In the past two years, the Indian aviation industry has seen several casualties. Air Deccan was swallowed by Vijay Mallya’s Kingfisher Airlines. Air Sahara fell prey to Jet Airways. And domestic national carrier Indian Airlines was merged into its international counterpart Air India in a government-ordained shotgun marriage.

Now, a second round of consolidation seems to have gripped the industry, particularly in the budget segment. The Wadia group, the promoters of low-cost carrier GoAir, is reported to be looking for a fresh infusion of funds. According to The Times of India, the Wadias are in an “advanced stage of talks to sell a substantial stake in the airline, which has already reduced its flights to cut down on losses.”

There is more action at SpiceJet, which like GoAir is a low-cost carrier. Its two largest shareholders are the UK-based Kansagra family (12.91%) and Dubai-based investment firm Istithmar (13.42%). Mallya is negotiating with both of them to acquire their stakes. Others in the fray to take over the ailing airline include the Madurai (south India)-based Paramount Airlines and an unnamed U.S.-based distressed asset fund. (Kansagra group chief Bhupendra Kansagra says he has no plans to exit.)

The joining of SpiceJet and Kingfisher would change the pecking order in Indian aviation. Jet Airways has been the market leader so far, with Kingfisher clocking in at number two, following its acquisition of Deccan. Now, with SpiceJet contributing its 11% marketshare, Kingfisher will vault to the top with 40% plus.

Yesterday, these low-cost carriers might have competed against the world. Today, they are breakfast for passing predators. What’s gone wrong?

“The biggest problem facing the industry today is, of course, the fuel price hike,” says Air Deccan founder G.R. Gopinath, who is no longer associated with the company after having sold out to Kingfisher’s Mallya. “But this is a problem of not only the aviation industry but also a national and international issue.”

“The present fuel crisis has accelerated this consolidation within the industry, but we would have fundamentally expected it,” says Wharton management professor Saikat Chaudhuri. “Whenever new markets open up there is a flood of new entrants, and after a few years there is a shakeout. Some go bankrupt and others are bought.” He recalls the first wave of privatization of the Indian airline industry in 1991 that claimed new entrants such as ModiLuft and Damania Airways, while others, such as Jet Airways, established themselves.

The turbulence in the Indian civil aviation industry gets more complicated, according to Chaudhuri, because the market is “very price sensitive” and the low-cost carriers fuelled much of the growth. “All those [passengers] who shifted from trains to planes will go back to trains,” he says, noting that Indian Railways has in recent years decreased fares on some routes, left some unchanged and only marginally increased them in other instances.

Charles Dhanaraj, associate professor of management at the Kelley School of Business, Indiana University, says, “Aviation fuel is one of the problems, although a major one. But it is a common problem across competition.”

Talk to the airlines themselves, however, and they will tell you that aviation turbine fuel (ATF) is the killer. “ATF is taking a heavy toll,” says Jitender Bhargava, executive director of communications for Air India.

The high cost of ATF is, of course, an international problem, given the way crude oil prices have been galloping. Bhargava points to the International Air Transport Association (IATA) global industry financial forecast for 2008, which has been revised to a loss of $2.3 billion against the earlier projected profit of $4.5 billion. The forecast uses a consensus oil price of $106.5 per barrel crude (using the “Brent” classification). Crude for August settlement has crossed $145 a barrel in London trading. So, bigger losses may be in store. According to IATA, if oil holds at $135-plus a barrel for the rest of the year, the losses could climb to $6.1 billion.

Chaudhuri observes that airlines in the developed markets are responding in varied ways to the fuel price increases. He says European airlines, too, are bleeding, “but they are in better shape” as they are focused on intercontinental and premium traffic and not on low fares. The relative strength of the Euro against the U.S. dollar also provides European airlines some insulation from oil price increases.

The U.S. airlines “are truly in trouble,” unlike their European counterparts, says Chaudhuri. “They have been trying to emulate the low-cost model and shift more to international operations, but it is not a geographically natural option as in Europe.”

Levies and Losses

Things are more critical in India, particularly for the low-cost airlines. The problem is with the levies. The government has long treated flying as a luxury and the taxes on ATF have reflected that.

