Case 14

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KINGFISHERAIRLINES – ACQUISITION OF AIRDECCAN: INDIA’S FIRST LOW-COST CARRIER

Mahmud Hossain and D. G. Allampalli

Publication No: ABCC-2009-004Print copy version: 12 Nov 2009

Associate Professor Mahmud Hossain and D G Allampalli prepared this case based on public sources. As the caseis not intended to illustrate either effective or ineffective practices or policies, the information presented reflects theauthors’ interpretation of events and serves merely to provide opportunities for classroom discussions.

COPYRIGHT © 2009 Nanyang Technological University, Singapore. All rights reserved. Not to be reproduced,stored, transmitted or altered in any way without the written consent of Nanyang Technological University.

For copies, please write to The Asian Business Case Centre, Nanyang Business School, Nanyang TechnologicalUniversity, Nanyang Avenue, Singapore 639798Phone: +65-6790-4864/5706, Fax: +65-6791-6207, E-mail: [email protected]

In 2005, Vijay Mallya, Chairman of United Breweries Holdings Limited, founded Kingfisher Airlines(Kingfisher), a premium Full-Service Carrier (FSC) aiming to be a market leader by 2010. Twoincumbents, Air Sahara, a FSC and Air Deccan, a Low-Cost Carrier (LCC)offered low fares andwere giving Kingfisher tough competition. By 2006, as some FSCs and most LCCs incurred losses,the Indian aviation industry was headed for consolidation.

In March 2007, Air Deccan, India’s first LCC promoted by Captain G.R. Gopinath, which offeredlow fares for early birds, had garnered more than 20 percent market share and was looking forstrategic investors. As Air Deccan’s fares and competition had hurt all FSCs including Kingfisher,Mallya was looking for opportunities to acquire it. With negative earnings before interest, taxes,depreciation, amortisation and aircraft rentals, and no financial or stock-market comparables tovalue the loss-making LCC, Mallya came up with an offer of Rs. 5,500 million for a 26 percentstake in May 2007. As Kingfisher and Air Deccan inherited different business models, brands,management and leadership styles, and organisational culture, industry analysts and aviation expertswere divided on the valuation and offer of Kingfisher, and the alignment of the two founders’leadership style and vision.

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KINGFISHER BUYS STAKE IN AIR DECCAN

At end-May 2007, Vijay Mallya, Chairman of UBHoldings Limited (UBH) agreed to buy a 26 percentstake in Deccan Aviation Limited, Bangalore (DAL)from the owners of India’s first LCC, Air Deccan.Mallya made an open offer to acquire an additional20 percent stake from the open market. The newstake would make UBH the largest shareholder inDAL. Further, the combined 32 percent market shareof UBH-promoted Kingfisher and Air Deccan wouldenable it to surpass the 31 percent share held by JetAirways and Air Sahara, and become the marketleader. David Huttner, a Belgium-based internationalaviation analyst, commented:

Common shareholding in itself is notlikely to change much. We have thesame capacity chasing the same market,just under bigger umbrellas, therefore,its hard to see fares rising in the shortterm.They need to put together acoordinated and well thought out strategyas to how they will allocate their assets,improve efficiencies and lower theircosts, all the while enhancing revenue.1

UNITED BREWERIES HOLDINGS LIMITED

Mallya began his career with Hoechst (now Aventis),an American corporation and worked in the UnitedStates and United Kingdom before joining his fatherat the Bangalore-based United Breweries Limited in1980. Three years later, after the demise of his father,he took over chairmanship of UBH, a group ofcompanies with core business interests in liquor andspirits, which had diversified into pharmaceuticals,paints, agrochemicals, polymers and food products.

Within two decades, UBH’s spirits business becamethe fifth largest beverage alcohol group after Diageo,Pernod Richard, Allied Domecq Spirits and Wine Ltd,and Bacardi by sales. Further, its spirits businesshad seven millionaire brands and 36 percent share inthe Indian beer market, and its flagship brand‘Kingfisher’ was sold in 32 countries.2

1 Mallya buys 26 pc in Deccan for Rs 550 crore. (2007, May 31). Hindustan Times, India.2 Vijay Mallya: beyond the “liquor baron.” Sify Finance. Retrieved 31 March 2008 from http://sify.com/finance/

fullstory.php?id=132214903 Leahy, J. (2007, October 26). Vijay Mallya FT.Com.4 ibid.5 A millionaire brand: Beverages that accounts for sale of one million cases or more. (SWC adds 6 millionaire brands to UB Group.)

(2005, Mar 26). The Financial Express, India.

Founder to Brand Icon

At the age of 28, Mallya took over the family business.His lavish lifestyle brought him into the corporatelimelight at an early age. On corporate India then, hesaid:

But of course India in those days,particularly, corporate India was far moreconservative. So obviously my lifestyleattracted a lot of attention and [my career]began with a lot of adverse comments,that my lifestyle would drive UB down thetube.3

In 1992, Mallya decided to deploy his youth andpopularity to boost UB Group’s brands and coinedthe “King of Good Times” slogan for the company’sbeer. However, good times arrived for Mallya outsideIndia when he made a US$66 million profit after buyingand selling the UK-headquartered Berger Paints whichhe spent on fast cars, yachts and maintaining his40-odd international homes. On his transformationfrom chairman of the UB Group to its brand icon, hesaid:

My own lifestyle got intertwined with thebrand personality and so without reallyplanning it that way I became almost myown brand ambassador and that’s justthe way it’s kept on developing.4

By 2006, UB Group had grown into a Rs 6.82 billionbusiness conglomerate and the liquor business hadcreated 15 millionaire brands.5

KINGFISHER AIRLINES LIMITED

Startup

In 2005, UBH decided to enter the aviation industry,by leveraging on its unique strengths acquired throughthe spirits and beer business over the past twodecades.These were understanding the evolving Indianconsumer, creating premium products, building brandequity and market leadership while operating in a

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regulated market (see Exhibit 1), and exploiting thegrowth potential offered by the Indian aviation industry.

