Cathay Pacific -- a fallen star of the air?
Despite overhaul, Hong Kong's premium airline set for rare loss
JENNIFER LO, Nikkei staff writer
HONG KONG -- A Cathay Pacific Airways Boeing 747 aircraft flying over the roofs of high-rises in the crowded, aging district of Kowloon City was a typical picture-postcard image of colonial Hong Kong. Last October, dozens of nostalgic fans flocked to see the last flyover of the double-decker, dubbed the "Queen of the Skies," as the Hong Kong-based airline phased out older planes for lighter, more economic models.
Some commentators sentimentally described the moment as the "end of an era" -- when the jumbo jet propelled international travel, transforming Hong Kong from a regional seaport into a global hub of finance and trade. It was also a time when the homegrown airline wowed international rivals and impressed shareholders with its growth prospects and distinguished earnings records.
"It only made losses in two out of 70 years of operations," wrote Mohshin Aziz, an aviation analyst at Malaysia's Maybank Kim Eng, in a report on Jan. 17. "No other airline has a better track record."
Cathay Pacific has indeed been reigning over the skies of Hong Kong since 1946. The airline is one of the core businesses of Hong Kong-listed parent Swire Pacific, which owns a 45% stake. Swire Pacific's regional activities include property, beverages, marine services, retail and trading. It is one of the largest Coca-Cola bottlers in the world.
Cathay's ultimate parent is John Swire & Sons, a London-based family conglomerate with over 200 years of history and more than 130,000 staff worldwide. It owns 55% of Swire Pacific and in 2014, appointed John Slosar, an American, as that company's first non-British chairman. He also chairs Cathay Pacific.
Cathay's winning streak is likely to be broken. Some analysts expect the airline to post its third full-year loss in March-- and its first full-year loss since 2008. A major reason for its problems: Cathay's business model is looking outdated, with a full rebound in demand for its premium service perhaps impossible given shifts in corporate and individual travel spending. At the same time, fuel costs are rising after several years of weakness and budget airlines and state-backed airlines from China and the Gulf are challenging Cathay on far more routes than before.
On Jan. 18, Cathay announced job cuts and hinted at a leadership reshuffle in what it said would be its largest restructuring exercise in two decades. "2017 is going to be a year of significant change" in an "increasingly competitive aviation landscape," the airline said in a statement, after a review meeting by its leadership team.
Cathay said the overhaul would create new positions but "some jobs will no longer be needed." Citing the need for a "leaner, simpler structure," it said key changes would "start at the top" and take effect by the middle of the year. The airline will also tap into data analytics and digital capabilities for consumer insight and reducing wastage.
An employer of some 27,000 workers, Cathay gave scant details on how many positions would be cut. But it appeared that front-line workers would be less affected due to the recent addition of new services to Barcelona and Tel Aviv, extra flights to Toronto and new lounges in Hong Kong and Singapore. "Most losses would be in the back office," said Dora Lai Yuk-sim, head of Cathay's flight attendants union, who attended the leadership meeting.
The market responded negatively to the strategic plan, with some investors calling the measures too late, too little. Cathay's share price lost 4% the next day, nearly erasing the gains since news of its impending restructuring surfaced on Jan. 16. The slump brought its valuation to the lowest levels in eight years -- since the global financial crisis -- making it one of the worst-performing airline stocks across the region.
"Cathay's new strategy stands out for not a single mention of growing partnerships. It's a big world to be alone in," said Will Horton, a Hong Kong-based analyst at consultancy CAPA Centre for Aviation. His overall comment on the plan as outlined in the Jan. 18 statement: "805 words don't say what is actually going on and what they are actually going to do."
Behind the negative reaction lies a much deeper issue: Cathay's outlook is challenged as a capacity glut continues to weigh on its two pillar businesses -- cargo and corporate travel.
Last October, the airline abandoned its forecast that the second half of 2016 would be better than the first half. Net profit dropped 82% year-on-year to 353 million Hong Kong dollars ($45.3 million) in the first six months last year compared with the same period a year earlier. Revenue reached HK$47.5 billion, down 9.3% from a year earlier.
The airline blamed dwindling cargo traffic amid weak global trade and corporate downsizing that has hurt demand for its premium-class seats. About a third of Cathay's capacity has been configured for first- and business-class passengers, according to brokerage firm CLSA.
"We've seen softer traffic demand with customers trading down from front-end to back-end, from long-haul to short-haul," Cathay Chief Executive Ivan Chu Kwok-leung said at the company's earnings briefing in August. "And there is a lot of capacity in Asia."
Discussions have emerged on whether Cathay's premium market is facing a cyclical downturn or permanent loss of business due to changing trends. To some extent, geopolitical and economic uncertainty has hampered international travel. A surge of budget alternatives has also created a new breed of leisure travelers who fly frequently, but at cheaper fares.
