Aviation. Equity Research INDIA. International segment to offer value for domestic carriers

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Equity Research August 14, 2017 BSE Sensex: 31214 Limited is the author and distributor of this report Top Picks Indigo (BUY) TP: Rs1446 SpiceJet (BUY) TP: Rs150 Research Analysts: Ansuman Deb

1 Equity Research August 14, 2017 BSE Sensex: Limited is the author and distributor of this report Top Picks Indigo (BUY) TP: Rs1446 SpiceJet (BUY) TP: Rs150 Research Analysts: Ansuman Deb INDIA Aviation International segment to offer value for domestic carriers Reason for report: Sector update The second edition of Economic Survey (ES) for , one of the most important policy guidebook for India, released in August 2017 have given a special emphasis on Indian aviation. The main focus has been on the low Indian ownership (38%) of the international air traffic emanating to and from India. Apart from fact finding to suggested prescriptions, ES has highlighted the need to repatriate some of the lost international market share from foreign to domestic carriers. We have outlined the key highlights from ES below. One of the most important takeaway remains that the Government is clear about reforming Air India and divestment is one of the prominent options on the table. The concerns expressed by ES with the International air segment, especially its low ownership among Indian airlines, exploitation of the 6th freedom of the air by Middle Eastern airlines to capture an ever increasing Indian traffic, unused bilateral rights of Indian airlines are some of the very arguments which were given by InterGlobe Aviation (IndiGo) in its bid for the international operations of Air India. The method to regain equitable market share for domestic carriers in the international air segment of India can be through policy measures or through organic growth (Like Go Air, Air Asia and Vistara) or through divestment of Air India among other airlines. The views of the ES and its recommendations are harbingers of positive policy action in this regard for Indian airlines. We do believe that substantial economic value can be transferred from the Middle Eastern airlines to Indian carriers in the process. IndiGo, which has the strongest balance sheet and highest domestic market share is understandably interested to accrue some of this value through entering the low cost long haul market. Maintain IndiGo and SpiceJet as the top pick in the space. Highlights from the excerpt on Economic Survey (ES) on civil aviation: Civil Aviation emphasized by the Government as a sunrise sector. The ES has highlighted that civil aviation has the potential for becoming a sunrise sector of growth. The underlining constructs remain that of favorable demographics, a rising middle class population, high disposable incomes, and faster economic growth. Strong focus on improving Indian share of the total Indian international air traffic. The ES has strongly opined about the skewed state of Indian International air travel segment, where Indian airlines compose of only 38% of the total international segment capacity as measured by Available Seat Kilometers (ASK). This is low when compared with other countries as understood by the domestic share of the international segment of other countries. The examples given by the ES are Netherlands (61%), China (49%), and UK (49%). The ES states that---. In other words, Indian (domestic) airlines have not been able to carry out import substitution in the case of international air travel services to and from India. It is surprising that a bulk of Indian traffic (to and from) are serviced by foreign airlines Gulf followed by SE Asian carriers have the major share of Indian International air travel segment among foreign carriers. The share of Gulf carriers in Indian traffic increased from 27 per cent in 2008 to 33 per cent in The share of the South East Asian countries increased over two times from 5.9 per cent in 2008 to 12.3 per cent in Please refer to important disclosures at the end of this report

2 Aviation sector, August 14, 2017 ES has outlined some of the main reasons behind such lower share of domestic airlines in the international segment. Round Tripping of Passengers via international hubs of Dubai and Singapore. This has been made through utilization of the 6th freedom of the air and increase in capacity entitlements under Bilateral Air Service Agreements (ASAs). This is evident from the chart 1 below. Middle Eastern countries comprise almost 54% of the total international air travel destination of India. However, these countries are not the end destinations of all passengers. In fact, these countries are invariably being used as stop-overs/ hubs by their respective home airlines to carry passengers for onward destinations of USA, Canada, and Europe etc. This is the 6th freedom of air which allows foreign airlines to fly from a foreign country to another while stopping in one's own country. The 6th freedom has to a large extent been responsible for reducing the share of direct long haul flights for Indian carriers from 25 per cent in to 20.5 per cent in Table 1 shows the total number of passengers flown by foreign airlines to their respective countries segregated into point to point traffic (i.e. direct traffic between India and the foreign country), and the 6 th freedom traffic. The percentage of sixth freedom traffic for most of the Gulf and South East Asian airlines is greater than 50 per cent. For countries of Qatar and UAE, this figure is greater than 60 per cent. This large utilization of the 6th freedom in turn has been made possible due to expansion in capacity entitlements under Bilateral Air Service Agreements (ASAs). One Sided benefit accrued to foreign airlines from Bilateral Air Service Agreement. During 2003 and 2017, the capacity entitlements (seats per week each direction) between Dubai and India have increased 6 fold (Table 3). The same for Oman and Qatar have increased 9 and 12 fold respectively. While capacity entitlements are reciprocal in nature, the benefit of such increases in capacity entitlements has accrued more to the foreign partner Vis a Vis India. This is because India s utilization of these rights has been lower than the foreign counterparts (Chart 2). This is again due to the absence of big, efficient and profitable domestic airlines for most part of the last ~40 years. The 5/20 rule and Fleet Constraints. The 5/20 mandates that for an airline to carry out international operations, it needs to have 5 years of domestic flying operations and would have to deploy 20 aircraft or 20 per cent of total fleet of aircraft, whichever is higher, towards domestic operations. As a result of this rule, only three private airlines had been eligible to fly abroad Jet Airways, Spice Jet and Indigo. In 2016, the Indian Government had relaxed this rule to 0/20. It is expected that more private players will now take advantage of this relaxation and take to international flying operations, thereby contributing to increasing the share of domestic airlines in international operations to and from India. High share of narrow body aircraft among Indian airlines. Another constraint has been that majority of fleet of Indian airlines consists largely of narrow body aircraft and not wide body aircraft, which are required for international long haul flights. With the exception of Jet Airways and Air India, which have 22 and 44 wide bodied aircrafts respectively in their fleet, all other Indian carriers have a narrow body fleet. 2

