25-Aug-2015 3:41 PM

Cathay Pacific 1H2015: 'Our commitment is unwavering.' But the market is not returning loyalty

Analysis

Cathay Pacific remains attached to its premium business model, which in 1H2015 showed some improvements from a low base while profits from subsidiaries and associates - namely an unhedged Air China - greatly helped the bottom line. "We must be doing something right," chairman John Slosar said.

But the going is getting tough. A 12% decrease in fuel net of hedging losses was largely passed on to consumers with a 9% decrease in yields, although there is some impact from foreign exchange. Premium long haul demand remains soft. Cathay's recipe for relying on efficiency improvements could be reaching a ceiling: aircraft utilisation may be tempered to address growing congestion while load factor is at 86%. A350s, and later, 777Xs bring improvements but other gains will be precious. Cathay must rely on incremental improvements to remain ahead of competitors that have better geography and bigger local markets. Restructuring of China's bloated state-owned airlines was once a fantasy but is now coming into focus, a concern for Cathay.

Summary

Cathay Pacific's premium business model is facing challenges as premium long haul demand remains soft and competitors consolidate to take on the airline.
The airline's underlying improvement in core airline business in 1H2015 was driven by a decrease in fuel costs and efficiency improvements.
Cathay Pacific's load factor reached 86% in 1H2015, the highest among major Asian carriers, but further growth may be limited due to its larger premium exposure.
The North American market, which accounts for over a quarter of Cathay's network, saw the highest yield decline of approximately 10.2%.
Cathay Pacific plans to introduce A350s to open new routes, including London Gatwick, Copenhagen, and Madrid, and to up-gauge some A330 Australian routes.
The airline is considering additional long-haul aircraft purchases, including top-up A350 and 777X orders, to replace its 53-strong fleet of 777-300ERs.

"Our commitment to our world-class team and to the aviation hub in our home city, Hong Kong, is unwavering," Mr Slosar said. But further clashes with staff - Cathay's largest cost after fuel - seem inevitable. And should competitors consolidate to take on Hong Kong's flagship airline, it is perhaps not far fetched to see Cathay turning to a second home market, as Singapore Airlines has done.

Cathay's underlying improvement in core airline business as ex-fuel costs decrease

Whereas in 2014 profit contribution from subsidiaries and associates boosted the bottom line, 1H2015 achieved underlying improvement at the airlines. This was 139%, far less than the headline 468% figure given for the net position. The profit margin has moved from an anaemic 0.7% to a weak 3.9%; cost of capital continues to be an elusive goal.

Cost per ATK with fuel fell 9.2% while cost ex-fuel fell 3.6%, continuing some recent improvements. The into-plane fuel price decreased by 38.5% but this gain was only partially realised due to hedging losses that saw a net fuel bill decrease by 12.2%, although this includes a 4.9% increase in consumption due to more flying.

Cathay Pacific group profit composition: 1H2015

Cathay Pacific historical profit and margin: 1H2004-1H2015

Low fuel, load factor gains and yield decreases deliver complex gain

Fuel gains were largely traded for lower yields, although this is a complex story with foreign exchange impacting yields and strong competition requiring discounting. Cathay attributes lower fuel surcharges as the largest driver in the change of yield. Hong Kong regulates fuel surcharges, but given the elusive relationship between fares and surcharges these could always be lowered while base fares increase.

Cathay also attributed more connecting traffic - which carries a lower yield - as impacting overall performance.

Cathay Pacific passenger market development: 1H2015

But it is not a coincidence that capacity growth was matched with 8-10% yield declines. In the single market (India, Middle East, Pakistan and Sri Lanka) where capacity decreased (by 10%), yields declined only by 4.3% while the load factor gained by 5.5ppt - the largest load factor gain of any market.

Cathay Pacific market summary: 1H2015

The yuan's depreciation has caused considerable interest and concern for Cathay given its China exposure. Cathay has been eager to distance itself from any impact from the yuan, noting that while it may be down in the short-term, it is still up in the long-term and Cathay's exposure is limited. Cathay has dealt with more significant currency changes including declines in the Euro, Australian dollar and yen, with the carrier noting a 2% change in the yuan has less impact than a 20% swing with the euro.

