27-Jan-2016 2:11 AM

Cathay Pacific's difficult 2016: hedging loss, growth cuts, A350 delay, unions, 10 abreast response

Analysis

Asia's flag airlines are a stately bunch. They have generally avoided the major public upsets of European and American peers while state or family/conglomerate ownership grants a long term mindset, and their renowned service casts a public halo. Cathay Pacific especially strives for continuity. Thus it is an upset when, as now, prospects for the year shift.

2016 was to be notable for Cathay, financially and strategically. Cathay expected further benefit from fuel as it came off hedges. Delivery of its first 12 A350s were to open new routes, restore frequencies and right size capacity. This has changed - but not because of the Chinese economy, as some will be quick to speculate. The continuing decline in fuel prices has likely seen Cathay's unrealised hedging losses increase (to approximately USD1 billion) with much to become realised losses. This is in an environment where mainland Chinese carriers are unhedged and other competitors have shorter hedging obligations, disadvantaging Cathay in an over capacity market.

Growth is expected to be cut owing to a further A350 delivery delay and pilot union "contract compliance" that greatly reduces flexibility and the ability to train new pilots, limiting expansion. These new challenges add to existing concerns over weak passenger and cargo yields, and a falling stock price.

Further integration with wholly owned Dragonair is still planned (possibly with a re-branding) while finally moving to 10 abreast 777 economy seating reduces unit costs but invites an unwelcome response from passengers.

2016 will likely see Cathay under perform compared to peers, although this period is far from the uncertainty of 2008/2009. Cathay retains its signature optimism for the future. While the challenges Cathay has identified for 2016 are real, they do not present a structural change or dampen long term prospects. In fact, if Cathay accelerates restructuring there is an opportunity to create an advantage.

Yet unacknowledged by Cathay is the rise of competitors, especially in mainland China, who have expanded more quickly and boldly than Cathay (and others) expected. Even in a growing Asia, sharing space is becoming more challenging.

Cathay still to disclose 2015 profit, but 2016 risks under performance

Cathay will report its full year 2015 profit in Mar-2016. There has been no update to the market on 2015 trading conditions. The changes Cathay faces impact 2016 and risk under performance. This comes after a number of years in which Cathay has been unable to restore its operating margin to the approximately 10% levels it saw last decade. Yields impacted by greater competition and a soft cargo market have not been offset by aggressive enough cost cutting.

Cathay Pacific operating profit (left axis) and operating margin (right axis): 2003-1H2015

Decline in fuel prices is increasing Cathay's hedging exposure

The largest financial impact by far to Cathay Pacific is its fuel hedging position. The concern is the size increasing and the unrealised losses more likely to be realised. Unrealised fuel hedging losses are accounted for in Cathay's reserves. Realised hedging losses are accounted for in the net fuel cost and thus within the operating profit.

Cathay in Mar-2015 disclosed its unrealised hedging losses as at 31-Dec-2014 were HKD14.3 billion (USD1.82 billion), of which just under half - HKD6.7 billion (USD860 million) - concerned 2015. That left HKD7.6 billion (USD980 million) of unrealised losses for subsequent years. Although not an insubstantial amount, Cathay was not overtly worried: fuel prices were not expected to decline to the extreme they have. In fact, in Mar-2015 Cathay said unrealised losses had decreased by HKD3 billion (USD380 million). This occurred as some losses became realised while there were hedging gains due to Cathay continuing to hedge through Jan-2015.

In Mar-2015, Cathay stated its exposure would not significantly change as long as Brent remained around USD57 a barrel. 1H2015 saw crude Brent start and end at approximately USD62 with relatively limited volatility.

Crude Brent closing price (London): Jan-2014 to Jan-2016

The difficult periods are 2H2015 and the start of 2016. In 2H2015 Brent started at approximately USD62 and finished at USD38 - a 39% decrease (based on start and end figures, not averages). This period saw Brent dip below the USD40 level for the first time in recent history. Jan-2016 has seen a further 15% decrease. Between 30-Jun-2015 and 24-Jan-2016, Brent price decreased 48%. Jan-2016 saw Brent price below USD30, a price that is literally off the fuel tracking chart Cathay has used (below, last updated by Cathay for Nov-2015).

