Idle Capacity

There is very little doubt about the growth in Indian aviation but what has always caused anxiety among investors is certainty and sustainability of profitability. With a market share of close to 37%, InterGlobe Aviation, which owns Indigo, has emerged as an alternative given its low cost and asset light business model. That though did not stop its stock price from correcting almost 45% from its peak of Rs.1,395 in January this year to a low of Rs.725 in February. It now trades at Rs.930. While there are reasons to worry about in the short term, Indigo still remains a favourite.

So, what are the worrywarts? Despite a 18.5% year on year growth in volume, revenue in Q1FY17 grew by mere 8.7% as a result of drop in yield (PAX revenue per KM), which fell 10% to Rs.3.75 in Q1FY17, because of competitive pressure. In comparison, FY15 yield was Rs.4.4. From a peak of revenue of Rs.5,600 per passenger, it has dropped to Rs.4,650. Companies are not passing on the additional costs to customers as they want to keep their load factors high after inducting new aircrafts.

Indigo has planned to induct 29 aircrafts targeting a 34% growth in capacity. “The industry is operating at peak utilisation of 80% capacity. Since more and more aircrafts are getting inducted companies don’t want to take the risk of having idle capacity and thus are cutting ticket prices. Players like Indigo, SpiceJet are still operating at close to 30% operating margin,” says an analyst who is tracks the sector a foreign broking house.

Investors are also building in higher fuel and non-fuel cost. For Indigo, fuel cost accounts for close to 50% of its total cost. For every 10% increase in fuel cost there is a 12% impact on earnings for Indigo. Since April this year, the crude oil price has gone up from $39 a barrel to $46 currently. That apart, since the company is inducting new aircrafts, the other associated cost such as employees has also seen an uptick resulting in lower profitability. To put it in perspective, on a year-on-year basis, revenue per passenger for Indigo has fallen by Rs.481 in Q1FY17, but total operational cost has fallen only by Rs.85 per passenger indicating that ticket prices have fallen much steeper than the operational costs.  

"Amidst heightened competition and sustained pressure on yields, Indigo’s profit growth will lag volume growth. We are now modeling a 7% drop in yield for FY17 and have cut FY17 and FY18 estimated earnings by 20% and 18% respectively," says Santosh Hiredesai, analyst, Edelweiss Securities. FY17 consensus estimates have also been slashed by 16% from Rs.70 a share to Rs.58.6 currently. The dip in stock price has however discounted it and hence the stock is trading closer to the consensus 12-month target of Rs.960.

While fuel cost and falling yields are putting pressure on profitability, which might stay for some more time,Indigo still has headroom in terms of margins. Jet Airways make about 24% operating margins followed by 31% in the case of SpiceJet and 35% in the case of Indigo. Consensus estimates suggest that profit growth for the next two years would be around 17%, which is lower than the growth in volume pegged at 22-24%.

More importantly its business, which does not require capital as aircrafts are on lease and there is negative working capital. As customers pay in advance whereas fuel and other costs are paid after the revenue is booked. No wonder its payable days stay at 15 days as against debtors at 3 days.

Not just working capital, In FY16, it was sitting on a cash equivalent of Rs.3,720 crore as against its equity of Rs.1,834 crore indicating that literally there is no equity employed in the business. This is precisely the reason that its business makes good cash flows (FY16 free cash flow at Rs.2,745 crore on a reported net profit of Rs.2,000 crore), which was distributed through dividend. Most of the dividend flows to the promoters given their 86% holding. Will the dividend largesse continue in FY17 remains to be seen.