promoters and lenders of Jet are engaged in a frenetic pace of negotiations to get the legacy carrier out of the ICU. They may even succeed as Singh did in 2015. However, unless the embedded fault in the cost structure of the airline industry is corrected, many other airlines could also experience rough weather in the Indian skies.