Bad Math for Cath
Some airlines are well-positioned for the recovery. Not Cathay Pacific.
Long before anyone ever heard of Covid-19, Hong Kong’s Cathay Pacific was an airline in trouble. Surprised to hear that? Maybe because Cathay was never really close to running out of money. Its reputation for excellent service, even among the most discriminating corporate jetsetters, was never compromised. Hong Kong, meanwhile, has long been one of the world’s greatest airline markets, loaded with premium traffic, leisure traffic, cargo traffic, and sixth-freedom connecting traffic. And it was on the doorstep of mainland China and its four-decade-long economic miracle.
Even so, Cathay repeatedly failed to produce healthy profit margins throughout the 2010s. It began the decade promisingly, earning an 11% operating margin in 2010 itself, a strong bounceback year from the global financial crisis. But it would never again top 7%, and more typically averaged between just 3% and 4% (see chart below). Worse yet, when much of the world’s airline industry was enjoying robust demand and cheap fuel in 2016 and 2017, Cathay posted losses. It was during these times, in fact, that Airline Weekly often highlighted its even-worse results than India’s forever-troubled Jet Airways; Jet would eventually collapse. Air France/KLM was perhaps a more appropriate comparison, with its similar global stature and similar chronic dysfunctions.
Like Air France/KLM, Cathay enjoyed some uplifting trends throughout the 2010s, including long periods of strong premium demand, particularly on intercontinental routes. During the first half of the decade, it consistently outperformed its longtime rival Singapore Airlines, which didn’t have nearly as much exposure to the lucrative North American market, and which struggled with heavier low-cost competition. Cathay by contrast, was protected from LCCs to a degree, a reality highlighted when Hong Kong’s government blocked an attempt by Qantas and China Eastern to launch a local Jetstar affiliate. That was in 2015, the last year in which Cathay would outperform Singapore Airlines. As the latter steadily improved its margins in the second half of the 2010s, Cathay encountered one major headwind after another.
For starters, it was unable to enjoy the cheap fuel bonanza of 2015 and 2016, because of extremely bad fuel hedging. Later, when tariff wars dented global trade, the airline’s heavy reliance on cargo revenues became a big problem. China’s economy began slowing, which depressed the value of Cathay’s 18% stake in Air China. For a time, the mainland’s HNA Group backed an aggressive expansion of Hong Kong Airlines, which entered some of Cathay’s most important longhaul routes, including Vancouver, Los Angeles, San Francisco, and Auckland. HNA was the power behind the throne at fast-expanding HK Express too. Between 2013 and 2017, the LCC roughly quadrupled its seat capacity, according to Cirium schedule data.
In the meantime, Cathay faced increasingly severe congestion and air traffic delays. Mainland rivals in neighboring Shenzhen and Guangzhou expanded their intercontinental offerings. A major cyberbreach of customer data generated bad publicity. Confrontations with the airline’s pilot union were all too frequent. Years of U.S. dollar strength thinned the revenue Cathay was generating in markets like Europe, Canada, Australia, India, and points within East Asia including mainland China.
This only begins to convey the difficulties Cathay was facing. Traffic flows between Taiwan and mainland China, once Cathay’s single largest source of demand, first diminished as cross-Strait deregulation allowed a growing number of nonstops, and then diminished as the cross-Strait market contracted due to political tensions between Beijing and Taipei. Political tensions between Beijing and Hong Kong itself, however, hurt Cathay the most. The umbrella democracy movement protest of 2014 was a first major instance of demand disruption.
Protests that erupted last summer, though, proved far more disruptive. They also caused strife within the airline, leading to the ouster of CEO Rupert Hogg, appointed just two years prior to help return Cathay to profitability. A number of employees were dismissed for their political activism, after Beijing threatened to revoke the carrier’s mainland flying rights. Tensions in Hong Kong have only grown worse in 2020 and represent a key flash point (one of many now) between Beijing and Washington. Hong Kong’s status as a global center of finance, commerce, aviation, and tourism, all the while, is under threat.
Cathay itself somehow managed to squeeze out a small profit last year despite the protests, which at one point even caused Hong Kong’s airport to close. The airline even earned a small operating profit in the second half of the year, when the unrest got really bad. Significantly cheaper fuel helped enormously. So did the cost-cutting Cathay was forced to do. One helpful move, started a few years earlier, was densifying B777s with 10 coach seats across rather than nine. Last fall, it began cutting capacity, reversing an overaggressive intercontinental expansion that in recent years saw new service to Seattle, Washington, Dublin, Brussels, and Cape Town.
