Cathay Pacific and Dragonair experiment with fare offerings, but is structural change in the wings?


Cathay Pacific publicly remains steadfast that its business is on track despite growing LCC pressure and long-haul competition, all affecting yields while constraining Cathay and its Dragonair subsidiary in new, lower-cost markets.

The view may be to shore up investor confidence as largest shareholder Swire looks to sell, but beneath the surface Cathay is apparently implementing new initiatives to try to keep a hold on the budget-conscious market.

The carrier has launched "Fanfares", limited-offer and typically last-minute travel deals. More recently it has offered discounts on business class and premium economy travel, only to the Hong Kong market, which has long felt "hub captive" as Cathay commanded a yield premium for non-stop flights.

But these offerings focus on fare cutting and not cost-cutting or structural changes to its business that will enable it to compete more effectively without sacrificing profitability. The pattern occurred in America and Europe before airlines realised their costly operations could not take lower-cost competition head-on. Although a mature airline, on this front Cathay is seemingly going through adolescence, with some awkward bumps along the way.

Cathay's strategy is segmentation – but aviation is not conducive to it

Cathay's big-picture strategy objective is to segment its product – aircraft – to meet the needs of the market. Its three classes of first, business and economy were supplemented with premium economy in 2012. Cathay is about 45% owned by Swire, which provides much of the carrier's management as they rotate through various Swire companies.

Cathay CEO John Slosar previously oversaw the turnaround of Swire's Coca-Cola division, and uses his experience there as an example of how airlines can segment their product. The basic Coca-Cola product, a Coke, can be sold inexpensively in supermarkets, slightly more in convenience stores and significantly more at movie theatres and sport stadiums, even though the basic product is the same.

As LCCs have gained traction in North Asia, and especially Hong Kong, pressure has mounted on Cathay to explain its position of not responding in kind. Mr Slosar's response is typically a jovial comment that Cathay has always offered low fares to the market and always will. But this echoes what a number of other full service airlines used to say before they moved to more targeted market responses.

The belief in segmentation holds that any passenger could be attracted to Cathay's economy class as a minimum. But unlike Coke, airline products have structural cost differences, and low-cost carriers have exploited these with success. Where Cathay argues it can simply discount economy class tickets, that challenges profitability but also does not fully compete with LCCs. LCCs use smaller aircraft while Cathay is an all-widebody operator, enabling LCCs to build frequency on competing routes but also open new cities that full-service carriers cannot; AirAsia with its narrow bodies thus serves more points than Malaysia Airlines. Jetstar is a larger international carrier than Qantas. Ryanair and easyJet are the largest carriers in Europe by far.

An advantage for Coke, and disadvantage to airlines, is that Coke is largely sold on marketing and has a high margin. Airline seats are highly commoditised with a low margin, largely because aviation is not conducive to segmentation. Online travel agencies and other distribution platforms show a seat as a seat irrespective of brand, service and other differentiating factors airlines would like to include and now have become somewhat hostile towards GDSs for not facilitating differentiation. Cathay undoubtedly has some brand magnetism thanks, but a USD20 fare difference will usually be sufficient to overcome that.

Small scale segmentation can be successful, and it is these avenues Cathay is now exploring and experimenting in with "Fanfares" and its premium class "bundles". They are welcome additions but they are just that: additions, not the structural changes that will see Cathay better compete with the tremendous change occurring around it.

Dragonair's 'Fanfares' seek to fill incremental seats

One low-risk but high-gain opportunity for airlines is filling incremental seats on flights. Substantial work needs to go into filling a flight with profitable traffic, often O&D (third and fourth freedom traffic). From there airlines have historically looked at sixth-freedom traffic, linking an available seat on two flights into an attractive itinerary. If all goes well, load factors average around 80% with premium (in Cathay's case) 55-65% in premium cabins and 85% in economy.

