Hong Kong Airlines IPO Part 1: reportedly profitable but with improvements needed


Hong Kong Airlines, the third largest airline in its namesake hub, has filed an application to be listed on the Hong Kong stock exchange. Its application discloses many figures for the first time in the airline's history, but is not yet a formal prospectus. The application shows Hong Kong Airlines has been profitable, but with significant contributions from sub-leasing of aircraft.

The first part of this report benchmarks Hong Kong Airlines' yield, cost, labour productivity and aircraft utilisation against Cathay Pacific and Dragonair, its most significant competitors. Cathay has a yield premium over Hong Kong Airlines, while cost figures are impacted by very different average sector lengths.

Hong Kong Airlines does appear to benefit from being a younger airline in having lower labour costs, but will need to gain more cost efficiencies and yield growth. Its strategy will be examined in part two of this report.

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For Part 2 of this report, see: Hong Kong Airlines IPO Part 2: Main opportunities may lie in partnerships, careful strategic growth

For Part 3 of this report, see:Hong Kong Airlines IPO Part 3: Improved links with group airlines and new partnerships essential

Hong Kong Airlines' profit is heavily dependent on aircraft leasing

Hong Kong Airlines has reported a profit for three consecutive years from 2011 to 2013. However it should be noted that not reporting a profit is not optional as Hong Kong regulatory requirements dictate a company be profitable before listing.

Hong Kong Airlines' profit shows potential weakness, namely profits appearing to be derived heavily or evenly exclusively from sub-leasing aircraft to other airlines - a practice that is believed not to be uncommon and to have kept a handful of other airlines profitable. Hong Kong Airlines has commented only that leasing comprises a "significant" part of its profit.

Selected Hong Kong Airlines financial metrics (HKD 000s): 2011-2013




Hong Kong Airlines total revenue




Hong Kong Airlines leasing revenue




Hong Kong Airlines operating profit




It would be more valuable to have access to an operating profit figure that reflected Hong Kong Airlines' flying business alone (passengers and freight) and not combined with the leasing part of the business. However, it is not possible to simply subtract leasing revenue to derive a more reflective operating profit.

This is because some of the aircraft sub-leased by Hong Kong Airlines are not aircraft it owns but rather aircraft it leases, and as such is also paying a rent for. Subtracting lease revenue would also require subtracting some - but not all - costs.

As of 31-May-2014, Hong Kong Airlines leased or sub-leased 17 aircraft. This includes five A320s it owns (average age: 1.8 years), five A330s it has on lease (average age: 2.7 years), four 737-800s it has on lease (average age: 13.0 years) and three 737-300SFs it has on lease (average age: 20.4 years).

Hong Kong Airlines is leasing some of the most attractive aircraft it owns: young A320s in a high-density configuration. In contrast, Hong Kong Airlines is sub-leasing some of its most unattractive aircraft: 737s nearing or at the end of their life. Based on market rates, Hong Kong Airlines is likely paying small lease rates for the 737s while obtaining high lease payments for the A320s. However, this cannot be definitively stated as Hong Kong Airlines has not disclosed particular lease arrangements. There is uncertainty on rates as the aircraft are being leased to airlines affiliated with HNA.

Yield: Cathay Pacific retains a premium over Hong Kong Airlines

The raw numbers supplied by Hong Kong Airlines indicate the airline between 2011 and 2013 had a 27-34% yield premium over Cathay Pacific (including Dragonair). However, the stark difference in their network profile distorts the figures. Cathay Pacific's average sector length is nearly double that of Hong Kong Airlines. This is owing to Cathay's short-haul routes being complemented with medium-haul, long-haul and ultra-long-haul routes. Hong Kong Airlines in comparison is primarily a short-haul operator.

This difference is important as long-haul operations are more efficient. On long-haul operations, aircraft are typically bigger, have higher utilisation rates and fixed costs can be spread over a longer period of flight. As a rudimentary example, a passenger on Hong Kong Airlines' two hour Hong Kong-Shanghai flight will be given one meal, but a passenger on Cathay's 16 hour Hong Kong-New York flight will be given two or three meals - not eight. Efficiency reduces costs and, in turn, allows for lower yields.

