CFA Institute Research Challenge hosted by CFA Society India submitted by Indian Institute of Management, Ahmedabad (India) The CFA Institute Research Challenge is a global competition that tests the equity research and valuation, investment report writing, and presentation skills of university students. The following report was submitted by a team of university students as part of this annual educational initiati ve and should not be considered a professional report. Disclosures: Ownership and material conflicts of interest The author(s), or a member of their household, of this report does not hold a financial interest in the securities of this company. The author(s), or a member of their household, of this report does not know of the existence of any conflicts of interest that might bias the content or publication of this report. Receipt of compensation Compensation of the author(s) of this report is not based on investment banking revenue. 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This report should not be considered to be a recommendation by any individual affiliated with CFA Society India, CFA Institute, or the CFA Institute Research Challenge with regard to this company’s stock. Interglobe Aviation Limited Exchange - NSE Ticker Symbol - INDIGO Sector - Services Industry - Airlines Recommendation - BUY CMP – INR 1,159.60 (as of 24-10-17) Target Price – INR 1,463 (26% increase) Business Description Indigo, the current market leader in the domestic aviation industry of India, has been able to find its niche since its inception in 2006. After the liberalizing steps taken by the Indian government in 2003, many Low- Cost Carriers (LCCs) – led by Indigo - have entered the market to fulfil the ensuing demand of affordable air travel from the Indian middle class. Apart from providing budget seats to passengers with a no-frills experience, Indigo has successfully created a niche by following a single-fleet strategy (A320s) and placing bulk orders for the same in order to achieve cost efficiencies, thereby ensuring price leadership in an extremely price-sensitive customer segment. This significant competitive advantage has ensured consistently positive bottom lines and free cash flows in what is generally a loss-making industry. A measure of the magnitude of its operations can be gauged by its fleet size of 135 aircraft, an order book of 480 aircraft (including 50 ATRs) and its operations which are spread to over 45 destinations globally, with it enjoying a domestic market share of around 40%. Indigo was founded in 2006 by two industry veterans – Rakesh Gangwal, who is the former CEO of the US Airways Group and has over 30 years of experience in the airline industry; and Rahul Bhatia, who has more than 25 years of experience in the travel industry. The company’s success led to a successful public listing in 2015, making Indigo one of the only three listed airlines in India. However, it is prudent to note that Indigo still remains a relatively closely held company, with promoter shareholding close to 78% (Exhibit 1). As the next step in its bid to become the undisputed leader of Indian skies, the company has decided to diversify into ATR 72s, in order to cater to Tier-2 city traffic under the RCS scheme (UDAN). While it followed a model of leasing the aircraft till now, Indigo is making an active shift to the ownership model having achieved stability in the market and on account of superior economic viability. Indigo has also expressed interest in acquiring the stressed national carrier, Air India, as a part of its “low cost long haul” plan of growing in the international market, where it is a very small player currently with a market share of just over 5%. Industry Overview India is the ninth largest aviation market in the world as measured by total domestic and international passenger carried (158mn) and the third largest market in domestic air passenger traffic (103mn). Going forward, Geneva-based International Air Transport Association (IATA) expects India to replace the United Kingdom as the third-largest aviation market (both domestic and international traffic) by 2026. It has also projected India’s air passenger traffic to grow to 442 million by 2035 – 4.5 times the current market size, based on Revenue Passenger Kilometres (RPKs) (see Exhibit 2 for Porter’s Five Forces Analysis of Aviation). Market Growth Since the liberalizing steps taken by the government in 2003, the Indian air travel market has witnessed impressive growth in domestic passenger volume at a CAGR of 19-20% between FY04 and FY10. The global financial crisis tempered the growth rate between FY2010 and FY2014 to a CAGR of 7-8%, however it is again on an ascent. FY17 witnessed another year of strong volume growth in domestic industry (+22%) as the underlying demand remained robust (Exhibit 3) Growth Drivers Strong Economic Growth The IMF, in its latest World Economic Outlook (IMF, 2017), expects India to be one of the fastest growing economics in the World over the next two years. With Real GDP expected to grow at 6.7% YoY and 7.4% YoY in FY18 and FY19 respectively, the country is expected to grow at a much faster pace compared to other big aviation markets like China, USA, UK, Japan etc. This will aid the growth and further adoption of air travel in India. Population and Per Capita Income Growth The UN, in its latest World Population Prospects report (Nations, 2017), has highlighted that by 2025, India is expected to surpass China as the world’s most populous nation. The CAGR of 1.3% is higher than the average growth in population of the top 20 domestic air travel markets in the world, thus continuing to be a major driver of domestic air traffic. India’s per capita income has grown from INR 46,249 in FY2010 to INR 1,03,219 in FY17 at a CAGR of 12%, according to data from the Ministry of Statistics and Programme Implementation (MOSPI, 2017). Underpenetrated market It is a severely underpenetrated market as annual domestic seats per capita of India are around 0.08, which is significantly low compared to other developing markets such as Brazil, Turkey, Indonesia and China, where penetration rates are between 0.35 and 0.65 annual seats per capita, as revealed in the latest report of Centre for Asia-Pacific Aviation (CAPA). Tourism Growth According to the latest Tourism statistics released by the Ministry of Tourism (Tourism, 2017), the number of domestic tourist visits in India grew by 12.7% in FY17 to over 1600mn. The number of foreign tourist arrivals has also grown at a healthy rate of 9.7% to 8.8mn. World Travel & Tourism Council has elucidated in its latest report (Council, 2017) that the total contribution of Travel & Tourism to India’s GDP was USD208.9bn in 2016 (9.6% of GDP). It is forecast to rise by 6.7% p.a. to USD424.5bn, 10.0% of GDP in 2027. Impact of GST While there was a lot of unease in the industry over the prospect of the government imposing a 5% GST on the import of leased aircraft, there was a huge sigh of collective relief when that was pegged down at ‘nil’ by the government. Under the UDAN scheme, the government is making a definite push to make air travel a reality for the masses, and has opted to keep GST on economy class tickets at a lower 5% against the anticipated 6% level. Both of these moves will help the margins of the LCC carriers engaged in a consistent price war. National Cabinet Aviation Policy In June 2016, Union Cabinet approved the National Civil Aviation Policy (NCAP 2016). Since independence, this is the first time an Integrated Civil Aviation policy has been brought out by the government. The policy focuses on taking “flying to the masses” and making it “affordable, convenient, cheap.” It provides for the Regional Air Connectivity Scheme (RCS)- UDAN, that aims to link all the under-served and un-served areas of the country. To make it lucrative for the operators, tax sops and viability funding will be provided by the Government. Industry Financials Increasing disposable incomes, narrowing difference between Tier-2/3 railways and airline fares and a concerted push from the government to increase the penetration is set to propel India to become the third largest market by 2030. The growth in domestic passenger volumes in FY17 was partly driven by competitive fares, as airline operators sacrificed yields to ensure higher yield factors. This was a result of a strong capacity growth (+20%), highest in a decade. On the other hand, the international segment has grown at a steady 9% since FY07 (Exhibit 4). Over the last three years, there has been an industry-wide increase in load factors as demand (RPKM) growth has outpaced capacity (ASKM) growth (Exhibit 5).