By this point, costs for the flight are covered and any additional passenger, once incremental weight and meals are paid for, is largely profit. Because the passengers needed to boost load factors are so few, historical marketing channels – all-encompassing without ability to pinpoint segments – have traditionally ignored this incremental potential. But the internet, and social media in general, have provided a very low-cost way to fill incremental seats.

While some airlines have offered weekly fare deals for weekend travel, the myriad of combinations across networks have seen only a few city-pairs promoted while very mature markets like the US have honed in on 90% load factors, reducing the need for incremental passengers. JetBlue largely led the way with its "Cheeps", offered every Tuesday for last-minute travel. Promoted on Twitter (which has almost no costs) with the fares available online, JetBlue can target very specific markets when a flight at a certain day and time is light. The Cheeps Twitter account has 344,000 followers, but word of mouth makes penetration much larger.

Dragonair's "Fanfares", introduced in late 2012, are in a similar vein. Released every Tuesday morning, they cover a range of short-haul and long-haul destinations (although associated with Cathay's short-haul Dragonair subsidiary, the fares include travel on Cathay) but primarily focus on short-haul sectors. Fares range from mighty attractive – a quarter of the normal price – to only a minor discount. There are caveats.

A HKD290 (USD37) fare excluding taxes from Hong Kong to nearby Sanya is normally HKD1190 (USD154), but the HKD290 fare is only available on two sets of departure and arrival days and there is only one flight a day.

Dragonair Fanfare promotion availability window to Sanya: 08-Jan-2013

Fares with a larger range of travel days and duration are more expensive, and can be offered in greater quantity: 220 tickets for sale to Singapore during a two-week window versus 60 for the Sanya promotion.

Dragonair Fanfares promotion (return, excluding taxes): 08-Jan-2013

Fanfares are effective in their task of filling incremental seats and also gaining awareness: interest may be spurred but dates do not mesh, leading a passenger to book a regular, more expensive ticket. (The other major strategy to fill incremental seats is to build a web of partners as Etihad is doing, but that is a very different approach.)

Yet this concept is new to the Hong Kong market and there is confusion about its intent. Some mistakenly see this as Cathay and Dragonair competing with LCCs, not only because the fares are low but the very marketing – bright and varied colours – is unlike anything else the typically reserved Cathay and Dragonair have done. And no doubt Cathay will be eager to promote Fanfares as a response to LCCs and to further quell the market's growing agitation for a formal response to the LCC threat.

But Fanfares cannot be a substitute for competing with LCCs.

The Fanfare promotion for 08-Jan-2013 includes a HKD990 (USD128) ex-tax fare from Bangkok to Hong Kong. It is a very low fare for the market, and like the Sanya offer is only available on a limited combination of dates (three).

Cathay/Dragonair Fanfare promotion availability window to Bangkok: 08-Jan-2013

For those dates, the Fanfare is the lowest offering by far, under-cutting the USD258 (inclusive of taxes) offered by some fifth-freedom carriers with late night arrival or departure times. Thai AirAsia is USD307. At any other time, Cathay is significantly more expensive – USD350 – despite offering about 13,000 seats a week. Booking in advance, Thai AirAsia has return fares inclusive of taxes from USD163 – less than Cathay's Fanfare promotion.

Hong Kong International Airport to Bangkok (seats per week, one way): 19-Sep-2011 to 30-Jun-2013

So while Cathay and Dragonair can fill the odd seats with cheap tickets, it is not a year-round solution to target the growing budget end of the market. Cathay's lower-cost competitors, Hong Kong Airlines and Thai AirAsia, have about 3,100 and 2,500 weekly seats. In this example for Cathay to capture that market - profitability - for 43% of its existing capacity, it cannot better segment its existing product. To enable year-round lower prices, it needs structural change.

Critics will point to Thai AirAsia having a higher fare than full-service carriers as an example LCCs are not low-price. They are indeed low-cost but in some instances are not always low fare because they do not need to be: Thai AirAsia's flight may already be significantly full or it is banking on passengers assuming it has the lowest fare and automatically booking with them, amongst other reasons. (Southwest, the go-to example of an LCC, no longer typically has the lowest fares in the market. And Aer Lingus used to complain that people ignored the cheaper fares on their site, assuming that Ryanair would always be cheaper - the reverse effect of having a higher quality brand).