USD/Bbl - Brent- Daily Closing Price and 250 Day Simple Moving Average: 2007-2015

With the decrease in fuel price in 2H2015, unrealised hedging losses would be expected to grow. Depending on other factors (any hedging gains or exiting of contracts), the unrealised losses could be placed at around USD1 billion. Whereas before there was optimism hedging losses would decrease as fuel price went up, the decline in price makes it more likely for the unrealised losses to become realised.

In Mar-2015, Cathay said it was 61% hedged at USD95 while for 2016 it was 60% hedged at USD85. With 2016 fuel prices tracking significantly below 2015 and expected to remain so, the 2016 hedging position is uncomfortable.

Cathay Pacific Brent hedge position: as of 18-Mar-2015

Year	Hedge Amount
2015	61% at USD95
2016	60% at USD85
2017	50% at USD89
2018	37% at USD82

Cathay for 1H2015 reported a HKD3,743 million (USD480 million) fuel hedging loss compared to a HKD1,024 million (USD131 million) gain in 1H2014. The 1H2015 fuel hedging loss of HKD3,743 million (USD480 million) compares to Cathay's 1H2015 operating profit of HKD2,362 million (USD303 million).

Cathay Pacific was able to go longer on fuel hedges than most airlines. This increases exposure, reduces competitiveness

IATA expects most airlines by mid-2016 will come off their expensive hedges. Airlines often but not always hedged for about two years. Cathay however has stated its hedge position is for four years. This had been seen as an advantage, with Cathay's strong balance sheet enabling it to hedge out longer than most other carriers. Cathay in Apr-2013 extended its hedging into 2016, and now in 2016 it has fuel hedges out to 2019.

If fuel prices remain lower than what Cathay hedged - and it appears they will, dramatically so - it will take Cathay far longer than competitors to come off its hedges and have the full benefit of low fuel prices. Some competitors including the mainland Chinese carriers and Emirates do not hedge at all. They receive the immediate benefit.

Cathay's 1H2015 fuel expenditure before the cost of hedges was down 35.5%. This was despite a 4.9% increase in consumption due to growth - i.e. Cathay used more fuel but for significantly less cost. Yet when including the loss on hedges, the net decrease of fuel was 12.2%.

Looking at a sample of competitors for performance in the first six months of 2015, ANA and Singapore Airlines saw about a similar reduction in fuel cost despite ANA growing 3% and SIA shrinking 2% compared to Cathay's 8% capacity growth. Cathay fared better but the future will be a concern: SIA's hedging period is less than Cathay's four years. ANA hedges out four years but at significantly lower volume: in Mar-2015, Cathay said it was 60% hedged for the 12 months to 31-Dec-2016 while ANA said it was 35% hedged for the 12 months to 31-Mar-2017.

Other airlines - the unhedged - are doing far better. Air China and China Southern saw a nearly 30% decrease in fuel cost (Cathay: 12% decrease) despite ATK growth (approximately 15%) nearly twice that of Cathay (8%). China Eastern also saw a 30% decrease in fuel cost but 11% increase in ATKs. These are for the six months to 30-Jun-2015. Emirates, reporting for the six months to 30-Sep-2015 (including the period when fuel started to decrease even more) gives a sample of what is likely to come: ASKs grew 16% while fuel costs declined by 41%. If fuel remains as is and Cathay does not exit hedging contracts (although this comes with considerable cost), there will be a wider gap in fuel savings between itself and competitors.

Sample of net fuel cost change and capacity change: 6M2015 versus 6M2014

EVA is increasingly a competitor to Cathay. Detailed results for EVA are not available, but the carrier said its unrealised fuel hedging losses are TWD5480 million (USD162.6 million) as of 15-Jan-2016, which takes into account early 2016 when fuel decreased even more. EVA of course is smaller in size than Cathay (putting unrealised losses in proportion), but EVA said its hedging obligations extend to only two years.

Fuel net of hedging losses/gains comprised 38% of Cathay's operating costs in 1H2014 and then 34% in 1H2015. As expected, carriers that saw a bigger windfall in fuel savings also saw fuel comprise a smaller percentage of operating costs. Air China and China Southern had fuel account for 36% of operating costs in 1H2014 (similar to Cathay's 38%) but 27% in 1H2015. Emirates in the six months to 30-Sep-2014 had fuel comprise 38% of costs, the same as Cathay (to 30-Jun-2014) but this fell to 28% in 2015 compared to Cathay's 34%. Not all comparisons are equal, with carriers like ANA and Lufthansa reporting lower overall shares (in both years) due to higher costs elsewhere in the business.