On 9 May 2005, UB Group set up Kingfisher as a100-percent owned subsidiary (see Exhibit 2). Themanagement of Kingfisher hoped to provide superiorexperience in air travel to its customers by beingahead of the competition in product and serviceofferings. It deployed brand new aircraft and chose afive element product concept: highest seat pitch,personalized entertainment, hot meals, home deliveryof tickets and valet service at the airport (see Exhibit3).6 Further, it considered the travellers on Kingfishernot as passengers or customers but asserted thatthey were its “guests”.

To reduce boredom on the ground and onboard, thecarrier provided X-box games in its lounge andinstalled state-of-the-art in-flight entertainmentsystems including video-on-demand, live television7

and WiFi services, raising the bar for rival carriers.Further,should a guest spill coffee or tea on their attire,the carrier would gift a brand new white Arrow shirt.8

With excellent service and punctuality, the carrier wonthe hearts of corporate travellers as well as marketshare from its competitor, Jet Airways. Kingfisherbegan with four flights per dayand spread its domesticnetwork to 104 flights per day to 16 cities by inducting17 aircraft in one year. Also, it set the world recordfor fastest aircraft induction in the year 2005-06.9

Organic Growth: To expand domestic routes and enterinternational routes, Kingfisher decided to increaseits fleet and placed orders for many wide-bodiedA340-500s,A330s, and A350s, and became the first carrierto sign-up for A380 type aircraft in April 2007. Mallyasaid, “Kingfisher Airlines needs more wide-bodies for2009-10, partly because of delay in the A380”.10 Also,he was very optimistic that the Ministry of CivilAviation(MCA) would waive the five-year operations eligibilityrule to grant Kingfisher the rights to fly internationalroutes before May 2010.11

By 2007, the carrier expanded its route network to34 cities and its fleet to 34 aircraft, while doublingthe frequency to 208 flights per day.Also, it introducedKingfisher first to increase yield and also exploredthe opportunities to acquire existing airlines. From2005 to 2007, the market share of Kingfisher increasedfrom two percent to 13 percent and the market shareof its competitor, Jet Airways, dropped from 45percent to 22.7 percent.12 By providing safe and truevalue air travel, Kingfisher hoped to attain marketleadership by 2010 (see Exhibit 4).13 AlthoughKingfisher was not required to report its financialspublicly, its management occasionally sharedfinancial data during corporate presentations. Forfinancial year 2006, the carrier’s loss before tax wasRs 1,908 million (see Exhibit 5).

Although Kingfisher experienced high traffic on themetrpolitan city routes like Bangalore, Mumbai, NewDelhi, Kolkata and Chennai, congested airportinfrastructure in these state capitals limited its organicgrowth. With airport modernization in these cities setto be completed14 between 2008 and 2010, and toughcompetition from a large number of new entrants andLCCs offering low fares, the carrier’s future growth inthe domestic market depended on the ways itincreased its market share.15

Inorganic Growth: In 2005-2006, the clouds ofconsolidation began to appear due to a large numberof new entrants, creation of excess capacity due to alarge number of new aircraft, fierce competition andunrealistic pricing by LCCs which led to industry-widelosses and created opportunities for mergers andacquisitions. Both Kingfisher and Jet Airways wereexploring potential markets to expand theiroperations. In late 2005, they bid for the acquisitionof Air Sahara, whose valuation by Ernst & Youngcaused a furor in the market. In response, Mallyasaid:

We will put in an indicative offer, whichwill show the price valuation range that

6 UB Group Presentation. (2006, September). Retrieved 27 May 2008 from http://www.theubgroup.com/finance-presentations.aspx7 Emirates and JetBlue were the other carriers to provide such in-flight services8 Mehra, P. (2007). Flying colours. Businessworld, India.9 United Breweries Holdings Limited. (2005-2006). Annual Report.10 Ionides, N. (2007, June 12-18). Kingfisher makes swoop for additional widebodies, Flight International.11 ibid.12 Mehra, P. (2007). Flying colours. Businessworld, India.13 UB Group Presentation. (2006, September). Retrieved 27 May 2008 from http://www.theubgroup.com/finance-presentations.aspx14 2008 – Bangaluru & Hyderabad; 2010 – New Delhi, Kolkata, Mumbai & Chennai; and 2012 – Navi Mumbai14 Allirajan, M. (16 Nov

2007). Flight or Fancy. Businessworld, India.15 Allirajan, M. (2007, November 16). Flight or Fancy. Businessworld, India.

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we are willing to offer before the deadlineexpires. However, the US$750 million -US$1 billion initial estimates are way toohigh in relation to earnings.16

In October 2005, Mallya conducted an independentdue diligence of Air Sahara and stated that he hadoffered “substantially less” than what Air Saharaexpected for the sale of its 100-percent stake.17 Uponscrutinizing the bids, the management of Air Saharafound that Kingfisher’s US$600 million offer was spreadover three installments while Jet Airways’ offer wasall in cash but slightly lower than Kingfisher Airlines’at US$500 million. As such, Kingfisher lost theopportunity to acquire Air Sahara and was on thelookout for new airlines to acquire or fly oninternational routes (see Exhibit 6).

DECCAN AVIATION LIMITED

In December 2006, Mallya and Captain G. R.Gopinath, Chief Executive Officer (CEO) of DAL metin Mumbai to explore the possibility of a mergerbetween Kingfisher and Air Deccan, India’s first LCCset up in August 2003. Air Deccan began scheduledflights with a single ATR turbroprop aircraft to flypassengers from Bangalore to Hubli, an industrial townin Karnataka. It envisioned the provision of a cost-effective and commercially successful alternative tothe traditional ways for domestic travel used by theIndian mass consumer market.