Mr Slosar appeared frustrated with the foreign exchange topic, saying: "Guess what? We're an international airline. We deal with this every year. We're used to it. We deal with it."

Cathay Pacific profit reconciliation: 1H2014 v 1H2015

There are larger, underlying concerns. Cathay noted its Australian business "performed satisfactorily", an underwhelming description considering Australia is Cathay's second largest market after the US. To offset decreased mainland Chinese visitors to Hong Kong, Cathay has turned to more connecting traffic, reporting only "some success".

This is worrisome given how many opportunities in the future are pegged on accessing the China market, which will become more competitive as Chinese airlines step up their offering. But Mr Slosar envisages a more positive future, even remarking of China, "the best is yet to come".

Cathay Pacific and Dragonair ASKs by market: 17-Aug-2015 to 23-Aug-2015

Cathay has relied on load factor and aircraft utilisation efficiency. These have limits

In recent times Cathay has pushed its network and financial performance through efficiency, making better use of aircraft and selling seats that would have otherwise flown empty. Earlier in 2015 Cathay noted its 777-300ER utilisation of 16 hours made it the world's third highest operator in terms of utilisation, and if Cathay flew the aircraft for only 12 hours a day, it would need 13 more aircraft (at a substantial acquisition cost).

Further aircraft utilisation improvements may be limited - even if it does not actually decrease.

Cathay is looking to restore schedule integrity linked to delays mostly around mainland China. HK Express has seized on this, promoting its 83% on-time performance, compared to 69% for Cathay and 53% for Dragonair. (On-time performance for sister carrier Hong Kong Airlines is not stated.)

HK Express website ad promoting on-time performance strength: Aug-2015

"Our ability to run a smooth operation out of the Hong Kong hub is facing major challenges. Extensive air traffic control delays over Hong Kong and mainland Chinese airspace have been compounded by a multitude of issues relating to operations at our increasingly congested home airport," Mr Slosar said. To reduce delays Cathay is considering options including longer ground time for aircraft as well as schedule padding.

Cathay has also been pushing load factor improvements. Its 1H2015 load factor reached 86%, higher than the 84% in 1H2014 and 83% load factor in its banner 2010 year.

Cathay Pacific load factor: 2008-1H2015

The strength of Cathay's load factor performance is apparent when comparing with its peers.

Cathay has the highest load factor of major Asian carriers and its 1H2015 performance begins to place it in the top tier of global peers: Delta achieved 85% in 2014, easyJet 91% in 2014 and Ryanair 92% in 1Q2015.

However, it is unclear how much further Cathay can grow load factors due to its larger premium exposure, among other reasons. Retrofits to increase economy seating (and reduce unsold inventory) could help load factor growth. Cathay's business is different from easyJet and Ryanair, but there could be lessons as Cathay's short haul load factors tend to be lower than long haul, and short haul is all that easyJet and Ryanair fly, albeit with a very low cost structure.

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

Once fixed costs of a flight are covered, incremental passengers need to have their variable costs covered, which are low, allowing Cathay to sell more and reduce overall unit costs. But with a limit on aircraft utilisation and load factors, Cathay needs gains elsewhere in the business to remain slightly ahead of peers.

Should or when competitors pursue higher utilisation and load factors, Cathay's search for cost savings will be more difficult.

North American yield weakness stands out

Europe, North America and North Asia all saw yield declines of approximately 10%, with North America the highest at 10.2%. North America however stands out for a few reasons, not all of them good ones. Unlike other markets, the local outbound market was not impacted by currency movement. The US dollar has remained strong.

The US is the largest market for Cathay in North America, and the Hong Kong dollar is effectively pegged at the US dollar.

Cathay Pacific currency exposure: 1H2015

North America is also Cathay's largest market by ASKs. North America accounts for over a quarter of Cathay/Dragonair's network, and is 24% larger than Cathay's next largest market, North Asia. Cathay has increased North America's importance in recent years. North America accounted for 23% of the network in 2009.

