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Cathay Pacific’s New Livery Signifies Fresh Direction

By Daniel Tsang

On the face of it, Hong Kong based Cathay Pacific’s (OTCPK:CPCAY) (OTCPK:CPCAF) 2015 first half net profit of HK$1.97 billion (US$254 million) was disappointing viewed from every lens despite being 468.3% higher than prior year period’s figure of HK$347 million. Not only did the headline figure miss the Wall Street consensus of a HK$2.22 billion result, but the passenger yield also plummeted by 9.31%, owing to a triple whammy of considerably reduced fuel surcharge, foreign exchange impact and more connecting 6th freedom traffic. Coupled with a 1.4% Chinese yuan devaluation on August 11th, these precipitated the longest losing streak on the airline’s stock in 14 years.

Yet, Cathay Pacific’s next chapter is not about gloom and doom. On the contrary, it is about leveraging Hong Kong’s superior geographic location at the doorstep of China to add new long haul destinations, tapping into the doubling of outbound Chinese travellers to 200 million by 2020. While it is true that Chinese carriers are expanding internationally aggressively, including a 140% increase in the number of weekly seats to the US since 2010, Cathay Pacific is throwing down the gauntlet to competition and adapting to the new normal.

As the oneworld member is widely anticipated to unveil a new aircraft livery on November 1st, Aspire Aviation investigates its fresh direction.

One off re basing of yield fuel hedgingFingers were quick to point at the HK$3.74 billion (US$482 million) fuel hedging loss, which drastically negated the 35.47% saving in gross fuel cost to only a 12.21% net fuel cost reduction worth HK$2.31 billion. Had there not been such a loss, some observers say, Cathay would have posted a HK$5.715 billion first half net profit and a net margin of 11.34%, instead of just 3.9% on a 0.89% lower operating revenue at HK$50.39 billion.

This, alongside others’ hedging losses, raises the question at large of the merits of fuel hedging itself and the moral hazard that comes with it.

Sceptics say this especially puts carriers that hedge at a distinct cost disadvantage against those which do not, yet have to match declining fares as a result of competitive pressure. But the inherent highly cyclical nature of the airline business makes the visibility of future cost base one of hedging’s most important benefits, if not the most. This essentially amounts to an inter temporal "cost smoothing" that makes capacity decisions less susceptible to the whim of fuel prices. For a growing carrier such as Cathay, this ensures and protects the continuity of its network expansion strategy without the state support enjoyed by its Chinese counterparts.

In fact, in a sample of 7 Asia/Pacific carriers, Cathay Pacific is not faring poorly amongst those that hedge. Besides the two outliers Air China (OTCPK:AIRYY) and China Eastern (NYSE:CEA), which enjoyed a close to US$800 million and US$700 million reduction in their respective net fuel costs and do not hedge, Cathay managed to save almost US$300 million, after Qantas’s (OTCQX:QABSY) US$400 million saving in the January June period. Its arch rival Singapore Airlines (OTCPK:SINGY), which hedged 44.4% of its FY2015/16 second half jet fuel needs at US$94 per barrel, only managed to save as much as 50% of Cathay’s at US$163 million in the same period. ANA, on the other hand, only saved US$100 million.

The second indicator, measuring the percentage of net fuel expenditure being saved on the prior corresponding period’s bill, adjusts for the size of the airline and any foreign exchange effect. One such standout is Japan Airlines (JAL) (OTCPK:JAPSY), which saved 17.44% in the first 6 months of this year, yet the size of saving is being partially offset by the depreciating Japanese yen.

All told, a 2.51% drop in operating expenses from HK$49.26 billion in 2014 first half to HK$48.03 billion in 2015 first half, combined with a largely steady revenue stream, led to a 49.87% surge in operating profit from HK$1.58 billion to HK$2.36 billion. Such sensitivity underlines the need for fuel cost smoothing, of which Cathay slightly bolstered its 2018 hedging position from 37% to 42% at US$81 per barrel at Brent prices and extended it http://www.achaten-suisse.com/ to 15% at US$75 per barrel in 2019.