3 Aviation sector, August 14, 2017 Prescriptions to improve the share of Indian airlines in the international segment. Divestment of Air India. There is a need for committed action plan on privatization/ disinvestment of the national carrier Air India to enhance its operational and management efficiency because it is a major carrier of international traffic to and from India, accounting for 11.4 per cent of the total international travel. The recent announcement of the Government towards privatization of Air India is a well thought out decision. Need to reconsider 0/20 rule. There is need to reconsider the 0/20 rule so as to allow private airlines to fly abroad. In return, private airlines can be mandated to fly to under-served airports in Tier 2 and Tier 3 cities in order to have greater regional connectivity (UDAN is a good initiative in this direction). This will be a much awaited move for airlines like Air Asia, Vistara. This can even propel many international airlines like Qatar to start off an Indian subsidiary in order to be able to use the unused bilateral rights. We do not think that this will be a good step unless the principles of Substantial Ownership and Effective Control remain undiluted. The Government may consider identifying major cities as aviation hubs because India is as advantageously placed in terms of geographic location as Dubai or Singapore. UDAN (Ude Desh ka Aam Naagrik), a key element of National Civil Aviation Policy 2016, is an innovative Regional Connectivity Scheme to supplement air traffic growth in regional aviation through a market based mechanism. UDAN provides few seats at affordable passenger fares of Rs. 2,500 for an hour-long flight. Under UDAN, 70 airports and 128 routes are connected, and over 100 more unserved airports are to be connected in the next rounds of bidding of routes. Chart 1: Destination wise breakup of Indian International air travel: Q1CY17 Source: DGCA 3

4 (%) Aviation sector, August 14, 2017 Table 1: Percentage of Sixth Freedom Passengers Carried by Foreign Airlines to and from India ( ) Total pax bidirectional (mn) (mn) (mn) carriage Point to point pax 6th Freedom pax % 6th freedom Name of Airline Country UAE Airlines* UAE Gulf Air (Bahrain) Bahrain Kuwait Airways Kuwait Oman Airways Oman Qatar Airways Qatar Malaysia Airlines Malaysia Singapore Airlines Singapore Thai Airlines Thailand Source: CAG, *UAE Airlines include Air Arabia, Emirates, Etihad Airways and Fly Dubai Table 2: India s Capacity Entitlements with Select Countries Seats Per Week Each Direction (Summer Schedule) (In '000s) Dubai(UAE) * Oman Kuwait Bahrain Qatar Saudi Arabia (seats) +DMM Open Sky# Singapore units^ plus seats@ Thailand Malaysia 7 (+1500 negotiable) 20.7@ Source: CAG & MoCA * However, thousand seats are the capacity entitlement for UAE (including, Dubai, Sharjah and Abu Dhabi) as a whole in 2017 # Open sky Agreement with Dammam city of Saudi Arabia as per which only India Airlines can fly unlimited seats to Dammam ^ 1 unit = Destinations with unlimited seats on particular cities as agreed upon in the Bilateral ASAs Chart 2: India s & Partner Country s Utilization of Capacity Entitlements (2017 Summer Schedule) Foreign India Qatar Oman Thailand Dubai Kuwait Bahrain Source: MoCA 4

airlines and its share Chart 4: Total international traffic of India and its growth Price chart InterGlobe Aviation* SpiceJet Jet Airways

5 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Apr-17 Jun-17 Aug-17 Aug-14 Feb-15 Aug-15 Feb-16 Aug-16 Feb-17 Aug-17 Aug-14 Feb-15 Aug-15 Feb-16 Aug-16 Feb-17 Aug-17 (Rs) (Rs) (Rs) Aviation sector, August 14, 2017 Chart 3: International traffic carried by Indian airlines and its share Chart 4: Total international traffic of India and its growth Price chart InterGlobe Aviation* SpiceJet Jet Airways *Note: Listed on November 10, 2015 Source: Bloomberg 5

6 Aviation sector, August 14, 2017 In case of industry/sector reports or a report containing multiple stocks, the rating/recommendation for a particular stock may be based on the last released stock specific report for that company. This report may be distributed in Singapore by, Inc. (Singapore branch). Any recipients of this report in Singapore should contact, Inc. (Singapore branch) in respect of any matters arising from, or in connection with, this report. The contact details of, Inc. (Singapore branch) are as follows: Address: 10 Collyer Quay, #37-16 Ocean Financial Tower, Singapore , Tel: and navneet_babbar@icicisecuritiesinc.com, Rishi_agrawal@icicisecuritiesinc.com. "In case of eligible investors based in Japan, charges for brokerage services on execution of transactions do not in substance constitute charge for research reports and no charges are levied for providing research reports to such investors." New I-Sec investment ratings (All ratings and target price refers to 12-month performance horizon, unless mentioned otherwise) BUY: >15% return; ADD: 5% to 15% return; HOLD: Negative 5% to Positive 5% return; REDUCE: Negative 5% to Negative 15% return; SELL: < negative 15% return ANALYST CERTIFICATION We /I, Ansuman Deb, MBA, BE; Research Analysts, authors and the names subscribed to this report, hereby certify that all of the views expressed in this research report accurately reflect our views about the subject issuer(s) or securities. We also certify that no part of our compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or view(s) in this report. Analysts are not registered as research analysts by FINRA and are not associated persons of the Inc. 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