The 2014 and 1H2015 North America share of around 27% of the total network brings Cathay back to the 27% share North America had in 2008 - although the North American network in 2014 was 17% larger than in 2008.

Cathay Pacific North American ASKs and share of total: 2008-1H2015

Cathay's North American market is heavily reliant on premium traffic, and in North America premium demand is the fastest to fall - and to shoot back up in the good times. Cathay finds the pattern to be unpredictable and currently the situation is one of under-performance, although it is a mixed bag. Cathay's newest route, Boston, is performing well.

New York JFK is under pressure given considerable capacity increases added by competitors - with more to come. China Southern has increased frequencies while China Eastern will shortly do the same. Xiamen Airlines in the next few years could look to open service to New York as well, to name only a few developments.

New York City (JFK and Newark) to NE/SE Asia (seats per week, one way): 19-Sep-2011 to 7-Feb-2016

Gulf carriers are increasing their focus and capacity on the Southeast Asia-North America market, a core staple for Cathay - so much so that Cathay calls itself the national carrier of the Southeast Asia to North America market.

Qatar Airways has launched a third daily Doha-Singapore flight, and this service is timed to connect to North America. Emirates has added frequency to New York JFK while Etihad later in 2015 will deploy its A380 to New York.

See related reports:

Cathay considers its Newark route to be its greatest challenge. There is more competition here as well, with Air China to open a Newark service. Newark is Cathay's sixth-largest largest while New York JFK and Los Angeles tie as the largest.

Combining New York JFK and Newark, the New York City area is Cathay's largest global market based on ASKs and one of the 10 largest based on seats.

Cathay Pacific North American airports ranked on available seat capacity: 17-Aug-2015 to 23-Aug-2015

Rank	Airport		Total Seats	Percentage Market Share
1	JFK	New York John F Kennedy International Airport	15,792	22.4%
2	LAX	Los Angeles International Airport	15,792	22.4%
3	YVR	Vancouver International Airport	11,844	16.8%
4	SFO	San Francisco International Airport	9,588	13.6%
5	YYZ	Toronto Pearson International Airport	7,332	10.4%
6	EWR	New York Newark Liberty International Airport	3,948	5.6%
7	ORD	Chicago O'Hare International Airport	3,948	5.6%
8	BOS	Boston Logan International Airport	2,256	3.2%

Cathay's A350s could open London Gatwick, Copenhagen and Madrid and be used to Auckland, Rome and Manchester

Cathay Pacific in Sep-2015 will take delivery of its 53rd 777-300ER, which will be the last of its current 777 order. 777Xs arrive next decade but first Cathay will take A350s. Cathay has 48 A350s on order, including 22 -900s and 46 -1000s.

The first -900 is due in Feb-2016 and is expected to be the first to feature Cathay's new livery following a brand refresh earlier in 2015.

Cathay in Aug-2015 confirmed Auckland will be the first long-haul A350 route after previously just saying Auckland would be one of the first. Cathay also flagged the A350's opportunity to open new routes, including the European destinations of London Gatwick (supplementing existing five daily London Heathrow service), Copenhagen and Madrid.

Cathay has been on a long haul expansion streak, opening six markets over 18 months. Europe is a focus as Cathay has been under-exposed on the continent compared to peers including Air China and Singapore Airlines.

Launch date of Cathay Pacific long-haul markets served or planned to be served as of Feb-2015: 2005-2015

Reports from Israel have also suggested Cathay is considering A350 service to Tel Aviv.

The A350 will also be used to up-gauge some A330 Australian routes as well as take over thinner routes currently served by the 777-300ER. Some of these like Rome were previously served by the A340-300 until that type was pulled-down from long-haul service. Manchester is expected to be changed from a four weekly 777-300ER service to daily A350-900, given Cathay's consistent, at least daily, offering it likes to have in markets.

Other markets are expected to be changed to the A350, allowing right-sizing since in recent times the 777-300ER was Cathay's smallest long-haul aircraft. The A350's introduction will allow re-deployment of 777-300ERs.