Share of net fuel costs of total operating expenses at sample carriers: 6M2015 versus 6M2014

Fuel hedging has been a net benefit to Cathay - so far

The brash would call for those responsible at Cathay for hedging. This shows short-term mindedness. Like other carriers, Cathay's hedging policy is not aimed at consistently profiting but rather using hedging to manage the voaltility of fuel prices. If fuel suddenly increased, hedges would allow for greater time to adjust to the new conditions. Aviation has been profitable at high fuel prices and at low fuel prices; the challenge is managing the change.

An index of Cathay's capacity output (ATKs), volume fuel consumption and net fuel costs shows the task at hand: consumption and capacity are intertwined with some deviation due to matters such as aircraft efficiency and average sector length. In steady fuel prices, net fuel cost can conform to the other two metrics. In volatile times, there is no alignment: Cathay's 2012 fuel cost increased despite a decrease in volume of fuel consumed. In 2013, Cathay's fuel consumption decreased 1.4% but its fuel bill decreased a faster 5.7%. (Cathay's home currency, the Hong Kong dollar, is pegged to the US dollar. This eliminates the foreign exchange factor airlines in other markets could be impacted by.)

Index of Cathay Pacific net fuel cost (unadjusted), fuel consumption volume and ATK capacity: 2006-2014 (2006=100)

Again, the purpose of fuel hedges is not to profit. Yet Cathay has been fortunate in that hedging has proven financially successful. From 2005 through 2014, the cumulative total (not adjusted for inflation) of Cathay's hedging gains is HKD4 billion (USD510 million). Even taking into account the large 1H2015 fuel hedging losses, Cathay has still profited on the whole. Full-year 2015 fuel hedging losses, and extending into 2016, will see a net loss. This could be an inevitable downwards cycle after almost a decade of fuel hedging profits.

In 2009, 2011, 2012 and 2013, hedging gains comprised a quarter or third of Cathay's operating profit. This uses an adjusted calculation: prior to 2011 Cathay included mark to market losses in its operating figures. Even in Cathay's record year of 2010, there was a small fuel hedging loss.

Cathay Pacific realised hedging gains (loss) and adjusted operating margin (left axis, HKD millions) and gains as share of adjusted operating margin (right axis): 2005-1H2015

Cathay says its fuel hedging policy is as follows:

Provide a level of insurance against fuel prices rising beyond the point at which the airline is viable - 'sustainability insurance'. Provide lower earnings volatility (through a reasonable certainty of cost) by giving a level of protection against sudden upward movements in the price of fuel - 'volatility management'. No speculation.

Hedging and speculation should be kept separate. As Cathay says, its hedging is for risk management and not speculation. As a result, risk management may need re-evaluation. Cathay's switch to longer hedges is relatively recent according to company filings. The longer hedges and higher exposure are more unique amongst global airlines. Just as Cathay's long-term fuel hedge position could be questioned now, by the time some of the latter hedges come up, fuel price could change considerably and Cathay's fuel hedge position could look very smart. Yet for an airline that likes to have consistency and typically delivers on it, the current fuel hedges are bringing high volatility.

A350s delayed to mid-2016 due to issues with Zodiac business class seat

Cathay Pacific faces a longer delivery delay of its first A350s. The aircraft is understood to be fine as far as Airbus production is concerned; the issue is with Cathay's business class seat (a slightly modified version of its existing product) and likely post-deadline changes Cathay requested for the seat.

Cathay calls the seat FB2+ and it is based on the Cirrus design and manufactured by Zodiac. Although Zodiac has become embattled with various issues (Airbus has cited Zodiac lavatory problems while American Airlines dropped Zodiac as a supplier), it is unclear how much blame is with Cathay for requesting late changes versus any problems with Zodiac. The first Cathay A350 was originally expected in Feb-2016 but then delayed to Mar-2016, as CAPA noted in Nov-2015. A further delay now sees mid-2016 delivery as the likely target.

Cathay Pacific passenger aircraft delivery projections: as of Nov-2015

Aircraft Type	2016	2017	2018	2019	2020	>2021	Total
A350-900	12	10	-	-	-	-	22
A350-1000	-	-	6	10	10	-	26
777-9X	-	-	-	-	-	21	21
Total	12	10	6	10	10	21	69

Cathay has orders for 48 A350s, including 22 -900s (last planned to be delivered in 2016 and 2017) and 26 -1000s (delivery 2018-2020). After A350 deliveries, 777X deliveries commence and are projected to run through 2024, according to CAPA's Fleet Database.