Business Model: Low-Cost Carrier

The management of Air Deccan emulated the LCCmodels from the west to create a “no-frills, low-cost”business model for India. Some of the elementsconsidered in Air Deccan’s strategy were offering lowfares on new routes to stimulate demand fromuntapped markets, and reducing costs by higheraircraft utilisation and standardisation in its fleet.

From mid-2005 to early 2007, Air Deccan offered alarge number (10,000 to 200,000) of low-fare ticketsin the price range of Rs.1, Rs.2, Rs.3, Rs.5, Rs.6,Rs.499 (inclusive of taxes) and Rs. 999 (inclusive oftaxes) to celebrate the carrier’s anniversaries,Christmas, and events like Air Deccan attaining 21.2

percent market share in June 2006, when it becameIndia’s second largest airline.18 It used Internetservices and other unconventional sales channels suchas Call Centre, SMS and GPRS technologies todistribute air tickets.

To better serve the metropolitan and regional air travelmarkets of India, the management of Air Deccanadopted a two-type aircraft fleet strategy:- 11 Airbus A320 jets for the trunk routes connectingthe six largest cities of India.- 18 ATR turboprops to serve the regional cities.

It noticed high demand for point-to-point travel fromsmall towns/cities to urban cities and feed traffic tometropolitan cities which were hubs. Creating thisconnectivity enabled Air Deccan to create newmarkets and expand the size of the aviation marketby attracting several first-time air travelers. It believedthatATR turboprops were best suited for such routes.Of 29 such aircraft, 26 were on operating lease19 inMarch 2006 (see Exhibit 7).

Operations and Performance

Tapping into the demand generated by low fares, AirDeccan grew its operations. The routes flown by thecarrier grew from 14 routes in 12 airports in 2004 to85 routes in 52 airports by late November 2005.During the same period, the passenger load factor(ratio of the number of available seats to the numberof passengers flown) improved from 62.6 percent inMarch 2004 to 76.4 percent in March 2005. FromApril to November 2005, the number of passengersflown reached nearly 16 million and the load factorremained around 73 percent. Air Deccan’s incomerose from Rs. 314.18 million in 2004 to Rs. 2,669.46million in 2005, and for the first eight months of 2005,its income touched Rs. 4,458.98 million (see Exhibit8).20

Despite the sales growth, Air Deccan incurred netlosses (after all adjustments) during FY2004, FY2005and the first eight months of 2005 amounting toRs. 117.10 million (March 31, 2004), Rs. 352.32million (March 31, 2005) and Rs. 1,179.36 million(eight months ended Nov 30, 2005), respectively.21

Its net worth had turned negative to Rs. 123.73 million

16 Mallya to put in ‘indicate offer’ for Air Sahara stake. (2005, October 30) Business Line, India. Retrieved July 27, 2006, from http://www.thehindubusinessline.com/bline/blnri/2005/10/30/stories/2005103001960100.htm

17 Mallya offers less than US$750 million for Air Sahara. (2005, November 30). The Financial Express, India.18 Air Deccan. (2005-2006). Media Releases.19 A type of ownership when in an airline leases an aircraft from its owner in exchange for rental payment20 Deccan Aviation Limited. (2006, April 28). IPO Prospectus, .pp8-9.21 ibid.

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by March 2005 and further increased to Rs. 1,141.48million by November 2005. The carrier met part of thelosses by increasing its share capital which rose fromRs. 161.99 million to Rs. 462.57 million and theincreased loss of Rs. 1,017.75 million was fundedusing a mix of secured loans, unsecured loans andcurrent liabilities (see Exhibit 8).

The management of Air Deccan attributed its poorperformance to non-availabilityof aviation infrastructureat key airports in cities which provided efficient point-to-point connectivity, traffic density and parking spaceto maximise passenger yield. Further, the losses werepartly attributed to delays in the allotment of aircraftparking lots in Mumbai where its competitors hadmore aircraft parking lots and were able to mountmore flights. Commenting on the fare tactics adoptedby some dominant incumbents, Gopinath recollected:

You know what Jet, Sahara and IndianAirlines did in those days? If I [AirDeccan] had one flight at 1000 hrs, theyhad 10 flights a day. They would put aflight at 0930 hrs and slash the fare belowmine and increase it on all the otherflights. That’s the reason we had toexpand the way we expanded.22

With no hangars at these key airports, Air Deccanexpanded on low-density traffic routes and sufferedpoor turnaround of aircraft. Furthermore, several birdhits to aircraft, resulting in reduced availabilityof suchaircraft and cost of repairing blades and engines, aswell as lower fares contributed to the losses.

Financing Growth: Private Equity and IPO

As internal cash generation was insufficient to fundits expansion and growth,Air Deccan was dependenton injection of external capital for financing operationsand growth. By 2004, the management raised Rs.1,840 million (US$40 million) by placing private equitywith ICICI Ventures (India) and Capital International(USA)23 to fund the purchase of 60 aircraft (30 ATRs

and 30 AB320s) over the next five years using a mixof buying and leasing.24 Next, it raised capital fromthe market through an initial public offering (IPO) byoffering 24,546,000 equity shares of Rs. 10 eachthrough the book-building process in the price bandof Rs. 150 to Rs. 175 and hoped to raise Rs. 3,800million or Rs. 4,440 million, respectively. It hoped todeploy these funds to set up a training centre (Rs.656.69 million), hangar and maintenance facility (Rs.400.20 million), infrastructure at airports(Rs. 170.83 million), market development initiatives(Rs. 452.20 million) and debt payment (Rs. 1,327.50million).25

