Analyzing the Aviation Industry in India and measuring efficacy of hedging practices in stabilizing cash flow

Presented By: Ashaf Faraz Khan Roll No : 11BM60024

AbstractThe latest International Air Transport Association ( IATA) and domestic industry estimates ironically indicate that despite India having an insignificant share of just around 2 percent of the $470 billion global aviation industry, the Indian airline industry is likely to account for one-third of the world’s total accumulated losses .This can be attributed to many factors like lack of mature players in the Indian Airline Industry, high volatility in ATF Fuel prices ,high prevailing tax rates and large capital expenditure that these Airline generally have to incur. Though this prima facie comparison appeals to ones sense immediately, it is not logical to compare the foreign Airline with Indian Airlines as they operate in a completely different regulatory and cost structure environment.This research focuses on the following:• Historic evolution of the Airline Industry and studying the current scenario in the Aviation Industry• Identify the key issues faced by the industry.• Effect of volatility in ATF prices on Indian Airlines and to what degree would the hedging practises have

had helped in achieving stability

2April 8, 2023

Literature Survey• Naresh Chandra Committee Report (2004) on aviation sector in India

– Focus on Safety , Infrastructure development and Regulations in Aviation sector• Use Derivatives to Tackle Turbulence in the Air (MCX)- V. Shunmugam and

Niteen Jain– Employ derivatives to defeat volatility

Derivatives to Turn Commodity Risks into Corporate Opportunities (MCX) - V. Shunmugam and Nazir Moulvi– Compares the pre-hedging and post hedging Impact on Zinc Industry

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Industry Overview - History

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Phase I (1912-1986)

Phase IV 2006 onwardsPhase III (2003-2006)

Phase II (1986 – 2003)

• First domestic air route was unwrapped between Delhi and Karachi by the Indian State Air Services • Tata Airline (1912) was renamed as Air India (1946)• Government in the wake of deteriorating financial conditions of the Airlines decided to step in and nationalize the air transport industry and accordingly, two autonomous corporations were created on August 1, 1953

• 1986 ,private sector players allowed to operate as air taxi operators• 1995 ,scheduled carrier status given 6 private players , only 4 started operation• Regulatory conditions were tough to operate

only deregulation continued

• Only 2 private players survived .• The duopoly of Jet and Sahara as private carrier was challenged in 2003 by Air Deccan• Air Deccan gave India its first Low Cost Carrier • Shift from the stereo type economy fares & business fares to the era of web fares , internet auctions ; Special discounts and Corporate plans• Air traffic growth since then has witnessed tremendous growth rates.

• Witnessed M&A across airlines• Post consolidation these players captured 80%

market • Inefficient management and tough regulatory environment made airlines to shutdown or go bankrupt

Air Traffic in IndiaDOMESTIC AND INTERNATIONAL TRAFFIC CARRIED BY SCHEDULED INDIAN CARRIERS FOR THE LAST 26 YEARS

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Year

1987

-88

1990

-91

1994

-95

1997

-98

2000

-01

2003

-04

2006

-07

2009

-10

01000020000300004000050000600007000080000

PASSENGER Domestic( '000)

PASSENGER Domestic + International ( '000)

' 000

Year

1986

-87

1988

-89

1990

-91

1993

-94

1995

-96

1997

-98

1999

-00

2001

-02

2003

-04

2005

-06

2007

-08

2009

-10

- 100,000 200,000 300,000 400,000 500,000 600,000 700,000 800,000

CARGO Domestic (TONNES)

CARGO Domestic + International (TONNES)

To

nn

esLast twenty years has witnessed annual average growth rate of 8.6% which is about 1% lower than the passenger growth

Source : DGCA

Key Players in the Indian Aviation Industry

Market Share of Schedules Domestic Airlines in India

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Air India ( Dom); 20.70%

Jet Airways; 18.30%

Jetlite; 6.90%Spice Jet; 19.50%

Go Air; 7.40%

Indigo; 27.30%

Mantra; 0.09%

Fleet Size (As on 31st March 2011) 340No. of scheduled Aircraft Departures per day 1,734No. of scheduled passengers carried per day 1,83,564

Total Number of Employees (as on 31st March 2011)

59,697

Performance Metrics in Aviation

• Revenue Passenger Kilometres (RPKs)

RPK of an airline is the sum of the products obtained by multiplying the number of revenue passengers carried on each flight stage by the stage distance i.e it is the total number of kilometres travelled by all passengers. It is a measure of sales volume of passenger traffic.

