We believe the recent increase in crude prices may lead to superior yield management by Indigo as well as better price discipline in the industry given limited scope for absorption of high fuel price by peers. Further, the decision to purchase aircraft in the future may yield long-term benefits such as reduced forex risk and lower overall cost of ownership. We retain our estimates assuming crude price of $57-65/bbl over FY2018-20 with target price of Rs 1,400. Maintain Add.
Fuel price increase may not necessarily imply weaker earnings
ATF prices posted by IOCL are already up by 11% q-o-q in Oct-Nov 2017; recent uptrend in crude prices indicates that December pricing may pull up the quarterly average further. We believe some increase in crude prices may actually be a positive for Indigo, given limited headroom available with competitors to absorb higher crude prices without simultaneously increasing ticket prices.
Competing LCCs may not have much headroom to absorb higher fuel prices.
We note that despite crude prices remaining benign in FY2017, Indigo’s revenue less cost spread declined by 52% y-o-y, primarily due to weak yields. We believe the weakness in yields was on account of competition from peers (particularly Spicejet), as well as Indigo’s rather conservative yield-management policy. We note that despite Indigo’s per unit costs being 20% lower than that of Spicejet, its spread has been broadly in line with that of Spicejet since mid-FY2016. We believe this may change going forward as rising fuel prices lead to better price discipline between airlines. While there may not be large headroom to increase ticket prices given end customer price sensitivity, lesser price competition as well as superior yield management by Indigo may lead to sustained yield improvement and stable margins.
Outright purchase of an aircraft may lead to lower ownership costs
Our analysis of Indigo’s buy versus lease strategy to increase its fleet indicates that even after adjusting for the upfront incentive received from manufacturers, buying aircraft makes sense for the long term as: (i) overall cost of ownership reduces, (ii) there is no future risk from rupee depreciation (as opposed to lease rentals, which are $-denominated), and (iii) owned asset can provide a higher tax shield on accelerated depreciation allowed for tax computation.
Capacity addition to revive volume growth; retain ADD
After a relatively lackluster capacity addition of 16% y-o-y in 1HFY18, Indigo is set to increase its capacity by 28-29% in 4QFY18, indicating renewed growth momentum. We retain our estimates and model 19% and 17% ASK growth in FY2019 and FY2020. Retain Add with target price of Rs 1,400 based on 14X Sep 2019E earnings.
ATF price increase may not necessarily result in lower spreads
ATF prices have been inching up, in line with the trend in international crude prices. While this may have some negative impact on Indigo’s margins, we believe there is a case for yields to improve, which can lead to relatively stable margins. For Indigo, we believe as long as crude prices remain below $75/bbl, the company could look to optimise yields and pass on some of that impact to customers. Nil increase in yields can see a 4-8% increase in crude prices denting profits by 8-15%.
Given sensitivity of end customers to absolute ticket prices, we believe Indigo and its competitors would resort to minor price hikes, better price discipline (read under-cutting) and better yield management to pass on the impact of higher crude prices. Assuming 80% of the crude price rise is passed on to customers, we believe the earnings impact of higher crude prices could remain limited, provided crude prices remain below $75/bbl. We believe despite having a better cost structure, Indigo did not benefit adequately from weak fuel prices in FY2017, given price competition from peers and conservative yield management. The company has now improved its yield-management function by beefing up its employee strength and utilising more data analytics to price its fares better (higher).
Buying of part of the fleet may lead to lower ownership costs
Indigo’s strategy to outright acquire aircraft versus leasing has raised questions on the economics behind this change in stance. We observe that the lease rental and ownership scenarios are relatively similar NPV scenarios, though we believe there are additional risks in the leasing scenario in the form of: (1) higher-than-expected rupee depreciation, (2) higher maintenance costs on account of higher-than-contracted use of engine cycles. Overall, we believe purchase of aircraft should be beneficial for Indigo in terms of lower cost of ownership.