Aviation, Talking Point

Turbulent times

Hong Kong’s flagship airline wrestles with new challenge from China


More seats to fill: Cathay Pacific welcomes the first of a new order of 48 Airbus A350s in Hong Kong

Longtime Cathay Pacific frequent flyers fondly remember the days when Chateau Lynch-Bages flowed freely at the front end of the plane. These days in business class the choice of reds does not feature the famed Pauillac wine but it does include a 2016 Tenacity Old Vine Shiraz. That Australian wine can be purchased for about $13 a bottle (a bottle of Lynch-Bages from the same year costs $100 more).

There is a reason for this type of economising. This month Cathay reported a net loss of HK$2.05 billion ($262 million) for the first six months of the year. That was its worst first half performance for around 20 years, and analysts forecast that Hong Kong’s flag carrier is heading for the first back-to-back annual losses in its 70-year history.

Continuing losses on poorly-timed fuel hedging contracts get some of the blame for the deficit, although Cathay’s executives have been keener to highlight the challenges from other airlines. Some of Cathay’s long-haul routes are under attack from Middle Eastern carriers and low-cost airlines have been biting hungrily into its regional business, especially in Southeast Asia.

But some of the toughest competition has been coming from Cathay’s state-owned competitors in mainland China, one of which also happens to be a major shareholder…

What has gone wrong for Cathay?

Cathay is better placed to carry Chinese passengers than its international rivals, largely because its subsidiary Cathay Dragon (formerly Dragonair) flies between Hong Kong and more than 20 cities on the mainland.

As former chief executive Tony Tyler outlined in WiC38, the network was painstakingly established and it feeds many of Cathay’s longer-haul international routes from Hong Kong.

Tyler explained at the time that Cathay Dragon puts its parent in a unique position: “We’re still not a pure international airline as far as relationships with mainland China are concerned, but nor are we a mainland carrier.”

With a home market in Hong Kong of just 7.4 million people Cathay needs to pick up passenger flows from China. Fortunately the potential is huge: the Chinese are already the world’s largest source of outbound tourists but they lag substantially behind Europe and North America in terms of trips per capita.

Yet local airlines have been capturing an unexpected share of the pie with direct flights to cities in Europe and North America. By flying direct to more destinations, they are reducing the need for passengers to connect through Hong Kong. Cathay is discovering that its prime position on China’s doorstep isn’t as profitable as it had hoped.

Who are Cathay’s key challengers?

Much of the 10% of capacity growth on international routes out of China so far this year is coming from the big three state-owned carriers: Air China, China Southern and China Eastern. But other carriers are opening new routes as well, such as Hainan Airlines, which has started flights to 15 international destinations this year and has just announced plans to fly to more cities also served by Cathay, including Tel Aviv, New York and Brisbane.

Sichuan Airlines is another lesser-known airline flying internationally – its home base in Chengdu now offers flights on local airlines to more than 20 of the same international destinations as Cathay.

Admittedly the scheduling isn’t always as frequent but there are other advantages, including much shorter flights to Europe and the Middle East than routing through Hong Kong. The context is similar for flights to many parts of the United States from China’s central and northern provinces, where local competitors offer shorter trips.

Cathay counters that a lot of these routes aren’t profitable without financial incentives from the local authorities. But Chinese airlines are resiliently maintaining the routes, perhaps because they want to make the case for their home hubs. The main carriers are also mid-way through receiving an influx of new aircraft from Boeing and Airbus, which have to be put to work. Although demand is growing quickly, capacity has grown faster, almost tripling. The competition keeps fares lower, pulling down profits.

The fare discounting is hurting Cathay, whose European and North American routes contribute around 45% of its passenger revenue. Revenue yields on its long-haul routes to North America and Europe declined substantially in the first six months of this year, down 8% and 7% respectively.

Cathay’s critics say that it needs to find a more competitive cost structure, despite the risk that the cost-cutting puts pressure on the front-end, longer haul business from which it derives about 45% of its passenger revenue.

“While Cathay bet on its hub in Hong Kong to build a clientele of wealthy business passengers prepared to pay premium fares, the mainland players became rich – China Southern flew about 38 million more passengers since 2010 – tapping into the boom in tourists and first-time fliers spawned by China’s economic boom,” Bloomberg warned last month. “During the same period Cathay added over 7 million fliers.”