It is important to view yields in the context of each airline's average sector length. The airlines do not directly disclose these figures, but can be approximately calculated based on the data they supply to OAG, although this sometimes excludes charter flights, slightly skewing the data. Comparing Hong Kong Airlines' and Cathay's yields to average sector length, it is evident Hong Kong Airlines has higher yields than Cathay. But since Hong Kong Airlines' average sector length is shorter, its costs are higher and therefore must charge higher yields.

Creating a like-for-like sector length-adjusted comparison is difficult given the limited data, but based on information available, Cathay Pacific on a like-for-like basis retains a yield premium. This is not surprising given the group's wider brand, recognition and premium strategy.

Cathay Pacific and Hong Kong Airlines (HKA) sector length (vertical axis) versus passenger yield in HKD (horizontal axis): 2011-2013

Airlines are not providing enough clarity on costs

Average sector length also impacts operating costs. However, this is difficult to assess. Cathay Pacific only provides a cost per available tonne kilometre while Hong Kong Airlines provides no cost figures. In the absence of data, we calculate the CASK of each airline. Both carriers supply ASK figures, but a CASK comparison has inherent limitations since it does not measure the output of cargo operations, which has costs but does not produce seat kilometres. The CASK figures are once again measured against average (passenger) sector length.

Hong Kong Airlines appears to have made significant cost improvements between 2012 and 2013, based on the limited information available. In comparison, Cathay's improvements were minor.

A sector-length adjusted comparison would likely show Hong Kong Airlines having a lower operating cost, not surprising given the company's outsourcing and more basic service offering. However, this does in turn correlate to weaker yields for Hong Kong Airlines.

Cathay Pacific and Hong Kong Airlines (HKA) sector length (vertical axis) versus CASK in HKD (horizontal axis): 2011-2013

Cost composition structure: fuel and staff costs are lower at HKA than at Cathay

The overall cost composition at the two airlines, as they segregate the data, shows large differences. Fuel comprises 39% of Cathay's costs but only 30% of Hong Kong Airlines. This can be attributed to Cathay's longer sector lengths, with fuel costs on ultra-long-haul flights being particularly high (over 60%). As airborne costs go up (due to fuel), ground-based costs often decrease. This is visible with Hong Kong Airlines spending 17% on landing, parking and route expenses compared to 14% at Cathay. This is consistent with the trend of short-haul carriers typically having higher ground costs and low fuel costs than long-haul carriers.

The proportion of costs spent on staff at Hong Kong Airlines is 12% compared to 17% at Cathay. Labour productivity will be examined in the next section. Depreciation and operating leases comprise twice the proportion (26%) at Hong Kong Airlines as Cathay (12%). Cathay groups depreciation and leasing costs into one category while Hong Kong Airlines breaks this category out to depreciation being 12.5% and operating leases to 13%; the combined figure is 25.5%, rounded to 26% on the chart below.

Cathay Pacific and Hong Kong Airlines operating cost composition: 2013









Landing, parking and route expenses



Depreciation and operating leases



Aircraft maintenance



Inflight service and passenger expenses









Net finance charges



Selling and market expenses



Labour productivity: Hong Kong Airlines has an advantage

Hong Kong Airlines has a clear labour productivity advantage over Cathay. The average Cathay employee is paid 83% more but only generates 55% more ASKs and 38% more revenue. The figures are once again slightly distorted by measuring only ASKs (which does not include freight) and Cathay only disclosing employee numbers for the group, which includes sizeable ground-based activities like catering and ground handling that produce no ASKs and can be resource-intensive (but generates stable profits). As a result, on this basis Cathay's productivity is understated. Different sector length as well as type of aircraft used need to be considered as well, generally tilting the balance in the other direction.