Cathay Pacific projected delivery dates for aircraft on order: as of 24-Jan-2016

A350s will usher in growth and provide network recalibration

The A350 provides Cathay not just expansion but smart growth and network recalibration. Cathay fell behind competitors in replacing four-engined 747-400s and A340s. This became an issue as fuel prices continued to climb in 2012, and in May-2012 Cathay announced an accelerated retirement plan for the 747 as well as pulling 747s and A340s from long haul routes faster than planned. This saw the 777-300ER take on routes. In Europe this created some over capacity as the 777-300ER was larger than the A340 while North America saw a capacity dip as 747-400s were replaced by smaller 777-300ERs. North American capacity has since grown (considerably) while network profitability greatly improved even if capacity was down.

The result however is that Cathay's long haul network has the 777-300ER as its smallest type. (This is a similar challenge facing Emirates, hence the Dubai carrier's expected order for A350s/787s.) Cathay's long-haul (Europe, North America, Johannesburg and Auckland; excluding medium-haul Australia and the Middle East) network from Hong Kong has grown from about 21 daily departures in 2010 to 30 in 2016. The 777's share of this flying has increased from 38% in 2010 to 96% in 2016 as overall services have grown and the 777 has replaced A340s and 747s.

Cathay Pacific average daily long haul departures from Hong Kong (left axis) and the 777's share of these flights (right axis): 2010-2016

The A350-900 is a three class (business, premium economy, economy) aircraft to broadly replace A340-300 type routes: thinner long haul markets like Auckland (one of the first destinations) and off-peak additional European frequencies. It is not envisioned serving peak European frequencies or to be used on ultra long haul missions to North America. The A350-900 could be on medium range Australian routes to grow capacity. The A350-900 seats 12% more passengers than the three class A330-300 used for most Australian frequencies. Most of the seat gains are in the economy cabin (business class decreases from 39 on the A330 to 38 on the A350). Hong Kong carriers are constrained from adding non-stop flights to key Australian cities but they are able to use a larger aircraft (the bilateral is based on frequency, not seats).

Cathay Pacific three class long haul aircraft configurations: Jan-2016

	Business	Premium Economy	Economy	Total
777-300ER 3 Class	40	32	268	340
A330 3-Class	39	21	191	251
A350-900	38	28	214	280

Cathay Pacific three class long haul aircraft cabin proportions: Jan-2016

	Business	Premium Economy	Economy
777-300ER 3 Class	12%	9%	79%
A330 3-Class	16%	8%	76%
A350-900	14%	10%	76%

The A350-1000 (possibly with first class) could replace some lighter 777-300ER services (it has a closer capacity and range, but the 777-300ER exceeds on both metrics) and be used to North America, where the -900 is unlikely to be deployed.

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Cathay was expected to deploy the A350 on regional routes for a few months before commencing long haul service to Auckland (replacing the A340-300, which has Auckland as its only long haul route) and then open a new London Gatwick service on 02-Sep-2016. An unspecified mid-2016 delivery would be expected to delay A350 long-haul deployment.

In Aug-2015 Cathay flagged that the A350 could open service to London Gatwick, Madrid and Copenhagen. London Gatwick and Madrid have eventuated (Madrid with the 777-300ER, at least initially) while it appears Copenhagen is now at least a 2017 timeframe. Tel Aviv could also be in a 2017 timeframe.

Cathay also planned, without giving a timeframe, for the A350 to take over smaller European routes including Dusseldorf, Manchester, Rome and Zurich. With the exception of Rome, services to these cities have been launched in the past two years using the 777-300ER, Cathay's only available aircraft (the 747-400 and A340-300 have been removed from long haul flying, with the exception of Auckland). Switching from 777-300ER to A350 will allow a combination of capacity right sizing (the A350 will seat 280 compared to 340 on the three class 777-300ER) and frequency growth, such as moving from four weekly 777-300ER flights to a daily A350 service. Cathay generally prefers a consistent proposition, such as that of a daily (at least) offering. This enables 777-300ER growth elsewhere, notably North America.

Frequency restoration could also occur. The peak for Cathay's Paris route was in 2013, when Paris was served 13 times weekly (daily 777, six weekly A340). As the larger 777 replaced the smaller A340, frequency was cut. Cathay served Paris with approximately 10 weekly 777 flights in 2015 and expects to do so again in 2016. The frequency cuts saw a double digit decrease in seat capacity, indicating the reduction in frequency was not just to keep capacity broadly in line with the change in aircraft types. Other factors could have been underlying demand and/or that aircraft were needed elsewhere.

