India's Airline Industry Consolidates, but Change Is Still in the AirPublished: April 17, 2008 in India Knowledge@Wharton
Economic reality is reshaping India's airline industry. Just a few years into a third wave of private operators, the high cost of fuel has led to a number of mergers, including a high-profile agreement to combine Indian Airlines with Air India. Other issues, including infrastructure constraints, increased competition, and wage inflation, have left low-cost carriers, such as Sahara and Air Deccan, with no alternative but to merge with larger airlines.
But the turbulence is likely to continue, as new carriers enter the fray to fill the gaps left by consolidation. And for the newly merged entities, the struggle has only begun, as the usual issues that accompany post-merger integration -- along with some that are particular to the airline industry -- come into play.
The industry has had a storied past in India, beginning in the early 20th century when a host of private airlines tried their luck. Chaos reigned in the absence of workable regulations, and in 1953, a few years after independence, the airlines were nationalized and merged to set up two flag carriers -- Air India for international operations, and Indian Airlines for the domestic sector.
The private sector wasn't allowed to reenter the arena until the early 1990s during the first flush of economic liberalization. Several promoters, including ambitious chicken farmers and individuals with underworld connections, took to the air. Most crash-landed, and a government in reform mode refused to bail them out. While the chicken farmers went back to their birds, others met a sorrier end: Takiyuddin Wahid, managing director of East West Airlines, was shot and killed in his Mumbai office. The airline collapsed.
A new crop of airlines has sprung up in the last few years. Deccan Aviation, India's first low-cost carrier (LCC), began operations in 2003. SpiceJet, also an economy carrier, took wing in 2005. Kingfisher Airlines, headed by the flamboyant liquor baron Vijay Mallya, started the same year. Other newcomers include GoAir and Paramount, while East West and another old-timer, ModiLuft, have returned.
It didn't take long for the shakeout to begin. In April 2007, Jet Airways took over Air Sahara for Rs. 1,450 crore. (Both of these second-wave companies started operations in 1993.) Kingfisher acquired an initial 26% stake in Air Deccan for Rs. 550 crore. (Mallya has subsequently paid more to increase his holdings.) And in the mother of all mergers, the government-owned Air India and Indian Airlines have joined to form the National Aviation Corporation of India Ltd. (NACIL).
More deals may be in the works. "We are open to buying out smaller domestic carriers," Naresh Goyal, Jet Airways' chairman, said at a recent news conference. Kapil Kaul, Indian subcontinent head of the Centre for Asia Pacific Aviation, noted the effect of significant internal and external changes in the last four years. "Mergers were the only options left for many airlines," he said.
The main reason for the consolidation is economic. Both Deccan and Sahara were low cost carriers, and with the rising cost of fuel there was no way they could make a profit. Mergers with full-service carriers such as Kingfisher and Jet Airways were the alternative to closing shop.
A 'Relentless Focus on Reducing Costs'
"Deccan was founded on the simple but grand vision that every Indian must fly," CEO G.R. Gopinath said. "To achieve this, it was imperative to have a ruthless and relentless focus on reducing costs through eliminating everything that was not essential but without compromising on the fundamentals like safety and schedule integrity."
Reality didn't support Gopinath's vision. "Price inclusivity alone is not enough," he said. "It is also very important to be inclusive from a geographical point of view. The infrastructure constraints in different cities mean having different aircraft for different geographies, which goes against the very fundamentals of the LCC (low cost carrier) business model. So, geographical inclusivity also meant increasing complexities by way of inventory management, logistics and maintenance."
When airlines add aircraft and routes, Gopinath added, "it affects the cash flow and the profitability in the short run because any new route takes six months to one year to become profitable. It is also a socioeconomic reality that for any new service or product, it takes some time for a consumer shift to happen.
"These were all challenges that we were aware of from the very beginning, but they did impose a huge strain on our resources," Gopinath said. "In addition, there were issues of infrastructure constraints, increasing fuel prices, wage inflation and excess capacity because of a whole lot of new players who came on the scene after Deccan."
