Between a rock and a hard place

‘From that minute on I just wanted to fly.’

Just how much that will be, if indeed it is a loss, is difficult to assess. Cathay scrapped its second-half profit forecast in October, when it also launched a review of its business. The results of that review were announced last month (January). The outcome? An unprecedented overhaul of the airline’s corporate strategy and a reorganization of its business that will include job cuts. Some analysts even believe there will be a change of leadership sometime this year, with current chief operating officer Rupert Hogg taking the helm from Chu. Indeed, when the reorganization was announced Cathay said that key changes would “start at the top” and take effect by the middle of the year.

Whoever is in charge, they face a tough road regaining lost ground and getting the iconic Hong Kong flag back to its once dominant position. The airline’s stock price has tumbled to its lowest level since the depths of the global financial crisis in 2009, and not one of 18 analysts polled by Thomson Reuters had a “buy” recommendation on its stock. Deutsche Bank was also less than enthusiastic about plans to overhaul the business. The broker downgraded Cathay to “Sell” even before it unveiled the results of its strategic review. Analyst Joe Liew’s biggest issue: Cathay’s declining passenger yields, which have fallen to a level not seen since the global financial crisis.

Cathay is under siege from all sides. As leading analyst Shukor Yusof, principal at Malaysia-based Endau Analytics, put it, a lot of factors are hurting Cathay’s financial health. “Among them is forex volatility. It is good that the HK Dollar is pegged to the USD but costs go up too, and Cathay has really expensive labour. It has poor hedging methods – somehow Swire isn’t as smart as we think (or they think) they are – and they’ve got it consistently wrong the past few years. There is no clear strategy on how to fend off mainland China airlines, the Gulf carriers and those pesky LCCs. And they have very poor passenger yields, especially in the premium segment, which is partly due to the soft global (corporate) economy.” Yusof believes it “will get worse before it gets better”.

Cathay is operating in a new world. Gone are the days when it dominated traffic between Australasia and Europe through a hub that had become a major global financial centre. Like Singapore, Hong Kong has suffered from the rise and rise of the Gulf operators, Emirates Airline, Qatar Airways and Etihad Airways. Emirates, for example, has deployed Airbus A380s on some of its routes from Europe to Australia, with stopovers in Dubai, stealing market share from Cathay, which has been flying from Europe to Australia for years. Against the Hong Kong airline, Emirates has advantages in price and convenience. Cathay is caught between a rock and a hard place, with the Middle East operators, their growing capacity and fierce pricing competition on the one side and the fast expanding Mainland Chinese operators – China Southern Airlines, China Eastern Airlines, Air China and Hainan Airlines – on the other.

‘I’m a very conservative pilot I think. Very risk averse.’

While Cathay and its rival Singapore Airlines are set to grow their capacity by 3 per cent and 2 per cent respectively this year, and another 4 per cent and 2 per cent in 2018, the Chinese airline operators are far more aggressive. Air China is expected to increase its capacity by 9.4 per cent in 2017 and 9.1 per cent in 2018, having expanded 9.6 per cent last year. Similar growth is forecast at China Southern and China Eastern. At the same time, in its own backyard, local carrier Hong Kong Airlines (owned by Hainan Airlines) has been building a network across the Asia-Pacific to Australia and New Zealand. It has gained one-third of the Hong Kong-Auckland market and the carrier’s chief operating officer Li Dianchun says the airline will deploy an Airbus A350 on a long-haul route to North America, puting it in head-to-head competition with Cathay.

Worse, Cathay now has to deal with an “Open Skies” deal signed in December between China and Australia which will allow the aggressive Chinese operators to add further capacity, syphoning off passengers who previously flew to Asia or on to Europe through Hong Kong.

Carriers such as Air China and China Eastern are offering more direct services from mainland cities to Australasia, making it less attractive for passengers to travel via Hong Kong,as they did historically. Australia is a key market for Cathay for both direct flights and connections throughout Asia and to Europe. Flights to the South West Pacific and South Africa – the bulk of them to Australia – represented 13.6 per cent of Cathay’s capacity in the first half of 2016. The open skies deal allows mainland carriers unlimited capacity on routes to Australia, at a time when Cathay is not allowed to add any more flights to Australia’s biggest airports and can only increase capacity by using larger aircraft. Capacity between Australia and mainland China grew by 61.6 per cent in the five years ended 2016, according to data from Flightglobal. Over the same period, capacity between Australia and Hong Kong grew by just 2.6 per cent. The Hong Kong government has not held major talks with Australia about expanding air access since 2015, when no deal was reached. Chinese hubs such as Guangzhou, Shanghai and Beijing have seized market share as a result.

Regionally too, Cathay is under constant attack. With no domestic operations, like Singapore, it faces the continually growing presence of a swathe of budget airlines competing head-to-head on its regional routes. Unlike other full-service carriers in the region Cathay has steadfastly refused to give birth to a low cost arm or adopt the multi-brand approach now normal practice for all of its legacy rivals. Sources suggest costs at its short-haul,full-service, subsidiary Cathay Dragon are nearly as high as those at the parent.

‘So it was a confluence of ideas and events and people.’

