Sector consolidation likely to benefit IndiGo and SpiceJet; stocks gain

Given multiple headwinds and weak financials, the situation may worsen for Jet Airways

Despite the weak macro environment and severe competitive intensity in the aviation sector, Interglobe Aviation (IndiGo) and SpiceJet stocks gained 3.5–6.5 per cent over the last two trading sessions. On the other hand, delay in announcing its June quarter results and a stretched balance sheet saw Jet Airways share price shrinking over 11 per cent last week. 

While headwinds in the form of high oil prices (and hence, air turbine fuel), weak rupee and competitive pressures remain, the gains for IndiGo and SpiceJet, according to analysts, are on the expectation of sector consolidation. Investors and analysts believe any industry consolidation will drive capacity rationalisation and therefore, improve prospects for players with better balance sheets. This was the case in FY13 when sustained weakness in the operating environment resulted in the rationalisation of capacity (Kingfisher closed down) as airlines were trying to arrest their losses. Capacity dropped between 3-14 per cent in that year and again in December 2014 as SpiceJet, too, corrected its capacity. So, will history repeat?

According to Santosh Hiredesai and Chalasani Teja of SBICAP Research, “In times of such capacity shocks, the industry has either witnessed a sharp increase in yields (FY13 saw 20 per cent year-on-year jump across airlines) or a substantial improvement in passenger load factors or PLFs, which increased 600 basis points in FY15. Revenues and profitability, too, increased during this period.” 

Friday’s stock reaction suggests that the street is now starting to assume that a similar scenario could play out if the situation worsens for the sector. Such signs are visible on the operating front (the June quarter results of IndiGo) and in the worsening debt situation as is the case with Jet Airways. In fact, the aggregate debt of the sector, which stood at Rs630 billion as of FY18 could rise as operating performance worsens. 

Kinjal Kirit Shah, vice-president, Corporate Sector Ratings, ICRA, says, “The sharp rise in crude oil prices and rupee depreciation are likely to exert pressure on operating profitability of airlines in the near term. Further, with the expected capacity addition, the competitive intensity will increase. Pressure on yields would mean that profitability of most airlines in FY19 would be weaker than in FY18.” 

Borrowings levels, too, are expected to be high given large capacity expansion plans, which may be either owned (debt funding) or on operating lease, Shah adds. 

Despite high passenger growth, severe pricing pressure in a high-cost environment could mean deteriorating operating performance. In such a scenario, it will worsen things for Jet Airways, which has the weakest balance sheet among listed peers. The company, which has a debt of Rs85 billion, had reported a loss of Rs7.7 billion at the operating profit level in the March quarter of FY18. Given that IndiGo, which is the most cost-efficient airline in the country, reported a June quarter operating loss of Rs111 million, the numbers for Jet will hardly be flattering, say analysts. 

Though SpiceJet did better than IndiGo in the March quarter due to its yield performance, analysts are not too hopeful about its June quarter performance.

All eyes in the short term will be on Jet Airways. Though the company is gradually reducing its cost structure, its non-fuel per unit costs continue to be 25-50 per cent higher than peers. Analysts believe that unless the company reduces its debt further (debt is down 30 per cent from FY15 levels), given the lack of profitable growth, its net debt-to-operating profit could well turn negative in FY19. While domestic competition continues from low-fare carriers which have expanded capacity rapidly, a weak Asian market in the past has compounded the problem for Jet Airways. The competitive intensity has in fact gone from bad to worse as airlines fight to win customers in a quarter which is seasonally the weakest for the sector. 

Given the situation, analysts believe that Jet will need to infuse funds to bolster its balance sheet even as it continues its cost-cutting programme. 

Thus, going ahead while consolidation does help, investors should keep away from the sector for now, given both macro uncertainty as well as sector and company-specific issues.