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Cathay Pacific 2014 profit: remaining slightly ahead. Seismic change needed but seemingly unlikely

While Cathay Pacific hopes to remain in passenger views one of the world's best airlines, financially it appears to be settling in for a period of mere average performance. Its long-term cost growth remains ahead of passenger yield improvements while cargo yields are low. The situation could be worse – compared say with Singapore Airlines – but the outlook shows more challenges than opportunities. Yield declines are all but certain as transit traffic and near system-wide competition increases, especially in North America (where yields were down 4%). Europe was the only market for yield growth, but this may change with 2015's new routes and competitive growth. Staff productivity is at record lows and ongoing wage negotiations may limit damage rather than give a leap ahead in efficiency.

2014's group profit increased 20% to HKD3.2 billion (USD412 million) while the airline profit before tax figure increased only 1.4% to HKD2.4 billion (USD311 million). The group operating margin was 4.2%. Cathay reported a HKD911 million (USD117 million) hedging loss in 2014 with HKD12.5 billion (USD1.6 billion) in unrealised losses through 2018. Older aircraft retirements are in the final stage, limiting further cost savings, while receiving A350s and 777Xs ahead of competitors will provide a few years of cushion. Cathay is approaching fragility in a harsh industry where changes can be sudden and deep.

Cathay Pacific Group financial summary: 2014

Cathay Pacific and Dragonair Operating Results Analysis: 2014

Hedging losses dominate the short-term story. Fuel savings to be passed to customers?

As expected, fuel hedging losses dominated the headlines about Cathay's 2014 result. Cathay reported a HKD911 million (USD117 million) hedging loss in 2014 compared to a HKD985 million (USD127 million) gain in 2013. Gross fuel cost (excluding hedging) was up 0.7%, lower than the 5.9% and 10.4% increases in ASKs and ATKs respectively. 2014 fuel consumption was 41.7 million barrels, up from 39.5 million barrels in 2013. Looking at net fuel costs, there was a 5.7% increase in cost. 

Cathay has HKD12.5 billion (USD1.6 billion) in unrealised losses through 2018, which caused a net asset reduction of 17.7% to HKD51.853 billion (USD6.68 billion). Other carriers have been caught on their hedges but Chinese carriers will see a benefit since they do not hedge.

Cathay Pacific fuel expenditure and hedging: 2013-2014

Cathay chairman John Slosar said the carrier hedges to prevent fuel "rising to a level beyond which the existence of the airline is threatened – pure and simple". Mr Slosar said Cathay would continue to hedge where it sees fit, with the long-term benefits still outweighing occasional losses.

Cathay Pacific 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 Pacific maximum fuel hedging exposure: as of 18-Mar-2015

Cathay expects a stronger benefit later in 2015 from lower fuel prices and is one of the few airlines to say it will pass savings onto consumers. Mr Slosar said: "There will be plenty of good offers and good fares for our customers", noting that was for both passengers and shippers. It was unrealistic to think airlines would keep all of the fuel savings, so the question is exactly how much of the savings will be passed on – and if Cathay really does intend to pass on many savings or said so for a good comment to the media.

Cathay had a better 2014 than 2013, but the long-term trend is not encouraging

2014's year-on-year improvement was driven by a 1.8% passenger yield decline being slower than a 2.2% reduction in cost per ATK including fuel (1.9% excluding fuel). The passenger load factor improved 1.1ppt to 83.3%. Cargo saw a steeper 5.6% decline in yield but 2.5ppt gain in load factor.

Over the long-term however this merely narrows the yield-cost gap in the passenger business. Comparing key metrics to 2010, costs including fuel (cost per ATK, Cathay's preferred metric as it reflects passenger and cargo costs) have grown ahead of passengers yields while cargo yields have weakened.

Cathay Pacific index (2010=100) of passenger yield, cargo yield, total costs and costs ex-fuel: 2007-2014

2014 was the second consecutive year of declines in unit costs (including fuel) but these modest improvements are still some distance from battling the large increases that occurred between 2010 and 2012 that were greater than passenger yield improvements. Cathay largely held unit costs ex-fuel between 2009 and 2011 but these increased in 2012 and 2013. 2014 was the first year in recent memory where there was a notable decline in ex-fuel unit costs (there was a small 0.5% decline in 2011).

