View: Financing India's airline growth plans and why a rethink is required

The last decade has seen voluminous aircraft orders by India’s airlines. Collectively India’s airlines are flying a fleet of around 600 aircraft. Over 80 percent of this fleet is on lease. Add to this an aircraft order pipeline of 850 aircraft which needs to be financed and deployed. For weaker players without the backing of a strong parent or a balance sheet, deploying and financing these assets is slowly emerging to be a challenge. And with interest rates rising, the rupee depreciating and yields falling, some airlines are staring at a very real challenge. Namely, financing the growth. The old methods will not hold up. A rethink is required.

The sale-and-leaseback model was made popular by Indigo and driven by the three pillars of planning, volumes and pricing. Specifically, Indigo focused on two years of extensive planning including contingencies; a sizeable order of 100 aircraft in 2005 with several follow-on orders; and pricing on the asset that was expertly negotiated. Together, these helped the airline firmly establish itself in the India market. Other airlines soon saw evidence of this success and went ahead with their own large orders. But they focused only one or at best two pillars of the Indigo model. Sale-and-leasebacks were the primary method of financing the orders.

A sale and leaseback model (SLB) is where the airline acquires the aircraft at an attractive price and sells the aircraft to a lessor — ideally at a profit — and leases it back for its own use. The SLBs are important as they are cash generative and also help the airline with fleet flexibility. In addition, as the airline inducts new aircraft the operational costs — most notably the maintenance costs — remain competitive. Shorter fleet replacement cycles also enable the airline to induct new technology faster. But the flip side is that airlines are left with asset light balance sheets, over time they end up paying more for the asset. And where clauses are not fully provisioned for this leads to pain for both the airline and the lessor. This is a fact that is gradually emerging.

The late last decade saw an era of low interest rates, flowing aircraft orders and a very competitive leasing industry. With several new lessors eager to do business, airlines were offered very attractive terms without the credit strength that would normally be required. But unfortunately, this is just not the case with the industry today.

With changing macro-economic and geopolitical conditions, the aircraft financing market especially the sale-and-leaseback market has seen marked changes. Lessors are relooking at risk profiles and there is a flight to quality. Add to this the fact that the cost of capital across the globe is rising and within the aircraft leasing space, lessor consolidation is ongoing. In the India market, this means the stronger and well capitalised airlines are able to negotiate fairly competitive deals while the weaker ones struggle. Some airlines are staring at a scenario where aircraft have been ordered but other aspects such as maintenance, lease terms and asset recycling are not where they need to be. Competitive financing for these is just not to be found.

Even worse is the fact that because of balance sheet weakness, some airlines enter into financing arrangements including sale-and-leasebacks towards releasing working capital. Add to it the fact that the airline is then left with one additional aircraft to deploy and it is impacting yields across the industry. And thus the capacity and fare wars which are set to intensify in the near term at the cost of cash-flow and profitability. Calls on capital are all but certain.

As of this writing, structural issues including balance sheet strength continue to be overlooked. The pandemic laid bare the fault-lines and for lenders looking for assets on the balance sheet, they were few and far between. Thus came liens on cash-flow, promises of future funding and the continued deferral, delay, renegotiation and requests. And for some fault lines have never quite been addressed. This situation is untenable to say the least and only defers the inevitable towards some future date.

Looking ahead a diversification of funding sources is required. Both because the sale-and-leaseback without lining up all fundamentals continues to be a very expensive form of financing and also because management has to focus on balance sheets. Failing that, liens on cash-flow, emergency credit lines or at worst shutdown will be the norm not the reality. And any airline shutdown is very painful and the scars of the shutdown continue for years to come. Indeed, no discussion of Indian aviation is complete without a mention of Kingfisher and the erstwhile Jet Airways. Not to mention a host of smaller airlines that have come and gone.

Despite the narrative on traffic growth and market potential, when India’s airlines are viewed through the lens of profitability there are very few that make it through. Consistent profitability that delivers an adequate return on capital is found wanting. And with aircraft being the largest capital costs for airlines, these have to be planned for, negotiated and deployed keeping in mind the risks. All hopes cannot just be pinned on growth. Because when this growth stalls there are just no avenues for recourse.

As the market matures, aircraft financing is also set to evolve. Airlines are well advised to look at structures that enable them to have the right to the asset at the right costs and terms. Finance leases and asset purchases that were once shunned may very well be the way forward. Similarly, structures that are fit for purpose and designed for the Indian market with a view to market risk, currency risk and credit risk may are the way to go. But these require focused deliberate and decisive planning. And some managements find themselves so intensely involved in day-to-day fire-fighting that these fall by the wayside.

For Indian aviation, the demand is certainly trending right. And the capacity will follow. But that capacity needs to be financed. And financing India’s airline growth plans is a task in itself. And a rethink is required.