Earlier this month, Boeing announced a $1.5 billion order for 10 aircraft from Jet Airways, India’s largest private airline. Jet Airways currently has 60 aircraft and is expected to increase that number to 90 in two years. Such rapidly growing airlines are where manufacturers like Boeing and Airbus are filling their orders these days, tapping into a civil aviation boom in both India and China.

Although it is starting from a low base, India’s civil aviation passenger growth stands at 20% — among the highest in the world — saturating most metro airports and a handful of fast-growing smaller cities. Many airlines are bulking up on capacity as well: Ten Indian carriers recently placed orders for about 400 aircraft worth $15 billion. But this good news is marred by looming overcapacity along with the fact that, given new competitive pressures, most airlines are losing money. India Knowledge at Wharton spoke to the heads of some of these airlines, senior officials of aircraft makers and Wharton faculty to visualize the flight path ahead for Indian aviation.

India’s civil aviation market has been severely underserved for several decades. Less than 0.01% of the population used air transportation and, until last year, this country of over a billion people had only 150 large jets. But in the past few years, a rash of new low cost carriers has been tapping into the growing passenger traffic. Meanwhile, India’s strong economy in recent years has lifted people’s disposable incomes, while increasing urbanization. In addition, more diverse business investments in non-metropolitan regions have brought new demand for air services. “The opening up of the skies had led to similar boom situations in other markets, like the United States in the 1980s and Europe in the 1990s,” says Dinesh Keskar, vice-president of sales at Boeing.

Airsickness at Higher Altitudes

Keskar, who has been selling aircraft to airlines in India for nearly two decades, follows the market very closely. While the current boom should translate into orders for Boeing aircraft, he is concerned that the growth in seat capacity today is much higher than demand would justify. Airlines are undercutting each other to grab market share at the cost of profitability, he says. “This is an okay strategy for a few days or weeks, but it will not help them in the long run. This is what we are a little concerned about.” In earlier years, he adds, while the yields were low for the Indian airlines, they at least had high loads. In the current scenario, even loads are dropping.

“It is wonderful that India is getting all these planes, and we as manufacturers are happy,” says Keskar. “But we would obviously be happier if [the airlines] don’t incur losses.” Yet Boeing, he says, remains bullish on the longer term potential for India’s civil aviation industry. India’s air passenger traffic grew last yearsome 20% to 52 million, up from 43.4 million in the year before.

Despite this growth, Indian civil aviation’s numbers are still small in absolute terms compared to larger international markets. China’s total air passenger traffic was expected to be 160 million in 2006, and is forecast to grow to 187 million in 2007, according to a report on the China Daily website. The total fleet size of all commercial aircraft in India is now about 263 compared to roughly 8,000 in the U.S., according to aviation industry databases. China’s aircraft fleet is expected to grow to about 1,000 in 2007 with the addition of 155 planes currently on order, China Daily reports.

Many of the Indian airlines are facing severely eroded pricing power due to increased competition and investments in additional capacity, and almost all the airlines are currently incurring losses. “This is a typical prisoner’s dilemma: Airlines add capacity and have to fill the planes and lower the fares to do so,” says W. Bruce Allen, Wharton professor of business and public policy, and director of the Wharton Transportation Program.

Even as the airlines are battling over their discounting strategies, the chiefs of all the large carriers met with India’s ministry of civil aviation in mid-2006to try and find a way out of their depressed profit margins. A few of the airlines, particularly the legacy carriers, had hoped the ministry would step in and control fares or put in entry barriers for newer entrants to prevent a bloodbath in the marketplace. The government has refused to intervene and has, at least for the present, left the airlines to their own devices. However, media reports say the government is now asking all new airline promoters to submit detailed business plans and is checking out their financial soundness before granting approvals.

Meanwhile, full service airlines like Jet Airways, the government-owned Indian and Kingfisher are under pressure from the low fares being offered by no-frills airlines such as Air Deccan, SpiceJet and Indigo. Airline stocks have taken a beating on the Indian bourses, as pressure on yields combined with high fuel prices make navigation tough for the airlines. For example, for the latest quarter ending December 31, 2006, Jet Airways reported a 34% fall in profits at Rs. 40 crore ($9 million) over that in the corresponding quarter a year ago. Its revenues in the latest quarter at Rs. 2,030 crore ($456 million) were, however, 35% higher than the Rs. 1,499 crore ($337 million) in the year-ago quarter. The LCCs that posted losses include SpiceJet ($8.15 million loss on revenue of $87 million for the quarter ending November 2006), and Jagson Airlines ($237,000 loss on revenues of $1.9 million for the quarter ending September 2006).

The possible consolidation within the industry is a recurring topic of conversation, with many observers seeing no way out for weaker airlines except to be swallowed by those that are stronger. Jet Airways failed in its attempt last year to buy Air Sahara, although the possibility of such a deal still gets discussed. Will consolidation lead to stability within the industry? “Maybe, maybe not,” says Allen. “To some extent, you get to control the capacity more because your competitors have been merged into you. But if you then raise fares, new entrants will come in. The coming together of two loss-generating airlines can make a profitable carrier.” The USAirways-America West merger is an example “which seems to be working out,” he adds, noting, however, that “they were complements rather than substitutes.”

