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Cathay Pacific's flight to profit stalled by surging fuel prices

Second half looks healthier but legacy hedging costs still haunts

Cathay Pacific Chairman John Slosar was upbeat about the company's second half but expressed concerns about the potential impact of an escalating trade war between China and the U.S. (Photo by Kenji Kawase)

HONG KONG -- Reporting another six-month loss, is Hong Kong flagship carrier Cathay Pacific Airways on track to recovery as it claims? The company reported solid revenue growth, but unfavorable legacy hedging contracts and uncertainties such as an escalating global trade war cloud its horizon.

"This is surely a substantial improvement," Cathay Chairman John Slosar said Wednesday during a news conference announcing its latest half-year results. "The positive revenue and profit trends reflect the fact that our transformation strategy is really having an impact on the business and results."

Cathay is in the middle of a three-year restructuring that kicked off in 2016. It intends to cut 4 billion Hong Kong dollars ($510 million) in costs, streamline its overall operations and boost revenue.

Cathay Pacific reported that its revenue surged by 15.7% to HK$53.07 billion in the six months ended June from the same period last year. Its net loss also narrowed to HK$263 million from HK$2.05 billion from a year ago.

The airline has been in the red for two consecutive years, but the magnitude of the loss has reduced greatly. This bodes well for the company ahead of the traditionally strong second half, which is typically boosted by the summer holiday travel seasons in the northern hemisphere, higher business travel in the fall, and big cargo shipments in the run-up to Christmas. Although Slosar refrained from making forecast, he expects "this to be the case in 2018."

One of the main drags on its earnings at this point is higher oil prices. Its fuel costs -- that make more than 30% of total expenses and forms the largest single cost item -- has increased by 7.4% or HK$1.1billion. This was on a par with net finance charges during the reporting period, which dragged the bottom line into the red, even though the airline regained a profit of HK$697 million at the operating level, compared with a loss of HK$1.70 billion a year ago.

Higher fuel costs have hit all major regional carriers. Cathay's rival Singapore Airlines saw its net profit for the April-June quarter fall by 59% year-on-year to 139 million Singapore dollars ($101 million). Japanese competitor ANA Holdings recorded a 68.5% drop in net profit to 16.11 billion yen ($145 million) for the same quarter, citing rising fuel cost.

However, the difference between Cathay and these airlines lies in its fuel hedges, or futures contracts aimed at mitigating volatility in oil prices. Singapore Airline would have posted a loss, as its fuel cost before hedging was S$312 million, but that was cut in half by its forward contracts which were hedged favorably.

But for Cathay, a wrong call on the oil market is still haunting it -- it made a fuel hedging loss of HK$653 million during the first half. Though that had decreased by about 80% from a year ago, the amount is more than twice the recorded net loss.

Chief Financial Officer Martin Murray said the legacy contracts, which will finally expire at the end of the year, covers about 45% of costs at an average price of $80, substantially higher than the current Brent oil price of around $75 per barrel. Murray said that the average hedged price for 2019 is below $69.

Hedging costs aside, analysts are generally positive on the latest results. Corrine Png, founder and CEO of Crucial Perspective, expected Cathay to make a loss in the first half but return to a full-year profit of around HK$202 million.

The revenue growth "was stronger than our expectations, mainly driven by the strong global cargo market, improved passenger traffic mix and more favorable forex movements," she said on Wednesday. On top of that, she expects stronger results in the following years, as expensive hedging contracts finally expire.

After slashing 600 jobs in Hong Kong last year, the airline is opening a record nine new routes this year, including many long-haul flights to Dublin, Washington D.C. and Cape Town, while 77 new planes are set for delivery over the next few years. The growth in network and fleet size will result in hiring of 1,800 front-line employees this year.

These aggressive moves could push up underlying unit cost, which has already risen over the first half, but CEO Rupert Hogg said he was "focused" on that and would keep that figure in check through "700 different initiatives" under the restructuring arrangement.

Looming uncertainties over the trade war between China and the U.S. and geopolitical risks could still drag on Cathay. Although Hogg pointed out that "we haven't seen any impact" on both its cargo and passenger businesses so far, Slosar said the airline is "keeping a close eye on things, especially how tariffs and currency movements could impact demand for travel, and our revenues and cost."

The impact may not be apparent at this moment, but "there's no doubt that the potential impact on our businesses could be significant," he added.

Png warned that the biggest downside risk for Cathay is failure to trim costs that will hit its long-term competitiveness, "especially if fuel prices rise further and escalating trade tensions drive slower air travel and air cargo demand growth."

Investors seemed to have remained concerned about Cathay's future. The stock dropped by 1.8% to HK$11.86, recording most of its losses in the afternoon after the release of the results during the lunch break. The benchmark Hang Seng Index gained 0.4%.

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