Even if it were possible to better account for these figures, Hong Kong Airlines would likely retain a large labour cost advantage. The airline is younger and thus benefits from paying more junior staff whereas Cathay has long-serving senior staff, as well as unions that have been successful at negotiating pay increases. Hong Kong Airlines has a small expatriate workforce, whose costs are high, and has outsourced functions to locations in mainland China, where labour costs are lower.

Hong Kong Airlines has been growing ASK output per employee (19% higher in 2013 compared to 2011). Cathay's productivity has decreased (6% lower in 2013 compared to 2011), but this is impacted by Cathay replacing 747-400s with smaller (but more profitable) 777s.

As Cathay's productivity decreased, average cost per employee increased - an unwelcome equation. Hong Kong Airlines has seen dramatic increases in costs per employee (up 44% in 2012 compared to 2011), but costs decreased in 2013. 2013 costs per employee were up 37% compared to 2011. Hong Kong Airlines attributes the increase in 2012 to its establishment of A330 line maintenance.

Cathay Pacific and Hong Kong Airlines ASKs (left axis) and cost (right axis) per employee: 2011-2013

While Hong Kong Airlines has a lower cost per employee than Cathay, Hong Kong Airlines also sees less revenue generated per employee than Cathay, but this once again depends on the type of flying and focus on premium passengers.

Similar to the trend observed with ASKs, Cathay's revenue generated per employee has slightly decreased while Hong Kong Airlines' has increased.

Cathay Pacific and Hong Kong Airlines revenue generated (left axis) and cost (right axis) per employee: 2011-2013

One conclusion to draw is that Hong Kong Airlines has been able to make labour cost efficiencies but Cathay still holds many other efficiencies that come through virtue of size, longer establishment and relationships with suppliers and vendors. Further cost gains at Hong Kong Airlines will be dependent on growth (difficult owing to regulatory restrictions) and a stronger reputation in the industry.

Hong Kong Airlines records 10.6 hours of block utilisation

Hong Kong Airlines says its passenger fleet achieved 10.6 block hours of utilisation in 2013, down from 10.8 in 2011 - fairly creditable levels for a short haul operation in congested skies. For the first five months of 2013, utilisation is 11.3 hours, up from 9.7 hours in the first five months of 2012.

Hong Kong Airlines does not break out utilisation by aircraft, so we can compare its 10.6 hours to Cathay's 11.8 hours, although Cathay's figure includes long-haul aircraft that work more hours. We can also compare Hong Kong Airlines' average 10.6 hours to the 9.1 hours for Cathay (Dragonair's) A320s and the 12.0 hours for A330s.

This likely places Hong Kong Airlines' utilisation in a solid position but without a clear advantage over Cathay. Cathay's overall utilisation is helped by using a larger portion of its A330 fleet on long-haul flights, which can allow for greater utilisation rates. However, its A330s also serve key mainland Chinese cities where unpredictable air traffic delays prohibit tight scheduling, thus hurting utilisation rates.

Cathay Pacific and Hong Kong Airlines passenger aircraft block hour utilisation rates: 2013












Hong Kong Airlines has been pushing high utilisation with overnight Bangkok-Hong Kong and Beijing-Hong Kong flights even though these services are only about three hours. But a potential advantage has been negated by Cathay subsidiary Dragonair following Hong Kong Airlines in having an overnight Beijing-Hong Kong flight.

Outlook: good, but not model, operating metrics. Room for improvement

Of the operating metrics surveyed here, Hong Kong Airlines is in a good position. It is an achievement to have built the airline so quickly in a competitive hub with entrenched competitors. But the market will be looking to reward not past accomplishments but future opportunities. Hong Kong Airlines' figures are not consistently ahead of Cathay.

There is still plenty of room for improvement at Hong Kong Airlines. Realising this will depend on Hong Kong Airlines' ability to grow, gain independence and mature.

Part Two of this report will review Hong Kong Airlines' potential to achieve these goals

This report does not in any way constitute financial or investment advice. Information and opinions contained herein are subject to change without notice and should not be taken as any solicitation to purchase. CAPA has taken all reasonable steps to ascertain the accuracy of the information, but readers should also conduct their own research.

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