Airline sector is a tough bet

One easy way to understand the impact of crude oil prices is to look at airlines companies. In the period October-December 2018, the Indian crude basket averaged out at US $67.75/ barrel while it was at $59.89/ barrel in October-December 2017. 


InterGlobe Aviation, the company that runs India’s most profitable and largest airline, IndiGo, reported net profits of Rs 191 crore in October-December 2018 versus net of Rs 762 crore (this was Rs 1,071 crore before exceptional items) in October-December 2017. This was despite logging 28 per cent increase in revenues in Q3, 2018-19, along with higher other income and forex gains. Profitability was affected by higher fuel prices and by a weaker rupee as well. This is not surprising because fuel costs usually amount to about 40 per cent of total operating expenses.


IndiGo’s Q3 results were also a sequential improvement on the July-September 2018 quarter (Q2, 2018-19) when InterGlobe registered a loss of Rs 652 crore. The July-September 2018 quarter saw crude prices averaging out at higher $74.63/ barrel versus $51/barrel for Q2, 2017-18.


Spice Jet and Jet Airways did much worse than IndiGo in Q2 and they are also expected to struggle in Q3. However, lower crude prices in November and December after a peak of $80/ barrel in October may have helped other airlines limit their losses though Jet’s continued defaults suggest it is still deep in the red.


Aviation Turbine Fuel (ATF) prices were cut in early January and that would help all the airlines slightly in Q4. However ATF prices remain dependent on crude oil prices and crude oil prices have risen somewhat in mid-January as Opec production cuts have kicked in.


The legendary Richard Branson once said, “The quickest way to become a millionaire is to start with a billion and launch an airline”. As the promoter-founder of Virgin, he was possibly half-joking. Another legend, Warren Buffett once said, “If a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favour by shooting Orville Wright down.” (The Wright brothers built the first aircraft, imaginatively called the “Flyer” and made the first powered flight at Kitty Hawk, North Carolina, USA, in 1903). Ironically, Buffett himself now owns stakes in four different airlines so, he may have changed his mind.


Is InterGlobe worth a contrarian bet at the moment as the only “desert flower” in an industry that continues to look in bad shape? Valuations are reasonable and it should gain market share, if Jet and Spice implode. Assuming India’s economy continues to grow at reasonable pace, air passenger traffic should also continue to grow at double-digits.


Air India is an unknown quantity. The national carrier continues to lose money hand-over-fist and it has both a huge overhang of debt and a massive workforce. But so long as it is not shut down, it will continue being a retarding factor for the entire industry.


Air India has massive accumulated losses because it is not, and never has been, run on commercially viable lines. That also means it can do irrational things like deep discounting of tickets that may trigger another price war that ruins the market for every player. It is also apparent after the contortions of the past two years that no government is going to be comfortable offering AI for sale on terms that will make sense for any buyer. So Air India is very likely to carry on bleeding and playing spoiler.


Despite the apparent change of mind on Buffett’s part, the airline industry is a genuinely dangerous sector for investors. Crude oil is a tough variable to factor into expenses and high crude prices affect every airline. Occupancy, load factor and yield per km all rise for an airline when there’s lots of business activity. But crude oil prices also rise under those circumstances. In addition, India’s policymakers create problems for operators, given frequent policy changes and odd ideas on discounting, number of slots at airports, criteria for eligibility to run international operations, etc.


If you look at the broader picture, companies across many sectors reliably deliver good results, when crude oil prices are down. And of course, almost every industry outperforms airlines when crude prices are up. So there are few circumstances where airlines will outperform the overall market.

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