• Freight Tonne Kilometres (FTK)

FTK measures actual freight traffic. It can be understood as RPK equivalent of freight .Some airlines disclose Cargo Tonne Kilometres (CTK) which explicitly includes unaccompanied baggage and mail, avoiding ambiguity.

• Available Seat Kilometres (ASK)

ASK measures an airline's passenger carrying capacity. Calculated as seats available multiplied by distance flown. This number should be calculated per plane, but is (at least in an investment context) usually quoted per airline.

• Passenger load factor (PLF)

PLF of an airline is a measure of how much of an airline's passenger carrying capacity is used. It is passenger-kilometres flown as a percentage of seat-kilometres available. This is a measure of capacity utilisation and an important efficiency measure, but it does not consider the pricing and the profitability at which the capacity is sold.

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Comparison of Operational Performance of Indian player with Global counterparts

8April 8, 2023

Percentage Share National carrier Private carrier Total National Carrier Private carrierPassengers carried (‘000) 15,713 51,288 67001 23.5 76.5Passenger - Kilometer Performed (mil.)

36,232 66940 103172 35.1 64.9

ASK (mil.) 54,361 83130 137491 39.5 60.5Passenger LF % 66.70% 80.50% 75% Frieght carried (tonnes) 176 444 620 28.4 71.6Mail carried (Tonnes) 21 3 24 86.5 3.9

2011Europe US Asia Pacific Latin America

RPKs (mil.) 834,693 11,04,257 7,24,718 2,09,570ASKs (mil.) 1,078,965 13,43,837 9,48,167 2,79,669Pass. (000) 3,63,203 6,13,000 1,89,926 1,39,151Pass. LF (%) 77.4 82.2 76.4 74.9FTKs (mil.) 33871 77,725 61,426 4,085

India :

World :

2010-2011

Financial Performance comparison

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CARRIER/AIRLINE OPERATING REVENUE OPERATING EXPENSE OPERATING RESULTS

EBIT Margin

NATIONAL CARRIERSNACIL(AI+ICcombined) 1,42,551.10 1,79,959.10 -37408 NAALLIANCE AIR 3582.6 3847.9 -265.3 NATOTAL 1,46,133.70 1,83,807.00 -37,673.30

CARRIER/AIRLINE OPERATING REVENUE OPERATING EXPENSE

OPERATING RESULTS EBIT Margin

JET AIRWAYS 1,27,146.30 1,20,346.20 6,800.10 5.35%JET LITE (P) Ltd 17,610.70 18,220.50 -609.7 NAKINGFISHER 63,596.40 65,963.30 -2366.9 NAINDIGO 38,254.10 32,229.20 6,024.90 15.74%TOTAL 2,46,607.50 2,36,759.10 9,848.40 3.93%GRAND TOTAL 3,92,741.20 4,20,566.10 -27,824.90 NA

PRIVATE SCHEDULED DOMESTIC AIRLINES:

NATIONAL CARRIERS:

Financial Performance comparison

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Comparison of EBIT margin across Geographies:

It can be seen be seen that though Airline across the world have a positive EBIT margin ,especially Asia – Pacific has a the highest EBIT Margin across regions but the Indian Airlines sector has consistently operated at negative EBIT margin.

EBIT Margin as % of revenue2009 2010 2011

Global 0.40% 4.00% 2.90%Regions wise

North America 1.20% 4.70% 3.10%Europe -2.20% 1.90% 0.90%

Asia-Pacific 2.80% 6.00% 5.00%Middle East -1.50% 3.60% 3.50%

Latin America 2.80% 5.00% 2.30%Africa -1.20% 1.60% 0.80%

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Income Statement Analysis

Airline Industry Value Chain

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SWOT Analysis Indian Aviation Industry

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Indutry Rivalry

Potential New Entrant

Bargaining Power of the

Buyers

Substitute Products and

services

Bargaining Power of Suppliers

Foreign Carriers ,Regional Carrier Start ups ,Cargo Carrier Business

Travel Agents, Business Travelers, Federal Government, Pleasure Travelers, Charter Service, Military, Cargo and Mail

Aircraft Manufacturers ,Aircraft Leasing Companies , Labor Unions ,Food Service Companies ,Fuel Companies, Airports ,Local Transportation Service ,Hotels

Alternate Travel Services, Fast Trains, Boats, Private Transportation, Videoconferencing, Groupware,