In other cases, demand in Asia is so pent-up that LCCs can charge almost that of a full-service carrier and enjoy a healthy margin. Again, critics have called Peach Aviation's service between Osaka Kansai not low-cost because the fares are high, but the service is full and Peach would add a second daily offering if only it could receive suitable slots to its tight aircraft utilisation regiment.

The argument for Cathay to launch its own LCC grows by the day.

See related article: Cathay Pacific must seize the moment and launch a low-cost carrier

Premium fare bundles give sales to Hong Kong, with which Cathay has had a contentious relationship

Cathay on 07-Jan-2013 launched a two-week premium travel "bundle" offer, which it reportedly last did in 2008, although this time there is an atmosphere of aggressive business class sales from carriers to various destinations.

The offer is convoluted and available for booking via a call centre or travel agents. Passengers are able to combine, for a set rate, a long-haul flight with a short-haul flight in either business class or premium economy.

Cathay Pacific premium bundles (excluding taxes): 07-Jan-2013

The devil is in the detail, and it is not clear what date limitations there are. Already certain city and fare combinations (like premium economy to London) are excluded, while on routes with multiple frequency (such as New York) the offer is restricted to certain flights.

Although unusually structured and seemingly aggressive for bookings, this smells more like testing the waters than of a change of strategy. There is a long lead time to travel, by 15-Jul-2013, and tickets must be booked by 23-Jan-2013, by which time corporate accounts will still be in a post-holiday slowdown. Cathay appears to be targeting small business owners as well as premium passengers travelling for leisure; British Airways has estimated about a quarter of its premium passengers are travelling for pleasure.

Combined with Fanfares, Cathay seems to be trying to forge a better relationship with the Hong Kong market, a connection that has been difficult and at times contentious. While the Hong Kong market enjoys the top-notch carrier that is Cathay, they have felt hub-captive when it comes to prices.

This phenomenon - and the media reaction - is not so unusual in hubs with a conspicuously high quality home carrier, but the impact is accentuated by Cathay/Dragonair's unusually high, near-50% market share by seats; even Singapore Airlines/Silkair have a lesser hold and SIA's regional subsidiary does not have the same premium marque as Dragonair.

As passengers value direct flights more than those with stops, airlines understandably put a yield premium on non-stop flights. A passenger originating in Hong Kong will typically have to pay a premium on Cathay compared to a passenger originating from another market. This can be typical with airlines, but the Hong Kong market tends to feel this is occurring at the extreme with Cathay.

For example, looking at advance purchase tickets in May, Hong Kong-London business class fares on Cathay are approximately USD6,000. But Xiamen-London via Hong Kong on Cathay Pacific is under USD4,000 despite the additional flights between Xiamen and Hong Kong (the two are 497km apart). It is not unheard of for some passengers to purchase an inexpensive ticket from Hong Kong to a nearby destination (such as Xiamen) and then backtrack through Hong Kong on a ticket originating in a foreign city, and thus able to take advantage of lower fares. While large corporate accounts would not do this, a small business owner could find it worthwhile to fly a few extra hours to save USD2,000 – and earn some extra frequent flyer miles!

The HKD33,800 "bundle" offer Cathay has from Hong Kong to Europe (including London) is approximately USD4,360 return excluding taxes but this also includes a short-haul flight. So the "bundle" fares are comparable to what passengers in other markets might pay on a regular day.

In this relatively open market though, it is fundamental that fares will typically be pitched as close to what the market (at each end) can bear. If Hong Kong residents feel it is expensive to buy a Cathay business class return to Sydney, they may feel relieved to find that buying the same seats originating in Sydney will cost 70% more! A strong Australian dollar and still-strong economy means the capacity to pay is still there.