On the Air Deccan IPO, an analyst said, “The loss-making company would breakeven only after twoyears. So the investors were a bit bearish since thefirst day of the issue. The carnage in the marketaggravated their fears.”26 Also, some analysts felt thatthe leading merchant bankers such as ABN Amro,JP Morgan and State Bank of India (SBI), who wereinvolved in the preliminary discussions, were droppedin the management of the final issue because thesemerchant bankers did not agree to the valuationsproposed by the management.27 Another analyst, said:

Since Air Deccan isn’t making any profityet, a P/E comparison isn’t possible. AirDeccan’s issue size is Rs 430 crore28 atthe higher end of the price band for 25%of the post-issue equity - the valuationof the company works out to Rs 1,718crore. The other listed players in theaviation business - Jet Airways andSpiceJet – command valuations ofRs 8,281 crore and Rs 1,315 crorerespectively. While Jet Airways is a largerairline with a fleet of over 50 aircraft,SpiceJet has a fleet of less than 10aircraft.29

In an interview with an online portal for aviationindustry, Gopinath responded:

22 Bhargava, A. (25 September 2006). Captain Gopi Defends Himself. Businessworld, India.23 Mahalingam, T.V., & Mitra, K. (2007, June 3). On a wing and a prayer. Business Today, India.24 Air Deccan inks US$40 million with ICICI Ventures. (2004,December 15). The Financial Express, India.25 Deccan Aviation Limited. (2006, April 28). IPO Prospectus, pp.30.26 Air Deccan extends IPO, cuts price. (2006, May 24). Rediff.com. Retrieved 4 June 2008 from http://in.rediff.com/money/2006/

may/24deccan.htm27 Dalal, S. (2006, May 28). Succinct Analysis. Indian Express, India. Retrieved 8 June 2008 from http://www.indianexpress.com/

sunday/story/5315.html28 Crore – Ten million rupees make a crore29 Vijay, P.N. (2006, May15). Your Money IPO Update. Retrieved 8 June 2008 from http://www.askpnvijay.com/IssueMtrArticlesPdf/

Deccan%20final%20report.pdf

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Many times, the bullishness orbearishness of a stock market is not thetrue reflection of the condition of acountry’s economy or a company. WhatI mean is that when the market is on anupswing, stock prices gallop, and acompany’s value goes up. And theconverse happens when it crashes. …Asfar as our own valuation is concerned,we had wanted the issue price to beRs 150-175 but because the marketcrashed, we lowered the allotment priceto Rs 148. In my view, this may not bethe true value for my company or for anyairline.30

As Air Deccan’s IPO failed to evoke investor responseand achieve full subscription before the closing dateof 23 May 2006, the management extended thedeadline and also pared the lower price-band by fourrupees. It hoped the extension would provideopportunities for investors whose finances werelocked up in the stock market. Thus, Air Deccan justmanaged to raise the targeted amount.

By June 2006, Air Deccan losses had touchedRs. 3,400 million for the last 15 months of operationsand it faced a tight cash-flow situation. In October2006, Air Deccan sought US$100 million (approx:Rs. 4,500 million) funding from Southwest TradingLimited (funded by two European Banks: Investecbank, UK and HSH Nord Bank AG, Germany) to payfor the 96 aircraft order which would be completed by2013 (see Exhibit 9).31 As debt would createadditional burden on the cash flow of the carrier, themanagement chose a ‘unique financial structuring’route. The disbursement of US$30 million of theUS$100 million, helped the carrier to show a modestprofit of Rs. 96.40 million on sales of Rs.6,370 millionfor the second quarter of 2006-2007 compared to aloss of Rs. 429.4 million in the previous quarter.32

Describing the achievement, Gopinath commented:

One way to look at it is that we have along way to go as we need to makeabsolute profits (operating profits). Butthen we have started turning around

now….If the airline is able to make Rs4,900 per ticket at 80 percent seat factor,it can turn profitable straightaway.However, it manages to make Rs 4,400per ticket now. …We have to find a wayto make an extra Rs. 400-500 per ticketand we could sail through. Three yearsago, only about 13 million passengersflew and today it has gone up to 30 millionwith Air Deccan alone flying 8 millionpassengers.33

Commenting on India’s domestic air travel marketpotential, he said, “We need to look at the big picture.We need to make 150 million-200 million middle classto make flying their part of lifestyle or work culture.”34

Analysing the Q2 2006-07 performance and futuregrowth in fleet, Mohan Kumar, Chief Financial Officer,said:

Our second quarter [Q2 of 2006-2007]revenues have increased by 19 percent.This has been possible mainly onaccount of being able to control ourcosts. Our cost per seat km is Rs 3.18,which is among the lowest in the country.Our average yield per passenger is Rs2,615 this quarter compared with Rs2,512 in the quarter ended December2005 despite a significant increase inseat capacity.35

During the quarter, Air Deccan inducted four A-320s.It has added 24 new routes, 38 new flights and sixnew destinations including three monopoly sectorsto its network. The airline carried 1,645,362passengers and launched its eighth aircraft base atAhmedabad in November. It had on order 81 newaircraft to be delivered over the next six years.36

However,Air Deccan could not sustain its performancein the third quarter of 2006-2007 when it incurred aloss of Rs 2,130 million on sales of Rs.4,574.5 million.The airline clarified that the modest profit of the secondquarter of 2006-2007 was due to the structuredfunding, and cited rising costs, including fuel, for thehuge loss in the third quarter of 2006-07.37 Also, the

30 Gopinath, G. (2006, July 4). Our IPO got caught in a tsunami. Retrieved 4 June 2008 from http://www.airlines.org.in/airline/air-deccan/page/4/

31 Deccan Aviation in deal with 2 European Banks. (2006, October 14). Business Line, India.32 Deccan Aviation Q2 net profit at Rs. 9.6 crore. (2007, January 27). Business Line, India.33 ibid.34 ibid.35 ibid.36 ibid.37 Dey, S. & Jha, U. (2007, May 31). SBI extends deadline for Air Deccan’s loan repayment. The Economic Times, India.