The cost of ATF has tripled in the past four years. It has gone up close to 70% in the past five months from $1 per liter to $1.70 per liter in India. By comparison, ATF today costs around $1 per liter around the world, and marginally less in places like Dubai and Singapore.

The reason for this increase is government duties and the margins of the oil marketing companies. The latter are unlikely to willingly cut their share of the pie as they have to partially subsidize other petroproducts. The central government did cut the customs duty in early June from 10% to 5%. But, by 1 July, oil companies had to raise prices of ATF by 7% to reflect international rates. This brought things back to square one.

If all the levies (not including the oil company margins and mark-ups) are put together, the total is nearly 35% of the final sale price. A good component of this is the sales tax charged by the state governments. This ranges from 4% in Andhra Pradesh to 30% in Gujarat.

The central government has appealed to the states to reduce the sales levy. But only a couple — such as Andhra, which brought down the tax from 33% to 4% — responded. Most of the other states say they see no reason to “subsidize” air travelers.

ATF accounts for close to 45% of the operating costs of Indian carriers, against an expected 34% for the global industry in 2008, according to IATA figures. The IATA data shows that the corresponding numbers for 2006 and 2002 were 29% and 13% respectively. “IATA has painted a gloomy picture if ATF prices continue to rise,” says Bhargava of Air India. “What will be the eventual scenario remains to be seen.”

Air India is not a listed company. (Its plans for an initial public offer have been put on hold in the current environment.) So, its results for 2007-08 are still not out. Analysts, however, estimate that it will show a loss of around $500 million. Last year, it had ended $167 million in the red.

Air India is not the only aviation company in financial trouble. SpiceJet lost $30.8 million in the year ended March 2008. Jet Airways saw a loss of $58 million. If you add to that Air Sahara, which was taken over last year, the losses mount to $150 million. Air Deccan chalked up losses of $149 million in the nine months to March. (The company has a June year ending.) According to the government’s own estimates, this year could see the Indian aviation sector losing $1 billion, which could go up to $2 billion in 2008-09.

The central government is aware of the problems. Apart from the duty cut, it is considering giving permission to Indian airlines to start international operations earlier. According to present norms, a domestic operator must have a track record of five years before it can fly abroad. International routes are more lucrative partly because aircraft can tank up abroad on cheaper ATF. They are also provided ATF in India itself at a cheaper rate. The union minister of state for civil aviation, Praful Patel, has also urged airports to reduce their landing and other charges to help bail out the airlines.

However, not everybody in the government thinks that the airlines are mere victims of circumstances. “The airlines complaining today are themselves the babies of this (Open Skies) policy,” civil aviation secretary Ashok Chawla recently told morning newspaper Daily News & Analysis. “They were left free to decide the revenue model, capacity addition etc…. The airlines should have studied global trends before creating capacities. No one expected continued 35-40% growth; nowhere in the world is growth in aviation more than twice the GDP growth. Today, excess capacity is almost 20% which is pretty high. Then, growth also happened because of undercutting; fares were kept unrealistically low and everyone continued to lose money. And despite our efforts, not all state governments have agreed to cut taxes on ATF so airlines have to look at realistic pricing.”

Chaudhuri argues that the problems facing Indian airlines are unique, in that they have been paying about 50% more for fuel than airlines in the west, because of higher taxes. “If the government were to create a level playing field on taxes they could bring [the Indian airlines] on par with global levels,” he says.

That fact also reveals a greater resilience to oil price shocks among Indian airlines, notes Chaudhuri. As oil prices rose to $140 a barrel, the impact on Indian airlines was as if they were at $200 a barrel, he says. Before oil prices spiked over the past year or so, Indian airlines were bleeding, but that situation had more to do with the initial losses associated with building a capital intensive business, he says.

Chaudhuri adds that Indian airlines achieve savings on other fronts, especially on wages for pilots, flight attendants and others. He says the recent spike in pilots’ wages is a temporary problem attributable to a shortage of such talent. Those costs will decrease as the supply of pilots increases in the coming years, since the Indian government has recently increased capacity for pilot training. With slower capacity addition, or capacity reduction, the demand for pilots would also fall and enable the airlines to cut back on relatively more expensive expat pilots, he notes.