The battle of the hubs

Cathay accounts for about half of the seats on flights to and from its home base of Hong Kong, although Hong Kong Airlines and HK Express are growing their own fleets aggressively and have plans to fly to more destinations.

Both have Hainan Airlines – China’s fourth largest carrier – as a leading shareholder (it is backed by the highly acquisitive HNA Group, see WiC362).

The broader perspective is that Asia’s aviation landscape is being shaped by a struggle between the home hubs of ‘city states’ like Hong Kong and Singapore and the biggest airports in countries with larger home markets, most notably China. In the past Hong Kong and Singapore have grabbed a disproportionate share of international passengers, but they are battling to maintain their hold as alternatives emerge.

Surrounded by populations the size of European countries, some of China’s provincial airports are contenders – cities like Chongqing, Chengdu and Kunming are already processing tens of millions of passengers every year. However, air travel is more concentrated around the three main hubs in Beijing, Shanghai and Guangzhou, according to the latest data from the Civil Aviation Administration of China. Airports in the three cities handled almost half of China’s passengers and about three quarters of its air cargo last year. The battle between them will intensify as billions of dollars is spent on new facilities, led by Beijing’s plan to open a second international airport in 2019. This will open up hundreds of new flights from the capital and China Eastern and China Southern will get a golden opportunity to grab new slots for flights to Europe and the US (see WiC338). China Southern is expected to deploy more than 200 aircraft at the new airport by 2020 and China Eastern will get a similar boost from its new hub, because Beijing is a better connecting point for Europe and North America, says Will Horton, an analyst at CAPA Centre for Aviation.

At the same time China Southern is championing its base in Guangzhou as China’s main hub for flights to Australia and Southeast Asia, with plans to add a fourth and fifth runway (London Heathrow has been debating whether to add a third runway for decades). Less than a hundred miles away from Guangzhou, Hong Kong’s airport is operating at close to capacity and it will have to wait for the completion of its own third runway in 2024 before it can welcome a meaningful increase in passengers.

These constraints are one of the reasons why Cathay says that it won’t be launching a budget airline to chase more of the low-fare market, a move that many analysts have been urging.

“Broadly speaking, we have no plans to start a low-cost airline,” the newly appointed chief executive Rupert Hogg told reporters following the airline’s results last week. “But we compete with low cost carriers on lots of different routes and clearly we have to have a proposition that price sensitive travellers, new travellers and first time travellers find attractive and prefer to fly on our airline relative to the alternatives.”

What role for Hong Kong?

Some of Cathay’s challenges reflect those of its home city. After serving as the gateway to Guangdong’s manufacturing economy in the 1980s and 1990s, Hong Kong has tried to maintain its role as a bridge between China and the wider world. More recently it has pioneered much of the internationalisation of China’s currency, the renminbi, as well as teaming up with the bourses in Shanghai and Shenzhen on cross-border trading programmes that improve access to China’s capital markets.

But it seems likely Hong Kong’s privileges in cross-border stock and debt trading will be extended to other jurisdictions, in the same way that other countries are now being allowed more freedom to trade and invest with the renminbi.

And in transport terms, Hong Kong lost its position as the dominant gateway to China some time ago and it’s no coincidence that Cathay’s travails come at a time in which the city’s ranking in global shipping has also been declining. Orient Overseas International Line (OOIL) – the city’s flagship container line – is currently subject to a $6.3 billion takeover by Cosco, a state-controlled shipping conglomerate from the mainland (see WiC374).

As Hong Kong’s relationship with China changes, much of its future depends on how it handles its ties with its neighbours across the border. As WiC discussed in a special edition on the Pearl River Delta last year (downloadable from our website), closer integration of the region’s urban populations will have far-reaching consequences. The impact for Hong Kong’s aviation ambitions is unclear. Of the PRD airports it is still the largest in traffic terms but Guangzhou and Shenzhen have been narrowing the gap. Macau and Zhuhai also have airports and there were reports in June that the authorities have approved the construction of a Rmb35 billion facility in Foshan’s Gaoming district for 30 million passengers a year.

