When IndiGo, India’s largest airline by passengers carried, reported a profit of Rs 787 crore in the 2013 financial year, it stunned many in a manner unusual for an earnings broadcast. Aviation has always been a thorny industry, one as is said only half in jest that makes millionaires out of billionaires, but Indian aviation has stood out as notoriously brutal owing to high taxes and costly airport charges.The year to March 2013 also happened to be the worst in recent years due to a steep increase in fuel prices and weakening rupee. During the year, Kingfisher Airlines shut shop and IndiGo’s competitors made losses of more than $1 billion.But IndiGo emerged unaffected from the wreckage. The latest numbers, revealed by IndiGo president Aditya Ghosh on September 24, burnished the airline’s reputation as the lone Indian carrier to prosper in a troubled industry.Even so, the quantum of profit was astonishing. Indi-Go’s profit had increased six-fold from a year ago. The profit surpassed a projection of $100-110 million (around Rs 550-610 crore based on the then exchange rate) by the Centre for Asia Pacific Aviation (CAPA), an aviation consulting and research firm. IndiGo’s own estimate done three years ago presaged a modest profit of Rs 57.5 crore in 2012-13.What is the secret of IndiGo’s continued profits? The airline has long been a subject of interest for air travellers and financial analysts alike. Travellers attribute IndiGo’s success to the efficient service they experience on board and planes that run on time. Analysts have speculated —IndiGo doesn’t have to make public its earnings as it is not listed — that it makes most of its money from sale-and-leaseback transactions.Under this transaction, operators sell newly acquired aircraft to leasing companies and in a parallel transaction lease the same aircraft. The price at which the aircraft is sold to a leasing company is usually higher than the price paid to aircraft makers like Boeing or Airbus.But InterGlobe Aviation — the company that runs IndiGo — raised eyebrows when it revealed that it did not make profits through the sale-andleaseback route. (It was the first time that IndiGo chose to go public with its annual results.) Ghosh told ET that IndiGo made an operating profit of Rs 993.2 crore, a figure he said will end speculation that a large part of his airline’s profits is generated by sale and leaseback of aircraft. On how IndiGo continues to deliver profits, Ghosh said the customers are rewarding his airline for focussing on a product that is basic, simple, even boring.True, Ghosh and his team run an innovative and nimble airline. A reputation for punctuality has helped IndiGo, a no-frills airline, charge more than full-service competitors like Jet Airways and Air India on many routes. Fares actually rose by more than 20% during the year, belying its claim of offering low fares.IndiGo has also shown it is ready to go against the grain. It has introduced an airport lounge service, again unusual for a no-frills airline. Hormuz P Mama, an aviation expert, says IndiGo’s aircraft utilization is the highest for any Indian airline. “That helps enhance revenues.”

A Money-Spinner



This, however, is only half the story. An analysis by ET Magazine of the airline’s books reveals that it is indeed sale-and-leaseback transactions that helped IndiGo record higher profits. In some cases, these transactions turned losses into profits as it happened in fiscal 2011. Financial documents that InterGlobe filed with the Ministry of Company Affairs (MCA) also show that the seven-year old airline consistently reported profits from its third year of operations. Of course, it’s not as simple as that.



Three accounting experts that ET Magazine approached say the transactions done by IndiGo adhere to Accounting Standards, and one of them called these accounting entries as financial engineering to drive more value out of investment.



The combination of operational performance and financial engineering has amplified IndiGo’s valuation. From an initial investment of around Rs 100 crore as equity capital by promoters, the airline today can be valued at Rs 12,200 crore ($2 billion) depending on “how investors treat the sale-and- leaseback model”, says Kapil Kaul, CEO of CAPA South Asia.



Indeed, analysts linked IndiGo’s decision to finally publicize its annual results as a gamble to attract investor interest and list on bourses. In September, Ghosh denied any such plan, saying the results were announced to end the “bizarre interpretations” people draw from the one or two sheets that are leaked every year when IndiGo makes regulatory filings. “So I thought [it is] best to be transparent and take the mystery out of it.”