Key Issues in Aviation Sector

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1. Infrastructure :In the developed countries, growth in infrastructure kept pace with growth in airline industry. These countries had built various secondary airports. For instance, the city of London itself has more than one airport. These countries also have a seamless ATC (air traffic control) system because of which it is able to handle the growing passenger number. In India no metropolitan city yet has a second airport. These secondary airports have a lower access, landing charges allowing for the cost rationalization. The LCCs in US and Europe have been successful also because of these reasons. In India, demand has been created in the aviation sector and now it is trying to create the needed infrastructure (supply side) to meet the increased demand. They key concern areas under Infrastructure are Airport and MRO (Maintenance, repair and Overhaul)

2 . Pricing :The domestic overcapacity in 2011-12, led to fare wars in the domestic business with nearly all airlines selling seats below cost. This led to severe losses for the Industry as a whole (annual report Jet Airways Directors report).A pricing framework is the need of the hour to identify and curb predatory and excessive pricing within the context of India‘s civil aviation sector (AERA may be the solution)

Key Issues in Aviation Sector

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3 . Slot allocation Policy :

Airport coordination is mostly done at the Level 3 airports where demand for airport infrastructure significantly exceeds the airport‘s capacity, necessitating slot allocation process. In India, there are six designated Level 3 airports at Mumbai, Delhi, Hyderabad, Bangalore, Chennai and Kolkata.

Key guiding principles of slot allocation process, as followed in India are –

1. Slots are only allocated for planning purposes by a duly appointed coordinator at a Level 3 airport.2. IATA‘s WSG guidelines establish grandfather rights for runway slots, which permit airlines to use

those slots in the future which they have already used in the past.3. Airlines lose grandfather rights if they do not operate them for at least 80% of the time of the

respective flight period (use-it-or-lose-it)—one flight period is six months4. Slots may be freely transferred or exchanged between airlines, or used as part of a shared

operation, subject to the provisions of these guidelines and applicable regulations.

Suggestion : Slots could be allocated through market mechanisms, like alternative primary trading (eg, auctions) and secondary trading mechanisms (barter or inter-airline trading), rather than through purely administrative criteria

Key Issues in Aviation Sector

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4 . Lack of Fuel Hedging Practices :

Aviation Turbine Fuel (ATF), the biggest cost component for an airline,it is available to foreign airlines at a much lower price than Indian airlines (India Players pay about 60% more than their Foreign counterparts ), However with Indian government announcing ATF as declared good as part of Budget 2013 and allowing Indian Airlines to Import ATF directly this significant cost difference in fuel prices between the Indian and International players will soon fade away. However no player is currently hedging the Fuel cost

With declared good status the tax burden is expected to come down however the volatility in the ATF fuel price remain a concern

Measuring the Efficacy of Hedging Practice

• Hedging as a practice is used to stabilize the cashflow prediction is not a tool for increasing the profitability• However given the volatility in the fuel prices Hedging will ascertain price of the fuel

To measure the impact of hedging ,I have used Jet Airways as a sample company for analysis and retrospectively applied Hedging practices of ATF fuel , using 3 months forward contracts form 2008 to 2012 .Based on the forward prices of the fuel ,I have recalculated the cost of fuel to the company and hence reprepared the Income statement of the company .Since ATF in India were not traded in 2008 , cross hedging was used ,with the commodity being hedged is crude Oil .Crude Oil is Highly correlated to ATF Price ,as ATF is a derivative of the crude oil . Hence a Minimum Variance Hedge ratio was calculated to find out the optimum number of Contracts to be Hedged .

April 8, 2023 17

Company >> Finance >> Profit & LossJet Airways (India) Ltd 1 Fluid barrel = 119.240471

Hedging Ratio 60%Industry :Transport - Airlines Size of Contact 11924.0471

(Rs in Crs)45,849.55 60,320.94 52,020.52 60,050.50 66,156.41

Year Mar 08(12) Mar 09(12) Mar 10(12) Mar 11(12) Mar 12(12) INCOME : Sales Turnover 8,852.15 11,571.15 10,465.92 12,933.53 15,266.17Revenue from International Operations 35.2% 53.0% 58.70% 57.2% 58.0%Revenue from Domestic Operations 64.9% 47.0% 41.3% 42.8% 42.0% Excise Duty 81.05 94.17 78.88 196.77 450.26 Net Sales 8,771.10 11,476.98 10,387.04 12,736.76 14,815.91 Other Income 779.86 659.83 306.33 262.45 489.67 Stock Adjustments 0 0 0 0 0 Total Income 9,550.96 12,136.81 10,693.37 12,999.21 15,305.58 EXPENDITURE : Raw Materials 0 0 0 0 0 Power & Fuel Cost 3,048 4,461 3,099 4,171 6,034

