Q2 Results and Prof. Sanjiv Kapoor's Introductory Class on Airline Economics

Key points

• SpiceJet appeared close to securing an investor, hinted at through unusual confidence and careful wording.
• A 19% rise in load factor drove a 12% rise in total RASK (revenue per available seat kilometre).
• RASK did not grow as fast as load factor because fares were cut to stimulate demand, which lowered yield.
• The lower yield was more than made up by fuller aircraft. Had the discounting hurt, RASK would have fallen, not risen.
• Ancillary revenue grew, and its share of total revenue rose by one percentage point.
• Seasonal dips in RASK can be softened by stimulating the market and flying fuller aircraft.
• The Q400 earned INR 4.99 of passenger revenue per ASK, 82% more than the Boeing 737.
• October load factors fell because the revenue model was still being calibrated.
• Costs stayed high because of the lack of funding.
• A smaller fleet hurt schedules; the airline expected 31 active Boeings by end November and 35 by end December.
• Cancellations and delays raised concern about the brand.
• The per ASK financial statement looked encouraging.
• Airlines are not a cost plus business, because demand changes with price.
• SpiceJet stopped matching the market leader's fares.
• Up to 30 to 40% of seats on the weakest off peak flights were discounted, and 1 to 3% on peak flights.

The professor

Sanjiv Kapoor holds an MBA in strategic management from the Wharton School and a BA in computer science and government from Dartmouth. He was so unhappy with media reports on SpiceJet's future, or lack of one, that he decided to hold what amounted to a class on airline economics before showing the numbers for the quarter. He proudly wore his airport entry pass, although the class was held away from the airport.

The audience behaved like any class. Some sat in front and took notes, some played with their phones, some dozed with their eyes open, and some asked questions before the subject had been covered. Others skipped the lecture but were quick to comment. One airline commander, when told about the session, offered the line that statistics are like bikinis: they can hide the most interesting and important parts.

Kapoor, who was also SpiceJet's Chief Operating Officer, was joined by Kaneshwaran Avili, Chief Commercial Officer, and Kiran Koteshwar, Senior Vice President Finance and acting CFO.

The talk

Kapoor opened by saying there was no big announcement, which most had expected. He then stressed the need for recapitalisation, and immediately added that SEBI rules prevented him from discussing it. That alone suggested something was in the works. He promised an invitation titled An Important Announcement Regarding Recapitalisation should the time come.

To establish his credentials he mentioned 20 years in the airline industry, either inside airlines or advising on turnarounds at carriers such as Malaysia Airlines, Aeroflot and British Airways-Iberia.

After a short lecture on RASK and CASK, during which the class asked no questions, he moved to SpiceJet's figures. Profitability, he explained, is the gap between cost per available seat kilometre (CASK) and the sum of all revenue streams per available seat kilometre (RASK). Everything is measured per ASK because the ASK is an airline's unit of production.

Compared with the same quarter of the previous financial year, RASK had risen and CASK had fallen. The two lines converged, and the loss between them narrowed. Kapoor's explanation was that load factor rose 19%, which lifted total RASK by 12%. RASK did not rise the full 19% because the extra load came from lower fares. If the lower fares had hurt, the higher load would have been cancelled out and RASK would have dropped. Instead it rose 12%, and total CASK fell 7%, giving a 19 point swing.

The average fare in Q2 FY15 was INR 3,367, which was INR 344 less than the INR 3,711 of Q2 FY14. But the airline carried 3,525,086 passengers, 728,570 more than the 2,796,516 of a year earlier. Multiplying fares by passengers in each quarter gives a difference of almost INR 150 crore in the airline's favour.

Relative RASK and ancillary revenue

Kapoor said SpiceJet's RASK was now close to, if not level with, other airlines, driven by fuller aircraft and ancillary sales. A discounted passenger still buys a meal or pays for excess baggage, so revenue per passenger is more than the ticket. Ancillary revenue rose 31% year on year while total revenue rose only 15%.

The Flying Engineer did not find the 31% figure very useful. Ancillary revenue naturally rises when capacity and passenger numbers rise, and the presentation did not normalise for that. Measured as a share of total revenue, ancillary rose by one percentage point to 10%, which showed there was still room to grow.

How low cost carriers maximise RASK

Kapoor described the standard LCC approach. In the low season, fly fewer empty seats by stimulating demand with price. In the high season, use yield rather than discounts, and accept a temporary dip in load factor. October was a stronger month, so the airline deliberately stimulated less, knowing loads would fall, in the hope of better yields.

A month by month look at RASK showed how seasonal it was. In March capacity grew faster than passengers and RASK fell. In April capacity was cut sharply while passengers rose, lifting RASK despite the elections. May, a very strong month, saw more passengers and less capacity, and RASK peaked. June slumped with demand. Through July, August and September, Q2, the ratio of passengers to capacity kept rising and RASK held roughly steady, even in September, usually the worst month for travel. Stimulation had flattened the usual low season dip.

The October argument was harder to accept, for two reasons. First, Kapoor himself had said airline seats are the ultimate perishable product: you cannot store them and you cannot slow the production line. Second, May, a stronger season than October, had a load factor of 81.3% domestic and 86.3% international, 81.6% overall. So why not fill more of the 20% of seats that flew empty in October while still working on yield?

