Interglobe Aviation: Flying high

India has emerged as the third biggest aviation market regarding passengers and has steadily grown at a CAGR of 18% in the last five pre-COVID years and 12% in the previous twenty years. With solid growth ahead as India's GDP per capita increases and luxury becomes a necessity, The passenger aviation space is set to continue growing at a similar pace, and the industry will reap its benefits as the penetration is still very low. From this trend, a key beneficiary emerges Interglobe aviation. This blog will provide an overview of the industry, the risks associated with the industry, key variables, and the business of Interglobe aviation.

Industry structure

Its actually quite simple so I will try to keep it crisp and short.

There are two industries worth noting and two types of businesses that operate in this Industry.

• The domestic industry consists of travelling within India. Indigo dominates it with 60.8% of the market share as of July. Air India follows it at 14.6% market share and Vistara with 9.6% market share. Akasa Air stands at 4.8% market share and SpiceJet at 3.8%. It becomes obvious that the industry only has two big players: Indigo and the TATAs. While Indigo is already well established and profitable, TATAs will aim to do the same and fight their market share.
  

• The international industry is airlines going to and fro from India. Air India currently dominates this industry, but Indigo is clawing its way and trying to gain the market share. As of Q2 FY24, Indigo has a 15-16% market share in the India in and out segment. The international industry is an important segment because these are more lucrative margins and can offer a profitable opportunity to introduce premium and business classes.
  

Now that we know the sub industries, let's understand the types of businesses.

• Low cost carriers: Low-cost carriers are businesses that eliminate additional features and services such as food and beverages, screens, bigger boot space and leg room. These businesses focus on cost optimisation and nothing else. They mostly only have economy class. This allows them to charge lower prices for the same destination while making decent money. Moreover, since India is a value-conscious market, this strategy has worked well for them. Example: Indigo is a low-cost carrier.
  

• Full service carriers: These businesses include food and beverages in the ticket, have a bigger boot space and leg room. They focus on services and also offer premium economy and business class. These have a higher opex and charge a higher price to make up for it. Example: Vistara.

Why do airlines fail?

We all have this perception that airlines can not be wealth creators in the long run. To some extent, it is true. Although there are companies that have cracked the code and succeeded. Lets first 'invert' and look at what destroys value in this industry before we learn what creates value here.

Porter's five forces

1. Supplier power: There are only two companies that produce aeroplanes. These two are Boeing and Airbus. Because these two are responsible for the global supply, they command strong pricing power and charge hefty prices for these aeroplanes. Moreover, with Boeing suffering in the recent past due to safety issues, Airbus has been filled to the brim with its order book and, hence, has more premiums. As of January 2024, Airbus has an order book, an astonishing 8600 jets, and some orders are to be delivered in 2030 or so! The supplier power does not just end there.CFM International ( JV of General Electric and Safran aircraft engines)  and Pratt and Whitney command a market share of 39% and 34% each in plane engines. You know what's funny? GE's own division commands a 14% market share. Airlines don't have it accessible from the supplier side, and they get squeezed with the rates.

2. Buyer power: For a long time, airlines have been unable to differentiate themselves and hence have fallen prey to pricing war. Pricing war as Michael Porter says is a race to the pit. Due to this, airlines can not charge high prices and mostly work on wafer thin margins fearing to not be cut by their competitors.

3. Substitutes:The final aim of an airline is to transport people. With this base logic, it is easy to conclude that some of the biggest substitutes emerge in the form of trains and passenger vehicles. These modes of transport are quite cheap and more accessible. For example, there are currently 146 airports in India, and 13 additional ones have been approved for construction. How many railway stations does India have? 7349! Accessibility-wise, airlines do not even come close.
   

4. Threat of new entrants: Finally, a force which is not negative for the airline industry. Airline industry is cut throat and hence not a lot of new players enter and the ones that enter fail. Moreover, it is a very capital intensive industry which prevents many from entering this sector.

5. Competitive rivalry: As we discussed above, these businesses fight on prices and thats the worst kind of business competetion. This way, they undermine each other and lose out on profit margins.