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carrier needed funds to repay the State Bank of India(SBI) the two tranches of Rs. 1,000 million it borrowedby providing its cash flow as collateral before June2007. The management revealed that although SBIextended the original payment deadline, the bank didnot indicate any period for such extension and thetime-frame for the repayment of the Rs.1,000 millionloan.38

Valuation

In order to shore up depleted finances and meet AirDeccan’s cash flow needs, its management decidedto divest part of the promoters’ 22.13 percent stake39

to a strategic investor. In early 2007, it appointedEdelweiss Capital, a Mumbai-based investmentbanker to advise the company on the deal.40 In mid-2006, though Mallya had evinced interest to invest inAir Deccan, Gopinath was reluctant to sell the entirestake in the carrier which he had built with passion.

The Target

Mallya felt that Air Deccan was an ideal target forKingfisher. Compared toAir Sahara, he observed thatAir Deccan’s fleet, engines, brakes, avionics androtables41 including the vendor for maintenance,Lufthansa Technik, were common to Kingfisher.Drawing parallels with KLM-Air France and Qantas-JetStar, Mallya felt that the combined carrier wouldbe able to mount 537 flights per day, connect to 69destinations and be a market leader.42 Further he hadseen the total passenger traffic in India grow from15.68 million in 2003-04 to 25.20 million in 2005-06at a compound annual growth rate (CAGR) of around20 percent but the domestic passenger traffic hadgrown at a higher CAGR of 22 percent.43

However, the Indian airline industry performance wasmixed. In line with the rise in passenger traffic, theoperating performance of private scheduled carriers(PSC) was better than the national scheduled carriers(Indian Airlines and Air India), which incurred acombined loss of Rs.3.63 billion in 2005-06 (seeExhibit 10). The PSC made profits in 2003-04 and

2004-05 but incurred a loss in 2005-06 due toovercapacity, overcrowded market and competitionfrom the budget carriers, and their lower fares. Thetotal operating revenue of all scheduled carriersdeclined from Rs. 274.3 billion to Rs. 198.9 billionand then rose to Rs. 255 billion during 2003-04, 2004-05 and 2005-06, respectively.

Industry consolidation became necessary to attainoperational scale and economies for the domesticcarriers. Further, analysts felt that acquiring AirDeccan would enable Kingfisher to launchinternational flights in 2008 because it completed the‘five-years-in-operation’ requirement for flying oninternational routes. However, in 2007, industryexpertshoped that the Ministry of Civil Aviationwould relax the eligibility to three years.44 During thisperiod, India’s gross domestic product grew between6 to 8 percent and it was likely to sustain the samepace of growth in the future and thereby boost thedemand for domestic air travel.

The Deal and Valuation

After the IPO of Air Deccan in May 2006, theshareholding was widely held with promoters owning22 percent (Gopinath - 11 percent, and the rest byCaptain K. J. Samuel and Vishnu Raval). Theremaining 78 percent was held by the public includingfour bulk owners who held between 7.5 to 13.5 percentstakes and were waiting for a right price to cash out.45

In the last week of May 2007, Mallya sprang a surpriseand made another offer forAir Deccan at Rs. 155 pershare for a 26 percent stake but assured continuedinvolvement of Gopinath in the carrier’s management.

Further, Mallya’s offer was higher than the IPO lower-band price as well as the closest contender’s,Reliance-Anil Dhirubhai Ambani Group, whichapparently had offered Rs. 140 per share. FromMallya’s new offer, Gopinath felt that the Air Deccanbrand and its LCC model would continue. Mallya’sbid at Rs. 155 per share put the stake valuation atRs. 5,500 million.

38 Dey, S. & Jha, U. (2007, May 31). SBI extends deadline for Air Deccan’s loan repayment. The Economic Times, India.39 Public – 33 percent, UK-based Investec bank – 1.96 percent and Corporate Investors – 45 percent)40 Anil eyes 26 percent in Air Deccan, leads race. (2007,April 19). Retrieved 3 April 2008 from http://annonline.in/bizimages/

newsdet.aspx?q=3089&q1=4/20/200741 Component or inventory item that can be repeatedly and economically restored to a fully serviceable condition. (Source:

BusinessDictionary.Com. Retrieved 24 April 2009 from http://www.businessdictionary.com/definition/rotable.html)42 Bhargava, A. (2007, June 18). Sultan of the skies. Businessworld, India.43 Air Transport Statistics. (2005-2006). Director General for Civil Aviation, India. Retrieved 12 January 2009 from http://dgca.nic.in/

reports/stat-ind.htm44 Mahalingam, T.V. & Mitra, K. (2007, June 3). On a wing and a prayer. Business Today, India.45 ibid.