Peter Harbison, executive director of the Centre for Asia Pacific Aviation, a Sydney-based aviation think tank, has been a keen observer of the Indian airline industry for the past several years. He says consolidation “is not the answer, as the merger of two loss-making entities will not necessarily result in a profitable one.” The airlines are facing higher costs in the form of higher salaries, fuel and aircraft leases, he points out. Also, India is going through a shortage of trained pilots and almost every airline is hiring foreign pilots to operate their planes. “The challenge is to grow the yields to make business sustainable,” says Harbison.

To Regulate, or Not

Allen cites the case of the U.S. aviation industry to show the downside of government regulation. “In the U.S., some LCC’s have been successful, e.g., Southwest, JetBlue, AirTran — but many would-be LCCs have gone bankrupt, such as National, Independence and Hooters,” he says. “Legacy carriers have cut costs significantly and appear to be more successful. Capacity cuts and greatly increasing demand have even made them profitable, although it probably isn’t sustainable because of the prisoner’s dilemma.” If the government were to intervene and restrict capacity additions, he adds, that “would protect the less efficient carriers; it’s the reason we got rid of government intervention.”

Harbison agrees that government intervention and regulation could be counter-productive. “It took a while for the world to be convinced that India has finally opened up, and investor interest is currently very high,” he says. Instead of raising entry barriers that could send the “wrong signals” to investors, the Indian government should look at measures like the establishment of a “transparent competition authority” that could, for example, determine guidelines for airline M&As, he suggests.

Boeing’s Keskar suggests that the airlines look at uncharted territory for growth. “Secondary towns and cities are potential areas that are currently being neglected by these airlines,” he says. But that is not easily accomplished. India currently has seven large domestic airlines, each with a nationwide network served by planes that seat more than 100 passengers each. Government rules make it mandatory for airlines to service some unprofitable routes, too, such as the Northeast part of the country and some small towns.

However, many airlines own a single type of aircraft that doesn’t allow them to operate profitably to smaller cities. “Connections between secondary city pairs [sets of two cities that have significant air traffic between them, such as Mumbai-New Delhi or Bangalore-New Delhi] have not been explored enough,” says Keskar. Several of these towns have a population of over 5 million each and can be profitably connected to other cities, he says. “Gimmicks like Rs. 500 ($10) fares don’t work for long,” he warns.

Capt G. R. Gopinath, CEO of Air Deccan, India’s largest low cost airline, defends the low-fare strategy and says the objective is only to attract a whole new category of first time fliers. “We obviously don’t sell all the seats at very low prices,” he notes, adding that his airline has a yield management system that optimizes margins by selectively releasing seats at pre-determined prices. Unlike the past, when about 85% of fliers were business travelers, the traffic of leisure and VFR (visiting friends and relatives) passengers is growing steadily.

“We are not targeting existing passengers from other airlines,” adds Ajay Singh, director at the Delhi-based, low-cost airline SpiceJet. “It is the train traveler who today takes 24 hours to reach New Delhi from Mumbai.” SpiceJet has a fleet of 10 aircraft, and plans to increase that number and launch new metro to non-metro connections. Last month, India’s Tata Group, Goldman Sachs and two other foreign investors bought a 25% stake in the company for approximately $71 million.

When Costs, Too, Start Flying

Apart from the pressures of price wars and fleet acquisition debt, the airlines are also finding costs rising significantly for fuel, manpower and aircraft leasing. Staff costs at Jet Airways grew 107% in the April-June quarter of 2006 over those in the corresponding period a year ago.

“Almost all the major cost areas are up, but on the revenue side it is a downward slide,” Keskar says, adding that, unlike the U.S., Indian companies don’t enjoy Chapter 11 protection from creditors as they reorganize themselves: If they don’t pay up, they go under. “This will make market consolidation a reality instead of prolonging things,” he notes. The last round of consolidation in Indian civil aviation was about a decade ago, when several new airlines went bankrupt under the weight of overcapacity.

Much of the growth has come from first-time fliers who can now afford to fly. In Asia, the trend started just five years ago as a primarily Malaysian phenomenon, with the launch of its budget carrier AirAsia. Low-cost carriers have since sprouted up in Thailand, Indonesia, Singapore, the Philippines and Macau as governments have deregulated air transport. In Malaysia, the no-frills AirAsia now commands more than half the domestic market.

Even in India, despite the temporary setback in terms of profitability, most industry watchers remain bullish about long term prospects for the airline industry. Kiran Rao, vice-president, sales (India and Africa) at Airbus Industrie says the growth phase in Indian aviation will continue into the near future. Both Boeing and Airbus have revised their India forecasts in the past year. Among the most recent positive signals from the government is a decision to allow more foreign investment in non-scheduled operations, cargo airlines, helicopter services and seaplanes. That is likely to spur interest in these segments, where growth has tended to be sluggish.

The growth mood has traveled the entire aviation chain. Two of the country’s largest airports — Mumbai and New Delhi — were privatized earlier this year. Two greenfield airports are being built at hubs in the southern part of the country. Investments are pouring into almost all aspects of the industry, including aircraft maintenance, pilot training and air cargo services.