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Special Report: Doomed Ascents

The business of airlines is not something that gets smart people excited, elsewhere in the world

As of 1992, in fact-though the picture would have improved since then-the money that had been made since the dawn of aviation by all of this country's airline companies was zero. Absolutely zero.
-Warren Buffett in 1999

If the Wright brother were alive today Wilbur would have to fire Orville to reduce costs.
-Herb Kelleher, Southwest Airlines in 1994

This is a nasty, rotten business.
-Robert L Crandall, CEO & President, American Airlines

From these statements, it is clear that the business of airlines is not something that gets smart people excited elsewhere in the world. On the other hand, we have seen a great deal of excitement in India. There was a frenzy in the Jet Airways and the SpiceJet stock for a brief period, but that was a short-lived euphoria. Had the Deccan Aviation IPO come at any other time that too could have rustled up enough hungry investors.

Elsewhere in the world, high capital costs, huge operating costs and extremely competitive markets have made airline stocks a long-term sell, with few exceptions. As in many other things, we in India are behind the curve as compared to western countries, but the business dynamics do not change much. India's state-owned carriers Air India and Indian Airlines have been weak companies despite being monopolies till a few years ago.

Since the domestic sector was opened up, we have had a list of airline companies going under, be it Damania, NEPC or East West Airlines, with the only survivors being Jet Airways and Air Sahara. As business goes, it has posted phenomenal growth, its service is impeccable and its customers are sticky. All these were great reasons for investors to lap up the Jet Airways stock when it came out with its IPO in February 2005. It was a leader in an under-penetrated business in a rapidly growing economy with high disposable incomes. The issue priced at Rs 1,100, reached a high of Rs 1,379. While all other things are the same, the Jet stock has halved in value since then.

Does a good company become attractive after it is available at less than half its price a year ago? That is not a question that comes up frequently in our stock markets during the past three years, as stocks have only gone up one way, which is up. Still, there were a few cases where stocks have more than halved. Dr Reddy's Laboratories and Ranbaxy are two stocks that lost a lot of their value from the highs, and while Dr Reddy's has regained lost ground, Ranbaxy is yet to recover the fall. Hindustan Petroleum is another example, of a stock trading near 50 per cent of its high.

When stocks fall in bull markets, there is obviously bad news coming with it. Both Ranbaxy and Dr Reddy's were facing pricing pressure in the US generics market, which eroded profitability, and were also embroiled in patent battles with global majors. No wonder, then that the stock prices declined. In case of Hindustan Petroleum, the subsidy burden reduced the gross refining margin and the stock tanked.

The Jet IPO came out at a time when the Indian bull market was just above 6,500 points. It was also the first time that a successful airline was going public. But over the past year, things have only worsened, as Jet's operating margins remain continuously under pressure. High crude oil prices have kept ATF (air turbine fuel) prices high. Competition has not only come from discount airlines, but also from players like Kingfisher, and even Jet has had to introduce apex fares. Also, staff costs have been on the rise. These are not new problems for airlines, but suddenly the market started realising them in case of Jet as the operating margins kept coming down. The EBITDAR (earnings before interest, depreciation, rentals and taxes) margin has fallen from about 33 per cent in the first quarter to 28 per cent in the fourth quarter.

Since yield per passenger has been under pressure, growth in the airline business is only possible by renting or leasing more aircraft thereby increasing seats, and improving the passenger load factor. In January 2006, Jet announced that it was acquiring Sahara for an enterprise value of $500 million. And since then, the Jet stock has only been down as the market has been worried about the high cost of acquisition of a loss-making airline. In the past six months, the closure of the deal has only extended as government permission got delayed.

Meanwhile, the operating environment changed and the valuation of airlines has come down dramatically. In case of Jet, investors have not liked the Sahara merger as the stock which was trading at Rs 1,150 has only come down since then. Obviously, Jet was paying too much for Sahara, but it was fine as long as its own stock price remained high and it could raise equity capital at those valuations. Now that the Jet share price has come down, it will mean more dilution in its equity capital for the Sahara acquisition, which neither promoters nor investors will like. In airline language, the deal will only go through at a super apex fare.