At end of 2012, Cathay's premium traffic had returned to pre-GFC levels, bucking global trend

Short of significant change in market outlook, Cathay's premium fare bundles are not a response to depressed premium travel. While IATA's latest premium traffic report (Oct-2012) shows that premium traffic is still well below pre-GFC levels, Mr Slosar in Nov-2012 reported that Cathay's premium traffic had rebounded above earlier levels after dipping.

International air passengers by seat class (seasonally adjusted): Jan-2007 to Oct-2012

Premium passengers as percentage of total (seasonally adjusted): Jan-2007 to Oct-2012

Between 2006-2012 premium traffic accounted for approximately one-third of passenger revenue, but during the 2009 slowdown tipped to 20% (it has since returned). On certain routes, such as to the US and Australia, premium traffic can account for 40-50% of passenger revenue. (Cathay excludes premium economy from its "premium" calculations.)

Premium traffic ex-China saw a slowdown in 2H2012 as China prepared for a leadership changeover, which slowed down nearly all aspects of China's economy (its airlines saw their own traffic slow). But premium traffic outbound from China in CY2012 still doubled compared to 2008. During this period Cathay and Dragonair increased frequency between mainland China and Hong Kong by about 17% while premium seats saw a similar increase. While Cathay may be growing outbound traffic ahead of supply, yields are lower from China, as noted in the above example from Xiamen.

The market is also different: while the financial industry typically has the largest uptake of premium seats in global markets, in China Cathay has found it to be manufacturing, IT, property, communications, with the financial industry well down the list. That partially reflects the internationalisation of China's economy.

A challenge to Cathay will be how much competitive connecting traffic it can rely on, versus pulling down some parts of its network to focus more heavily on O&D traffic, as British Airways did last decade.

See related article: Cathay Pacific explores new growth opportunities as pressure mounts in traditional markets

Cathay is tilting towards more premium seats, and in particular in business class and premium economy.

Mr Slosar has remarked that on the future of first class, Cathay is keeping an open mind – which is not a strong endorsement for a cabin that has seen gradual decreases. Cathay's long-haul workhorse, the 777-300ER (which is replacing 747-400s) has a larger proportion of business class and premium economy seats. Business class on the 777-300ER comprises 19% of seats compared to 13% on the 747-400 while premium economy on the 777-300ER is 12% of seats but 7% on the 747-400.

Cathay Pacific 747-400 and 777-300ER (four class models) comparison: 08-Jan-2013

  First class Business class Premium economy Economy Total
747-400 9 46 26 278 359
Share 3% 13% 7% 77% 100%
777-300ER 6 53 34 182 275
Share 2% 19% 12% 66% 100%

Does Hong Kong risk becoming a hub to nowhere?

In Asia particularly, the travel market profile is changing dramatically. While overall expansion can disguise some of these structural new directions, longer established airlines cannot hope to remain unchanged without losing share to new, more focussed models. Without corrective action, Cathay's current advantages risk being significantly whittled away across its network, and this has implications for its hub structure. Market share may not be the name of the game, but losing substantial share does offer real risks to the network role - as European hub airlines are finding only too painfully.

For the North American market, Beijing to New York via Tokyo is 1,983km shorter than via Hong Kong. While Cathay Pacific may boast a lower operating cost than ANA or JAL, its itinerary proposition via Hong Kong entails 1,983km of extra costs, offsetting a higher cost base over a shorter distance from ANA or JAL. The bigger worry comes from the Korean carriers, whose hub at Seoul Incheon is more convenient for China-North America traffic flows, shaving a further 900km off Tokyo's advantage. As a further advantage, the Korean carriers have a lower cost base than Japanese peers.

To Europe, the Middle East network carriers maintain an advantage, with Beijing to London shorter (by only about 300km) via Dubai than Hong Kong, but the advantage of Abu Dhabi, Doha and Dubai becomes stronger the further south and west the Chinese city is, bringing it closer to the Middle East hubs. Chengdu to London via Dubai is 700km closer than London (small chips compared to the 2,700km advantage held by Finnair and its small but growing Helsinki hub) but the scale of the Middle East carriers is growing, which translates to lower costs - and certainly to maraket power. The Middle East carriers still have a light footprint in ChinaQatar will be the largest in terms of destinations when it launches Chengdu, complementing Beijing, Chongqing and Shanghai – but they will grow, further closing in on Cathay.