The business is being helped by improved load factors, with 2014's 83.3% load factor just under 2010's record 83.4% load factor. That load factor proved to be an anomaly, with 2009 and 2011 have 80% load factors. Now Cathay is aggressively targeting high system load factors. Competitive markets show significantly higher load factors, such as Europe's 88% load factor in 2014 and North America's 86.1% load factor in 2014 (and an even higher 88.8% in 2013).

Higher load factors can be one way to gain a competitive advantage. It can also allow lower-priced tickets to be sold so Cathay – while opposing Jetstar Hong Kong and competing with HK Express – can be seen to be making an effort towards budget travellers. As Mr Slosar said at the results briefing: "We want to make sure we're participating in the growth of the market, that we're giving all segments of the market reasons to travel on Cathay Pacific and Dragonair. As long as we're doing that, we think that's pretty successful. And you can see that in some degree in our load factors, by having them rise up a little bit."

Cathay Pacific passenger yield (HKD cents, left axis) and passenger system load factor (right axis): 2007-2014

The weak cargo yields and slow passenger yield growth means further cost reductions are necessary. Unlike carriers in Europe or Southeast Asia, Cathay is not unprofitable or on the brink of losses, but its margin is weak and the group is not meeting its cost of capital.

Cathay Pacific operating expenses: 2014

More cost reductions, especially with under-productive labour, are necessary

Lowering costs are a guaranteed friend while growing yields can prove to be fickle and even a foe. In Cathay's case, there should be no betting of on improving yields. Its summary of conditions in almost every market mentions yield weakness or competition.

Cathay Pacific revenue challenges: 2014

Market Commentary
 Ex-Hong Kong "The depreciation of the Japanese yen increased demand for travel to Japan, but increased capacity put yield under pressure" 
 Middle East "Competition has intensified and market conditions are difficult in the Middle East." 
South Africa   "It was adversely affected by the weakness of the South African currency and, in the second half, by a decline in group travel to Africa as a result of negative publicity about the Ebola outbreak in West Africa."
 Southeast Asia "Strong competition affected the performance of our Philippines routes. "
 
 Europe "Revenue on the Moscow route was affected by political instability and economic sanctions."
 
 North Asia "Demand for premium class travel from Mainland China was affected by restrictions on public spending."
 
North America "Strong competition affected the performance of our Canada routes, putting yield under pressure."
Freight "Over-capacity in the air cargo market put downward pressure on rates in the first half of the year. But rates increased in the second half in response to improved demand for shipments from Hong Kong and Mainland China. Demand for cargo shipments to North America was particularly strong, reflecting exports of consumer electronic products."

There were some upbeat components, but isolated.

Cathay Pacific revenue opportunities: 2014

Market Commentary
South Asia
"Passenger traffic on our South Asia routes was generally robust in 2014."
New Zealand
"The New Zealand route was robust in 2014, helped by the joint venture with Air New Zealand. We increased the frequency of the Auckland service to twice-daily in the northern winter."
Europe
  • "Demand was strong on most European routes in 2014. Demand for premium economy class seats was good, particularly on the Frankfurt and London routes."

  • "The London route performed well in 2014, with good loads in all classes. Demand for travel to and from the Southwest Pacific through Hong Kong was strong."

  • "We introduced a four-times-weekly service to Manchester in December 2014. Initial results are encouraging."

Korea

"The performance of our Korean routes was very strong in 2014. Revenue was well above expectations, primarily due to high demand from Hong Kong."

In short, Cathay typically saw stronger performance in its smaller markets (New Zealand) than bigger markets (North America, Asia, etc.) The Hong Kong dollar's peg to the US dollar means traditionally strong inbound markets like Japan have become weak. Outbound travel from Hong Kong to Japan has not replaced in value traffic from Japan to Hong Kong (and beyond).

Cathay Pacific Group (Cathay and Dragonair) top markets ranked on ASKs: 16-Mar-2015 to 22-Mar-2015

Cathay does not disclose market-by-market yield information but does provide year-over-year percentage changes. After a volatile end to the last decade with strong yield growth followed by rapid yield declines and then yield growth, performance is heading in a southernly direction.