The merger gives Kingfisher obvious economies of scale. It also provides an advantage peculiar to the Indian environment. Airlines must complete five years in the domestic market before they can fly the more lucrative overseas routes. Through the Deccan merger, Mallya hopes to get permission for international flights earlier than he would for a standalone Kingfisher. "That the merger would allow Kingfisher to use Deccan's license to start international operations was a major factor, but it was not the most important factor," Gopinath said.
Kingfisher says the merger -- which awaits formal court clearance even as operational integration has begun -- has helped in many ways. Synergies have helped cut costs. Greater passenger volume has allowed for the airline to renegotiate agreements. Schedule integrity has improved.
The story is the same at Jet Airways, which was India's largest domestic airline by far before the Kingfisher-Deccan combination. It still is, but by a slim margin. According to figures from the Directorate General of Civil Aviation, Jet and JetLite (the new avatar of Sahara) had a market share of 29.9% as of the end of December. Kingfisher-Deccan had 29.3%. Indian Airlines had just 19%. (As standalone entities, Jet, Deccan and Indian all lost market share.)
An Inevitable Combination
While the Jet takeover of Sahara set the consolidation ball rolling, the Indian Airlines-Air India merger attracts the most attention. The combination was inevitable considering that domestic carrier Indian Airlines was losing market share year after year. The merger, originally blocked by the late Prime Minister Rajiv Gandhi more than 20 years ago, was a long time coming.
Raghu Menon took over as chairman and managing director of Air India on April 1. (Though the company is registered as NACIL, it will be known as Air India.) To Menon falls the job of seeing through the two national carriers' integration process. "There is a lot of work to be done," he said. "I have to take everybody on board."
His first challenge is to put the organization's financial house in order. In 2006-07, Air India lost Rs. 448 crore and Indian Airlines Rs. 240 crore. The results for 2007-08 are not yet ready, but Menon acknowledges that the losses could be higher. Analysts say the combined entity, in its first year reporting as such, could end up Rs. 1,400 crore in the red. A sale-and-leaseback deal for eight aircraft late in the financial year should stem the red ink a bit -- a common but only temporary fix.
The financial situation is likely to become worse before it gets better. The airline has placed orders for 111 aircraft from Boeing and Airbus; 31 have arrived. They have been financed through loans from the Export Import Bank of India and the market, and interest payments will take a toll.
The other big burden on Air India -- and all airlines operating outside country -- is the high price of air turbine fuel. "ATF accounts for 40% of our costs," Menon said. According to the Federation of Indian Airlines, a lobbying group, ATF prices are 70% to 95% higher in India than in other places for domestic operations. For international operations, prices are some 30% higher. "Fuel costs are an issue that can plague industry profitability," said Charles Dhanaraj, professor of management at the Kelley School of Business at Indiana University.
Plans to take Air India public have fallen through. "Our balance sheet won't allow it," Menon said. Instead, the company will turn to the government. Whether it will seek an equity infusion or debt has not been decided. Jet Airways, meanwhile, postponed a Rs. 1,600 crore rights issue last month for the third time and is looking for other funding options. "We will go to the market when conditions improve," Goyal told an early April news conference.
The Proof Is in Execution
The market may bounce back soon. But what about the airlines? In 2006-07, the domestic carriers had combined revenue of Rs. 15,000 crore and losses of Rs. 2,000 crore. With these numbers, consolidation has become an imperative.
Yet what looks good on the drawing board is not necessarily easy in execution. "The success of any merger depends entirely on the sensitivity and the maturity with which the management handles it," Deccan's Gopinath said. "Mergers will succeed when the managements know what to synergize and what to leave alone. It has to be done with sensitivity, intelligence and commitment."
Consider Air India's other challenges. A loss of Rs. 448 crore recorded by the international carrier in 2006-07 was mainly because of a Rs. 425 crore payment of salary arrears. At Air India's domestic counterpart, Indian Airlines, similar arrears are being negotiated. In the run-up to the merger, Indian Airlines ground staff went on strike over the issue last June.