Cathay has been reigning over Hong Kong skies since 1946 and its survival certainly isn’t under question. It is one of the core businesses of Hong Kong-listed parent Swire Pacific, which owns a 45 per cent stake. Beijing-based Air China holds a 30 per cent 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. The Cathay group itself has 33,700 employees and currently operates a fleet of 125: 41 Airbus A330-300, 4 A340-300 (to be retired in April), 10 A350-900, 5 Boeing B777-200, 12 B777-300 and 53 B777-300ER. It has 10 more A350-900 and 26 A350-1000 on order as well as 21 B777-9. With fleet planning pretty well in place the major task for Cathay now is implementing its reorganization plan. “2017 is going to be a year of significant change” in an ‘increasingly competitive aviation landscape,” the airline said in what most observers regard as an understatement. It has confirmed it will lay off staff, though it hasn’t yet provided specifics. A statement from the airline said the reorganization “will create new jobs and redefine others” while acknowledging some positions will no longer be needed. There will be a strategy shift to deal with competition in markets it once dominated. “We need a leaner, simpler structure that is driven by real insights into our customers and their needs, and one that will allow us to respond quickly to change,” said the statement. The airline said it will reorganize itself into seven divisions: customer, operational, commercial, people, cargo, IT and finance and strategy and it aims to implement the majority of the changes by the middle of this year. Cathay is also examining the feasibility of its shorter-haul subsidiary Cathay Dragon taking over a small number of its regional flights, though no decision has been made.

The airline attributed the reorganization to changing customer expectations, dramatic growth in competition, the unpredictable nature of the global economy and a host of other factors. As part of its reorganization plan, its flight operations unit will also undertake a review of its current structure to make sure that it has the right model in place, something it said had not been looked at for many years. Cathay also dampened increasing speculation that the strategy and reorganization was part of a plan to get the airline ready for a sale to Air China. “The Cathay Pacific Group will continue to operate under its current shareholding structure, with Swire continuing to provide management services,” said the airline.

‘Often I’ve thought: are these things too valuable to fly.’

One key aspect of the reorganization is changes to its fuel hedging policy. Cathay lost US$1.1 billion in the three years to December 2015 as a result of fuel hedging. In the first half of last year, the loss was $578 million. Chief operating officer Rupert Hogg told local media Cathay “won’t hedge as far forward as we have in the past”. Jet fuel would now be hedged for two years, shortening the period from a past practice of four years, he said. “If our cost base is too high, we’ll have to find ways to be more productive and more efficient… Cathay Pacific needs to become more agile and efficient in dealing with challenges ahead.”

One thing that has puzzled many observers is a comment by chief executive Ivan Chu, in a message issued at the same time as the reorganization statement, that Cathay would “grow efficiently by keeping our costs per available tonne kilometers flat as we expand our productivity”. That, analysts point out, shows a lack of determination to actually bring costs down. “The Swire boys may have lost the plot – costs to stay flat? Which planet are they on?” said Endau’s Shukor.

Will Horton, a Hong Kong-based analyst for aviation consultancy CAPA, described what had been said so far as underwhelming given the scale and pace of change. “It’s shocking to see Cathay say that costs will be flat… costs need to come down without considering that mainland Chinese airlines will one day be able to significantly restructure and become even cheaper.”

In a report, Deutsche Bank analyst Liew wrote that the lower fuel price of the past two years has emboldened Asian airlines with respect to capacity growth plans. “Competition and overcapacity in the region has put pressure on CX’s yields… in addition, the global economy is not what it used to be. As a premium full-service airline, Cathay is more affected by dwindling business travel: Weakness in corporate travel, especially the financial sector, is adversely affecting CX’s premium business. The suspension of fuel surcharges and currency movements have also impacted yields adversely. As a result of intense competition, management has said that it is difficult to raise underlying fares to offset the decline in fuel surcharges and the impact of currency movements. Almost half of Cathay’s revenue is in U.S. dollars (Hong Kong dollar is pegged to the dollar). As the dollar gets stronger, Cathay’s airfare become more expensive for consumers.”

At least Hong Kong authorities seem to recognize there is a major issue. The government of the Hong Kong Special Administrative Region has announced measures intended to cement its position as a major Asia-Pacific airline hub. Cathay welcomed the commitment by the government to increase its role as a “super-connector” hub for the region. Hong Kong is part of China, but retains a certain degree of autonomy after being handed back to Beijing in 1997 after some 150 years as a British colony. The new measures are part of China’s “Belt and Road Initiative” designed to expand trade along the historic lines of the ancient Silk Route through Central Asia to the west, as well as along maritime and aviation routes. A Cathay spokesman said both the airline and its sister company Cathay Dragon welcomed the government’s continued support for the Belt and Road Initiative, “which has great potential to strengthen the Hong Kong hub through the development of new air services. In March, Cathay Pacific will commence operations to Israel and we hope the government will continue to seek to discuss air services agreements with other countries along the Initiative’s routes.”

Whether any of that will be too little too late remains to be seen. It is difficult to see Hong Kong – or even Singapore for that matter – totally regaining the level of former glory days. Of course Hong Kong will remain a major regional hub. But Dubai, Abu Dhabi and Doha, Shanghai and Guangzhou, and even Istanbul with its massive new airport project, are permanently changing the landscape that is long-haul air travel. Overall, Cathay’s announcement of a major reorganization has been lacking in fine detail. And whether it will be enough to turn the tide, only time will tell. One thing is certain: the pressure is not going to let up and pressure from the Gulf and Chinese majors, along with the budgeteers will increase, making it extremely difficult for Cathay to regain lost ground.