FDI in Aviation: Structural challenges to limit investments

India Ratings says that the government of India's recent decision to allow the foreign direct investment (FDI) limit in aviation up to 49% is expected to improve the capital structure of airlines with viable business models. The possible equity infusion would not only deleverage the sector but also provide funds for long-term growth. However, structural challenges may limit the attractiveness for such foreign investors at least in the medium term. 

In addition to equity infusion, stronger strategic and operational ties with foreign partners with stronger credit profile, may potentially improve the credit profile of domestic airlines. This may have a beneficial impact on the funding cost of this sector known for its high capital intensity.

While the long-term growth potential of the Indian market may draw interest from International Airlines, the continuing structural weakness and regulatory risks may increase the perceived risk in such tie-ups. Other key considerations of prospective JV partners would be the lack of majority equity control in addition to specific board constitution.

The key structural weakness of the Indian airlines industry is its higher operating costs, driven primarily by a higher tax on aviation fuel, compared with that of the other emerging markets. The cost of infrastructure development is also higher for the Indian industry which usually translates into higher airport usage charges. This is in addition to the currently limited airport infrastructure which acts as a bottleneck to significantly improve scheduling efficiency - which is a direct drag on operating cost. 

For the financial year ended March 2012 (FY12), EBITDA margin of three of the listed airlines ranged between 1% to negative 37%. In India, air turbine fuel (ATF) accounts for 40%-50% of the airlines' operating costs compared with a standard of 30%. This is mainly because of higher taxes on ATF at around 35%-40%.

The airlines customer base is dominated by corporate travel (which is comparable to a lot of other emerging markets). The household-level spending on airlines is usually limited to no more than top 10 percentile households and is majorly towards low-cost airlines. The high-cost structure of the Indian airlines industry would always keep airfares high relative to the income of even this top 10 percentile households. Besides, high availability of much lower cost substitutes (such AC III tier and AC II tier long distance trains), whose pricing may not always be driven by pure economic consideration, would to an extent limit the growth of domestic air travel market in the short to medium term.