CAPA report suggests rather than be dissuaded, it is time to pursue disinvestment with even greater determination
A strategic investment in Air India would have provided the successful bidder with a critical presence in what is forecast to be the world’s fastest growing aviation market for the next couple of decades. The carrier also possesses a significant pool of skilled resources, valuable slots, bilateral entitlements, a well-established brand, and an ideal geographic location for developing an intercontinental hub.
Which is why – despite the undoubted challenges and complexities associated with the transaction – CAPA anticipated that there would be significant interest in the privatisation of Air India, at least at the Expression of Interest (EoI) stage.
The preliminary terms and conditions outlined in the EoI document were far from ideal, indeed several of them diverged from CAPA’s recommended “Key Success Factors for the Divestment of Air India” released in Oct-2017. However, the structure of the tender process also meant that several key conditions would only be known at the RFP stage.
Parties had to first qualify by submitting an EoI. Since these would be non-binding and did not involve any financials, this was a limited commitment for prospective bidders to remain in the running. They would have been free to subsequently drop out of the race if the final terms were not investor-friendly in the Request for Proposal, which was always expected to be the stage when the transaction would face challenges.
Based on our internal assessment on the ground, we expected – wrongly as it turns out – that the EoI stage would elicit responses from a number of parties, including some notable entities. But ultimately, whether due to deal-related or strategic challenges, no submissions were received.
Views expressed by some opponents to the privatisation process that the government was giving away the national carrier on overly generous terms are not reflected in the outcome, otherwise bidders would have been lining up.
The failure to attract even a single EoI is a sad reflection of the state of Air India and its deep structural risks. Clearly investors concluded that based on the preliminary terms and conditions presented, the risks associated with Air India’s weaknesses and challenges far outweigh its positive strategic attributes and potential.
Government of India had to balance diverse stakeholders in the EoI terms and conditions, but the resultant offer carried too high risk for prospective investors
It is critical that the Government of India understands that for the new investor, the price paid for the acquisition of 76% equity in the airline represents only a portion of the investment they are signing up to.
The successful bidder will have to plough significant funds into enterprise-wide restructuring, requiring capital expenditure in enhanced products and services, as well as fleet expansion. Returning the carrier to profitability is likely to take at least 2-3 years, during which time the new owner will have to absorb a couple of billion dollars of losses.
Faced with such a commitment, it is perhaps not surprising that bidders baulked at the offer terms which expose the investor to labour risks; limit the opportunities to create synergies with a strategic investor’s other airlines; and which leave open the prospect of political interference on strategic and day-to-day matters as a result of the government’s retention of a 24% shareholding.
As CAPA had recommended in its Oct-2017 note, the terms and conditions needed to be simple, practical and realistic, so that they are more closely aligned with the expectations of serious investors, whilst ring-fencing them from political and other risks.
The failure of the divestment process at this juncture is undoubtedly disappointing. And with a general election due in less than a year, the natural inclination may be to shelve the transaction until the next government is formed. In our view, that would be a serious mistake.
The government now needs to pursue divestment with even greater determination, in part because the alternative is far worse
When taking a decision on its next steps with Air India, the government needs to keep in mind the following:
- Air India is expected to lose a total of USD1.5-2.0 billion over the next two financial years, namely FY2019 and FY2020: These losses will need to be funded by the Indian taxpayers. And this is in addition to the USD4.0 billion of public funds that have been used to subsidise the airline since 2012. In fact, it because of the billions of dollars infused to date and other perceived risks, that the government is faced with a delicate balancing act, as is evident from the terms in the EoI. Taking a more significant haircut than was planned in the EoI will be politically sensitive, but the alternative is to keep pouring more money into the airline indefinitely. The government needs to be prepared to take a bold decision on this for the long-term benefit of public funds.
- The carrier’s debt burden will continue to increase further: Air India’s debt stands at USD7.5 billion and the outlook for the airline suggests that this will continue to rise.
- Air India’s domestic market share is expected to drop below 10%: India’s carriers are scheduled to take delivery of an unprecedented 120-125 aircraft in FY2019 alone, and more than 500 over the next five years. Most of these deliveries will be deployed in the domestic market. Air India has plans to induct just nine aircraft, on lease, primarily for replacement rather than expansion. As a result, Air India’s will continue to lose market share and relevance, dropping well below 10%.
- Air India is expected to lose its mantle as the largest international operator: With IndiGo and Vistara both set to announce wide body aircraft orders in the next few weeks, and SpiceJet also planning to take wide bodies on lease, the international long haul market will become increasingly competitive. Jet is also expanding overseas, strengthening its partnerships, and evaluating a new aircraft order.
Air India’s position as the largest carrier on international routes will come under severe pressure. And this in an environment where most of the largest foreign carriers are bilateral constrained. However, we expect that the government will relax the current bilateral policy settings in the near term to support inbound tourism, which will further intensify competition. In the longer term, Air India could be significantly marginalised on international routes as well as domestic.