In Rome, Cathay operated six or seven weekly flights with the A340 between 2010 and 2014. When the 777 replaced the A340 in 2015, frequency decreased to approximately five weekly. Unlike in Paris, overall capacity increased (but still down from highs in 2010 and 2011). A hypothetical six weekly A350 service to Rome would introduce an additional frequency but decrease overall seat capacity. A seven weekly A350 service would restore Rome's seat capacity to 2011 levels, if warranted. Maintaining five weekly flights but all on the A350 would see a 20% reduction in seat capacity.

Cathay Hong Kong-Rome average weekly seats (left axis) and frequency (right axis): 2010-2016, A350 hypothetical scenarios

Expansion limited due to pilot union 'contract compliance'

Even if the A350s were to arrive on time, it is unclear how many of them could be fully utilised, how much growth could occur with other fleet types and even how much of the existing schedule could be retained.

Cathay Pacific's pilots in Dec-2014 started work to rule procedures, or "contract compliance". This commenced after salary negotiations with the union (AOA) broke down. Although Cathay has not (yet) gone on the public offensive, the industry informally ranks the Cathay pilot package as one of the best globally (and superior to that of wholly-owned Dragonair). In 2015 the pilots raised workload, lifestyle and fatigue matters as additional concerns.

Contract compliance sees pilots work as obligated in their contracts and nothing more, such as making themselves available for extra, non-required work like flying (for pay) on days off and being willing to extend flight duty times in the event of disruption. Contract compliance reduces flexibility for Cathay, adding costs and reducing schedule integrity. Cathay has not put a figure on costs from contract compliance over the last year but in recent times Cathay has admitted contracting compliance is causing damage, with Cathay unable to run the full schedule it would like and having to re-consider expansion. There has been no public figure about what the ASK adjustment could be be.

Cathay management blamed contract compliance action on being unable to bring four weekly service to each Boston and Manchester to daily in 2016, as reported in the South China Morning Post. Contract compliance was also cited in Cathay having to launch London Gatwick service in Sep-2016 (as announced in Dec-2015) rather than an unspecified earlier period. However, this appears a more complex topic. Cathay in Nov-2015 took delivery of its 53rd and last 777-300ER aircraft. There have been no additional passenger aircraft deliveries and there are no plans for deliveries until the A350s arrive. Unless there are extenuating circumstances, net growth would require a net increase in aircraft. It is possible A350 delays are postponing network adjustments and are exacerbated by union activity.

There has been a particular impact on fewer pilots willing to be training captains, an optional role pilots are not obligated to take up, and so under contract compliance do not do so. With not enough trainers, Cathay cannot replenish its pilot pool (which sees normal retirements and attrition) or train additional pilots to facilitate capacity expansion.

In Aug-2015, Cathay reiterated its earlier passenger growth projection of 8.4% for 2015 remained unchanged. However by the end of 2015 capacity grew only 5.9%. Cathay has not attributed a breakdown for the lower result (such as market demand, weather/slot disruption, contract compliance). Cathay expects in the medium to long term to grow 3-5% annually (compound) with the short term likely to continue to see higher than average growth. Cathay has acknowledged its growth has been above what the market can absorb, a result of strategic growth but also the nature of aircraft deliveries being a long term plan while passenger demand changes on short notice.

Whatever the exact impact, Cathay is looking for a resolution to contract compliance, and one at a lower cost than what the union has offered. It is in neither side's interest for this matter to escalate to a strike. There is no recent pilot strike to compare to. The last strike from Cathay pilots - in 2001 - resulted in over 50 pilots being fired, including 49 in a single day (hence the group being referred to as the "49ers"). A disproportionately high number of the terminations were pilots active in the union. Although a legal battle ensued (with Cathay, years later, largely losing) the damage was done to the pilots. It is firmly remembered today. Pilots are worried terminations could be repeated with little immediate reprise.

For Cathay, pilot strike activity culminated in Jul-2001 and that month saw a 22% year over year decrease in passenger volumes (the month also saw impact from a typhoon, but Cathay's 22% decline was greater than the airport's 4% decrease in passenger throughput that same month). The strike ended in Oct-2001 due to the post 9/11 deteriorating environment.