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Keeping in mind the concerns and expectations ofthe two leaders, Edelweiss Capital prepared a revisedproposal after the duo negotiated the share price(Rs.160 versus Rs. 155) and number of directors (4versus 3) and closed the deal. An agreement wasprepared, both the parties signed and Rs. 1,500million was deposited by Kingfisher in an escrowaccount.46

To complete the acquisition, DAL would need to issue35.20 million new equity shares to the UB Group atRs. 155 per share (a premium of Rs. 8.80 over theclosing price of DAL’s share at 146.20).47 Gopinathclarified that there was no sale of promoter’s holdings:

The entire Rs. 550 crores will comethrough preferential shares…There hasbeen no sale of individual shares. Noneof us have sold shares. We (Air Deccan)will continue to be an independent identityand pursue our low-cost business model.Our combined market share will go upto 33 percent – Air Deccan 22 percentand Kingfisher 11 percent.48

Although industry analysts welcomed theconsolidation, investment bankers were divided overthe price paid by Mallya. Covering the event, Rediff,an online portal reported the response of aninvestment banker:

This is a crazy valuation. Mallya has paidsubstantial premium to Air Deccan forno reason. Kingfisher Airlines, which ismaking Rs. 500 million a month, hasjoined hands with Air Deccan which ismaking huge losses.49

However, Ravi Nedungadi, Chief Financial Officer ofUB Group defended the arrangement and said:

It is a good deal. We are paying the rightprice for Air Deccan. It would make bettersense to pay Rs. 5,500 million for AirDeccan, which has 23 percent marketshare rather than acquiring Air Saharawith a market share of less than 8percent.50

Another business analyst, reporting for the businesssegment of a weekly magazine, observed that thevaluation of airlines in India was tricky as they werevalued high despite negative earnings before interest,taxes, depreciation, amortisation and aircraft rentals(EBITDAR). As most airlines were making losses,the EBITDAR was negative and valuation techniquesfailed to estimate the true value of the carrier. Forexample, the valuation of Air Sahara by Jet Airways,in which Mallya also participated, was found to beexcessively high and Jet Airways needed torenegotiate the agreed enterprise value. In the caseof Air Deccan, a business analyst estimated that theenterprise value was Rs. 21,150 million (on the basisof Rs. 5,500 million for 26 percent stake) as againstthe current market capitalization, a proxy forenterprise value, which was Rs. 14,540 million.51

ACQUISITION AND MERGER

As soon as UB Group bought 26 percent equity inDAL, the management of Kingfisher took control ofAir Deccan. While Gopinath was made the ExecutiveChairman of DAL, Mallya became its Vice-Chairman.The Boards of DAL and UB appointed KPMG asconsultants and Dalal & Shah as charteredaccountants to develop the merger structure for thetwo carriers. The continuation of Air Deccan’s ChiefOperating Officer, Warwick Brady, was dependent onthe terms offered by the new management. Alreadyrumours abounded that Brady would leave the airlineand Air Deccan had appointed Spencer Stuart to hirea CEO for the carrier. Moving forward, the twomanagement set up an integration team anddeliberated upon the issues that the two airlines wouldface in aligning their mission and vision.

Brands

The Board of DAL rechristened Air Deccan as“Deccan” and its corporate tagline ‘Simplifly’ became‘Simplifly Deccan.’ Deccan operated as a LCC butits logo was replaced by the red Kingfisher image.Brand management experts felt that it was brandextension without the name ‘Kingfisher’ and wonderedhow it would drive sales and improve the profitability

46 Bhargava, A. (2007, June 18). Sultan of the skies. Businessworld, India.47 26% makes Mallya Air Deccan co-pilot. (2007, June 1). The Financial Express, India.48 ibid.49 Sanjai, P. R. (2007, June 1). Did Mallya pay more for Deccan pie? Rediff.Com. Retrieved 12 March 2008 from http://inhome.rediff.com/

//money/2007/jun/01deccan.htm50 ibid.51 Kaul, P. Prasad, A. (2007, July 5). When the clouds clear? Outlook, Business, India.

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of Deccan.52They also pondered on the issue of whatKingfisher had bought: a brand or business?

Several first-time flyers from the new cities which AirDeccan flew had made Gopinath synonymous withlower fares and air travel.53 Some industry expertsbacked Gopinath as a brand ambassador for the low-cost airline industry and Deccan. They were not surewhether Deccan would become a drag and Kingfishera driver or vice-versa. Also, they noted that the valueattrributes of the two carriers were different andwondered how these two companies could build bothbrands in the future. Although these decisionsimpacted future brand building and marketing plans,the integration team’s primary task was to tap thesynergies and achieve cost savings.

Operations

The team realised that streamlining the routes andoperations of both carriers was not easy, due toinfrastructure bottlenecks on the metro routes thatprovided high traffic density and load factors. Firstly,the team needed to strike a balance between themetro and regional routes or profitable high trafficdensity routes versus the low traffic density regionalroutes. Secondly, while Kingfisher’s immediatepriorities were profitable route operations and growth,the priority for Deccan was cost control and to raiserevenues to improve yield.

Deccan’s strategy was to unlock value for the IPOinvestors by setting up maintenance, repair andoverhaul organisation and eventually, spawning theseinto new businesses. While Gopinath focused ondomestic network growth and low fares, Mallya waskeen to mount international flights.As Deccan beganoperations in 2003, it was about to reach the ‘five-years-in- operation’ condition to fly overseas, whichmeant that Deccan would have to remain standalone.The team also had to deal with aircraft orders placedby Deccan and Kingfisher which included AB320sand A380s.

Synergies

To tap the anticipated synergies, the integration teamconducted a review of operations, manpower and

back-office processes, Maintenance, Repair andOverhaul (MRO), purchasing and Frequent FlyerProgramme (FFP), and sales and marketing. Theyestimated that for the first year alone, the costsynergies would be Rs. 3,000 million.54 The teambelieved that there was a good operational fit and fleetalignment between the two carriers. Gopinath stated:

We both have Airbuses, we both haveATRs, the combined fleet will be now 71aircraft. So, negotiating with any vendor,any supplier globally, is going to give usa tremendous leverage in bringing downour acquisition costs, in bringing downour contract costs and bringing down thecosts for both airlines tremendously.55

In addition, there was potential for sharing commoncosts for security, ground handling, engineering, andinventoryof spare engines and other materials amongthe two carriers.