Uncontrollable cost factors

There are several internal/external factors that affect the profitability of business operations. The most important cost item is ATF fuel, which accounts for 40+% of operating costs and is influenced by multiple geopolitical factors. Rupee depreciation impacts aircraft leasing maintenance costs and fuel costs. There are multiple government levies and airport levies that can increase suddenly, resulting in an overall cost increase for the customers and no benefit for the airline operators. Further, because of the bloated cost structures, airlines must continue making large payments (like lease, maintenance, and employee) regardless of business conditions. Employee unions are pretty strong here, and pilots are always in demand. Hence, airlines have to agree to the many agreements that they might pose. When all these costs increase, airline companies often find it difficult to pass them on to customers due to competitive pressures, which results in losses or unpredictable profitability.

How do airlines succeed?

When I think of these forces and how one could succeed here, it becomes difficult to think of an answer. However, a few key traits can really help a business crack this industry.

1. Be a low cost business: In an industry where pricing and efficiency matters the most, one needs to devise a business model that is the lowest cost producer and hence can fight its competitors when needed. Being a low cost business helps survive the cyclicality of the industry which is extremely necessary.

2. Be a big business: Being a business of sizeable scale is quite important here. It helps tackle a few forces such as Supplier buyer and competeitve rivalry. With a big business, you not only have economies of scale but also have a strong negotiating power against the suppliers. This way you save costs very well.

3. Consolidated industry: As we discussed that it is difficult to start a airline business, it is ideal to operate in an industry which is consolidated. This helps in maintaining pricing power against customers.

4. Asset light and cash rich: You need to have legs to stand on when the times are bad. Being asset-light reduces the burden of depreciation and other costs, and being cash-rich helps increase the terminal value of the business. A good way to achieve both is the 'lease back model.' An airline company purchases a few jets from Airbus and then sells them to a middleman. This guy will pay for it and lease it to the same company. This way, you remain cash-rich and asset-light. Moreover, jets keep upgrading every few years, which is fuel efficient. So, this model allows them to not tie themselves down to the older models and switch to the new ones immediately. This is possible because they do not own the old models!
   

Key variables to track

• Market share: Since it is a competitive industry, it is essential to know how the players are performing. Moreover, it is quite easy to find the exact market share of all the players due to the transparency of data from the Directorate General of Civil Aviation (DGCA). As we already discussed above, Indigo is the leading player in the domestic market by a considerable margin.
  

• Fleet order book: This is very necessary because of two reasons. First, it gives a perspective on the large opportunity that lies ahead of us. Secondly, it helps us grasp what the competetive scenario will most likely be in the coming times. Currently, Air India and Indigo have some of the biggest order books. Indigo has ordered for 950 aircrafts and all from Airbus while Air India has ordered for 470 from Airbus and Boeing combined.

• CASK: Cost of available seat kilometer. The cost incurred by the airline per kilometer it covers. The biggest component of costs are fuel, employee costs, maintenance costs and financial costs. Because of the fact that turbine fuel cost is uncontrollable, it is better to look at ex-fuel CASK.

• RASK: Revenue per available seat kilometer. Revenue earned divided by kilometer covered with passenger. So basically, the difference between RASK and CASK is the money the airline businesses make. We already discussed how can CASK be controlled, but now let's see how the RASK can be maximised. Airlines can make additional revenue by selling food and beverages, allowing more check in bags, premium services, seat selection etc. These methods don't cost much and can boost the business earnings well.

• Yields: Money earned per passenger per kilometer flown. The formula is: Passenger Ticket Revenue / Revenue Passenger Kilometer.

• PLF or passenger load factor: Capacity utilised of the aircraft. Since sots are fixed, a high PLF can lead to abnormal gains in earnings.
  

Interglobe Aviation

Interglobe aviation is the largest airline in India. It follows the Low cost carrier model and has been able to consistently increase its market share over time. As of Q4 FY24, Indigo/Interglobe aviation has a fleet size of 367 aircrafts. IndiGo took deliveries of seven aircraft during Q3 and closed the quarter at a total fleet of 367 aircraft compared to 304 aircraft in Q4FY23. Out of 367 aircraft, 31 are owned/finance-leased, 323 are on operating leases and 13 are on damp leases. Breaking up the fleet according to the aircraft type (nos.) – A320neo: 192; A320ceo: 31; A231neo: 94; ATRs: 45; A321 freighters: 3; and B777: 2.

Financials

I don't always share financials, but take a look at it because I will get to this later!

What I like about the business

• Favourable Industry structure :Indigo dominates the Indian aviation space. It is very difficult to dethrone them, at least in the medium term. Currently, only the TATAs have the cash and the capability to compete against Indigo. However, that, too, will take some considerable time to materialise. Indigo posted profits worth 8000 crores! while the rest of the industry combined a loss of 3200 crores. Any industry-level difficulties will only make Indigo's market share stronger as they are the only one with a solid cash-rich balance sheet. I try to think of scenarios of how Indigo can lose its market share, and there are barely anyways, and most are irrational to attempt.
  