- Air India Express’ financials are expected to deteriorate in the face of LCC expansion: Air India’s low cost subsidiary has been a solid performer over the last couple of years, but will face increased competition on regional international routes as AirAsia India, GoAir and Vistara all plan to launch overseas services for the first time, in the coming months. At the same time, IndiGo plans to deploy A321neo LRs on international routes while SpiceJet will be inducting 737 MAX 8s and 10s, providing them with lower unit costs. The planned expansion by Indian LCCs is potentially likely to happen from those airports where Air India Express has traditionally had a strong presence.
- Subsidiary units such as ground handling will come under pressure: The implementation of the new ground handling policy will see competition intensify as additional concessions are awarded at key airports. The Airports Authority of India has this week commenced a tender process for new concessions at 37 airports. This is expected to erode the value of Air India Air Transport Services Limited.
- Air India could experience a brain-drain of skilled resources: With the rapid pace of growth of Indian aviation, skills shortages are emerging across the industry, particularly for commanders, but also engineers and management. Continued uncertainty about the future of the airline may precipitate an exodus of valuable human resources.
Unlike its competitors, Air India currently has no long-term business plan
Over the last 12 months, since the divestment process was announced, the carrier has inevitably experienced a loss of direction, with no major strategic decisions being taken pending a new owner taking over.
This has happened at a critical time when most of the other Indian carriers are preparing for rapid expansion. This will increase losses in the near term at a cost to the taxpayer, while continued uncertainty about the airline’s future will also impact employee morale.
Turning Air India around from this position, in this competitive environment, is neither practical nor feasible under government ownership.
Continuing under government ownership will lead either to an indefinite drain on the exchequer or to the closure of the airline at a great cost to employees, taxpayers, and to the economy.
CAPA therefore supports the divestment process and urges the Government of India to put aside this setback and push ahead with the target of concluding the transaction before the end of FY2019, after taking on board investor feedback to structure a more realistic offer. We recommend the following next steps:
- Investigate the reasons why bidders ultimately stayed away: Despite initial positive interest, no submissions were received. The Ministry should engage formally and directly with prospective financial and strategic investors to understand their concerns.
- Bold decisions will need to be taken at the very highest level to structure more attractive terms and conditions: The government should divest 100% of equity; only aircraft-related debts should remain on the airline’s books; labour issues should be clarified; and a strategic partner should be permitted to integrate Air India with its existing airline operations.
The terms of labour restructuring should be clarified upfront: In order to enable labour restructuring by means of a voluntary retirement scheme (VRS), and potentially retrenchment, an arrangement similar to the Dharmadhikari Committee of 2012, should be established to provide clarity on the favourable compensation that will be paid out to those that choose VRS or lose their jobs. Proceeds from the divestment should be used to fund generous golden handshakes to employees so that labour risk is not transferred to the new owner.
The process and costs associated with handling voluntary retirements and retrenchment will be the responsibility of the special committee and not the investor – and will be carried out in line with terms agreed in advance with the unions. This committee will comprise of labour specialists who will take care of ensuring that full and timely compensation is paid, and who will also assist with re-skilling and facilitating the transition to new employment opportunities where possible.
- 100% divestment will deliver a better outcome for all parties: CAPA had recommended 100% divestment in Oct-2017 stating that any continued government involvement would deter investors. However, the offer document stated that the government would retain 24% and only exit completely after a few years, once the valuation had increased.
This is understandable from the government’s perspective, but clearly prospective investors were not comfortable with this. The government should divest 100% even if it means giving up future upside, because if retaining a stake is blocking the entire sale, it is saddling the government with billions of dollars of red ink. Far better to cut losses now and maximise proceeds today, especially as there is no certainty as to where the airline business cycle will be tomorrow.
And a stronger, restructured Air India can deliver significant indirect benefits to the Indian economy by stimulating tourism, trade and job creation, that far outweigh any notional future upside on the sale of 24% equity in the airline in the future.
- Air India should be placed under Special Administration: To ensure that Air India remains focused on operational and financial performance whilst the divestment process continues, the carrier should be placed under Special Administration, comprising a team of highly experienced and reputed professionals. This is a model that CAPA has advocated a number of times over the last seven years, and is similar to the approach the government had successfully implemented following in the case of Satyam in the IT sector.
Postponing difficult decisions on divestment will only exacerbate the pain
The government took a brave decision to proceed down the divestment path, one that several previous administrations had shied away from. This setback should not be allowed to derail the process, because the alternative is far worse. This administration is known for taking bold and strategic decision, and the privatisation of Air India is in the national interest.
After this setback, it will be particularly difficult to re-energise the airline under government ownership. Given the state of Air India’s health, the outlook for the external environment, and the government’s reluctance to divert public funds from other social service priorities to invest in the carrier, the airline is almost certain to experience rising losses and a declining valuation.
In contrast, a privatised and resurgent Air India has immense potential and the ability to deliver massive direct and indirect benefits to the Indian economy.