Introduction to Indian Aviation Sector
So there is this joke in the airlines industry, which goes something like this, that if you wish to become a millionaire, you should start with a billion dollars and you should go buy an airlines. Then you will face so much loss, so much loss that you will automatically become a millionaire starting from a billionaire. Now, this is unfortunately not just a joke. If you look at the balance sheet of major airlines companies across the world, they have been suffering very, very badly. If you take the numbers for Air India, for example, in India, here are the numbers for you. So in 2018, Air India suffered a loss of five thousand three hundred crores. In 2019, it suffered a loss of 8000 crores. And in 2020, this loss grew to approximately ten thousand five hundred crores. Now, you know what? This is not the problematic part. The problematic part is that if you actually work from anecdotes and if you have relatives or friends who travel from Air India and who are government officers, go and ask them how much money they pay from traveling from Delhi to Northeast or traveling from Delhi to Hyderabad. You will see that they are actually paying Air India in excess of 15, 20 thousand rupees per ticket, which is insanity. You can actually take a one way ticket to Europe at 25-26 thousand INR in a good season.
So despite the government paying so much money in making their employees buy Air India tickets at massive prices, still an airlines like Air India is suffering such massive loss.So on this case study, I’m going to cover three specific topics. So, number one, I will analyze why do airlines in India go bankrupt? What are some of the prominent reasons for the same? Second, I’m going to talk about an airlines which has been able to turn around its operations and it has become extremely profitable. So we will analyze its business model in a very short way and third we are going to take a look at whether or not airlines in India can also execute similar model and whether or not I will be investing in airline stocks.
Why do Airlines in India go bankrupt
So if you ask yourself the question that why do airlines in India go bankrupt, there can be multiple reasons for this. You might say that there are people like Vijay Mallya because of whom airlines industries go bust. They spend money like crazy, they party, they buy IPL teams. Of course, it will go bankrupt. Yes, I agree. But there is a more systemic thing at play here. You will understand that airlines typically have a very high fixed cost structure. For example, on this chart, you can see that there is thirty six percent expense that happens on the fuel, which is variable. It would depend on the frequency of flights, number of flights, etc. But if you take a look at the other typical expense heads, you will realize very quickly that these expenses are fixed cost. For example, if any airline has to lease any aircraft, then it’s a long term lease. So that becomes a fixed expense. The airlines will have to maintain that aircraft or air carrier. Again, fixed costs expense. Even the staff costs are very high and these are fixed up to a certain degree. Why do I say that? You might have heard that whenever an airline decides to shut shop, who are the first people who protest against these airlines? These are airline workers who are on the street demanding that their jobs be returned, even the government supports them. So for the airlines, it’s not easy to do away with their existing staff. So all these become major fixed cost expense that increases the cost structure of an airline.
The Margins of Airlines are very low
Now, let me demonstrate by analyzing the balance sheet of one of the most profitable airlines businesses in India, which is Indigo.
Now the chart should be there in front of you. And you can see if you analyze the data from June 2018 to March 2021, what will you notice? I would want you to notice the last head, which is operating profit margin percentage. So even in their best year in the last three or four years, their best operating profit margin has been 27 percent, which is not massive. That’s one. Second look at the years when the company has had to go through negative profit margins. There are numerous such years when the company had to go through negative profit margins. So this is a very worrying trend because this is one of the most profitable airlines in India. Right. That’s part one. But I would want you to look at this picture in conjunction with the two other pictures that I’m going to show. One look at the travel data, the number of people who have traveled in India from the financial year 2014 to 2020, you can clearly see an upward going trajectory. Every year almost the number of passengers from India have been going up, almost every year. So what should have that meant? It should have meant that the operating profit margin should have improved. It should have improved because more and more people are taking flights. So the economies of scale where large people buy a certain product or avail a certain product, the efficiency should have come in. But that is not happening. The profit margin, the operating profit margin has still been going down, as I showed you from the previous picture. That’s one. The second point, as I had shown you earlier, one of the major cost driver for an airlines industry is the expense on fuel. It approximately makes up one third of the entire expense. So let’s look at the oil prices, because oil prices can be a good proxy for the fuel prices that go into the aviation fuel. So if you look at the oil prices, back in 2012, 2014, you will see that the oil prices were trading at somewhere around 112 dollars a barrel. Now these are trading at seventy four, seventy five. There has been a major, major dip in terms of the oil prices, and it has traded literally in this range. From 2016, for example, the oil prices were trading at thirty dollars a barrel. In 2020, it came down and it has been trading in this range of 40-80 dollars a barrel. So the oil prices generally have come down over the last decade. But have the profits of the airlines gone up again? NO! despite the oil prices generally being low and more and more passengers taking flights from India, the profit margins have not improved for even one of the most profitable airlines in India. This is a very, very worrisome trend. And the major reason why this is happening is that new entrants enter the airlines industry and they undercut on prices. So airlines industries are not able to improve the margins. So it has by default become like a commodity good where all the airlines are just competing by cutting down their prices and thus decreasing their margins consistently. So this is a very, very big reason, very fundamental reasons why airlines is doing so badly in India.
