Air India is back in the hands of the Tatas and there are evidence of big investors betting on new airline companies. Does this mean that the revival is guaranteed?

According to the International Air Transport Association (IATA), India is the 3rd largest domestic aviation market in the world and is expected to overtake the UK to become the third largest air passenger market by 2024. Here are the air traffic metrics:

Source: Dare2compete

The rise in demand prompts sources to believe that India needs 2,380 new commercial airplanes by 2038 and has envisaged increasing the number of airports to 190-200 by FY40.

Fundamentals of an Airline company

The aviation industry is much more than what it looks like. You may be right that the airplane is the main product of innovation having the most utility, but a winner here is one who provides superior service quality. 

To understand profitability, let's look at the broad sources of revenues and major costs. 

Revenue, for Indian aircraft specially is driven by domestic demand and less by that of foreign travel. Cargo transport typically contributes a small percentage of income to airlines, but they're comparatively less volatile throughout the year. Most airlines want to focus on commercial aircraft and less on cargo post the pandemic to make up for the slump.

A form of non operating revenue for airlines is also leasing their airplanes to other airline companies. The small companies are incentivized to do so because of benefits due to less capital required to start out. This form of operation is becoming more popular lately.

Talking about costs, aviation turbine fuel (ATF) proves to be costly over the long term too, not only during crisis times such as now, but otherwise too. It sucks approximately 40% of the total costs. Heavy state levies and duties are partially responsible for the same.

And since aviation is a capital intensive as well as risky industry, banks charge higher interest rates for working capital debt that companies access.

Below is a depiction of current market leaders, but beware that innovation is bound to bring in more solid players that would operate on efficient business models.

Porter's 5

Considerations of the 'Porter's 5' theory gives us a closely accurate depiction of the profitability and nature of any industry. Applying it to the current one, here is what we can derive:

1. Suppliers Bargain: Key inputs in this sector are fuel, which is subject to foreign exchange and volatile prices; high level skilled employees which are costly and difficult to procure; and technology suppliers, which are not more than 3 in number.

2. Buyer's Bargain: Frequent price fluctuations and price wars have given consumers the benefit. Also, technology has enabled us to make more informed choices. 

3. Rivalry: Aviation is an oligopoly. 2-3 sellers have the most market share and there is fierce competition in both pricing and non-price elements.

4. Entry Barriers: One advantage to be seen here finally is that this is a difficult sector for a new entrant because of heavy government regulation and requirement of large capital.

5. Threat of Substitutes: Switching between airlines is low cost for the consumer and Indians would also compare prices to other modes of transport like rail and road, which commonly win due to low fares.

Given the above points, here are a few things that make investing in airlines risky.

Risks

Recessions are the biggest threat to airline companies. Already burdened by debt, declining demand quickly triggers losses to magnify until some kind of government relief or boost in demand is witnessed. In 2006-07, the Directorate of Civil Aviation (DGCA) banned Airbus (one of the prominent suppliers), and such decisions have resulted in most Indian airlines running into losses.

The authorities don't stop here. Regular changes in price floors and capacity constraints imposed by the government is also a worrisome hassle.

Slow technological adoption is to blame for lagging ATC (air traffic control) infrastructure compared to other countries. 

According to IBEF, domestic passenger and international passenger traffic declined at a CAGR of -9.02% and -28.64%, respectively, from FY16 to FY21, owing to COVID-19-related restrictions on flights in FY21. Around 36% of the employees were laid off this time. 

Positives

Though the article poses a grim picture till now, India, uniquely, has some reasons that fuels hope for the sector to rise in the coming years.

Post the pandemic, India has entered a cycle of not only economic recovery, but boom. Planes aren't a preferred option for the ordinary public of India yet but we boast of an underpenetrated market, with AAI spending $3 billions on non-metro projects over 2016 - 2020.

Recent headlines of the Tata Conglomerate buying back Air India (which is one of the major players) is expected to improve service, reach and profitability significantly. 

With lockdowns opening up, domestic travel is likely to drive demand. IndiGo is back at 80% of its operating capacity and India is all set to reopen borders, allowing tourists. 

Ace investor Rakesh Jhunjhunwala backed Akasa Air, expects to start flying next year. Subject to a few more clearances, the experienced management team is all set to launch this low cost carrier.

Govt Initiatives

The government is showing some kind of support, too. Lowering the custom duty from 2.5 to 0 on component parts and its aim of building 100 airports by 2024 (under the UDAN Scheme), the government promises to invest $1.83 billion to develop infrastructure by 2026.

Invest

An investor should remember that the market dynamics of this industry would allow only a few players to be profitable at a time. 

Focusing on experienced market leaders would be the best thing to do. But keep an eye for new innovators that have potential for disrupting the space.

One more thing to remember is that while analyzing revenue for such companies, those companies offering leases on their aircraft may report large revenues which do not come from regular operations and may not be consistent. This may lead to valuations quite in excess of book values.

An airline that focuses on excellent customer service would be preferable any day.

The capital goods industry such as metals is also expected to do better if demand for airplanes increases. 

Analysts recommendations for stocks that would most benefit from the boom of this industry are:

In a nutshell, 

Success of the industry lies in collaborative initiatives with public entities, with an approach to boost demand. With reduced costs, changing demographics and new entrants in the space, the industry can be one of the leading commercial aircraft markets in the world.