Cathay Pacific aircraft delivery plan: as at 30-Jun-2015

Cathay plans more long haul aircraft purchases

Cathay Pacific was late to re-fleet, operating 747-400s and A340s on long-haul routes for longer than its competition, and also passing up long haul growth opportunities until more aircraft arrived. This started to change with the A350, for which Cathay will be an early operator, and further emphasised with the 777X as Cathay was the first in Asia to order the type. Cathay's next-gen fleet of A350s and 777Xs totals 69, but the carrier in Aug-2015 noted it was not yet done with its long haul fleet plan, although it was most of the way there.

Options could include top-up A350 and 777X orders. It is expected some A350s, and in particular the -1000, will replace some of Cathay's earliest 777-300ERs. The airline is currently working through this exact plan. Many of Cathay's 777-300ERs are on lease, and Cathay could elect to renew leases if they are low enough. Some expect lessors to have a glut of 777-300ERs, making it more effective to renew leases at low rates rather than re-place the aircraft.

Even if some A350-1000s and then 777Xs replace the 777-300ERs, more aircraft will be needed to replace the 53-strong fleet of -300ERs. The 777X order stands at 21 and could be increased. There are suggestions Cathay could order additional Boeing aircraft when Cathay takes its last 777-300ER in a ceremony outside Seattle in Sep-2015.

Boeing is eager to sell so-called bridge 777-300ERs, the last 777-300ERs to be delivered before 777X production starts. Cathay's interest in this type is unclear, but CEO Ivan Chu told a 19-Aug-2015 Bloomberg TV interview that the carrier is not interested in the A380neo.

Fleet focus turns to Dragonair's Airbus narrowbodies. Boeing could be in the running

Cathay has kept its re-fleeting focus on widebody aircraft, seeing its long-haul flying determining how much regional feed it needs. With Cathay having done much work on its long-haul fleet, it is now examining the future narrowbody at wholly-owned unit Dragonair. Dragonair's 41 aircraft as of 20-Aug-2015 includes 18 A330s and 23 Airbus narrowbodies comprising 15 A320s and eight A321s.

Cathay will likely run a strong competition between Airbus and Boeing. Boeing won the re-fleeting at Silk Air, the short-haul unit of Singapore Airlines, and could look to overturn another Airbus market. However, SilkAir's order for 54 737s was twice the size of what Dragonair could be expected to order. (SilkAir may not take all 54 737s.)

Cathay expects Dragonair's narrowbody fleet to remain the same size or increase. In addition, there could be up-gauging. Asian peers are increasingly ordering larger versions of narrowbody aircraft.

Dragonair Fleet Summary: as at 20-Aug-2015

Aircraft	In Service	In Storage	On Order*
Total:	41	0	0
Airbus A320-200	15	0	0
Airbus A321-200	8	0	0
Airbus A330-300	13	0	0
Airbus A330-300E	1	0	0
Airbus A330-300X	4	0	0

Cargo is once again looking weak. Cathay's 747BCF has been reactivated to accommodate growing fragmentation

Cargo is a major component of Cathay but continues to under-deliver. The first few months of 2015 were strong as port blockages on the US west coast increased demand for air cargo. This pushed Cathay's RFTKs to exceed the peak levels of 2010 and 2011 while load factors around 65-70% were about back to 2012 levels, but not as high as 2010's performance around 75-80%.

Cathay Pacific monthly RFTKs: 2008-2015

Cathay Pacific monthly cargo load factor: 2012-2015

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Cathay Pacific monthly cargo load factor: 2008-2015

The trans-Pacific is Cathay's core market for dedicated freighter operations, with the rest of the world mostly relying on space in passenger bellies. This is from convenience but also necessity as the growth of Gulf carriers has made Asia-Europe dedicated freight services increasingly challenging. Cathay said the European cargo market "fell short of expectations" and is an "ongoing concern".

The strong cargo start to 2015 faded in May-2015 as the US port strike ended. Over-capacity and competition continue to cause challenges. An 8% increase in tonnage and 0.9ppt increase in load factor were accompanied with an 11.1% decrease in yield, leading the airline cargo revenue to decrease 1.6% (group cargo revenue decreased 2.5%).