Another unintended consequence of the plunge in fuel prices is the passenger yield, inclusive of fuel surcharges, has suffered from a one off re basing. While it has often been noted that jet fuel prices and passenger yield move in tandem, since fuel surcharge constitutes an important component, little research has been done on the extent to which this is so. Using company filings and the traffic share to discern Cathay’s fiscal second half passenger yield since 2009, Aspire Aviation has found a 0.875 correlation coefficient between its passenger yield and US Gulf Coast jet kerosene forward prices. While the company relies on Brent contracts to hedge due to its liquidity, this finding is nevertheless significant and explains that such a sudden decline has little to do with its management’s strategy, irrespective on the position taken on fuel hedging.

When the dust settles, it is the unit margin that counts and so far, Cathay’s all in unit cost, in cost per available tonnage kilometre (ATK), has matched the drop in passenger yield, from HK$3.57 per ATK in 2014 first half to HK$3.24 per ATK in 2015 first half. This implies that the company’s unit profitability inclusive of fuel is more or less stable. A more meaningful measure is the unit cost excluding fuel, which showed a solid progress of a 3.6% reduction from HK$2.20 per ATK to HK$2.12 per ATK in the same period, indicating an improved ex fuel unit profitability.

Chinese outbound travel story still intactIntriguingly, one of the purported threats facing Cathay Pacific a Chinese economic slowdown appears to have little supporting anecdotal evidence. As The Economist rightly points out, even a 5% growth this year in China would grow the size of the world economic pie more than a 14% growth in 2007 would have; and the stock market capitalisation as a percentage of the economy, a key indicator of financial depth, stands at just 33.3%, implying any volatility would be contained. Ironically, a rebalance away from manufacturing to consumption would boost the propensity to travel, not dampen it.

That said, another threat the aggressive expansion of Chinese airlines is more realistic. In the China US market, on which Cathay supplied 26.9% of its total system capacity to North America, the Chinese airlines have grown its number of weekly seats by 140% between April 2010 and April 2015, whereas US carriers only added 80% of weekly seats. OAG now predicts Chinese carriers will outgrow their US counterparts as soon as 2022. A case in point is China Eastern’s proposed doubling on its Shanghai Pudong New York John F. Kennedy route from a daily service to a double daily one beginning December 12th. United Airlines, on the other hand, is launching a thrice weekly seasonal Boeing 787 service between San Francisco and Xi’an. In Europe, where Cathay allocates 16.7% of system wide capacity, Air China is launching the Chengdu Paris route this December.

The 140% and 80% growth over a span of five years amounts to a CAGR of 19.14% and 12.47%, respectively, compared to an annual increase of 17.5% in the number of Chinese visitors to 2020 predicted by the US Department of Commerce as well as an annual transpacific passenger traffic growth of 4.4% in Boeing’s latest Current Market Outlook over the next 20 years. A combination of these indicators mean capacity growth is ahead of demand growth, thus putting downward pressure on yields.

Overall, analysts are quite bearish on Cathay’s outlook, with Credit Suisse reckoning Chinese carriers now operate 40% more flights to Europe and 14% more to the US. Bloomberg’s compilation of analysts’ revenue estimates shows the Hong Kong based carrier’s 12% growth to 2017 lagging Air China’s 81%; China Southern’s (NYSE:ZNH) and China Eastern’s 31% and 32% respective growth.

Yet, this tale misses a few points.

Firstly, Cathay Pacific’s North American operation is robust and a franchise capturing feed traffic from a myriad of regions at an origin and destinations (O standpoint. For 2015 January September, Cathay flew 25.4 billion revenue passenger kilometres (RPKs) on 28.6 billion available seat kilometres (ASKs), at an 88.9% load factor. This is achieved despite increasing the frequency on its San Francisco route from 14 weekly to 17 weekly. Its Newark route performance improved considerably in the same time frame. In the week ending October 10, the US routes group enjoyed a 9% revenue efficiency or unit revenue improvement.