Gopinath of Deccan also feels that that the hardships are being somewhat exaggerated. “The current problems do not mean that the days of low-cost airlines are over,” he says. “It is perhaps the best opportunity for them to get their business into better shape. Low-cost airlines run on a completely different business model from the full-service airlines. The cost per available seat-kilometer of low-cost airlines is around half that of the full-service airlines. So even though the cost per seat may go up, the differential will still remain.”

Low-cost Survival

Gopinath feels that to say that low-cost airlines will close down because of the increase in fuel prices is like saying that the Udipi (cheap, mass market) or the Darshini (self service, no seating) hotels that serve idlis (a south Indian snackfood) will close down if the price of rice goes up. He points out that the lower cost of idlis in these hotels is not based on the one input of rice alone, but on the entire business model.

Dhanaraj of the Kelley School of Business says low-cost airlines will survive. But Indian carriers may have gone a little bit over the top when it came to promotions. At one stage, tickets were sold at 2.5 cents (Re1); the taxes and fuel surcharge were, of course, extra. It was cheaper to travel by air than by train.

“There is no free lunch,” says Dhanaraj. “It is okay to throw away a few seats for a zero price, if you can make it up by a higher price on other tickets. But if the airlines are to stay afloat, they need to cover the costs.”

Gopinath, the man who pioneered the zero-price ticket concept, has a somewhat different point of view. “The airlines are shooting themselves in the foot by increasing prices,” he says. “All the airlines are going at an average of 50% to 60% occupancy. If they can just stimulate demand and fill up the empty seats, it could reduce the losses considerably.

“Because of the increasing costs, the migration of people who travel by air may not happen at the pace at which it was happening earlier,” Gopinath continues. “It may not be as big a flood that Air Deccan created. But with only 2% of Indians travelling by air, there is still a great future for low-cost airlines. They are even more relevant today and in a better position [than the full-service providers] to cope with the rising costs.”

Route rationalization is an imperative for Indian airlines as they try to emerge from their current financial mess, says Chaudhuri. “You don’t have to have 45 flights a day between New Delhi and Mumbai — you have to bring some realism into it,” he says. He points to others that are taking similar steps: Thai Airways’ plan to discontinue its nonstop flights from Bangkok to New York, and Singapore Airlines converting its nonstop flights from Singapore to Los Angeles and Newark to higher-yielding business class.

“Route rationalization, fare increases and lower costs will make Indian airlines more efficient,” says Chaudhuri.

Low-cost and full-service carriers alike have taken steps to curb their losses.  Several are cutting down on routes and flights. They have also been forced to increase fares. “While the industry is trying to put an end to irrational pricing, airfares will now start impacting load factors,” says a report by broking house Prabhudas Lilladher. This is already visible in the growth rate. While passenger traffic had been growing at 25% to 30% the past couple of years, it is down to 10.5% in January-March 2008, according to civil aviation ministry figures.

“As airlines have been forced to increase fares and fuel surcharges, it has impacted load factors,” says Bhargava of Air India. “As a consequence of increased operating costs and reduced passenger load, Air India has taken a conscious decision to cancel some flights for a certain specified duration.” Industry-wide capacity is being reduced from 1,630 flights daily to around 1,450, a reduction of around 10%. The cuts are greater for low-cost carriers, which have slashed the number of flights by 14%.

“[Regarding] initiatives taken by Air India to reduce costs, these basically include reduction in the number of uneconomical flights operated; elimination of unwarranted travel by staff; and intimating travel agents of our intent to discontinue agency commission on tickets sold by them so that the global practice is extended to India as well,” adds Bhargava.

As a public sector organization, Air India cannot fire staff. Others have not had such inhibitions. All the airlines — particularly the low-cost carriers — have been trimming their employee numbers. The numbers are not clear on this front, but industry estimates that around 5% of the staff (including pilots) has been given marching orders. Expat engineers and pilots have faced the brunt of this downsizing. First, they are more expensive that their Indian counterparts. Secondly, they make much less noise when they are asked to go.

Airlines are also looking at other options for sourcing ATF. Mallya has been talking to Mukesh Ambani’s Reliance Industries for direct import. This will take the fuel out of the state sales tax net. But this has operational problems, particularly in infrastructure. And the states are unlikely to easily give up this source of revenue.

