Divestment of Air India Ashish Parikh Manavendra Singh Sial Nikolay Nazarov Pallav Jain

Agenda  Case Introduction  Background Duke Air  Background India  Background Air India  Transaction  Issues  Our Analysis  Our Valuation  Case Update

Case Introduction Synopsis  Duke Air is considering an investment in Air India Learning Objectives  Cost of capital considerations  Comprehensive DCF Modeling

Background: Duke Air  Finland’s leading airline  Most profitable European airline in 2000  European revenues make majority of total revenues  Interested to diversify into other markets

Background: India  Largest Democracy  Second largest country - population  Per capita GDP $471  Huge income disparity  In the midst of economic liberalization  Severe corruption

India: Key Economic Indicators

Background: Privatization “…Learning from our experience, especially over the last decade, it is evident that disinvestment in public sector enterprises is no longer a matter of choice, but an imperative…” Address by the President to Parliament in the Budget Session

Background: Privatization Process

Background: Air India  Founded in 1932 as Tata Airlines  Nationalized in 1946 and turned into Air India  1999 Revenues - $1B (Rs 44B)  1999 Assets - $834M (Rs 36B)  18,000 employees  200 world-wide destinations  3.37 million passengers annually

Background: Air India  100% Government owned  Strong Brand image  Strong Operational Capabilities  Strategic partner would increase operational efficiencies  Competitive disadvantage due to small fleet size

Transaction Acquire a 40% equity stake in Air India Requirement of an Indian partner Foreign partner can not have more than 26% stake Additional 20% to be sold to Indian institutional investors All cash transaction Possibility of Indian Airlines divestment

Option to buy Indian Airlines  Probability of IA divestment by 2005 – 40%  Probability of acquiring IA after acquiring Air India – 50%  Expected synergies from such a transaction – 15% of Air India’s operating cash flows

Air India operating details  Air India travel market share of 21% (air traffic in India)  Indian Airlines travel market share of 11%  Major markets: India/U.S. India/U.K. India/Europe India/South East Asia

Air India operating details  Other sources of revenue (MM USD): YearCargoMailCharter

Air India operating details  Fleet size

Air India projections  Revenue growth of 10%  Major costs – aircrafts and fuels tied to US dollars  Fuel costs based on a stable oil price of 27.5 USD/barrel  High capital expenditure in and for fleet augmentation  Prices consistent with competitive carriers  Debt refinancing assumed to maintain high D/E ratio

Air India projections

Issues to consider  Adjustment to operating cash flows  Adjustments to cost of capital  Other adjustments  Incorporating Indian Airlines option (probability of 0.4 and 0.5)  Other qualitative issues

Our Analysis

Analysis: Risks Entry and Market Risk Competition: IA, regional airlines Lack of similar deals - little learning Operational Risk Little resource risk: AI has great infrastructure Fuel Prices Labor unions: long term contracts risky Operational control Sovereign Risk Currency Expropriation risk Creeping expropriation risk Political instability Indo-Pak Conflict Financial RiskHigh Leverage but reduced due to involvement of GOI Need for an Indian partner: risk factored by Duke Air

Analysis: Mitigants Entry and Market Risk No timing or pre-completion risk Operational Risk AI has great infrastructure VRS scheme Potential to obtain operating control Sovereign Risk Revenues consistent with competitors Low expropriation risk due to high D/E ratio High creeping expropriation risk (low corporate tax) Project impacts other divestments Financial RiskHigh Leverage but reduced risk due to involvement of GOI Various business houses interested to venture into Indian air market

Analysis: Cost of Equity  ICCRC India Assumptions:  Risk Free Rate = 4%  US Market Risk Premium = 3%  Anchored to US ICCRC Cost of Capital for India Cost of Equity (ICCRC)19.5%

Analysis: Cost of Equity

Analysis: Use of Multiples  Acquisition Multiples Not meaningful, due to regional and other differences  Trading Multiples P/E: Regional differences, AI negative earnings EBITDAR: Best multiple for industry, but also problematic due to high leverage and lack of comparables

Analysis:Changes in Valuation  DCF approach - Free Cash Flow to Common Equity (FCFCE).  Operating Cash Flows were adjusted down by 5% to reflect resource risk and operational inefficiencies.  Risk adjustments reduced the cost of equity capital from 19.5% to 19.03%

Analysis: Changes in Valuation  Scenario wrt. equity investment in Indian Airlines (real option)  Terminal Value growth rate – 2%  Exchange rate is determined from the Purchasing Power Parity -Assumptions -US inflation rate 2% -Indian inflation rate 5%

Our Valuation

DCF Model  FCFCE projections for the next 13 years  Main Issues Revenue Projections (10% growth rate over the next 10 years) Alliance/Consolidation Benefits Fuel Costs Debt Pay down

Valuation  Monte Carlo Simulation -Jet fuel price is modeled as a function of oil price. -Simulation of oil price as random walk with a drift. -Embedded parameters in oil price simulation are conservative. -Since jet fuel is a part of COGS, after-tax effect is imputed.

Expected Value AI

AI Value with IA option

DCF Present Value  For AI only Expected PV– US $75.16 million Likelihood of positive NPV – 80.76%  For AI considering the synergistic benefits from acquiring IA Expected PV (median) – US $ million

Valuing AI with real option  Probability of IA divestment – 40%  Probability of acquiring IA by Air India – 50%  Decision tree framework – expected value for Air India

Decision tree

Multiples Valuation (regional airlines)

Valuation: Bid Value  Bid - 77 MM USD  AI great strategic fit Bid

 Duke Air did not win the bid  Political issues surrounded the privatization process  Trade unions raise concerns over divestment  Government defers divestment of Air India Case Update

Questions?

Air India References  Information memorandum and valuation model from a leading Investment Bank  Other Emerging Market cases  Presentation by HSBC on divestment in India  Discussions with Ministry of Civil Aviation  Some of the case facts, cash flow projections and probabilities have been modified for simplification