IndiGo, however, did not share its balance sheet or profit and loss account with the media. On why it didn’t, Ghosh said he didn’t think on those lines and “gave out data from the form submitted to the DGCA [aviation regulator]”.



Reliable Model



IndiGo promoter Rahul Bhatia too insisted that his airline is transparent. Anyone interested in examining IndiGo’s finances is free to approach the regulators, he told ET in November. Ghosh, also the airline’s spokesman, did not comment on the finances for this article. “We do not discuss any of these [financial] items in the press,” he said.



Nevertheless, the sale-and-leaseback model helps explain why IndiGo reports consistent profits while competitors are losing money and are saddled with mounting losses. Still, it begs the question: why can’t other airlines do the same? Actually, many airlines, including those in India, do. The benefits of this transaction are significant (see Sale-and-Leaseback Model).



In their book Foundations of Airline Finance: Methodology And Practice, Bijan Vasigh, Ken Fleming and Liam Fackay wrote that thanks to sale and leaseback, “the airline will receive a cash inflow which will then be used to pay down the debt associated with the aircraft. If the sale value is greater than the amount of debt against the aircraft, the airline will receive a positive cash flow.”A leasing company agrees to such an arrangement, they wrote, because it is provided with an asset and an established customer without having to buy a brand new aircraft, but still generates lease income from the airline.Alex Wilcox, CEO of JetSuite, a private jet company in California, says airlines in the US typically own about half their fleet and lease the other half. “Some airlines capitalize their leases and longterm maintenance and some expense them,” says Wilcox who was earlier COO at grounded Kingfisher Airlines.As a financial model, sale and leaseback is popular among no-frills airlines for the flexibility it renders to keep balance sheets light. As aircraft are owned by a lessor, an airline can save on the depreciation provision, which increases profit and saves tax.As it happens, IndiGo has been the most active user of sale-and-leaseback financing among no frills carriers, according to Flightglobal, a news and information website. IndiGo completed 37 such transactions in the past two years to May 1, followed by Virgin Australia with 35 transactions and Lion Air, India’s SpiceJet and Norwegian with 28 each, it said in a report.But the key difference in IndiGo’s strategy was to incorporate the purchase of 100 aircraft into its business plan even before launch. Other operators even now are talking of only a fraction of that order size, according to Kaul.Placing a huge order helps airlines to bring down the cost price sharply. GoAir CEO Giorgio De Roni says a huge order hands the buyer huge bargaining power. “It is true for not just airlines, but also people who buy tomatoes and potatoes,” he says.A January 2013 report by accounting and consulting firm PricewaterhouseCoopers (PwC) on aviation finance says the list price of all airline order back log is $1.2 billion as of mid- 2012, but the real cost is likely to be “in the order of $700 million”. That is a discount of 42%.Mark D Martin, founder of Martin Consulting and an aviation industry expert, says he would not be surprised if IndiGo grabbed a discount in excess of 40% of the list price. He reckons the sticker price for an Airbus A320 — the only type of aircraft IndiGo uses — at $60 million in 2007 when the airline signed the agreement. Using one type of aircraft helps IndiGo keep operations simple. It is a trick it learnt from America’s Southwest Airlines, the only airline in the world to make profits without fail for nearly 40 years, which flies the Boeing 737.Quoting Chris Wahlenmaier, vice-president of ground operations at Southwest, Seth Stevenson wrote in Slate: using one type of aircraft “results in all manner of cost-saving efficiencies: we only need to train our mechanics. We only need extra parts inventory. If we have to swap a plane out at the last minute for maintenance, the fleet is totally interchangeable — all our on-board crews and ground crews are already familiar with it...”Operational gains apart, airlines can derive other significant advantages by buying one type of plane from a manufacturer. Pascal-Emmanuel Gobry, the founder of Noosphere, a market research firm, wrote earlier this year discount airlines are almost always the biggest customer, which means plane companies are eager to please them and give them volume discounts. “For example, [European airline] Easyjet, which is committed to Airbus like Southwest is to Boeing, placed the biggest order in Airbus’s history after 9/11. They got them at bargain-basement rates [they went on to resell the planes at a profit].”Even so, Easyjet was an established airline, having started its operations in 1995. IndiGo was not even off the blocks. It also had just Rs 100 crore (around $20 million) of promoter money. Yet, it managed to strike a deal for 100 aircraft and by parting with a low down payment at that. How did IndiGo do it? The credit goes to co-founder Rakesh Gangwal, a veteran of nearly 35 years in the airline business).