Cathay year-over-year change in yield by market: 2007-2014

Cathay's overall story would be far better if the cargo situation improved. But this would not correct fundamental weakness in the passenger business. Further, while cargo is showing encouraging signs (as it has done in the past) there is no proof yet of a sustained recovery and Cathay said it would need to wait before declaring a structural upturn.

So the focus must turn to cost-cutting, a proposition Cathay like other prestigious peers (such as Singapore Airlines and All Nippon Airways) must carefully and quietly address. There will be no defining passenger-facing cuts as seen in the US market or the very public sour relations between staff and management as seen in Europe.

As is often the case, labour is the defining cost reduction opportunity but is equally challenging. Staff wages in 2014 comprised 27% of non-fuel operating costs, up from 25-26%, despite productivity decreasing. ATKs per HKD1,000 of wages decreased from a high of 2,106 in 2008 to 1,750 in 2014, a decrease of 17%. 2014 staff productivity was the lowest in over a decade, second to 2013's 1,720. Cathay is transitioning its fleet, with an impact on staff productivity, but this cannot be the sole explanation.

Cathay Pacific ATK per HKD1,000 of staff costs (left axis) and staff cost share of non-fuel operating expenses (airlines only, right axis): 2007-2014

North America is Cathay's largest market for growth – and yield declines

Cathay in 2014 grew ASKs by 5.9%, including 19.1% in North America, the fastest growing market by far. Cathay's second-fasted growing market, North Asia, grew by only 4.2%, below the average 5.9% growth, reflecting how strong North America's growth was. The growth also had a strong negative impact with a 2.7ppt decline in load factor, although still high at 86.1% (and above the system average 83.3%). Yields declined 3.9%, faster than the overall decline of 1.8%.

Cathay Pacific traffic summary: 2014

The situation in North America will intensify. 2014 did not even see a full-year of strong capacity output. In mid-2012 Cathay pulled down North America capacity and did not restore it until part way through 2014. Jan-2015 North America capacity is up 16.7% and Feb-2015 up 11.9%. A new Boston service and frequency increases to other destinations (planned as of only Mar-2015) will see Cathay's North American ASKs up 6% in 2015, but further growth is possible as the year progresses.

Cathay Pacific monthly available seat kilometres to North America: 2008-2015

Cathay joins nearly every other North/Southeast Asia-US player in growing on the trans-pacific during 2015.

United States of America to NE/SE Asia (seats per week, one way): 19-Sep-2011 to 30-Aug-2015

See related reports:

Europe shows yield increase but expansion will dampen performance

Once the doldrums, Europe in 2014 was Cathay's only market to report yield growth (4.6%). This was on the back of a 2.2% decrease in ASKs. 2014's ASKs were the lowest since 2010 (with many changes due to replacing 747s with smaller but more profitable 777-300ERs). 2015 will be the year of European growth with an approximate 16% increase in ASKs, according to OAG data. This includes the full-year realisation of Cathay's Dec-2014 launch of Manchester as well as the 2015 launch of Zurich and Dusseldorf. The new routes come with typical start-up costs.

See related report: Cathay Pacific's new routes – Dusseldorf, Zurich, Boston – continue long-haul market expansion

North Asia-Europe capacity is growing with increases to Italy and SAS' new Stockholm-Hong Kong service. Etihad will enter the Hong Kong market (in addition to partially-owned Air Seychelles' existing service) and will compete for the European market. Southeast Asia-Europe may be a mixed bag with possible Thai Airways and Malaysia Airlines reductions as they restructure. Vietnam Airlines may increase its proposition as it moves to London Heathrow.

See related reports:

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

And elsewhere: intra-Asia competition grows, Johannesburg could be difficult, Australia cosies up with China

Another defining negative component to Cathay's 2014 was yield decline in Cathay's backyard of North Asia (down 3.0%) and Southeast (1.9%). There is some correlation with the North American yield declines (with that traffic connecting beyond Hong Kong to North Asia and Southeast Asia) but this also reflects growing short-haul competition including at the budget sector.

