SpiceJet: Not a smooth flight

After losing ground in calendar 2016, the stock of low-cost carrier SpiceJet has come back roaring in 2017, more than doubling over the past six months. A few factors have aided this rally. First, a dip in oil prices and strength in the rupee over the past four to five months that could reduce the fuel costs of airlines.

Next, reports suggest that yields (average fares) that had been under pressure in FY-17 have been looking up. Also, SpiceJet placing big aircraft orders at the recent Paris Air Show helped the stock. So did the commencement on flights on the regional connectivity scheme (UDAN) routes. However, the stock slipped last week on an adverse ruling by the Delhi High Court in the share transfer dispute with the Marans, the erstwhile promoters of the airline.

Despite this fall, the stock is still trading close to its all-time highs. Meanwhile, the airline’s financial performance slipped in 2016-17 due to higher costs and lower fares.

Weak earnings along with the market rally has made the SpiceJet stock quite pricey. At ₹124, it now trades at more than 17 times the trailing 12-month earnings, as against the average of about 10 times in the past three years. Investors can sell the stock, given its high valuation and likelihood of the company’s earnings staying weak.

This is primarily due to huge capacity additions expected in the sector that could keep fares subdued. The cost benefits are also not a given in the medium-to-long term. Besides, the share allocation dispute with the Marans remains an overhang.

SpiceJet had swung from loss to profit in 2015-16. But like its peers, it had a difficult 2016-17 with profit declining 4 per cent y-o-y despite 24 per cent growth in passenger numbers. Sure, SpiceJet put up a better show than peers IndiGo and Jet Airways, which saw profit shrink 16 per cent and 64 per cent respectively in 2016-17.

But the key factor that impacted the sector last year — lower yields due to high capacity additions and intense competition — is likely to continue affecting all airlines, including SpiceJet, despite good growth in passenger traffic. Rating agency ICRA says that the Indian aviation industry added sizeable capacity during 2016-2017, reflected in the 19.6 per cent y-o-y growth in domestic available seat kilometres (ASKM). SpiceJet’s capacity addition was a higher 29 per cent.

These additions accentuated the intense competition and saw airlines cutting fares, rather than raising them, in response to higher costs, primarily ATF which rose steadily from the lows of 2015-16. The average fare of SpiceJet fell 2 per cent last year.

Most airlines are on a capacity expansion spree that will add to competitive intensity and keep fares subdued. ICRA says that the industry’s order backlog of new aircraft is 1.78 times the current fleet size of the industry. It expects about 17-20 per cent growth in industry capacity (available seat kilometres) during 2017-18 due to fleet addition by majority of the incumbents as well as new entrants.

According to ICRA, IndiGo has the largest order book (405 aircraft), followed by SpiceJet (205); this does not include expected capacity addition for the regional connectivity scheme. SpiceJet’s recent order at the Paris Air Show for 40 Boeing 737 MAX 10 aircraft (including conversion of 20 Boeing 737 MAX 8 aircraft) and letter of intent for 50 Bombardier Q400 (including purchase rights for 25 aircraft) will add to its order book.

True, there is big potential in the domestic aviation market that calls for fleet expansion. But seat supply growing faster than demand is a key risk for the sector. Especially given that passenger growth rate has been moderating — from over 23 per cent y-o-y in calendar 2016 to less than 18 per cent during January-May 2017.

Growth moderation could continue with a higher passenger base and airport infrastructure constraints in big cities, at least in the near term. Growing fleet sizes and moderating passenger growth could put further pressure on airfares, notwithstanding the recent improvement in yields.

Over the past few months, there has been some relief on the cost front. Crude oil has dipped under $50 a barrel due to increased supplies and fears of the OPEC-non OPEC countries’ output cut deal being undermined due to the standoff between five Gulf nations and Qatar.

Also, the rupee has appreciated to 64-65 a dollar. But these benefits could reverse, given the unpredictability of oil and currency markets. Oil, now about $47 a barrel, could move in the $45 to $60 range in the medium term, given global demand-supply dynamics. The rupee, about 65 to a dollar currently, could keep swinging between 60 and 70 as it has in the past few years.

On July 10, SpiceJet will start two new daily direct flights on the Mumbai-Porbandar-Mumbai and Mumbai-Kandla-Mumbai routes. This is the start of the airline’s operations under the regional connectivity scheme (UDAN). In the first phase of auctions under UDAN, SpiceJet was awarded six proposals and eleven routes.

Out of the six proposals, four will cater to unserved markets of Adampur, Kandla, Puducherry and Jaisalmer, while two will be for the underserved markets of Porbandar and Kanpur. The airline has the advantage of using its existing fleet of smaller Q400 turboprops to cater to the regional routes. The UDAN scheme could supplement traffic growth for SpiceJet, but it doesn’t come without risks. One, if the selected regional routes do not deliver good traffic growth, the airline could be put on the back-foot. Next, airlines including SpiceJet that won routes in the first phase have until September to start operations or their performance guarantees could be encashed. Necessary approvals have to be in place soon; this could be challenging.

Last week, SpiceJet suffered a setback when the Delhi High Court ordered it to deposit ₹250 crore as cash deposit before August 31 in the share transfer dispute with the Marans, the previous owners of the airline.

The airline was also asked to furnish a bank guarantee of ₹229 crore in this matter. The Marans and their airline Kal Airways have sought issuance of stock warrants and convertible redeemable preference shares in SpiceJet to them as per an agreement of 2015, which had led to the transfer of ownership of SpiceJet to Ajay Singh, the current promoter.

They have alleged that the securities have not been transferred despite giving ₹579 crore to SpiceJet. The airline’s Annual Report for 2015-16 states that the Bombay Stock Exchange (BSE) has clarified that the issuance of the warrants under previously agreed terms has become an impossibility in law.

Reports say that SpiceJet may appeal against the Delhi High Court’s order in the Supreme Court. While the case is likely to drag on, it remains an overhang on SpiceJet.

If the airline eventually has to issue the warrants to the Marans, it could mean a sharp equity dilution of about 24 per cent — this will depress earnings per share and push up the stock’s valuation sharply. If the airline is told to refund ₹579 crore or more, it could dent its financial position which is recovering after the near-death experience in late 2014. As on March 2017, SpiceJet had ₹380 crore in cash and equivalents, bank balances and other financial assets.

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