“IndiGo is one of the few airlines that tracks and ensures it capitalizes on the warranty and guaranty clauses,” says a person familiar with the airline’s operations. “It has a full section in finance just tracking these financial items.”The rules governing aircraft financing stipulate that a down payment of only 4% for an entity with credit rating of AAA- BBB-, and 7.5% for the ones with lowest rating (CCC- C), according to the PwC report. (The rest is paid to the aircraft maker from the proceeds of the sale to the leasing company).This means IndiGo with a 40% discount on list price for Airbus 320 would have had to make a down payment of $151 million (see How IndiGo went about it) for placing an order for 100 aircraft. The company’s balance sheet then shows it was well capitalized — Rs 337 crore ($82 million)— to meet the payment schedule.An accounting expert, who did not want to be named, says the discount received from manufacturers will not be shown separately as it is in the normal course of business. But other forms of cash and non-cash payments from aircraft manufacturers can be counted in financial statements.That explains why the global fleet under leasing has now touched nearly a third from less than 12% in 1990, says the PwC report. (The numbers represent the entire leasing transactions and not just sale and leaseback.) “In my estimate, every sale and leaseback brings $4-5 million profit to IndiGo. And this acts as working capital,” says Kaul of CAPA. Curiously, the finances of IndiGo in the past six years do not show any profit for the sale and leaseback of aircraft.If IndiGo can’t show the discount it receives from purchase of aircraft, industry experts say it should be able to book profits when it sells newly acquired aircraft to leasing companies. Their logic is simple — the price paid by leasing companies for a plane is always higher than the cost price.CAPA’s Kaul estimates that IndiGo makes a profit of $4-5 million for every plane sold to leasing companies, and this translates into a monthly saving of around $50,000 on lease rentals. The entire fleet, barring 4 planes, is leased by IndiGo and any saving on lease rentals — which account for 19% of expenses — will boost profitability ().The Flightglobal report confirms that IndiGo makes $4-5 million from sale-and-leaseback of each aircraft. With an average lease term of five-and-a-half years, the airline is also benefitting from the frequent renewal of its fleet by avoiding costly maintenance repairs that creep in after six years, according to the report.Mama the aviation expert says returning aircraft to leasing companies after five or six years helps. “The maintenance cost will be lower for new aircraft. More important, the D-Check (the most comprehensive check for a plane) approaches around that time. It is very expensive. By returning planes before the DCheck is due, IndiGo makes big savings.” The only problem is that IndiGo has never disclosed profit from sale of planes to leasing companies.Instead, the only items it shows are cash incentives and non-cash incentives of around Rs 265 crore. These were reduced from lease rentals, boosting profits by a third in fiscal 2012 and helping the airline report a surplus in fiscal 2011.Without directly referring to IndiGo, Jamil Khatri, global head of accounting advisory services for KPMG, says aircraft manufacturers might have given cash incentives instead of discounts for placing the bulk order. Typically, noncash incentives given by manufacturers include free spare parts, extra engines, free training to pilots and engineers and support in obtaining credits from lenders. IndiGo is likely to have assigned a value to such spares and engines.Another accounting expert says, “If a company owns the asset, the practice would be to reduce the cost of acquiring the aircraft in the balance sheet. But in IndiGo’s case, the airline has leased the aircraft and so it is proportionately reducing it from the lease rentals.”If the cash incentive was $5 million on a purchase price of $50 million, the actual cost in the balance sheet would be only $45 million after reducing the cash incentive. But in IndiGo’s case, the aircraft is sold to leasing firms and so would not be accounted in its books. And if the lease period is for five years, $1 million — that is one fifth of cash incentives — would be reduced from lease rentals every year.In IndiGo’s case, this yearly component totalled Rs 262.7 crore for a fleet of 64 aircraft. Assuming 60 of them