Cathay Pacific monthly passengers carried: Jan-Jul 2000-2001

Recent threats of industrial action against Cathay from various unions (and not just pilots) have tended to focus on activity over popular Christmas and summer travelling periods. This is when volumes are high but mostly with leisure and infrequent travellers, although media attention is large. Smaller, unpredictable wildcat strikes as occurred in recent years at airlines such as Lufthansa and Qantas could have a larger material impact. They would affect corporate and frequent travellers and likely see passenger volumes decline even if a strike was not occurring that week: customers would shun Cathay while operational reliability lacked. Strikes would likely have a larger material impact during peak business travel, notably 4Q. Cathay is likely unwilling to have industrial dispute continue so far into 2016.

In the event of a strike, the long term, provided Cathay were to conduct recovery initiatives, would likely pose little threat: generally once industrial activity concludes, passengers return. Cathay has a strong balance sheet that could withstand financial damage resulting from industrial action; there is no concern of the carrier being shut down or even crippled. Having endured SARS and the global financial crisis, a pilot strike would be comparatively easy to manage.

While both sides want to avoid a strike, Cathay is also uninterested in seeing the union's "slow burn" continue much longer, and is unwilling to give in to what it sees as high demands. One solution could be Cathay unilaterally changing contract terms in order to secure future growth. (As can often be the case in global pilot union flare ups, it is forgotten that airlines generally have an ultimate aim to grow, thereby producing more pilot jobs.)

In a best case scenario, Cathay comes out ahead with reduced costs and greater flexibility for the long term, similar (on a lower scale) to gains from US carriers during Chapter 11 bankruptcy procedures. European carriers lack Chapter 11 restructuring and do not have the flexibility Hong Kong law affords. Asian flag carriers are often politically unable to restructure their inefficient workforces (Japan Airlines and currently Malaysia Airlines are notable exceptions).

Passenger volume and load factor at record highs but concerns for yield and cargo

Cathay Pacific (including Dragonair) carried 34.1 million passengers in 2015, up 7.9%. RPKs grew 9% against an ASK increase of 5.9%. This led to a 2.4ppt increase in load factor to 85.7% - Cathay's highest load factor.

Cathay Pacific Group annual passenger load factor: 2008-2015

All but two months of 2015 saw record passenger load factors.

Cathay Pacific Group monthly passenger load factor: 2008-2015

The cargo side of the business is not as cheerful a set of figures. Cargo volume was 1.8 million tonnes, the same as in Cathay's banner 2010 year. But efficiency and financial indicators are not as good: yield, not disclosed until Mar-2016, remains depressed while the cargo load factor remains approximately 10ppt lower than the peak 2010 achievement and lower than pre-2011 levels. AFTKs are up to 16.5 billion compared to 14 billion in 2011. This alludes to the excess capacity in the market.

Cathay Pacific AFTKs: 2011-2015

Cathay Pacific cargo load factor: 2008-2015

Cathay expected to finally introduce 10 abreast seating on the 777

Cathay's load factor increase is traded off with yield. The increase in load factor has been a deliberate strategy to lower unit costs by having more passengers to spread fixed costs. With greater competition and an uncertain yield outlook, lowering costs is the only guarantee. There have been some public benefits from higher load factors and lower yields: this has allowed Cathay to heavily discount tickets and offer a very small LCC-esque fare proposition. This gave Cathay some relevance to the LCC market while it was lobbying against Jetstar Hong Kong.

Carriers are still reporting 2015 annual load factors, which makes a global comparison difficult at this time. To re-visit a former comparison, Cathay in 2014 had the highest load factor (86%) of major Asian carriers and performance that rivalled or exceeded global peers.

Load factor comparison for Cathay Pacific (green) and select major Asian (red) and global (blue) airlines: 2014

Cathay's load factor is averaged by lower regional performance and higher long haul performance. Cathay's three long haul segments (Europe, North America and Southwest Pacific/South Africa) are nearing 90% load factors. This is likely comprised of higher economy load factors and lower premium cabin load factors, making it difficult to achieve significant additional gains with the existing aircraft configuration.