• Strong balance sheet:Due to the leaseback model, Indigo maintains an asset-light model and can switch to more efficient aircraft models really fast. Moreover, As of FY24, they hold free cash worth 20,800 crores and restricted cash worth 14,000 crores which allows them to survive considerable downturns and emerge stronger than ever.

• Industry opportunities: Indian aviation industry grows 2x of the GDP. With this, we can conservatively assume that the industry will grow at a CAGR of 10-12%. Moreover, Indigo is expanding to the international space( India to and fro), which allows for higher margins, leading to higher RASK and introducing business class seats, which allows higher earnings. That way, they can premiumise their offerings by still being a low-cost carrier and increasing their TAM considerably.
  

• Aggressive expansion:Indigo is set to receive an aircraft every single week of FY25. I had concerns that Air India is also receiving such an extensive fleet, but most are going towards replacements. Hence, the net increase in the number of air crafts is much higher for Indigo, which allows it to maintain its market share. Moreover, having a 1000 or so backlog of new orders assures that the TAM is huge and market leadership is here to stay.

• Cost efficient: Owing to their large scale and low cost operations, Indigo is very cost efficent which allows them to maintain competetive pricing while keeping a decent enough margins. As the competition increases, this will be key.
  

What worries me about the business

• Peak margins?: We witnessed a significant margin jump in FY24. The margin % nearly doubled, and that is a very high base to set. Moreover, we can see that CASK has had a bigger impact than CASK ex-fuel. This means that turbine fuel prices play some role in the margin expansion. I am not a big fan of that. I want internal efficiency to dictate the margin profile. Although the supply side remains a constraint for the FY25, I would be concerned about how it goes about.
  

• Industry nature : Whatever said and done, it is a brutal industry. Any economic downturn or poor consumption cycle, there can be massive falls in earnings. The business except fuel has quite a lot of fixed costs and hence can experience operating deleverage.

• Dependence on select few suppliers:Indigo was lucky to not rely on Boeing but that might not be the case all the time. Moreover, Pratt and Whitney's engines faced issues in FY24, which led to many airlines being grounded. Indigo had to ground 44 planes and Spicejet had to ground 26. This is one of the reasons Spicejet faced a lot of problems recently. Basically, these issues have been quite common and they are hard to predict.
  

• Irrational competition: TATAs have been quite open with their intentions of gaining market share. If this leads to pricing wars, there will be high pressure on Indigo's business earnings. In my opinion, this might be unlikely to happen as Air India and Vistara are already making losses and need a better balance sheet. I think using the mental model of game theory is very helpful here. If a company drives the prices down, the other company is forced to match it, and in the end, none of them gain anything.

Valuations

Valuations are an independent thought process, the risk appetite and portfolio expectations I might have would be completely different from yours and hence this should be looked at separately.

In my opinion, Indigo is quite undervalued at a PE multiple of 20 when it is growing its earning at 15-20%. Additonally, it has a strong balance sheet, is cash rich , high ROCE and a market leader. If the business sustains its impressive performance for the next few quarters, we can see an opportunity of rerating.

Technicals

Here is the weekly TF of Indigo. The business is currently in stage 2 and is consolidating at the top. It is higher than the 21 EMA and looks like is at a healthy distance from it. it will be interesting to see if it breaks the small consolidation its forming and proceed for a new All time high or not.

I hope the analysis was worth your time and you all had something to learn! Pease let me know if you have any doubts and Subscribe if you enjoyed the content!

Citations

• “I Studied a Large Cap Market Leader!” YouTube, 10 Dec. 2023, www.youtube.com/watch?v=CuFCctfYx8E&t=1296s. Accessed 18 July 2024.

• Balasaheb, et al. “Interglobe Aviation - Indigo.” ValuePickr Forum, 17 Oct. 2015, forum.valuepickr.com/t/interglobe-aviation-indigo/3195. Accessed 18 July 2024.

• Airports-IFR-VFR-200815.PDF, nocas2.aai.aero/nocas/AAI_Links/Airports-IFR-VFR-200815.pdf. Accessed 18 July 2024.

• Coverage report by Jefferies

• Kotak daily

• Concalls, Annual report and investor presentation of Interglobe Aviation