Pre IPO Valuation of Indigo: Time to be an Air-aholic?

Finally, the most awaited IPO in the Indian aviation industry was filed on 30th June 2015. Interglobe Aviation Limited plans to raise at least $400 million from the offering, giving the company a value of around $4 billion (according to media reports citing bankers ). I was curious as to how much the company was worth ( hence the freak part in valuation freak ) and decided to estimate the value of  the firm bearing in mind that the $4 billion value estimated by the investment bankers would be more of pricing rather than a valuation.

The Discounted Cash Flow Valuation:
Any Discounted Cash Flow Valuation can be broken down into four parts:

1. Estimating Expected Cash Flows
2. Estimating the Growth Rate in those cash flows
3. How risky are the cash flows? ( The discount rate )
4.When does the firm achieve Stable growth? ( Terminal Value )

Estimating Expected Cash Flows 

Building the Narrative
Before estimating cash flows, I tried to get a sense of the global airline industry. And it is not pretty. Globally, airlines have been consistently been generating returns below their cost of capital. According to a Mckinsey study for International Air Transport Association,Since 2000 the Return on Capital of the industry has been consistently below its Cost of Capital, thus consistently destroying value.

The Indian Airline industry fares worse then the Global airline industry. However, Indigo Airlines has been able to buck this trend. Being the only Indian airline company to consistently deliver positive earnings year and year, Indigo airlines has been able to enhance value by leveraging on suppliers for sweeter deals and ensuring low maintenance costs. Thus, my narrative for Indigo airlines is as follows:

Indigo is a highly efficient, young low cost carrier operating in the Indian Airline industry. A high market share and rising competition will make it difficult for the company to sustain high growth for a longer period. Being in a business where it is difficult to generate excess returns, Indigo would only be able to cover its costs in perpetuity.

Estimating Free Cash Flow to the Firm
I use a normalized operating margin to come up with the operating income for the base year. Since airline margins are highly correlated with oil prices, a normalized margin averages out this cost volatility. I also have to adjust the operating income for operating lease adjustment ( by converting operating leases to debt.). Thus, my adjusted after tax operating income for the base year is Rs. 14039 Million. Subtracting out Net Capex ( Capex- Depreciation ) of Rs. 8057 Million and Net Working Capital of Rs.7664 Million, I arrive at a negative FCFF of  Rs. 1683 Million for the base year.

Estimating Growth Rate and Growth Period
I use the fundamental growth rate to come up for the growth rate in operating income i.e.

Fundamental Growth Rate in Operating Income =  Reinvestment Rate * Non Cash ROC

The computed Reinvestment Rate as of 31st Dec 2014 is 111.9% which is (Net Capex+ Net Working Capital) as a percentage of after tax operating income. The Non Cash Return on Capital Employed as of 31st Dec 2014 is 24.59%. A high reinvestment rate and a high ROC enable the company to have a growth rate of 27.54% for the high growth period.

Length of High Growth Period 

Since Indigo is in the growth phase of its life cycle, I use a Three Stage FCFF Model. The length of the high growth phase is taken to be 3 years. I am implicitly assuming that Indigo's highest market share of 32% and increasing competition by new entrants in the market like AirAsia and Tata Vistara will make it difficult for the company to grow at such a fast pace in the future. I am also factoring in the increasing price wars in the Indian airline industry which will result in higher revenues but will put pressure on the margins. After 3 years, I assume that the growth rate would linearly decline to the economy growth rate of 5.60% in perpetuity.

Cost of Capital
My cost of capital for the high growth phase is 9.29%. The components of cost of capital are as follows:
 

Cost of Debt- Risk free rate+Company default spread+Country default spread
                    = 5.60%+ 1.20%+ 2.20% = 9.00%
 After Tax Cost of Debt = 9.00%*(1-33.99%) = 5.94%

The risk free rate is arrived by subtracting the default spread of 2.20% ( the spread for Baa3 rating which is the current local currency debt rating for India ) embedded in the 10 year G sec yield on the day of this valuation i.e. 7.80%. The company default spread is 1.20% on account of synthetic rating of A- which I compute using Aswath Damodaran's synthetic rating table. 

Market Weight for Debt- The Book Value of Debt as per the balance sheet is Rs. 40028 Million. To come up with a total debt number, I convert operating leases to debt as these are essentially contractual obligations. Converting the operating leases at a pre-tax cost of debt gives me a total debt value of Rs 75465 Million. I subtract out the Rs 11656 Million, the amount by which the company plans to reduce its debt through the IPO offering to arrive at a debt value of Rs 63809 million.

Cost of Equity- Risk free rate+ beta* ( Equity risk premium ) 

 ERP = implied mature market premium + country risk premium

                      = 5.60%+1.30* ( 5.81%+ 3.43% ) = 17.61%

I use CAPM to estimate the required return for stockholders. To come up with a levered beta for Indigo, I use a bottom up beta of 0.64 which is the global average unlevered beta of airline firms. I then relever the beta by the market D/E of 1.56 to get a levered beta of 1.30. For the ERP, I compute an implied equity risk premium for the US which is 5.81%. I add a country risk premium component for India of 3.43% ( CRP= country default spread * (Standard deviation of Indian Equities/ Standard deviation of Indian bonds ). Thus, my equity risk premium for India is 9.25%.

Market Weights for Equity
Coming up with a market value of equity was the tricky part. I used some patch work here. Across news stories, analysts estimate the IPO to raise at least $400 Million. I converted this estimate into Rupees to come up with my market value of equity which is Rs 25200 Million.

Stable Growth (Terminal Value)
I assume that the firm will go into a stable growth phase after Year 10. My assumptions for stable growth period are as follows:

1. Growth Rate- The growth rate in perpetuity is set equal to the risk free rate ( which is my long term economy growth rate ).

2. Cost of Capital
a) Beta- The beta of the stock will converge to the market beta of 1.

b) Debt and Equity Weights- The debt and equity weights converge to global industry average weights of 51 and 49%. Thus, the cost of capital linearly increases to 10.48% in perpetuity.

3. The Return on Capital- I have assumed that the company's ROC will be equal to its cost of capital in perpetuity.

Estimating Value of Firm and Equity
Discounting the Free Cash Flows for the next 10 years along with the terminal value at the cost of capital gives a Firm Value of Rs. 344226 Million . Subtracting out the market value of debt and value of employee stock options and adding on cash and liquid investments gives an equity value of Rs 307709 Million.

Factoring in the uncertainty: Monte Carlo Simulation
To incorporate changes in my assumptions, I did a Monte Carlo simulation wherein I assumed a uniform distribution for growth rate in operating income and normal distribution for return on capital. After 1,000,000 trials, the median value for equity is Rs. 291340 Million.

Conclusion

Buying into the IPO would be playing the pricing game rather than investing. Given my narrative, I will be comfortable with an equity value of Rs 300000 million.  However, I will have to adjust a key piece in my valuation i.e. market value of equity ( which is based on investment banker's estimates ) once the IPO hits the market and then do a post IPO valuation to take an investment decision.

Link to Valuation spreadsheet