Airlines sit on a Nuclear Bomb
Every time there is some kind of a major global tectonic event, be it terrorism, be it a nuclear blast, be it a volcano eruption, be it some kind of restrictions by a certain government. Airlines industry is the one that takes a massive hit. Now, here’s an example to prove it. In the US, when the 9/11 attacks happened,the US airline industry suffered a loss of 7.7 billion dollars in 2001, 7.7 billion dollars. Now, that’s a massive hit for any industry to take. Now, if you take the most recent example of coronavirus, it shows that the larger airlines have also been hit by the pandemic and more airlines, more than 10 aircraft fleets, even they have started to shut shops. Now, as the coronavirus situation evolves, more countries are going to put in travel restrictions. It will definitely decrease the frequency of flights because there will be more checkings. There will be longer wait time. There will be more processing time. So all of this will decrease the frequency of flights. Therefore, the airlines industry is going to have a tough time ahead. Now there are multiple miscellaneous factors as well that have been contributing to the decline of the airlines industry.
Restriction on fare increase by Government
the governments do not allow airlines industry to increase the prices as per their whims and fancies. The government would step in because people make a hue and cry that the airlines prices are going up. It’s just a transportation business. Why are airlines prices going up? So then government will step in. They will curb the prices. Similarly, the government keeps on increasing the taxation. In order to use the airports and different terminals, the airline companies have to pay higher and higher taxes that eats into their margins. So to cut the long story short, these miscellaneous factors mostly pertain to politics and that is somewhat hitting the airlines industry in a negative way.
There is a wonderful statement that was given by CAPA around the profitability of the airlines industry, and they say that most airlines today are technically bankrupt and are starved of cash to be able to operate. This is what drives them to discount fares, locking them in a cycle of instability. Unfortunately, this is not recognized at a policy level. Now this is a statement that came from CAPA India. And this is a very valid statement. This gets into the core of the economic argument that in industries where the margin is not preserved, for example, why is Apple such a big company? The reason is because it has wonderful margins. When they sell a Macbook pro or Macbook air, they are making 50, 60, 70 percent margins on that product. It’s a high margin product. But when an airplane company sells you a ticket, they are technically even losing money, sometimes. So that’s the unfortunate part. Now, you might ask me that why does that happen in the airline industry and why do they need to discount in order to win business? India is a very price sensitive and cost sensitive market. We as travelers tend to buy tickets that are the cheapest. So unfortunately, it has become a mad race just for cost optimization from the airlines. And they try to cut costs wherever they can. And it is a race to the bottom where all the companies are just trying to cut down prices just to stay alive and they are just trying to undercut each other. Whenever that happens in an industry, that industry faces massive amount of challenges.
Ryanair Airlines Business Model
It might be a great idea for us to analyze one of the companies called as Ryanair, which is one of the biggest European airlines and one of the most profitable airlines companies in the world. It’s important for us to understand their business model, how are they making money and whether or not that strategy can be used in India? So let me just quickly walk you through some salient points regarding Ryanair. So Ryanair is a Europe based, low cost airline and it has become the fifth largest airline in the world in terms of passengers carried transporting a staggering 142 million passengers per year. There is a 96 percent occupancy rate on Ryanair flights and the airlines has created very successful business model. Now, just by reading this statement, you might get very excited. You might say that Ryanair is just killing it. They are just acing this business and it’s just madness, why other companies are not able to execute it? But hold on for a second. It’s very important to understand other key critical components. So what you need to notice is that Ryanair ticket in 2019 was 37 euros, which was below their cost per passenger seat. This is a very important point to note that Ryanair, whenever it used to sell one ticket to a passenger, they were actually losing money like a majority of the other airline companies that I’ve been talking about.
How do Ryanair make Money ?
So the way that they are making money is that the airlines reported a 27 percent increase in ancillary revenues to over 850 million dollars. So let me quickly explain what ancillary revenues are. So ancillary revenues basically means that, for example, if I’m taking a flight, so the flight ticket price that I’m paying, that’s the base revenue for the airline company. Ancillary revenue would mean that if I’m bringing in more Check-In luggage, more than what the limit has been prescribed, if I’m buying more food and beverages on the airplane, if I’m using their Wi-Fi services, streaming services, whatnot. So these are ancillary revenues. So essentially the ancillary revenues has been growing the very core of Ryanair’s growth and profitability. Ancillary stream includes airport check-in penalties, baggage fees, priority boarding and in-flight beverages and food sales. So to cut the long story short, what is driving Ryanair’s profitability and growth is not the fact that it is optimizing the prices of its flight ticket or selling more seats, that they are already doing. But they are selling that at a loss. Their profitability is being driven by ancillary revenues. Now CAPA in India, similarly issued a statement saying that, there is a lot of potential money to be made by the airlines company if they are able to break this problem of getting more ancillary revenues. But unfortunately, getting this ancillary revenue in India is a very, very tough task.
Now, this is what CAPA says. One of the reasons that ancillary revenues are not better developed in India is that carriers face unnecessary regulatory hurdles that prevent them from maximizing such opportunities. For example, airlines are not permitted to offer fares with zero baggage allowance or nonrefundable fares, and currently they have to comply with fare caps and floors. So as I was speaking in the earlier section, that because of increased political intervention in the airlines industry, it seems like a losing proposition. Now, you might say that customers can chipin and actually save the airlines industry. But unfortunately, the problem in India is that India is a very, very price sensitive market. People are not going to pay for these ancillary services. It’s highly unlikely. the point that I am trying to drive home is very simple, that the Indian consumers do not want to spend money on these ancillary services. So therefore it is very difficult for airlines companies to make profit from these ancillary services.
Investing in Airlines Stock
This brings me to the final section of this case study, and you might have already figured out my answer that will I be investing in an airlines company? The short answer is no. Even Warren Buffet got out of airlines industry. So if you want to invest in airlines stock do your own researched with your own risk