Cathay Pacific long haul passenger load factors: 2008-2015

Cathay has long evaluated and resisted moving to a 10 abreast configuration in economy on its 777s that operate to Europe, North America and some destinations in Southwest Pacific/South Africa. Globally 10 abreast on the 777-300ER is becoming universal. Air China, British Airways and Singapore Airlines are some of the notable exceptions of carriers still with nine abreast in the 777-300ER. Delta and United fit nine abreast on their -200 variants but United will introduce 10 abreast on its first 777-300ER due this year while Swiss, also receiving its first 777-300ER this year, will also have 10 abreast. China Airlines and China Eastern received their first 777-300ERs in 2014 with 10 abreast while EVA Air and ANA are retrofitting some 777-300ERs with 10 abreast.

Cathay's move to 10 abreast would see it catch up rather than be an early adopter. This is consistent with the carrier's conservative approach but also shows the corresponding weakness. There needs to be greater agility at Cathay.

777s at Cathay have approximately 20-40 economy rows depending on the variant (regional, long haul) and configuration. Not all rows could gain an extra seat due to factors such as required minimum spacing for aisles. A gain of approximately 15-35 economy seats is a reasonable approximation and would give a high single digit/low double digit increase in economy seating density. In the South China Morning Post Cathay flagged density could be traded off to passengers with improved meals or in-flight entertainment. If this were to eventuate, the cost would be small compared to the relatively substantial gain in density.

Cathay COO Rupert Hogg, responding to a question from CAPA in Mar-2015 about cost cutting measures, remarked: "We are focused on driving down our costs and making sure we are productive. And the other key goal is we're focused on doing that in a way that keeps the customer experience the same or hopefully improves it." A move to 10 abreast is welcome yet overdue. There will undoubtedly be challenge in managing the public message of 10 abreast seating but this should come to pass and not see notable changes in passenger loyalty despite whatever initial outpouring there may be.

Foreign exchange not the risk it may seem

Approximately half of Cathay's revenue is tied to the US dollar. This has raised concern with the US dollar strengthening, especially with currencies that comprise notable amounts of Cathay's revenue. However management has generally not seen foreign exchange, at least to the fluctuation experience so far, as an issue. There are currency hedges while some currency losses are offset by costs in those currencies.

Cathay Pacific revenue mix by currency: 1H2015

Cathay has identified fuel surcharges as more important factors to revenue than foreign exchange. Surcharges however are decreasing. The Hong Kong Civil Aviation Department regulates surcharges for tickets sold for travel departing from Hong Kong (and thus impacts only part of Cathay's sales). The CAD is suspending surcharges from 01-Feb-2016. In Jan-2016 Cathay was permitted a short haul (Asia) surcharge of HKD24 (USD3.08) and for long haul (non-Asia), HKD109 (USD13.98). A year prior in Jan-2015, the short haul surcharge was HKD129 (USD16.55) and long haul HKD566 (USD72.61).

Dragonair to grow closer: 'Cathay Dragon'?

A long evaluated (and once previously cancelled decision) to bring Cathay Pacific and wholly owned Dragonair closer together looks likely to be implemented. Dragonair could be renamed "Cathay Dragon". This would see Dragonair benefit from the increasing brand awareness of Cathay and move the two from a fragmented group to a more unified one. This is important in the outbound China market, where Dragonair is the largest non-mainland carrier based on international seats, and some distance ahead of the second largest, Asiana.

China international seat capacity by carrier: 25-Jan-2016 to 31-Jan-2016

Mainland China accounts for 65% of Dragonair's seat capacity. The Dragonair-Cathay relationship is historical, and under Cathay's takeover agreement, Dragonair was guaranteed to retain its separate identity for a finite period of time. This clause has now come to pass. Dragonair operates narrowbody and widebody aircraft whereas Cathay only operates widebody aircraft. For a group comparison, Singapore Airlines only operates widebodies while regional unit SilkAir only operates narrowbodies. Dragonair is comparable to SilkAir but services more trunk routes (Beijing, Shanghai, Taipei) and thus the need for widebody aircraft.

Dragonair seat capacity share by market: 25-Jan-2016 to 31-Jan-2016

Dragonair is not simply an airline part of the Cathay Pacific group, albeit one that has grown increasingly close in terms of codeshares, website, aircraft interior, service etc. The two could not function, at least anywhere near their present size, without each other. Dragonair said that of its transfer passengers, 69% connect to Cathay Pacific, 23% connect between Dragonair while 8% connect between Dragonair and another carrier. Dragonair provides Cathay with key access to mainland China to support its regional and long haul network. Dragonair in summer 2016 is scheduled to operate upwards of 52 daily flights to mainland China compared to Cathay's six (Cathay serves only Beijing and Shanghai, which Dragonair also serves but with far greater frequency).

