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

Presented By: Ashaf Faraz Khan Roll No : 11BM60024

Abstract
The 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 worlds 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
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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

Phase II (1986 2003) Phase I (1912-1986)
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

Phase III (2003-2006)

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Phase IV 2006 onwards

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Air Traffic in India

DOMESTIC AND INTERNATIONAL TRAFFIC CARRIED BY SCHEDULED INDIAN CARRIERS FOR THE LAST 26 YEARS
80000 70000 60000 50000 40000 30000 20000 10000 0 Year 800,000 700,000 600,000 500,000 400,000 300,000 200,000 100,000 Tonnes ' 000

2009-10

1986-87

1988-89

1990-91

1993-94

1995-96

1997-98

1999-00

2001-02

2003-04

2005-06

2007-08

PASSENGER Domestic( '000) PASSENGER Domestic + International ( '000)

CARGO Domestic (TONNES) CARGO Domestic + International (TONNES)

Last twenty years has witnessed annual average growth rate of 8.6% which is about 1% lower than the passenger growth
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Source : DGCA

Key Players in the Indian Aviation Industry

Market Share of Schedules Domestic Airlines in India
Mantra, 0.09% Indigo, 27.30% Air India ( Dom), 20.70%

Fleet Size (As on 31st March 2011) No. of scheduled Aircraft Departures per day No. of scheduled passengers carried per day

340 1,734 1,83,564

Go Air, 7.40%

Jet Airways, 18.30%

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

59,697

Spice Jet, 19.50%

Jetlite, 6.90%

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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. 7

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Comparison of Operational Performance of Indian player with Global counterparts

India :
Passengers carried (000) Passenger - Kilometer Performed (mil.) ASK (mil.) Passenger LF % Frieght carried (tonnes) Mail carried (Tonnes)

2010-2011
Percentage Share National carrier Private carrier Total National Carrier Private carrier 15,713 51,288 67001 23.5 76.5 36,232 66940 103172 35.1 64.9 54,361 66.70% 176 21 83130 80.50% 444 3 137491 75% 620 24 39.5 28.4 86.5 60.5 71.6 3.9

World :
RPKs (mil.) ASKs (mil.) Pass. (000) Pass. LF (%) FTKs (mil.) Europe 834,693 1,078,965 3,63,203 77.4 33871 US 11,04,257 13,43,837 6,13,000 82.2 77,725 2011 Asia Pacific 7,24,718 9,48,167 1,89,926 76.4 61,426 Latin America 2,09,570 2,79,669 1,39,151 74.9 4,085

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Financial Performance comparison

NATIONAL CARRIERS:
CARRIER/AIRLINE OPERATING REVENUE OPERATING EXPENSE OPERATING RESULTS EBIT Margin NATIONAL CARRIERS NACIL(AI+ICcombined) ALLIANCE AIR TOTAL 1,42,551.10 3582.6 1,46,133.70 1,79,959.10 3847.9 1,83,807.00 -37408 -265.3 -37,673.30 NA NA

PRIVATE SCHEDULED DOMESTIC AIRLINES:

CARRIER/AIRLINE JET AIRWAYS JET LITE (P) Ltd KINGFISHER INDIGO TOTAL GRAND TOTAL OPERATING REVENUE 1,27,146.30 17,610.70 63,596.40 38,254.10 2,46,607.50 3,92,741.20 OPERATING EXPENSE 1,20,346.20 18,220.50 65,963.30 32,229.20 2,36,759.10 4,20,566.10 OPERATING RESULTS 6,800.10 -609.7 -2366.9 6,024.90 9,848.40 -27,824.90 EBIT Margin 5.35% NA NA 15.74% 3.93% NA

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Financial Performance comparison

Comparison of EBIT margin across Geographies:
EBIT Margin as % of revenue 2010 4.00% 4.70% 1.90% 6.00% 3.60% 5.00% 1.60% 2009 Global Regions wise North America Europe Asia-Pacific Middle East Latin America Africa 0.40% 1.20% -2.20% 2.80% -1.50% 2.80% -1.20% 2011 2.90% 3.10% 0.90% 5.00% 3.50% 2.30% 0.80%

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.