Cathay is not bullish on the prospects of a strong second half, when cargo usually spikes in the lead up to the end of the year. There is some hope for new consumer electronic devices to spike demand - an "iPhone recovery" - but this rush is not expected to be as strong as in past years, although the market remains difficult to determine, with cargo bookings coming in close to flight.

It is thus perhaps a juxtaposition that for the peak season Cathay in Sep-2015 will reactivate a 747-400BCF that was parked in Aug-2013. The reason for this, however, is that the manufacturing sector continues to fragment. Whereas it used to be concentrated around the Pearl River Delta, Cathay's hinterland, it is moving to western China and Southeast Asia. Previously, surface-based transport options could bring the cargo to Cathay's hub, but now Cathay has to fly the cargo to its hub before transporting it onwards.

Cathay continues to seek customers to use its cargo terminal as Cathay's own cargo throughput is lower than was anticipated when the terminal was originally designed to only be used by Cathay. The terminal is marginally unprofitable while Air China Cargo, in which Cathay holds a stake, has become marginally profitable.

Outlook: Cathay has many bets it cannot walk away from. There are few guarantees

In an environment where yields are uncertain, Cathay is turning to volumes. But this is approaching limits as long-haul load factors are at 88-89%, effectively meaning economy is full, while premium cabins experiencing lighter demand are not easily stimulated.

Recent years have seen Cathay grow significantly ahead of the market, and perhaps faster than it would like to, but this was the result of factors including wanting to grab slots at Hong Kong and the way aircraft deliveries have flowed. Cathay's 8.4% ASK growth for 2015 remains unchanged from Mar-2015 projections.

Future growth could be around 3-5%, although this depends on the exact aircraft retirement plan, a topic that retains considerable fluidity. Recent growth in connecting traffic could be dialled back to focus on point-to-point demand, but Hong Kong's local market shows signs of saturation. Further, Hong Kong Airport is looking to optimise its existing runways now that there is approval for the third. Optimisation can likely carry the airport through a number of years but definitely does not preclude the need for a third runway, a distinction that is probably lost on the public.

This may not be to Cathay's liking, as the carrier has invested in slots and aircraft on the assumption there will be limited slot growth. Like many home based flag carriers, a congested home airport can deliver considerable insulation from competition. Overnight Southeast Asian flights were to have their slots converted to long haul usage, while daytime cargo flights could also have their slot re-assigned. A lifting of Hong Kong's informal night ban would benefit competitors more than Cathay.

Hong Kong Airlines faces a tall task to mount a long haul network, but the payoffs could be considerable and to Cathay's detriment. Jetstar Hong Kong is quickly exiting the picture as Hong Kong Airlines - maybe with a strategic airline investor - builds up.

While the Hong Kong situation is uncertain, the wider world presents even more opaqueness. 48% of Cathay's throughput and 41% of revenue are from connecting passengers and there is increasing competition for this segment in nearly every direction. Economy loyalty is weak while sleepy neighbouring competitors are finally waking up and making a stronger push in premium services.

For some years Cathay has been waiting for a return, waiting for its revamped and now fuel efficient freighter fleet to take the loads while a passenger fleet with improved premium products flies high-yielding passengers. Cathay's bets are large and too significant to walk away from. Even if there are these fabled "returns", there is stronger competition where Cathay used to have a comfortable and invulnerable share.

The financial sector has in the past heeded Cathay's line that there will be a rebound, but with massive competition growth is now starting to question the assumption. Despite the 1H2015 profit increase - albeit lower than expectations - Cathay's share price slumped.

A new, alternative, strategy remains lacking. But perhaps Cathay is content, as Mr Slosar says, with "doing something right" rather than many or almost all things right. While competitors may still be catching up, they are moving quickly and will look to seize on any complacency.

As of 25-Aug-2015, Cathay's share price has shed over a quarter of its value in a matter of a couple of weeks. And with uncertainty in the air emanating from China, reflected through a continuing bumpy outlook for the stock market, Cathay's large neighbour may not be able to deliver salvation in the near term. Standing still may be comfortable but is seldom advisable.