Importantly and intentionally, this is not a merger. Retaining a separate brand and licence in a Hong Kong context is understood to have aeropolitical (traffic right) advantages. Dragonair is understood to have lower costs than Cathay although exact figures are not published. This gives Cathay a lower cost (but not LCC) vehicle for growth. Dragonair has taken over Cathay's Penang service and launched services to Bali Denpasar and Tokyo Haneda that are supplementary to Cathay. Network decisions are inherently complex, but Dragonair's lower cost cannot be ignored. The cost of maintaining a separate Dragonair brand is likely significantly less than operating the services on the Cathay licence.

Closer ties between Cathay and Dragonair come as Asia's airline families finally start to knit together and function as coordinated, integrated groups. Asia has been a sea of airline licenses not always fully leveraged to the parent company's benefit. EVA Air is considering integrating with subsidiary UNI Air while there are considerable changes at the Singapore Airlines Group. The group appears to be trying to integrate low-cost brands Tigerair and Scoot while Scoot takes over some full-service routes from SilkAir and Singapore Airlines.

China's HNA Group is a house of a brands, over a dozen airlines on multiple continents that have limited synergies with each other. The move of four of HNA's LCCs to form a LCC alliance (U-FLY) potentially shows the start of integration at HNA.

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Outlook: More challenges as stock already nearing five year low

There were no expectations of 2016 being a banner year for Cathay, but its dimmed prospects are unwelcome. They arrive as its stock price is a few percentage points off five year lows. In a two year index of Asian peers, Cathay has weakened while others have improved (perhaps arguably from a lower base).

Cathay Pacific stock price (HKD): 2011-2016

Shares Comparison for China Eastern, Korean Air, Cathay Pacific, All Nippon Airways, Air China (Jan-2014=100): Jan-2014 to Jan-2016

There are two notable differences about Cathay's upcoming challenging period compared to previous ones: the mid-2012 downturn and those of the previous decade. First is that in the current situation the weak indicators are relatively unique to Cathay. Mainland Chinese airlines are not hedged while carriers elsewhere in Asia (and the world) that Cathay competes with do not have as long hedging risks.

Cathay's union issues are confined to itself, but other unions are posing challenges to competitors. These range from comparatively smaller matters at Korean Air to larger ones at Lufthansa. The scope of Cathay's union challenge is unmatched in Asia, but unlike other Asian carriers that are effectively unable to restructure their workforce, Cathay is able to implement workforce changes should it choose to do so - a long term advantage. Various A350 delays are cropping up and the impacts are still to be played out. Cathay's business class seat problems could make its delay worse than competitors, but once aircraft arrive and the delivery stream catches up, there are generally few negatives to business planning.

The second difference is that Cathay's underlying business is stronger and with built in efficiency compared to past downturns. Older aircraft have largely been retired from long haul flying and the product is mainly uniform and now superior.

Cathay's network is bigger and stronger but also more susceptible to competition. Mainland Chinese carriers have grown internationally, short and long haul, faster and more boldly than Cathay and others expected. The number of mainland Chinese airports with non-stop service to Australia is expected to double (at least) from six in 2014 to 12 in 2016. Europe has seen secondary Chinese routes for some years while North America is seeing an uptick: Hainan Airlines in Jan-2016 launched Los Angeles service from Changsha, United Airlines will open seasonal San Francisco-Xi'an service while Xiamen Airlines is one of a few mainland carriers planning to enter the North American market in 2016. Even if the flights are marginally profitable, or unprofitable, they are still competition to Cathay.

Asia-North America remains over capacity and Asia-Europe in 2016 is looking likely to enter over capacity as well. In the Europe-Australia market Cathay competes in, Gulf carriers are once again kicking up growth (and musing of non-stop flights to New Zealand, a small but tidy market for Cathay as it is operated under a JV).

The three challenges - fuel hedges, A350 delays and unions - facing Cathay in 2016 will come to pass. Fortunately there is no significant underlying demand weakness as seen in past downturns, although demand could be much better. This means Cathay will be able to benefit once it passes through these challenges, although they should not be under-estimated in size or potential financial impact. The task afterwards is confronting a more competitive Asian landscape. Cost cutting initiatives through Cathay's "Lean" programme and the introduction of 10 abreast 777 seating are welcome, as is closer integration with Dragonair. This is a start.

More restructuring awaits.