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Income Statement Analysis

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Airline Industry Value Chain

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SWOT Analysis Indian Aviation Industry

Foreign Carriers ,Regional Carrier Start ups ,Cargo Carrier Business Potential New Entrant Aircraft Manufacturers ,Aircraft Leasing Companies , Labor Unions ,Food Service Companies ,Fuel Companies, Airports ,Local Transportation Service ,Hotels Bargaining Power of Suppliers

Indutry Rivalry

Bargaining Power of the Buyers

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

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

Substitute Products and services

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Key Issues in Aviation Sector

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 Indias civil aviation sector (AERA may be the solution)
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Key Issues in Aviation Sector

3 . Slot allocation Policy : Airport coordination is mostly done at the Level 3 airports where demand for airport infrastructure significantly exceeds the airports 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. IATAs 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 months 4. 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 13 April 2013 15

Key Issues in Aviation Sector

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

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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 .
Company >> Finance >> Profit & Loss Jet Airways (India) Ltd Industry :Transport - Airlines (Rs in Crs) 45,849.55 Year Mar 08(12) INCOME : Sales Turnover Revenue from International Operations Revenue from Domestic Operations Excise Duty Net Sales Other Income Stock Adjustments Total Income EXPENDITURE : Raw Materials Power & Fuel Cost Power, Oil & Fuel Fuel Cost No of Barrels ('000) Quantity of Fuel Used in '000 Litres Fuel Charges (per litre) Blended Fuel cost Domestic Operations International Operations Margin % of Expense Electricity Expenses Water Charges Employee Cost Other Manufacturing Expenses Selling and Administration Expenses Miscellaneous Expenses Less: Pre-operative Expenses Capitalised Total Expenditure EBITDA Depreciation EBIT Interest EBT Tax Fringe Benefit tax Deferred Tax PAT Mar 09(12) 8,852.15 35.2% 64.9% 81.05 8,771.10 779.86 0 9,550.96 0 3,048 3,048 33.448 7,641.6 9,11,187 36.14 11,571.15 53.0% 47.0% 94.17 11,476.98 659.83 0 12,136.81 0 4,461 4,461 37.212 10,053.5 11,98,783 41 Number of contracts to be Hedged 60,320.94 52,020.52 Mar 10(12) 10,465.92 58.70% 41.3% 78.88 10,387.04 306.33 0 10,693.37 0 3,099 3,099 29.976 8,670.1 10,33,825 30.49 37.77 25.36 29.0% 33.9% 19.23 0 1,220.54 2,231.64 2,239.30 343.68 0 9,153.38 1,539.99 961.96 578.03 993.01 -414.98 20.7 0 0 -435.73 Mar 11(12) 12,933.53 57.2% 42.8% 196.77 12,736.76 262.45 0 12,999.21 0 4,171 4,171 34.952 10,008.4 11,93,408 36.59 45.01 30.29 32.1% 38.4% 18.68 0 1,323.30 2,476.93 2,542.81 316.17 0 10,849.11 2,150.10 788.37 1,361.73 1,119.71 242.02 -12.1 0 33.63 220.49 1 Fluid barrel = Hedging Ratio Size of Contact 119.240471 60% 11924.0471 60,050.50 Mar 12(12) 15,266.17 58.0% 42.0% 450.26 14,815.91 489.67 0 15,305.58 0 6,034 6,034 45.894 11,026.1 13,14,753 50.43 60.2 43.36 39.4% 42.9% 17.74 0 1,580.89 3,028.19 2,816.58 575.73 0 14,053.12 1,252.46 939.88 312.58 971.23 -658.65 32.9 0 -33.63 -657.95 66,156.41

31.9% 36.1% 14.53 0 1,170.07 1,928.41 1,963.93 323.11 0 8,447.75 1,103.21 777.8 325.41 492.75 -167.34 8.4 10.02 -170.83 -14.90

36.8% 39.0% 20.87 0 1,409.56 2,663.93 2,360.38 514.8 0 11,430.49 706.32 -16.06 722.38 738.03 -15.65 0.8 8.49 -80.54 55.62

Reported Net Profit

-253.06

-402.34

-467.64

9.69

-1,236.10

Extraordinary Items Adjusted Net Profit Adjst. below Net Profit P & L Balance brought forward Statutory Appropriations Appropriations

388.33 -641.39 0 461.97 0 0

1,345.56 -1,747.90 -68.01 208.91 0 0

71.67 -539.31 0 -261.44 0 0

135.75 -126.06 0 -729.08 0 0

147.53 -1,383.63 0 -719.39 0 0

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Results of Hedging ATF Fuel

55.0 50.0 per litr price in Rs EBIT in Crores 45.0 40.0 35.0 30.0 25.0 20.0 2008 2009 2010 2011 2012 Fuel Cost (without Hedging) Fuel Cost (with Hedging) 1,600.00 1,400.00 1,200.00

1,000.00
800.00 600.00 400.00 200.00 0.00 -200.00 -400.00 Operating profit (without Hedging) 2008 2009 2010 2011 2012

Operating profit ( with Hedging)

Hence 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
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Scope for Future Work

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)

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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

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