Playing the slots

There are some similarities between the airline operations of the HNA Group from Hainan and Hong Kong-based Cathay Pacific. Both are perched on the edges of China’s vast aviation market. And although they both sit outside the tent of the country’s big three airlines – Air China, China Southern and China Eastern – the two both have a significant part to play in how China’s airline sector takes shape. Both have run into difficulties in the last two years, reporting substantial losses, and both are looking to transform their businesses as a result.

But while Cathay has regained some of its altitude after an uncomfortable ride through stormier skies, HNA is still fighting to survive a death spiral of debt, much of it unrelated to its aviation roots.

Last month the flight paths of the two carriers came together with news that Cathay is buying HK Express, a low-cost carrier currently under HNA’s control. Cathay will pay $628 million, partly in cash and partly by taking on debt, according to a stock exchange filing. The purchase could be pivotal: granting Cathay a new chance to prosper in a perennially perilous industry and giving HNA another slug of life-saving cash.

Why is HNA in such financial trouble?

HNA has hit the buffers after a long bout of frenetic dealmaking. This freewheeling style wasn’t entirely new to the company, as we noted in WiC362, although the recent spree was different in its intensity and international reach. The spending was spectacular: at least $61 billion in outgoings between 2015 and 2017 alone, funded mostly by heavily leveraged loans.

We wrote at the time that some of the buyouts made sense as part of plans to become a vertically integrated transport provider with a global scale. But other acquisitions were so scattergun in style that they were harder to squeeze into a coherent strategy.

It didn’t help that the HNA Group has a mysterious ownership structure that is hard to pin down (see WiC382). A confusing web of cross-shareholdings across hundreds of different companies led to whispers about HNA’s true backers, and whether the company was getting ‘air cover’ from influential figures in the Communist hierarchy.

Even if the rumours are true, the patronage hasn’t persisted. Instead HNA found itself in a huge hole as the mood turned disapproving of the type of deals that it had spearheaded. With credit conditions tightening nastily, it was forced into a mad scramble for cash, spending the last 18 months trying to sell off recently acquired assets including its shareholding in Deutsche Bank and its stake in the Hilton hotel chain.

Despite disposals amounting to more than $40 billion it has been difficult to keep up with debt repayments and the selling continues at a staggering pace. Now the aviation conglomerate is now under pressure to shed assets from its core operation: last month alone HNA disposed of a stake in Portuguese airline TAP, divested its controlling interest in its Hong Kong-listed property unit to Blackstone (after selling several expensive real estate projects in the territory’s old Kai Tak airport), and agreed a deal to sell Gategroup, the Swiss-based air catering business, to RJR Capital.

Of course, it also committed to sell HK Express to Cathay Pacific in a transaction that should be completed later this year.

Why has Cathay changed its mind on low-cost carriers?

The Cathay group (Cathay also operates a cargo carrier and a predominantly mainland China-focused airline called Cathay Dragon) isn’t cash-strapped like HNA. But it has come under a different kind of pressure from the shifting fault lines in the airline world.

For years Cathay generated substantial profits from its geographical position in Hong Kong as China emerged into the global economy. But about a decade ago its passenger and cargo businesses started to come under greater challenge from Chinese carriers that had built up large rival networks of direct routes around the world, diverting connecting traffic away from Cathay’s home hub.

The critics say that Cathay was slow to react to the changing circumstances and a long run of below-par performance came home to roost two years ago, when it reported some of its worst financial results for 20 years (see WiC377).

Realising that its competitive edge was eroding, Cathay embarked on a three-year transformation programme that saw it return to profit in its latest results announced last month. Much of the focus has been cost-cutting but the chastening times have brought about a fuller rethink, including a review of its stance on budget airlines.

Cathay’s senior management were first asked about a low-cost carrier in 2003 when longtime rival Singapore Airlines was starting one of its own, the South China Morning Post reported last month. But bosses at the Hong Kong airline were unconvinced by the low-cost model and successive managements took the same line, believing that Cathay was better to stick to its strategy of a premium service, flying larger aircraft with more passengers.

Some of that reasoning was that it would be difficult to keep things low-cost operating a budget carrier in one of the world’s most expensive cities. A quick look at the model that had seen Cathay prosper – mostly long-haul routes with a premium product and higher fares, plus a significant reliance on its cargo business – signalled attributes not normally associated with low-cost carriers as well.

Yet Cathay is now a latecomer to a trend in which plenty of full service airlines have established low-cost offshoots (it is the 17th full service carrier in the Asia-Pacific region to boast a low-cost subsidiary, according to CAPA Centre for Aviation). In part that’s because the business models of the two different types of airlines are no longer quite as distinct, with both sides adopting the more convincing elements of the other’s approach. Other airline groups have adopted a multi-brand strategy and Cathay is following carriers like Qantas and Singapore Airlines with its new approach. This seeks to combine a budget operator (HK Express) for routes popular with lower-yield leisure traffic, with Cathay Dragon feeding especially from China’s domestic market, while Cathay Pacific retains its premium service on longer-haul routes that are more supportive of business class demand.

Isn’t this more a question of airport capacity in Hong Kong?

Analysts have identified other advantages for Cathay in the deal. HK Express only flies to one city in mainland China, for instance, so there isn’t massive overlap with Cathay Dragon, which flies to a range of Chinese destinations. There is more overlap in flights to Japan, a market that accounts for about 12% of Cathay’s seats and by far the most seats for HK Express. However, the budget airline is serving mostly secondary cities, including seven destinations to which Cathay doesn’t fly.