Closer ties across the Pearl River Delta could help and hinder Cathay’s growth plans. For instance, Hong Kong’s media has been pondering the advent of new high-speed rail links and wondering whether more rapid railways will bring more passengers in Cathay’s direction or take them away. One possibility is that the bullet train to Guangzhou (which will commence service in the third quarter of next year) will make it easier to reach alternative hubs and that demand for shorter flights to cities like Xiamen and Guilin will suffer as passengers opt to take the high-speed train.

When China began to roll out its high-speed rail networks a few years ago, domestic airlines were forced to cut fares to remain competitive (see WiC213). Singtao Daily said Cathay is likely to face similar challenges next year.

But a commentator in the Apple Daily, another Hong Kong newspaper, took a more positive view, claiming that customers from cities as far afield as Changsha will catch the fast train to Hong Kong. “Hong Kong airport will become the most important transit hub between high-speed rail and flights in South China after the high-speed network opens to traffic,” he predicted.

Could Air China take control?

Cathay has played its political hand carefully in China for years, including a cross-shareholding deal in which it took an 18% ownership interest in Air China, with the mainland carrier getting just under 30% of Cathay in return.

It was an excellent defensive move and the profits from the Air China stake have softened the impact of some of the business that Cathay has lost to the mainland carriers in general.

The cross-shareholding was heralded as a win for Air China too – in offering an opportunity to learn from Cathay’s professionalism and granting new access to its international network.

But the mood now seems to be shifting as analysts wonder whether Cathay’s weakness might lead to a takeover attempt by its profitable shareholder. A combined carrier would emerge as the world’s second largest passenger airline and its largest cargo carrier, and the duo would operate from a powerful hub in Beijing, serving as a focal point for northern China, and a comparable base in Hong Kong, challenging China Southern’s aspirations to control the market in the south.

Cathay’s supporters say that the speculation is misplaced and that the current crisis will pass. Its management has already announced a major overhaul of its passenger business and it says that the worst of the fuel losses will tail off as the airline comes to the end of the punitive hedging contracts.

In contrast the Chinese airlines haven’t hedged their fuel requirements so they have been getting the full benefit of lower oil prices in the spot market. But that advantage will disappear if the price of fuel rises, making it harder to offer discounted fares and outcompete more conservatively minded operators like Cathay.

What are the prospects for a merger?

The Hong Kong Economic Times says that since Cathay eliminated 600 jobs in Hong Kong as part of its biggest revamp in two decades in May, the speculation about a takeover attempt by Air China has refused to go away. But aside from the political sensitivities in allowing another of Hong Kong’s prominent firms to fall into mainland hands, a key obstacle is the uncertain status of air traffic rights negotiated between Hong Kong and other countries if a Chinese entity were to take control.

Another concern is how the cultures of the two airlines would mix. The Swire family has controlled Cathay since 1948 and the airline has always been led by long serving company men, many of them from English universities like Oxford and Cambridge. Air China’s management has different backgrounds and different loyalties, and bringing the two together would be a mammoth task. Despite their current cross-shareholdings, integration between the two has been relatively limited – they are still members of rival global alliances, for instance.

Yet takeover talk has persisted and may explain the emergence of a new investor in Cathay’s shares. Kingboard Chemicals, a circuit boards maker which has turned its focus to real estate in recent years, has built up a stake of 9% in Cathay since last year, becoming its third largest investor. Perhaps Kingboard is hoping for something similar to the uptick in the shares of OOIL once Cosco’s interest was reported. The latter then offered a premium of almost a third on OOIL’s share price in its takeover bid.

In the meantime Kingboard’s founder is calling for Cathay’s largest shareholder to get more of a grip on its airline. “I hope someone in the Swire family – as Cathay Pacific is in hard times at the moment – will come out and lead the company for a while before handing control back to the professionals,” Cheung Kwok-wing told the South China Morning Post in late July.

James Tong, public affairs director at Swire, responded that it was “fully committed” and “remains confident about the future” of the airline. Yet Hong Kong’s diminishing claims as an aviation gateway must raise the possibility that Cathay’s main shareholder may eventually change its mind.

After all, OOIL was under the longstanding control of the family of Tung Chee-hwa, formerly Hong Kong’s leader, before it finally relented to the attentions of a state-owned buyer from the mainland. Like its largest container shipping line, perhaps Hong Kong’s flagship airline will eventually end up in Chinese hands too.

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