Chaudhuri says that while Indian airlines may go slow on their international route expansion plans, many of them are keen on entering the Gulf (or Middle East) sector because it would give them access to lower cost fuel. “In fact, some are even considering a technical halt in Middle Eastern countries to tank up on fuel to reduce their fuel bill,” he says. They are, however, hesitant about that because they feel passengers may not relish such technical halts. Air India is also considering using the polar route between New Delhi and New York as the shorter flying time would save fuel costs, he adds.

Optimism amid the Clouds

One exception to the current gloom-and-doom scenario among Indian airlines is Paramount Airways, which is an all-business-class airline. It is expanding operations, while others are cutting back. As managing director M. Thiagarajan told The Times of India: “True, we are all in the same boat, but my operations are better insulated than others. I am able to increase fares and yet maintain market share and high loads, which most operators are unable to.” In times of trouble, it may be better to turn to the classes rather than the masses.

Paramount is not the only sign of hope. Even as the storm clouds seem ready to engulf the sector, international accounting and consulting firm KPMG has seen a silver lining. A recently-released report — “Indian aviation: Flying through turbulence” — says that ATF price hikes can hurt the industry, but not kill it. Even weak and beleaguered individual carriers can ride out the storm if they concentrate on the right things.

“India operates one of the youngest fleets in the world and with new and more efficient engines, airlines gain from low fuel burn and improved operating efficiencies,” says the report. “The advantage accrued from a new aircraft fleet presents immense saving, which in turn leads to achieving breakeven faster.”

The report adds that domestic air travel can be adversely influenced by epidemic outbreaks, economic recession, terrorism, shift in policy, regulations and competitive market, but not by a rise in oil prices.

According to KPMG, airlines should set up an early warning mechanism to identify both low-yield and high-yield routes. These could sometimes be seasonal and the companies should be willing to juggle schedules. They should also cut costs where they can.

Gopinath of Deccan points to another area where savings can be made — at the airports. “Our airports are inefficient,” he says. “They need to cut their costs and pass on those lower costs to the airlines. They are simply adding profits to their costs. The cost-plus culture is what the government has not been able to get rid of. The government has done a great job in privatization but it has done a horrible job in creating private sector monsters. There are great airports but, as they are monopolies, the costs are still very high. The short-term solution is that all stakeholders must work at bringing down costs, stimulating demand and increasing volumes. It is self defeating for anyone to build a model that cannot grow.”

Dhanaraj agrees. “I think the issue that airlines cannot address on their own is the airport facility. Unfortunately, it takes a few weeks to get a plane and put together an airline business, but years to get an airport up and running. This is what I think may choke the industry. Airlines forming an infrastructure partnership with the government and other private agencies may help to overcome this.” Dhanaraj adds that the wage bill needs greater attention. “Keeping the wage structure flexible and manageable is key,” he says. “Most of the Western airlines went overboard on wages in the early phase and are now trying to go all the way down.”

But he remains optimistic. “I think the future for the industry is positive and bright,” he says. “We will see new innovations in India that may spell breakthroughs for the global aviation industry.” Echoes Gopinath: “Despite all the current problems, I am very optimistic about the aviation industry. The Indian economy is vibrant and, if it has to grow, so does this industry. It cannot be one without the other.”

The KPMG report points out huge investments have gone into fleets and support facilities. The breakeven period is a minimum of five-seven years. “Since a majority of India’s airlines are today in their third or fourth year of running, it becomes near to impossible for breakeven to occur any time before 2009 or 2010,” the report says.

Chaudhuri feels Indian airlines will find themselves in better shape sometime next year, and that their cost savings will more than offset any decrease in demand for airline seats. “The industry’s growth rate has been 35% to 40%; we will get to more reasonable levels like 10% to 15%,” he says.

Over the next couple of years, Chaudhuri sees three major airlines emerging from the rubble: a merged Air India-Indian Airways; a merged Jet-Sahara and Kingfisher Airlines merged with SpiceJet or some other airline. He also sees some niche players like Paramount Airlines and regional operators surviving. “In the airline industry, the best you can get to is an oligopoly,” he says.