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Business deals

Cathay Pacific eyes new growth with budget airline takeover

AirAsia chief predicts acquisition will bring 'family problems'

 The Hong Kong airline said Sino-American trade tensions were partly responsible for a downturn in its cargo business.(Photo by Shinya Sawai)

HONG KONG -- For the price of a handful of new planes, Cathay Pacific Airways' buyout of budget airline Hong Kong Express will reinforce the company's dominance over Asia's busiest international air hub as it completes a big expansion of capacity.

The premium airline announced on Wednesday that it had reached agreement to buy full control of Hong Kong Express from debt-strapped Chinese conglomerate HNA Group for 4.93 billion Hong Kong dollars ($628.12 million).

"We like the deal," wrote analyst Andrew Lee of investment bank Jefferies in a research note. Cathay can easily afford the cost, he noted, calculating it had the equivalent of HK$15.32 billion in cash available as of Dec. 31. Earlier this month, Cathay announced a net profit of HK$2.35 billion for 2018, ending two years of losses.

The Hong Kong government is currently investing HK$141.5 billion to add a third runway at the city's airport by 2024 and protect the city's hub role. Until now, the airport has been too busy handling large planes flying to more distant destinations to allow much room for the smaller, shorter-range jets that budget airlines usually depend on.

Partly for that reason, Cathay is the only large Asian airline, aside from Air China, that does not have a low-cost carrier (LCC) affiliate, according to Sydney-based consultancy CAPA - Centre for Aviation.

Cathay "needs to join its Asian peers with an LCC subsidiary in order to compete effectively and fully reap the growth opportunities in its home market as additional infrastructure comes online," wrote Brendan Sobie, chief analyst at CAPA, in a report on Tuesday.

"There is no denying that the bottom end of the market is growing faster with the rapid expansion in Asia's middle class and income levels," he said. "The opportunity to jump-start a new multibrand strategy with HK Express was too good to pass up, and Cathay could not risk HK Express being sold to a competitor."

Sobie said that Cathay has been considering a plan to expand its fleet, now at 184 jets, by 50% to capitalize on the coming capacity expansion at Hong Kong airport. Hong Kong Express operates a fleet of 24 Airbus planes.

According to CAPA data, Cathay currently has a 47.1% share of seat capacity at Hong Kong International Airport as against 5.1% for Hong Kong Express. Removing the smaller airline as a competitor should alleviate some of the market pressure to keep fares low, said analyst Edward Xu of Morgan Stanley in a research note.

Cathay is also likely to utilize the threat of further expanding Hong Kong Express to pressure its own pilots and staff into contract concessions, according to Professor Xiaowen Fu, who researches transport economics at Hong Kong Polytechnic University. The airline has been battling with its pilots' union for several years over contract terms as it has sought to control operating costs.

Investors nevertheless did not immediately embrace the deal, pushing Cathay shares down 2.5% in trading on Wednesday after the announcement..  

Some investment analysts questioned the price Cathay is paying. Both Morgan Stanley's Xu and Kelvin Lau of Daiwa noted that Cathay, known by its flight code "CX," is paying about 4.5 times the book value of Hong Kong Express' net asset value of HK$1.12 billion. By comparison, Cathay's stock trades at 0.84 times book value, according to Refinitiv data.

In Cathay's announcement, it disclosed that Hong Kong Express had posted a net loss of HK$141 million last year after earning a HK$60 million profit in 2017.

"We view the deal as costly," Lau said. "Network synergies are very limited. CX operates most of the routes that HKE has while those that CX lack are likely not profitable." Based on Cathay's previous buyouts of competitors Hong Kong Dragon Airlines and Air Hong Kong, he projects it could be years before Cathay can realize cost synergies.

According to CAPA, however, the takeover will give Cathay an edge on Japan routes, the most important market for both airlines. Sobie noted that Hong Kong Express will soon serve seven Japanese routes that Cathay does not.

Managing Hong Kong Express alongside its full-service brands though will be challenging for Cathay given the difference in operating style, business model and corporate culture, Polytechnic's Fu said.

"They need to really respect the autonomy of this company to operate like an LCC," he said. "If Cathay interferes too much, there will be big problems."

Tony Fernandes, chief executive of AirAsia, the region's largest budget airline company, is more skeptical. Speaking on Wednesday to The Nikkei, he said he had passed on buying the carrier himself and predicted Cathay would have trouble effectively integrating Hong Kong Express into its group given varying priorities and needs.

"It would be hard to manage," he said. "When you have one wife, who has a certain model, and another younger nimbler wife, it is going to cause problems. This is a tough business. The CEO of Cathay will be much more focused on Cathay Pacific than he is on Hong Kong Express."

Although Cathay said it aimed to close the acquisition by year-end, it disclosed that an unnamed shareholder of a holding company for Hong Kong Express has indicated it will make a legal challenge to the buyout agreement.

The sale of Hong Kong Express marks the latest in a long series of disposals for HNA Group. The conglomerate built onto its original control over China's Hainan Airlines with additional airline investments around the world as well as hotels, property projects and office buildings and stakes in companies like Deutsche Bank and Ingram Micro, but the dealmaking spree proved unsustainable.

With HNA overstretched, group airlines have encountered trouble keeping current on lease payments and other expenses. The Hong Kong government this month directed Hong Kong Airlines, a full-service carrier also controlled by HNA, to submit a financial improvement plan as a condition of keeping its operating license.

Additional reporting by Nikkei staff writer Mayuko Tani. 

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