Business Model

The team noted that the management of bothcompanies had the option of merging the two carriersunder one brand or running them as separate carrierswith independent brands, which industry expertscalled the ‘hybrid model.’

For example, after the merger of Air Sahara with JetAirways, the LCC was renamed as JetLite, and thesame group ran both the LCC and FSC, emulatingthe successful hybrid model of Qantas and JetStar.Jet Airways separated certain aspects of marketingand customer service, and tapped synergies betweenthe two airlines in the area of back-office operations,purchasing and FFPs.

Although, globally, value-based carrier (VBC)operations by large network airlines had failed, theteam needed to customize and recommend to themanagement of Kingfisher and Air Deccan a newhybrid model.56

Despite the business fit, Gopinath was not optimisticthat the merger of the two carriers would work. Hefelt that the high cost FSC and low-cost LCC model

52 Bhat, S. (2007, December 25-31). Deccan Plateau for Kingfisher. Businessworld, India.53 Mahalingam, T. V & Mitra, K. (2007, June 3). Business Today, India.54 Bhargava, A. (2007, June 18). Sultan of the skies. Businessworld, India.55 I told Mallya a merger won’t work:Gopinath. (2007, June 1). Moneycontrol.Com. Retrieved on 5 June 2008 from http://

news.moneycontrol.com/india/newsarticle/news_print.php?autono=284431&sr_no=056 Mahalingam, T. V & Mitra, K. (2007, June 3 ). On A Wing and A Prayer. Business Today, India.

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could not coexist, as employees of Kingfisher stayedin five-star hotels while Air Deccan’s employeesstayed in guest houses. Air Deccan also did not offercars to air hostesses. Due to these differences,Gopinath did not believe in the merger of the twoairlines.57

Management and Culture

To the general public, both Mallya and Gopinathseemed to be in control of the management. The teamfelt that senior industry executives were not sure whowas in control. A top executive of a rival airline stated:

After having burned so much money, andgambling Air Deccan’s future expansionfor cash upfront, it will be extremelysurprising if someone lets Gopinathretain a say in the management of theairline.58

The team learnt that depending on the way the dealwas structured, the holdings of Gopinath and hisassociate would go down from 22 percent to 16percent.59 At the same time, however, it found outfrom Gopinath that he could muster support of 35percent of the shares through his associates. In aresponse to Fortune magazine, Mallya explained:

With majority stake, that’s prettyinevitable, isn’t it? There is no questionof cut prices continuing in India –everyone wants to raise fares. Deccanis widely regarded as a market spoiler,and that will stop.60

Further, the team saw that the differences in businessfocus between Mallya and Gopinath were made knownto the public when the two leaders openly sharedtheir goals. While Gopinath focused on networkgrowth, load factors and lower cost, Mallya focusedon revenue management:

Earlier the focus was more on increasein the volumes being synonymous with

profits. We are now giving seriousattention to revenue management. Theresults are already showing. The financialcollection of Air Deccan have jumpedfrom Rs. 40 to 45 million per day to Rs.50 to 60 million per day. 61

As LCCs and VBCs accounted for over 80 percent ofnarrow-bodied aircraft orders fromAirbus and Boeing,Gary Kingshott, the CEO of JetLite felt they wouldcapture a significant share of the domestic market.62

FUTURE OUTLOOK

Despite the infrastructural and operational challenges,the senior management teams of Deccan andKingfisher were convinced that a speedyconsolidationin the aviation industry would lead to profitable growth.The hitherto highly fragmented Indian aviation markethad become an oligopoly with three dominant players:Kingfisher-Deccan, JetAirways-Sahara andAir India-Indian.

The integration team was optimistic that turningprofitable to ride on the air traffic boom of the countrywould align the two leaders’ vision, build a win-winpartnership and cement their differences. By foregoingdue diligence, closing the deal promptly and payinga substantial premium to the stock price, Mallya hadwon the trust of Gopinath although he did not believein low-fare operations (see Exhibit 11). Commentingon the expectations from the merger, Mallyaelaborated:

I still don’t believe in the low-cost modelbecause there is nothing low cost aboutoperating an airline in India. What I don’tbelieve in is the low-fare model and thehigh costs associated with operating inIndia. But two things are happening here.With synergy between Deccan andKingfisher, a lot of our joint costs willcome down dramatically. So, we can offerthe cheapest fares to most expensive

57 I told Mallya a merger won’t work: Gopinath. (2007,June1). Moneycontrol.Com. Retrieved 6 may 2008 from http://new.moneycontrol.com/india/newsarticle/news_print.php?autono=284431&sr_no=0

58 Mahalingam, T. V & Mitra, K. (2007, June 3). On A Wing and A Prayer. Business Today, India.59 Bhargava, A. (2007, June 11). Gone for 550 crore. Businessworld, India.60 Elliot, J. (2007, June 25). Fortune.61 Bhargava, A. (2007, June 11). Gone for 550 crore. Businessworld, India.62 Ibid.

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fares…Two, this will consolidate theindustry, which will end this bloodbath ofairfares, which is due to overcapacity inthe market.63

Accounting and tax analysts noticed that Kingfisherhad carried forward a loss of Rs. 12,000 million (as ofJanuary 2008) and Deccan had accumulated lossesof Rs. 8,000 million (as of January 2008) and that it

would be advantageous to keep the two carriersseparate to set off the loss against future profits.64

Going forward, there were many challenging taskson the hands of the team: to prove that Mallya’svaluation of Air Deccan was justified, realise thesynergies identified by the two leaders, and balancethe strong brands and leadership styles of the twoleaders.

63 Bhargava, A. (18 June 2007). Sultan of the skies. Businessworld, India.64 Kingfisher to wet lease 4 new Airbus to Air India. (12 January 2008). The Financial Express, India.