A raft of additional Australia-China capacity is likely to impact Cathay, as will Australia's reluctance to grant Hong Kong carriers (such as Cathay) greater traffic rights to Australia. A resurgent Qantas will try to claim back some of the growth Cathay and others like SIA have taken.

See related reports:

Meanwhile Air China's new Beijing-Johannesburg service will also likely impact Cathay. Although Air China is replacing South African Airways on the route, Air China will have far more muscle than SAA in China and around North Asia, source markets for Cathay's Johannesburg flight. Cathay says China, Japan and Korea account for 30% of revenue on the Johannesburg flight. Johannesburg was challenging for Cathay in 2014 (partially due to Ebola concerns) but early 2015 showed encouraging signs, with Cathay saying revenue grew 5% despite a capacity decrease and the route having an 85% premium load factor and about 75% economy load factor. Cathay's party in Johannesburg could be over as soon as it starts.

Besides Air China, Gulf carriers are growing in the Africa-Asia market, including opening new destinations in Africa that Cathay serves only offline. Avoidng a Johannesburg transfer does away with the issue of Chinese nationals needing a transit visa. Cathay is further concerned that from Jun-2015 passengers under the age of 18, even with their parents, will need to present English language birth certificates.

See related report: China's airlines pivot towards Africa, after making inroads in Europe, North America and Australia

Only three passenger 747s remain. A340s heading for part-out. A350 & 777X promise advantage – but for how long?

Cathay ended 2014 with seven passenger 747-400s and 11 A340s, but in Mar-2015 the fleet dwindled to three 747-400s and 10 A340s, with three more A340 retirements in 2015 and the balance removed by the end of 2017. 2015 sees the end of growth at Cathay's current fleet generation: three A330s join in 2015 (including one already delivered in Feb-2015) and six 777-300ERs in 2015 (including two delivered through Mar-2015). These are planned to be its final deliveries of these variants. (Not reflected on its fleet profile as a firm order, there will be an A321 leased to Dragonair in Apr-2015, according to CAPA's Fleet Database.)

Feb-2016 sees the delivery of Cathay's first A350-900 with deliveries through 2017. A350-1000 deliveries run from 2018 to 2020 and 777Xs from 2021 onwards.

Each type will offer an operating cost advantage over competitors, but this will likely be short-term as competitors catch up (or are able to take advantage of lower ownership/lease costs of current-generation aircraft).

Cathay Pacific group fleet profile: as of 31-Dec-2014

Outlook: More discipline needed to wrest back the initiative

Invariably, the question of low-cost carriers came up. Cathay remains one of Asia's few major airlines without a low-cost subsidiary and has always spoken negatively of LCCs. Mr Slosar has never minded being the only one in step, observing, "I don't think business model has anything to do with it. There's no such thing as a separate market for low-cost carriers. There's only the market. Airlines compete in the market...as long as we're doing so effectively, you know, we're going to keep doing that. If there ever comes a point where we discover we can't do that effectively, you know, we'll think of something else." 

Mr Slosar is partially right. It is not the type of business that can determine success – it is cost base. LCCs typically demonstrate strong cost credentials, but they are not alone. New world airlines, such as in the Gulf, are full-service without the legacy. There is even a full-service airline, Batik, established by Lion Air and which presumably has inherited the LCC's low-cost fundamentals. It is not necessarily what an airline does but the cost base it starts with.

Cathay has to prove it can have a low enough cost base for the yields it attains. It has not found this balance yet. This is especially critical as Cathay becomes one of the few airlines in Asia to talk about return on invested capital, which it is currently not meeting.

As many airlines can attest, the journey to low costs is difficult and seldom done with pleasantries. Cathay hopes to retain its polished reputation. As expressed by COO Rupert Hogg: "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."

Cathay has a productivity-increasing/cost-cutting programme "Lean" but declined to comment on cost reduction targets.

The options appear to be limited movement or serious action, with the likely resulting outcome mediocrity or a clash between management, staff and passengers.

Another airline restructuring could spur more necessary overhauls in Asia's aviation sector. JAL has been through the wringer and now Malaysia Airlines and Thai Airways are likely to join. More may need to come to the party.

That is a group better joined voluntarily than under duress.

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