Avili, the CCO, answered that the airline was still in a turnaround and only had data from the old model for the previous October. Many new flights and sectors had been added, so there was a learning curve. Assumptions about where yield could be maximised led to less stimulation than needed. He expected to do much better the following October, and in the next Q2, with solid data from the new business model. Kapoor added that the models would be recalibrated so that empty seats would not fly in the high season, and that the goal was profit maximisation or loss minimisation depending on the season, not market share.

The Q400's relevance

SpiceJet had 15 Q400s on its books, of which 13 or 14 were active. In Q2 they provided only 8.13% of total capacity. But the Q400s flew Tier II and Tier III routes where the airline had a monopoly or a duopoly, and that is where money could be made. Passenger revenue from the Q400 came to INR 4.99 per ASK, which is 182% of the Boeing 737's INR 2.74.

On costs

Kapoor said costs needed to fall further and that 7% was a good start. Costs are sticky because of long term contracts. With large payables from past losses, the airline could not ask suppliers for reductions; suppliers wanted their dues cleared first. Taking cost out of the system would take time and would need money, which would come with recapitalisation.

The management trio agreed that the active Boeing fleet (737-800s and 737-900s) had shrunk to around 26, although The Flying Engineer had data suggesting only 21 were active as of 20 November 2014. Several aircraft had left the country and others sat idle. One was in a C check, and another had been damaged by a buffalo at Surat.

Kapoor said the airline needed scale and that the dip in fleet came from the recapitalisation process, which also gave an opportunity to restructure the fleet and shed old aircraft. The plan was 30 to 31 active Boeings by the end of November and around 35 by the end of December, with the Boeing fleet reaching 50 by the middle of the next calendar year.

Fifty Boeings meant 15 more than the December target, roughly two a month. The question was whether crew could be hired fast enough. Fifteen 737s need about 75 sets of crew: 75 captains, 75 first officers, 75 senior cabin crew and 225 other cabin crew. Kapoor pointed to hiring CPL holders, expatriate captains and internal upgrades from first officer to captain.

Cancellations cost money through refunds and rebooking. If discounted passengers had to be rebooked on other airlines at higher fares, the cost grew further. Together with lower revenue from a smaller fleet and a revised schedule, this threatened Q3 profitability.

The bigger worry was the effect on high yield passengers such as corporate travellers, who book close to departure and care about punctuality, low cancellation rates, timings and network rather than loyalty. The team had worked hard to win them, and the state of the network put that at risk. Kapoor said the airline had handled the issue well.

On fuel and exchange rates, Q2 FY15 was kinder than Q2 FY14. Average fuel price per litre was down 4% and the average exchange rate was 3% better. Since the airline had said about 70% of its costs were dollar linked, The Flying Engineer estimated savings of INR 31 crore on dollar costs and INR 31 crore on fuel, about INR 62 crore in total. The airline put the combined benefit at INR 29 crore. The previous year had an unusual INR 78 crore rise in maintenance costs from engine shop visits bunching up; this year carried about INR 75 crore in one off and restructuring costs.

Per ASK financial statement

Breaking the financials down per ASK, income from operations was higher thanks to stimulation. Fuel cost per ASK rose, which fitted the earlier finding that flights had become shorter on average, meaning more departures and more fuel used in take off. A smaller fleet with higher utilisation lowered lease rentals. Fewer overnight parking charges and volume incentives lowered airport charges. The previous Q2 had carried a very high maintenance bill, almost INR 125 crore more than Q1 FY14, including the INR 78 crore engine item and costly Q400 maintenance.

Redelivery costs naturally rose. Other operating costs were largely unchanged. Salary increases added INR 8 crore, yet staff cost per ASK stayed flat, which pointed to better crew utilisation. Other expenses, including crew transport and hotels, fell, perhaps through better rostering. Depreciation and amortisation fell in both absolute and per ASK terms. Total operating expenses fell. Finance costs, however, rose sharply to almost INR 40 crore.

Further insight

Kapoor had completed one year at SpiceJet on 1 November. He explained why the airline had done badly the year before. When fares are high and demand falls below supply, the market leader takes all the profit, because a passenger choosing between three seats and two travellers picks the stronger product. When the market leader raised fares in September 2013 and everyone followed, the leader did well and the rest bled. The lesson was that airlines are not a cost plus business; raise fares in India and demand falls. From January the airline stopped blindly following the leader's pricing, since pricing is transparent and matching fares is how airlines usually behave, but doing so was like falling into a well while others flew over it.

The recap

Kapoor closed the class with three lessons.

• The airline industry is not cost plus.
• Seats are the ultimate perishable commodity; they keep coming at the same pace and must be sold before they go to waste.
• Sell early at good rates to attract leisure and occasional travellers. Do not discount at the last minute, because late bookers are the least price sensitive. Aim for little or no spare inventory close to departure.

Asked how much inventory was discounted, Avili said up to 30 to 40% of the aircraft on non peak flights and 1 to 3% on peak flights. Kapoor ended with a teaser: in the year after recapitalisation the airline would report an annual net profit.

The last word

The open discussion at the Q2 briefing suggested that the new team at SpiceJet had both improved the airline and learned about the market, admitting some estimation errors along the way. SpiceJet had suffered from too many management changes in the past. It takes at least a full year to build good data on how a market behaves under a particular model. The Flying Engineer hoped there would be no further changes at the top, because each one turned the airline back into a laboratory and held back its ability to grow and stay strong.