Escaping 2019 with a small profit was a victory of sorts, and a good omen for 2020. In its final monthly traffic report of 2019 (for December), management acknowledged huge declines in inbound and outbound passenger traffic. But with a hint of hope, it spoke of improving load factors on longhaul routes, a 15% y/y increase in sixth-freedom connecting traffic, strong peak season cargo demand, and “promising” advance passenger bookings for the Chinese New Year ahead. Little could it have imagined what actually would lie ahead.
Already in January, smack in the middle of Chinese New Year, the Covid-19 epidemic began its near-total demand destruction. February RPK traffic was down 54% y/y, and 87% on mainland China routes. March RPKs dropped 84% overall. For April and May, the decline was 99%. Even so, load factor last month was just 30%. Management is certainly under no pretense that it can pull another miracle and make money this year. In fact, it estimated its losses for just the first four months of 2020 at about $580m. According to Bloomberg News, more than $10m a day have been draining from its coffers. It entered last week wondering how long its cash would last.
It need not worry about that anymore. In the latest industry example of a government bailout, Hong Kong, together with existing shareholders, agreed to provide Cathay with a massive $5b rescue. Roughly half comes in the form of preferred shares the government will buy. Along with warrants, this would give the government a 6% ownership stake, with two non-voting board seats. Cathay will raise another $1.5b by selling additional equity to its three largest shareholders, namely Swire Group (which currently owns 45% of the company), Air China (30%), and Qatar Airways (10%). Their new claims will equal 42%, 28% and 9%, respectively. Hong Kong will also provide Cathay with a $1b loan. Until now, the government has mostly provided just wage subsidies, mostly designed to protect workers. The city’s airport has chipped in with some financial relief as well.
The government’s preference shares can be repurchased by the airline at any time. But while outstanding, it would owe the government 3% annual dividend payments for the first three years, then 5% in year four, 7% in year five, and then 9% thereafter, in perpetuity. So it’s in Cathay’s interest to buy them back sooner than later — management said it would aim to do so in 3-5 years. The loan money, meanwhile, can be drawn anytime in the next 12 months as needed. The carrier also secured wage cuts and other concessions from workers. It intends to implement another round of executive pay cuts and another early-leave program for staff.
Strategically, though, it doesn’t know what to do, at least not yet. Management says it’s waiting to see how market conditions develop, holding off on presenting a new business plan for now. It hopes to have a better idea — and a new plan devised — by the fourth quarter. But there’s at least one thing already certain about the plan: It will result in Cathay becoming a much smaller airline.
Will there be a future for the B777-9s Cathay ordered? Or will, as a recent South China Morning Post report suggested, the B777s be swapped for smaller B787-10s? Last year, remember, Cathay purchased the LCC HK Express, which could be a useful vehicle for expansion in a recovery phase likely to feature more leisure traffic than business traffic. HK Express was already allocated half of the 32 A321 NEOs the company has on order. Cathay, some reports indicate, wants to do away with its Dragon brand, used primarily for mainland China routes. Will the group’s commercial ties to Air China deepen? Will it do anything more with Air New Zealand, another close partner?
Helpfully, Hong Kong Airlines, which barely escaped last year alive, is in worse shape than even Cathay. Foreign rivals have their share of problems too. Hong Kong is now easing restrictions on travelers transiting through the city’s airport. Some tourist attractions are reopening. Importantly right now, Cathay’s cargo business is booming, albeit much smaller without the cargo hold capacity on its many grounded passenger planes. Cash flows, the carrier said last week, are starting to stabilize, despite a drain from more bad hedges. The city has fared well in its fight against Covid. Longer-term, the airport will get a third runway, and Cathay remains bullish about the future of the city as an aviation hub. Hong Kong after all, has overcome many challenges in the past, from Japan’s occupation during World War II to riots in the late 1960s and the British handover in 1997, which triggered an exodus of people and money to places like Canada, the U.K., Australia, and California.
The uncertainty, however, is heavy for all of the city’s businesses as Beijing gets more aggressive about challenging its autonomy. For Cathay, without any domestic routes to nurture a recovery, will fly just 4% of its normal capacity this month, and just 9% next month. Even that is subject to further relaxation of travel restrictions. Until at least Sept. 18, all non-Hong Kong residents arriving by air from any location other than mainland China, Macau, and Taiwan will be denied entry. Hong Kong residents and non-Hong Kongers arriving from mainland China, Macau, or Taiwan face a 14-day compulsory quarantine. Protests, meanwhile, continue. And so does Cathay Pacific’s agony.
By the Numbers
Cathay Pacific vs. Singapore Airlines
Operating margins by year, excluding special items
|Cathay (CX)||Singapore (SQ)||Winner|