The Gulf carriers also have a wide spread of European destinations, often with high frequency, while Cathay has a lonely seven. Emirates has over 30 while Etihad is forging partnerships giving it a virtual network in the hundreds (Cathay is light on partnerships globally). Even regional cities like Manchester receive 6 daily widebody connections by Emirates, Etihad and Qatar.

Combinations between the Middle East network carriers and Chinese carriers will become powerful, eroding Dragonair's strength in China that Cathay has relied on (and which the investment community likes most about the carrier). Etihad is already tied up with China Eastern and Hainan, the latter of which has shifted its Dubai flight to Abu Dhabi to open connections on Etihad, while China Eastern would like to expand its relationship with Etihad. Emirates has interlines with domestic carriers, but the fare combinations are not favourable to other options in the market.

Even Singapore Airlines has a larger network in Europe with 17 destinations but longer itineraries from China to Europe owing to Singapore's southern geography. It is growing in China across its multiple brands (10 in the full-service space, plus soon Shenyang and Qingdao from Scoot; Dragonair serves 18 in China) while Cathay may look to expand in Europe with A350s, but not until later this decade.

Cathay Pacific and Singapore Airlines network destination comparison by region: 08-Jan-2013

In Cathay's last major long-haul market, Australia, Chinese carriers are also making significant inroads. This initiative has been spearheaded by China Southern, and China Eastern is looking to join the mix, to a less extent, and could pose a new challenge to Cathay if – although when may be more accurate – the Shanghai-based airline ties up with Qantas

See related articles:

And this is not the end of the growth story. Taiwanese carriers are unable to sell sixth-freedom tickets from mainland China due to relations that are still developing, but when they can they will have a powerful marketing tool of a stopover in Taipei. Operationally a Taipei hub is convenient from mainland China, although route networks are still developing.

Many carriers could move in and steal Cathay and Dragonair's current thunder. But with the right moves – and not maintaining the status quo – this upside could be for Cathay's taking.

Air fare reductions have to be accompanied by structural cost reduction

Cathay's experiments are not as fragile as was the British Airways-Go experiment, or at least not yet, but lessons can be learned. BA in 1997 launched low-cost carrier Go, which became so successful it eroded BA's legacy, full-service network and, after a management buyout was later sold to easyJet. Yet the plan was in many respects before its time. It would still be well into the 2000s before airlines would try to strip costs out of a full-service business before realising they needed to start from scratch to compete with LCCs.

The turning point has largely occurred only in the last year as Finnair outsourced its short-haul flying and Iberia launched Iberia Express. The most significant developments have happened recently: Air France and Lufthansa have toyed with using existing brands to compete with LCCs, offering very detailed plans, but in late 2012 and early 2013 conceded fire had to be fought with fire. Lufthansa and Air France are scaling back their full-service brands in select markets in favour of low-cost brands Germanwings and Transavia, respectively. Qantas was an early pioneer with Jetstar, and Asian carriers have followed, but in Go, BA – and particularly then-CEO Bob Ayling who personally backed the project, defying the wishes of subordinates – had the vision that BA needed a separate venture distinct from itself rather than try to wean away frills.

There could have been improvements, like coordination between BA and Go, but arguably that critical principle about separation was realised and upheld. As veteran BA executive Barbara Cassani, who was tapped to found Go and become its CEO, recounts in her memoir Go: "Ten years of expensive bad habits at British Airways justifying high prices to customers by adding bells and whistles to the product don't die overnight."

So sudden change at Cathay, an airline that has very much gotten right the frills for certain markets, should not be expected – at least not soon. But Cathay needs to start progressing along the path, mainly well-heeled by carriers under duress, of making structural changes to its business, rather than hope limited measures like discounting tickets will see it through.

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