State-owned Middle Eastern and Chinese airlines are making aggressive forays into some of Cathay's traditional markets. China's "big three" -- China Eastern Airlines, China Southern Airlines and Air China, in which Cathay's parent Swire Pacific owns a 20% stake -- have offered both regional and trans-Pacific services at competitive fares. (Air China owns a 30% stake in Cathay.)
Some Asian players have pulled out of head-to-head competition. Malaysia Airlines suspended flights to Amsterdam and Paris last year and has no plans to resume them in the near future, as round-trip economy flights from Europe are selling for prices as low as $500. "Really, with the fares as they are, unbelievably low from Gulf carriers, I think it's going to be very risky for us to do that," Chief Executive Peter Bellew said on Jan. 18.
By Deutsche Bank's estimates, state-owned Chinese airlines and budget carriers, including Shanghai-based Spring Airlines, will increase their capacity by 9% to 12% annually in 2017 and 2018, nearly three times that of Cathay's.
The bank placed a "sell" recommendation on Cathay's stock, a day before the airline unveiled new strategies. "Competition and overcapacity in the region has put pressure on Cathay's [passenger] yields" -- an indicator of profitability in the industry -- to fall to its lowest levels in seven years, Deutsche Bank analyst Joe Liew said.
Rival Singapore Airlines is at a comparable juncture. Majority-owned by Singapore's state investment arm Temasek Holdings, the full-service airline saw its market capitalization nearly halved to $8.4 billion from 2010 as of Jan. 19, compared with Cathay's current $5.5 billion. Both are dwarfed by Air China's $12.6 billion market capitalization.
Some investors seem more impressed by Singapore Airlines' attempt to diversify into the low-cost market to take on rivals like AirAsia. Last year, Singapore's medium- and long-haul budget airline unit Scoot turned profitable for the first time since its mid-2012 launch and will fully integrate with Tigerair, another budget subsidiary of Singapore Airlines, under the Scoot brand in the second half of 2017.
Cathay does not have a budget airline affiliate. Rather than build one, its strategy has been to try to block ones from taking root at its Hong Kong hub. In June 2015, city authorities sided with Cathay to block Australia's Jetstar from setting up an affiliate in Hong Kong.
Falling Asian currencies are putting pressure on regional rivals who are burdened with many costs denominated or linked to the U.S. dollar, but Cathay and short-haul sister carrier Cathay Dragon aren't immune despite the Hong Kong dollar's peg to the greenback. Cathay derives about half of its revenue in foreign currencies, including the softened Chinese yuan. Previously known as Dragonair, Cathay Dragon's focus is on markets in China and Southeast Asia.
A wrong-way bet on oil prices is also taking a toll on Cathay's balance sheet. While most airlines had benefited from lower fuel costs, its hedging policy that locked in fuel at higher prices led to a hefty loss of HK$13 billion in the past 18 months until June 2016.
Cathay has vowed to shorten its hedging program but short-term losses will be unavoidable. With hedging positions at roughly 30% above current oil prices, it is still expected to suffer a loss of HK$6 billion to HK$7 billion this year, according to Daiwa Capital Markets. This is not to mention the looming cost headwinds -- rising fuel prices and an increase in landing charges in Hong Kong to subsidize the building of the airport's third runway.
"Weak profitability is more of a structural issue and therefore [we] do not expect it to be resolved in the near term," Kelvin Lau, Daiwa's aviation analyst, said, adding that Cathay is a "top sell idea." He attributed excessive expansion over the past few years as the major reason for its profit slump, although much of that impact was temporarily "hidden" due to fuel-cost savings.
Commenting on Cathay's strategy plan, Lau said it was "nothing new" and the impact would be limited without aggressive cost reductions. "We doubt how much Cathay can do," he wrote in Jan. 20 note. Drastic staff cuts will be difficult with the addition of new routes, he said, "which we believe is something Cathay should consider stopping."
Of the 18 investment analysts polled by Thomson Reuters, none have a "buy" recommendation on Cathay's shares. Nine have a "sell" recommendation and five have given a "strong sell" recommendation on the stock, which has tumbled more than 40% over the past two years.
Maybank's Aziz is one of the few who maintain a "hold" on the stock. He said the hope for a turnaround would rest on Cathay's success to prioritize quality growth over size. This would mean downsizing its operation and reducing the reliance on transit traffic, which has shrunk over time as Chinese airlines increase their international links. The outdated business model would need to be replaced with a "point-to-point strategy," he added, with a focus on strong niche markets.
"Cathay has an illustrious history," Aziz said. "However, this legacy has caused it to be too complacent with regards to embracing the changing profile and trends of air passengers."
Nikkei Asian Review deputy editor Zach Coleman in Hong Kong contributed to this story.