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Source: UB Group Finance Presentations. (September 2006). Retrieved 27 May 2008 from http://www.theubgroup.com/finance_presentations.aspx

• UB Group, having achieved dominance in its core beverage business, was looking to leverage its uniquestrengths ina) Understanding the needs of the evolving Indian consumerb) Creating premium products at true valuec) Operating in a highly regulated environmentd) Leveraging brand equity

• Aviation offers extraordinary growth potential

• Success based on three core strengthsa) Ability to tightly manage costb) Ability to manage scale upc) Ability to deliver a unique experience while remaining competitive

• UB Group is committed to the success of KFA through financial, management, brand and marketingsupport

EXHIBIT 1

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THE UB GROUP AND AVIATIONEXHIBIT 2

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EXHIBIT 4

KINGFISHER AIRLINES – MISSION & VISION

UB GROUP STRUCTUREEXHIBIT 3

CONCEPT OF KINGFISHER AIRLINES

• Superior Experience –

• Highest seat pitch• Personalized in-flight audio & video• Hot meals• Home delivery of tickets• Valet service at the airport

• Standard Aircraft type resulting in high aircraft utilization• All Brand new aircraft operated by International class cabin crew

Source: UB Group Finance Presentation. (September 2006). Retrieved 27 May 2008 from http://www.theubgroup.com/finance_presentations.aspx

VISION:

•The Kingfisher Airline family will consistently delvier a safe, value based and enjoyable travel experience toall our guests

VALUE:

•Safety, Service, Happiness, Teamwork and Accountability

MISSION:

•Be the most successful Full Service, True Value airlline operating in India•Create a following of ‘fans’ and not just loyalists.•Drive ‘Addiction’ to Kingfisher Class and Kingfisher first.•To be the Market Leader by 2010.


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EXHIBIT 5

KFA-INCOME STATEMENT (FY2005-2006)

FINANCIALS - UNAUDITED - FY06

Revenue Statement - Major Items

Rs. Mio Rs, MioIncome 5,845.00

Fuel Cost 2,356.00

Total Operating Cost 6,806.00

Other Cost 760.00

EBIDTA (1,721.00)

PBT (1,908.00)

EXHIBIT 6

KFA – INTERNATIONAL ROUTE STRATEGY

International traffic expected to grow between 18-20% per annum. Current Governemt policy requiring 5 yearsof domestic operations prior to flying overseas likely to be reduced.

As a contingency plan KFA has worked out “damp” lease arrangement with foreign carriers to operate KFAaircraft on international sectors. India – US – India nonstop flights present the most unique opportunity andreduced competition. KFA will concentrate mainly on this opportunity and has ordered specific aircrafy typesto undertake this mission.

KFAwill commence nonstop flights with AirbusA340-500 between Bangalore and San Francisco and Bombayand New York in Q1 2008. KFA will commence nonstop flights with Airbus A330-200 between Bombay andLondon and Bombay and Hong Kong in Q1 2008.All KFA aircraft will be configured in a class 3 layout, offeringSuper First Class, Ultra Business Class and Kingfisher Class.


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EXHIBIT 8

AIR DECCAN – BALANCE SHEET & INCOME STATEMENT FROM 2001 TO 2005

Source: Deccan Aviation Limited. (18 April 2006). IPO Prospectus, pp.57.

Source: Deccan Aviation Limited. (18 April 2006). IPO Prospectus, pp.7-9

Rs. in million

EXHIBIT 7

PROFILE OF AIR DECCAN FLEET (MARCH 2006)

Aircraft Type No. of Passenger Seats Model No. of Aircraft Average Age(years)

ATR 48 42-320 5 1248 42-500 9 8.5672 72-500 4 3

Airbus 180 A320-200 11 3

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EXHIBIT 8

AIR DECCAN – BALANCE SHEET & INCOME STATEMENT FROM 2001 TO 2005(CONTINUED)

Source: Deccan Aviation Limited. (2 April 2006). IPO Prospectus, pp.7-9

Rs. in million

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Source: Deccan Aviation Limited. (18 April 2006). IPO Prospectus, pp.61.

EXHIBIT 9

PROFILE OF AIR DECCAN NEW FLEET (2007-2013)

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Year Passenger Growth rates in Operating OperatingCarried1 Passenger Traffic (%)2 Revenues3 Result4

Domestic International NSC PSC NSC PSC2003-04 15,677,000 12.4 6.9 112.9 161.4 0.12 4.52004-05 19,445,000 24.0 18.6 134.5 64.5 (1.40) 8.92005-06 25,205,000 29.6 22.9 155.8 99.3 (3.63) (2.0)

1 Passengers flown - Table 4.7 of respective years2 Growth rates in percentage – Table 4.2 of respective years3 Operating revenues in billion rupees – Table 4.23 of respective years4 Operating result in billion rupees – Table 4.23 of respective years

Sources: Financial Results of Scheduled Carriers. (2003-04; 2004-05; & 2005-06). Directorate General of CivilAviation, India. Retrieved 12 January 2009 from http://dgca.nic.in/reports/stat-ind.htm

EXHIBIT 10

GROWTH AND PERFORMANCE OF SCHEDULED DOMESTIC CARRIERS


EXHIBIT 11

CONCEPT OF KINGFISHER AIRLINES

WHY FULL SERVICE & NOT LOW COST ?

• Over 60% of variable costs are common for any airline. This includes

• Fuel – 37%• Mainetenance – 10%• Landing and Parking Charges – 7% 60 %• Lease Rentals – 6 %

•Cost such as salaries of Pilots, Engineers etc, are standard and do nto differ between LCC and a fullservice carrier

• In India , there is no cost differential to jusitfy low pricing as in an LCC

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Case 14

Business

Transcript of Case 14