Power, Oil & Fuel 3,048 4,461 3,099 4,171 6,034Fuel Cost 33.448 37.212 29.976 34.952 45.894

No of Barrels ('000) 7,641.6 10,053.5 8,670.1 10,008.4 11,026.1 Quantity of Fuel Used in '000 Litres 9,11,187 11,98,783 10,33,825 11,93,408 13,14,753

Fuel Charges (per litre)Blended Fuel cost 36.14 41 30.49 36.59 50.43

Domestic Operations 37.77 45.01 60.2International Operations 25.36 30.29 43.36

Margin 31.9% 36.8% 29.0% 32.1% 39.4%% of Expense 36.1% 39.0% 33.9% 38.4% 42.9%

Electricity Expenses 14.53 20.87 19.23 18.68 17.74Water Charges 0 0 0 0 0

Employee Cost 1,170.07 1,409.56 1,220.54 1,323.30 1,580.89 Other Manufacturing Expenses 1,928.41 2,663.93 2,231.64 2,476.93 3,028.19 Selling and Administration Expenses 1,963.93 2,360.38 2,239.30 2,542.81 2,816.58 Miscellaneous Expenses 323.11 514.8 343.68 316.17 575.73 Less: Pre-operative Expenses Capitalised 0 0 0 0 0 Total Expenditure 8,447.75 11,430.49 9,153.38 10,849.11 14,053.12

EBITDA 1,103.21 706.32 1,539.99 2,150.10 1,252.46Depreciation 777.8 -16.06 961.96 788.37 939.88EBIT 325.41 722.38 578.03 1,361.73 312.58Interest 492.75 738.03 993.01 1,119.71 971.23EBT -167.34 -15.65 -414.98 242.02 -658.65 Tax 8.4 0.8 20.7 -12.1 32.9 Fringe Benefit tax 10.02 8.49 0 0 0 Deferred Tax -170.83 -80.54 0 33.63 -33.63PAT -14.90 55.62 -435.73 220.49 -657.95

Reported Net Profit -253.06 -402.34 -467.64 9.69 -1,236.10

Extraordinary Items 388.33 1,345.56 71.67 135.75 147.53 Adjusted Net Profit -641.39 -1,747.90 -539.31 -126.06 -1,383.63 Adjst. below Net Profit 0 -68.01 0 0 0 P & L Balance brought forward 461.97 208.91 -261.44 -729.08 -719.39 Statutory Appropriations 0 0 0 0 0 Appropriations 0 0 0 0 0

Number of contracts to be Hedged

Results of Hedging ATF Fuel

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2008 2009 2010 2011 201220.0

25.0

30.0

35.0

40.0

45.0

50.0

55.0

Fuel Cost (without Hedging) Fuel Cost (with Hedging)

per

lit

r p

rice

in

Rs

2008 2009 2010 2011 2012

-400.00

-200.00

0.00

200.00

400.00

600.00

800.00

1,000.00

1,200.00

1,400.00

1,600.00

Operating profit (without Hedging)

Operating profit ( with Hedging)

EB

IT i

n C

rore

sHence if the Airline of Hedging the ATF, the variance in the Operating Profit is could have been decreased and effective profit of Rs 1516 crores from 2008 – 2012 could have been made

Scope for Future Work

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• Since ATF is allowed to be traded , a study with actual ATF forward prices can help

in better estimation of Hedging outcome

• Analysis on Optimum Investment in Infrastructure that will suffice the Ailing condition of the Aviation sector in India

• Impact of Pricing with setting up of AERA (Airport Economic Regulatory Athority)

References• DCGA Website• IATA Website• Ministry of Civil Aviation• Naresh Chandra Committee Report (2004)• Working paper by : Use Derivatives to Tackle Turbulence in the Air (MCX)- V.

Shunmugam and Niteen Jain• Working Paper by : Derivatives to Turn Commodity Risks into Corporate Opportunities

(MCX) - Shunmugam and Nazir Moulvi• Jet Airways Annual report• Indigo Airline Annual report• Book on Derivatives by : John C Hull

April 8, 2023 20

Thank You