are leased, the cash and non-cash incentives alone amount to Rs 4.37 crore a plane a year. The amount of such incentives that can be claimed in future is Rs 1,180 crore, or Rs 19.6 crore per plane.IndiGo started disclosing the quantum of cash and noncash incentives only from fiscal 2011 in the financial documents submitted to the MCA, the regulator of companies. Prior to 2011, the company only disclosed that it receives credits from aircraft makers and these were being reduced from lease rentals. “One might argue that it is more appropriate to present this as income if a direct relationship with rentals is absent – which is often the case,” says the accounting expert quoted earlier.Khatri of KPMG says there is another possibility why cash incentives are subtracted from lease rentals. He points to Accounting Standard 19, which deals with sale and lease back transactions. Under this, let’s say if a company makes a profit of $5 million from selling a plane but in return leases the same at a rental higher than the market rate, the excess value has to be reduced from lease rentals.If IndiGo pays $400,000 as lease rentals a month compared with the market rate of $350,000, the excess $50,000 would be reduced from lease rentals. In our example, the excess would be $600,000 a year and it would have to be reduced from profit on sale of aircraft. That means only $400,000 will be considered as profit.If IndiGo shows only reduction in lease rentals and no profit from sale of aircraft, it would possibly mean the entire profit from sale and leaseback is being erased by higher lease amount.On a net basis, IndiGo still gains as lease rentals drops, boosting profits. According to Martin, the amount of discount negotiated by IndiGo would be much higher than other Indian airlines because of the order size. “That is one key reason why IndiGo’s operational cost is much lower than its competitors.”Start-ups start small, right? In 2005, IndiGo tossed this rulebook out of the window a year before launch. The airline shopped for 100 Airbus aircraft, a massive order for any airline, leave alone a fledgling one. IndiGo swung the deal because the management of Airbus, the European aircraft maker, was seemingly comforted by the presence of Rakesh Gangwal at the helm. Gangwal, cofounder and promoter of IndiGo, is a true-blue aviation veteran. He was previously associated in various capacities with Air France, United Airlines and US Airways, where he was CEO and president, stepping down shortly after American aviation was devastated by the 9/11 attacks. Gangwal has vast experience in buying aircraft for foreign airlines, says a person familiar with IndiGo’s operations. “He used his knowledge and experience to put together a fantastic deal.”IndiGo president Aditya Ghosh says Gangwal carries a tremendous reputation in the airline business, which translates into lots of credibility among aircraft makers. IndiGo made a bigger order in 2011, for another 180 planes from Airbus. That order came when a lot of airline powerhouses were chasing the order, says Ghosh. The massive aircraft orders have been both springboard and sustenance to IndiGo’s success. Kapil Kaul of CAPA says Gangwal’s ability to take risks and strike winning deals was reflected in IndiGo’s first 100 aircraft order, which proved game-changing both strategically and financially.Today, Gangwal and Rahul Bhatia, the other promoter, play an equally important role at IndiGo. Which is to stay away from management despite their huge experience (Bhatia runs InterGlobe, a travel services company).Allowing the management “do its thing” is an advantage, according to Ghosh. “In many places, owners get involved with management with disastrous results.” The most striking and recent example is Kingfisher Airlines and its promoter Vijay Mallya. Neil Mills quit as Spice-Jet CEO earlier this year owing to interference from promoter Kalanithi Maran. Kingfisher has been grounded for more than a year and SpiceJet is in turmoil.Shakti Lumba, a former vice-president of operations at IndiGo, says aircraft orders apart, Gangwal laid down the parameters on how the airline should function. “He is the visionary at IndiGo, guiding the airline at the macro level.” IndiGo’s decision to stay the course with one type of planes — the A320s — which renders benefits in terms of managing and training personnel and costs was Gangwal’s. IndiGo has stuck to its business plan and model religiously thanks to Gangwal’s supervision, says the person familiar with its operations.Gangwal, who earlier used to visit India occasionally, is now almost permanently based in the US. Employees at IndiGo say they rarely see him. He is low profile to the point of casting himself as a recluse. Ghosh says it is difficult to fathom that Gangwal is a shareholder, adding that the airline does not even have review meetings. “I am grateful for that.”