The trade unions said they didn't stand in the way of the merger because they expected that their arrears (from January 1997) would be cleared. They weren't. That has caused some alienation, which is compounded by the fact that there are more than 15 unions in the organization, all with separate representatives.
While the salary structure is quantifiable, the problems of corporate culture are more difficult to get a handle on -- at Air India as well as the other alliances. As Deccan's Gopinath explains: "The merger does have a lot of inherent challenges because the business models of Deccan and Kingfisher are completely different and, therefore, have distinctly different cultures. Kingfisher has the mind-set of a premium service provider, whereas we have a low-cost culture. As the two brands cater to very different segments, it is essential to have very distinct, separate identities for both. At the same time, one needs to create a certain emotional bonding between the employees for them to feel part of one organization."
Kingfisher's Mallya wants to de-emphasize the "Simplify Deccan" brand and its low-cost aspirations, but Gopinath is still fighting to maintain his company's identity. The Economic Times recently ran this headline: "Branding snag likely to end Mallya-Gopinath honeymoon."
At Jet-Sahara, a first merger attempt was aborted with both sides threatening to sue. Acrimony reached such heights that observers felt there was no way to repair the deal. When the deal was finally signed, Sahara ended up as the "lite" version of Jet in more ways than one: Little of the old airline remains.
At Air India, Menon agrees that integration is a priority. But some things simply cannot be done. For instance, pilots and ground engineers of one airline cannot move freely to the other. They get licenses for specific aircraft and cannot jump to another without extensive training. "Indian Airlines' biggest aircraft is smaller than Air India's smallest aircraft," Air India executive director Jitendra Bhargava pointed out. Pilots and engineers existed in silos within Air India; they will live in a larger number of silos in the new organization.
Menon and Bhargava are banking on the infusion of new aircraft into the fleet. "We have suffered from an image problem because our planes were very old," Menon said. "Today, some of our flights --Mumbai-Delhi or the new nonstop flight to New York -- have only new aircraft. Ask anybody who has traveled by them. This is the real Maharaja service." (The Maharaja is Air India's popular mascot.) The image revamp is also being aided by the new, private airports coming up in India.
Menon expects the new organization to benefit from a hub-and-spoke system being put in place. Indian Airlines will carry passengers from various parts of India to Mumbai, where they will be transferred to Air India's international flights. Air India is also joining the Star Alliance, a network of international airlines.
Joint ventures are being set up for maintenance, repair and overhaul, and ground handling facilities. These will be offered to other airlines and bring in some revenue.
Another big issue is external to the company: the growing competition in the skies, which sparked the consolidation and shows no sign of abating. As Dhanaraj of the Kelley School of Business explains, "Indian commercial aviation is still in its infancy. Deregulation started only in the late 1980s and only over the past decade has it really taken off. Traffic demand in the primary corridors -- Mumbai-Delhi, for example -- tends to be very high and intense. In the secondary corridors -- Calcutta-Bhubaneswar, for example -- it is still erratic. Over the next decade, as new airports develop and airlines learn to manage the scheduling process, things should take off even more dramatically.
"The interesting competition in India is not only among the different airlines, but also between airlines and the railways," he added. "The railways are trying to increase their speed and efficiency and, if they can ramp up, they will give stiff competition to the airways, particularly for short-duration flights."
"I am not afraid of competition -- I welcome it," Menon said, adding that it will help Air India become more efficient. Meanwhile, new airlines are springing up in the domestic arena to compensate for the reduced number of players that consolidation has brought about. The older companies are foraying abroad, even to the West Asian routes (there are 5.5 million Indians in the Gulf) that have been so profitable for Air India. And foreign airlines are landing in the country in ever-increasing numbers.
Every industry faces competition. What's so different about civil aviation? "The airline industry still remains glamorous in spite of the high mortality rates," Dhanaraj said. Adds Gopinath: "The glamour quotient of the industry does attract entrepreneurs and investments. But that alone cannot create a successful business."