Low level equilibrium in airline industry

Livemint has a story on Air Asia's turbulent first year of operation. In a sector where six airlines each disappeared in the first five years after open-skies in 1992 and since 2009, the immediate prospects look gloomy despite the boost to profitability from low fuel price (it declined by 24% between September 2014 and January 2015, or a 12% reduction in costs since fuel represents almost half the operational cost),

India’s airlines alone have lost more than USD10 billion combined since FY2009. Airline debt stands at around USD11.3 billion, rising to close to USD14 billion if liabilities to vendors are included. At an industry level airline debt is now equivalent to more than 100% of airline revenue. In FY 2015 traffic increased and losses declined but this was largely a function of lower fuel prices. 

Prohibitive operational costs, arising from higher taxes on Aviation Turbine Fuel (ATF) and high airport access charges, cut-throat competition which has bid down ticket prices to rock bottom, strongly price sensitive customer base, and heavy regulation are cited as contributors to the woes of airline industry. But for Indigo, all other carriers have been bleeding money for a long time and there is nothing to suggest any change in fortunes. No full-service carrier has made money on a sustained basis in the Indian market since the open-skies policy era began.

While all the aforementioned are important, there is a strong possibility that India'a airline industry may be entrapped in a low-level equilibrium from where exit may not be very easy. India is unique in that it is possibly the only large airline market without a significant full-service market. Low cost carriers make up nearly three-quarters of the domestic traffic, and a significant part of the full-service market is some version of the low-cost carrier model. This has had the effect of low-balling the reference price for low cost carrier tickets, further eroding their margin for profitability. In price-sensitive markets, since prices are very sticky upwards, recovering lost-ground from price-wars has proved very difficult. The willingness of public sector banks to keep supporting sinking promoters removed a critical backstop against the commercially destructive competition to the bottom. 

The absence of a strong full service market is also explained by the overwhelming dominance of the point-to-point service business model. Since regional markets are not large enough and are fragmented, no single full service carrier has the market power to operate a hub-and-spokes model, essential to the sustainability of a full-service model. Air India, the one full service carrier with the potential to leverage its size and international traffic to develop a hub-and-spokes model with regional hubs, has failed to do so due to its own inefficiencies and lethargy. 

Ironically, the rapid expansion of market share by Indigo, expected to rise from 36.4% in end-March 2015 to 45-50% in the next two years, can potentially help the industry break-out of the low-level equilibrium. It could help the industry regain some pricing power and increase profitability. However, it runs the risk of monopolistic dynamics that could adversely affect the long-term health of the market.

Update 1 (06.07.2015)

The IPO filing information of Indigo throws up a few interesting features. One, despite the lower fuel prices, its fuel cost as a percentage of the revenue for the last three quarters of 2014 was 48.4% against 31.3% for Jet Airways. Two, its maintenance costs at 3.1% of total expenses was just one-fifth of Jet Airways.