Strategically, the takeover also allows Cathay to control more than half of the flights from Hong Kong, cementing its position at its home hub. Paradoxically, Cathay’s earlier refusal to launch (from scratch) a budget airline was largely to do with Chep Lap Kok airport and a growing scarcity of capacity. Cathay management didn’t think it would have been able to get enough additional flight slots to make it a sustainable proposition.

That is going to change by 2024 when Hong Kong’s capacity will grow with the opening of a third runway. But the bid for HK Express shows that Cathay didn’t want to wait another five years, especially when HNA’s financial woes have granted an unexpected opportunity to take control of an existing carrier with ample slots. That gives Cathay the chance to run a budget operation without having to sacrifice slots for its pre-existing airlines and it also puts it in a better position to prepare for battle with the likes of Air Asia and Jetstar when new slots open up in Hong Kong in five years time.

So it’s good news for Hong Kong as an aviation hub?

At the very least, the bid for HK Express changes the tone at Cathay after a dispiriting period where it was losing passengers to longhaul rivals from the United Arab Emirates and struggling to explain how it was going to counter the challenge from competitors from China flying direct to new destinations.

Analysts were already expecting a major aircraft order in the months ahead as Cathay builds out its longhaul network. But the capture of HK Express brings it an unanticipated option in low-cost traffic as well as a revitalised focus on regional traffic.

Of course Cathay will have to prove that it can mould its new acquisition into a profitable business, delivering the budget operations that underpin low-fare travel. That’s not a given: full service carriers have often struggled to cultivate the low-cost culture that allows the best of the budget airlines to prosper.

However, there’s no doubt that more budget flights should boost Hong Kong’s claims as a leading hub. Currently low-cost flights account for a relatively low 12% of the total, for instance, compared to 31% in Singapore. Traditionally low-cost carriers have selected a model that sticks to point-to-point travel rather than connecting traffic. But transit passengers are especially important for airports like Hong Kong and Singapore, which lack domestic markets of meaningful size, and for their home carriers, which rely on connecting traffic for a greater proportion of their business.

Cathay’s strategic shift also comes as another landmark moment in Chinese aviation beckons, with the opening of Beijing’s second international airport in the autumn. The new hub is set to shake up the schedules as China Eastern and China Southern will move their operations there, getting a golden opportunity to grab new slots for flights to Europe and the United States (see WiC338).

The greater threat to Cathay is from China Southern, which has been championing its home base in Guangzhou – less than a hundred miles from Hong Kong – as a new hub for international flights. Cathay has been relatively surefooted in its strategy in mainland China, especially in establishing a cross-shareholding with Air China that cements a powerful alliance. The new runway in Hong Kong will give Cathay more flexibility to cope with its rivals. It may lead to more of a pincer movement, with Air China taking the lead from Beijing Capital Airport in the north and Cathay trying to get more of a stranglehold in Hong Kong in the south.

The outcome: two different gateways to the world’s biggest aviation market, according to IATA, which is forecasting that China will surpass the US in traffic terms in 2024, the same year that Hong Kong’s new runway goes into operation.

How about HNA: what happens next?

Having sold its stake in another budget carrier Hong Kong Airlines last year, the HK Express sale has effectively confirmed HNA’s retreat from Hong Kong as a challenger to Cathay. HNA now has to focus on more immediate horizons in its battle to survive. Chen Feng, its founding chairman, tried to steady the ship last November, telling the media that the “crisis was over” after raising billions of yuan to repay debt, and when the rumours returned in February that HNA was close to bankruptcy it denied them again, saying that it was through the worst of its financial distress.

Chen made similar claims late last month at the Boao Forum in Hainan’s Sanya, saying there would be more asset sales as HNA returns to a core focus on aviation.

“External factors can change, things don’t always work out as expected and the risks increase,” he explained to China Economic Weekly. “We have encountered changes in the environment at home and abroad, and we have problems where we are unable to complete the logic of these mergers and acquisitions.”

Media reporting last week said HNA continues to negotiate with China Development Bank, its largest creditor, about how best to reduce its debt. Sales of airport-cargo handler Swissport International and container-leasing business Seaco seem imminent, as well as the offloading of aircraft-maintenance firm SR Technics. Also up for auction is a majority stake in oil storage and logistics business HG Storage International as the humbled conglomerate hunts for cash.

Chen still hasn’t been able to ringfence its flagship carrier Hainan Airlines from the reverberations, which saw shares worth Rmb10.5 billion frozen by a court in Shandong last month after an aircraft leasing company said that HNA was behind on its payments.

In another sign of the financial tensions, Hainan Airlines has just sold two of its Boeing 737-800 planes for $27.5 million. These aircraft weren’t the same type as the Boeing fleet grounded by aviation authorities on safety concerns last month (see WiC444), analysts told the South China Morning Post, implying that the sale had more to do with easing the group’s fraught financial condition.

HNA’s fall from financial grace has been so sudden that its immediate focus is on finding a way of reconsolidating its core businesses from its home hub in Hainan. But if the task proves too overwhelming, there could be another round of realignment in the aviation landscape. After all, there was talk that Air China might increase its stake in Cathay two years ago when the Hong Kong carrier first reported its heavy losses. HNA is under much greater pressure than that. Although it denied another raft of rumours last December that it was close to selling its flagship airline to Air China, the speculation that Hainan Airlines is a target for predators has persisted.

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