Despite the hyperbole surrounding ultra long haul flights spurred by Singapore Airlines’ (SIA) decision to relaunch Newark and Los Angeles services with 7 Airbus A350 900ULRs capable of a 8,700nm (nautical miles) range, including those reports calling such developments as the beginning of the death for hubs whilst clearly ignoring the fact that only 0.4% of the world’s flights are longer than 8,000nm ("Making sense of ultra long haul flights", 8th Oct., 15); Cathay Pacific is likely to remain unmatched in frequency and the number of ports served in providing one stop Southeast Asia US service than either SIA or Thai Airways (OTCPK:TAWNF).

For one, Cathay flies 4 times daily to New York John F. Kennedy (JFK) airport, Los Angeles and 17 weekly to San Francisco. Chicago, Boston and Newark are also served on an once daily basis before ad hoc cancellations. Singapore Airlines’ A350 900 ULR operation with 7 aircraft, on the other hand, means a daily service to only 3 destinations are possible with one as spare. Assuming a 15,000km stage length on 3 ultra long haul routes and a 170 seat configuration, this would add roughly 459 million ASKs per month to SIA’s North American network. In comparison, Cathay supplies around 3.18 billion ASKs every month to North America. At press time, SIA is reportedly considering deploying a pair of A350 900 ULR to Sao Paulo, Brazil.

With such a high load factor, it can afford to choose to carry comparatively higher yield traffic in search of an optimal composition of O demand, at least to some degree. Optimising O composition via traffic substitution is pivotal especially given the price elastic, seasonal nature of the China US air transport market, giving rise to issues such as directional imbalance.

This is shown in the China US air traffic composition data in the Aspire Aviation database. By breaking down itineraries by origin of the point of sale (POS) in the China US air travel market, useful insights could be discerned. One is the variance of the passenger numbers originating from China is very close to twice that of those originating from the United States. While Chinese passengers are taking up an increasing percentage of the total booking, from 65% in 2014 to 70.3% in the January August period this year, it could be argued that the Chinese traffic is predominantly leisure with significant seasonal variation. This is particularly acute for the 2 months immediately after Chinese New Year. In February 2014 and March 2014, the number of Chinese passengers was just 60,649 and 97,420, respectively, against an average monthly figure of 136,121 for the whole year. For March 2015 and April 2015, it totalled only 140,374 and 147,887, respectively, against the year to date monthly average of 186,417.

In fact, Cathay noted in an internal message to employees that the outbound load factor (L/F) of 86% from China immediately after the Golden Week in the first week of October was much higher than the mid 50s L/F from Hong Kong to China. Traffic substitution using 6th freedom traffic is essential to optimise load and yield during these periods of time.

Furthermore, Cathay is not throwing in the towels without putting up a fight. This means accepting more 6th freedom traffic backed by a series of destination launches: 4 times weekly to D since 1st September; the same to Madrid, Spain beginning 2 June 2016 on board a 3 class Boeing 777 300ER aircraft. Other reports have suggested Copenhagen, Denmark; Tel Aviv, Israel; and Seattle are to follow. Consequently, Cathay is ending its codeshare with Qatar Airways beginning 15th February 2016 whilst simultaneously suspending its underperforming Doha route.

But with Hong Kong International Airport (HKIA) hitting full capacity in 2016 and running out of peak time slots, Cathay’s network expansion strategy will be stifled unless the government’s Schedule Co ordination Office makes available more take off/landing slots. A quick look into the government’s slot availability charts in S15 and W15 schedules reveals almost a full utilisation of existing slots, yet the number of plane movements between 00:00 and 08:00 totals fewer than 20 an hour on average.

A theoretical 2am departure time from Hong Kong would be ideal for the Copenhagen and Tel Aviv services, arriving into the Danish capital at around 7:30am 8:00am and the Israeli capital at 9am, taking into account the flight time and time zone difference.

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