Take-off time for aviation sector

It takes a brave man to buy an airline. Ask liquor baron Vijay Mallya, who has since taking over Deccan Aviation in September, 2008 accumulated losses of around Rs 2,500 crore.

Still, businessmen find the lure of owning an airline hard to resist.
The latest to join the league is Kalanithi Maran, who has picked up 37.75% stake in SpiceJet and will have to make an open offer for another 20%. His total payout on this score is expected to be around Rs 940 crore.

SpiceJet took off in May, 2005, and has accumulated losses of around Rs 550 crore. In fact, it has made losses in 14 of the 20 quarters since inception.

That’s the business Maran is taking over. No saying what gives him reason to suppose it will do any better under him.

True, a revival in the domestic economy and increased corporate and leisure travel in recent times has improved the prospects of the airline companies somewhat. While passenger traffic grew 16% year on year in FY10, growth in January-April, 2010 has been 22% over the same period last year.

Conservative capacity addition and steady fares have led to better load factors for the carriers. Over the last two quarters, the load factors for SpiceJet have been around 79%. Kingfisher has reported a load factor of 71% for the whole of FY10. Jet Airways has seen occupancy levels of 81.6% on its international routes while maintaining 73% levels in domestic operations in the quarter ended March 31, 2010.

Small wonder, the operating margins of the airline industry are on the rise.

The Ebidtar (operating profits not considering lease rentals) margin for SpiceJet has been at 19% (-4% last year). For Jet Airways and Kingfisher, this margin stood at 23% (as against 19% last year and 13%(-5% last year).

So things are improving.

The improvement in operating margins has largely been on account of lower costs. Airline companies are reaping the benefits of cost reduction exercises such as lowering employee headcount, moderate capacity addition and lower lease expenses by leasing out excess capacity.

Helping this in no small measure are low and stable prices of aviation turbine fuel, what with crude moving in a range of $70-80 per barrel.

Two out of the three listed Indian carriers reported gains for the second consecutive quarter in the three months ended March. While Kingfisher Airlines continued to bleed, SpiceJet reported a net profit of Rs 27.45 crore and Jet Airways’ posted a net profit of Rs 58.58 crore.

This fiscal, the global commercial aviation industry is expected to return to profitability after two consecutive years of losses. The International Air Transport Association expects the industry to report a net profit of $2.5 billion in 2010 as against a net loss of $2.3 billion the previous year. Asia-Pacific carriers are expected to report a net profit of $2.2 billion this year.

“Going ahead, overall passenger traffic is expected to grow more than two times the capacity, supporting an overall 4.5% increase in yields. Evident in the return to profits, Indian aviation too is set for a take off with increasing traffic, improving yields and a  limited supply of 6-8% of the existing fleet in FY11E.” Nikhil Vora, MD, IDFC Securities wrote in a report on the aviation sector dated June 8.

Analysts believe that while Jet Airways may join SpiceJet in terms of turning profitable for the full year by FY11, Kingfisher may take longer. They are positive on Jet and SpiceJet from a medium-term perspective, though there does not seem to be any immediate upside trigger.

But, oil prices remain the joker in the pack. As long as oil prices are low, airlines will make some money. The moment they shoot up, and cross say $100 a barrel, sustaining profits will become difficult —- raising ticket prices without killing demand will be hard.

Also, globally, very few airlines have been able to generate profits on a consistent basis. One of them, of course, is Southwest Airlines in the United States, which carries the highest number of passengers every year. It has made profits for 37 consecutive years, starting in 1973, though in the recent past its profits have come more from successful bets on oil derivatives than growth passenger traffic.

As Warren Buffett, wrote in his annual letter to Berkshire Hathaway shareholders, in February 2008 “The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”

Surely, Maran knows what he is up against.