Cathay Pacific (293:HK) Fair value: HK$14
Cathay Pacific (293:HK) Rating: Outperform (upgrade from Underperform)
Air China (753:HK) Fair Value: HK$7.70
Air China (753:HK) Rating: Outperform (unchanged)
27 July 2017, Asia Pacific – COSCO SHIPPING (1919:HK)’s recent proposed general offer for OOIL (316:HK) has reminded us to reiterate our previous thesis that it would make sense for Air China (753:HK) to acquire or merge with Cathay Pacific (293:HK) in the longer term with the combined carrier becoming the world’s largest cargo airline and second largest passenger airline. Interestingly, Kingboard Chemical Holdings (148:HK) and affiliates have recently accumulated an 8.34% stake in Cathay Pacific and could become instrumental in making or breaking an Air China-Cathay Pacific union in the longer term. We have revised our Cathay Pacific earnings forecasts and fair value to HK$14 and consequently upgraded our rating from Underperform to Outperform. We believe much of Cathay Pacific’s weak earnings outlook is already priced in and its recovery from next year and potential M&A interest could lift its share price higher.
A MARRIAGE WAITING TO HAPPEN
2017 is likely to be one of the worst financial years for Cathay Pacific since the global financial crisis in 2008 due to continued passenger yield pressure, market share loss, expensive fuel hedges and one-off restructuring charges. We forecast Cathay Pacific (293:HK) to incur a net loss of HK$1.5B in 2017 and dividend payments are unlikely this year as it undergoes restructuring.
As Cathay Pacific will continue to face a structurally more competitive market in the longer term and its profit margins are likely to be thin and volatile, we see a greater possibility that it will eventually be acquired by Air China in the longer term, in a transaction similar to COSCO SHIPPING (1919:HK) and Shanghai International Port Group SIPG (600018:CH)’s recent proposed general offer for Orient Overseas International Limited OOIL (316:HK).
Currently, Air China (753:HK) and Cathay Pacific already have a cross-shareholding structure with Air China owning a 29.99% stake in Cathay Pacific and Cathay Pacific owning a 18.13% stake in Air China (following its recent A share placement).
COMBINING AIR CHINA & CATHAY PACIFIC WILL FORM THE LARGEST CARGO AIRLINE AND SECOND LARGEST PASSENGER AIRLINE IN THE WORLD
Air China could significantly elevate its international expansion and access to premium travellers by leveraging on Cathay Pacific’s much broader international route network, more established branding and service reliability. Cathay Pacific provides a strong international platform (in terms of network, operations, branding) for Air China to accelerate its international route expansion as it would take much longer for Air China to build this up organically.
Moreover, Air China’s cooperation with Cathay Pacific seems to have reached a plateau in recent years and both are also constrained to some extent due to their membership in different global airline alliances as well as different management cultures. Cathay Pacific is a member of the Oneworld Alliance while Air China joined the larger Star Alliance.
Combining Air China and Cathay Pacific would elevate them to become the second largest passenger airline and the largest cargo airline in the world in terms of passenger and cargo traffic with a total fleet size of 830 aircraft.
Chart: Combining Air China and Cathay Pacific’s operations
CATHAY PACIFIC’S EFFECTIVE FREE FLOAT HAS FALLEN TO 17%
Cathay Pacific’s effective free float has fallen following the recent accumulation of shares by Kingboard Chemical Holdings (148:HK) and affiliates. Excluding Swire Pacific, Air China and Kingboard Chemical Holdings’ stakes in Cathay Pacific, the remaining publicly traded float is only 17% of Cathay Pacific’s total shares outstanding effectively. This is much smaller than Singapore Airlines’ public float of 44%.
Chart: Cathay Pacific Airways current shareholding structure
SWIRE PACIFIC & OTHER SHAREHOLDERS HAVE COMPELLING PUSH FACTORS TO SELL THEIR CATHAY PACIFIC STAKE
The key “push factors” for Swire Pacific Limited (19:HK) which owns 45% of Cathay Pacific and the minority shareholders would be:
- Rising capital costs needed to grow and upgrade Cathay Pacific’s aircraft fleet, persistently intense industry competition as some of the weak carriers continue to be supported by their governments and profit margins tend to be razor-thin.
- Weak profitability – Cathay Pacific’s earnings have been highly cyclical with limited long-term growth and its profit margins have been declining in the past 10 years.
- Structurally more challenging competitive landscape – Cathay Pacific is likely to lose more traffic to direct flights between China and the rest of the world over time.
- Growth constraints at Hong Kong hub base – Cathay Pacific could be stuck in a low growth trajectory until the Three Runway System is completed by 2024.
HOWEVER, THERE ARE HURDLES TO THIS DEAL
The key hurdles to such a transaction are:
- Legacy – Swire has owned Cathay Pacific for the past 69 years since 1948 and may be reluctant to sell its stake due to legacy reasons.
- Politics – It may be politically sensitive to sell Cathay Pacific, which is iconic to Hong Kong, to a Chinese state-owned enterprise although COSCO SHIPPING’s recent proposed general offer for Orient Overseas International OOIL has not triggered any public opposition or backlash so far.
- Air traffic rights – There could be controversy regarding the allocation and eligibility of international traffic rights if Cathay Pacific becomes 100%-owned by a Chinese carrier.
- Cash consideration – Air China may be reluctant to pay cash to acquire Cathay Pacific as this would increase Air China’s financial leverage meaningfully. Moreover, Air China is a more profitable carrier than Cathay Pacific.
- Valuation gap – Swire Pacific may not agree to alternative transaction structures such as a share swap agreement given that Air China (1.2x P/B) is trading at a 30% premium to Cathay Pacific (0.9x P/B) and Swire Pacific is unlikely to retain much management influence in the combined entity.
KINGBOARD CHEMICAL’S RISING EQUITY STAKE IN CATHAY PACIFIC RAISES QUESTIONS ON ITS REAL MOTIVATION
It would be interesting to monitor Kingboard Chemical Holdings Limited future role in determining Cathay Pacific’s strategy. Its sizeable stake could also make Kingboard Chemical a deal maker or breaker in the event that Air China intends to make a general offer for Cathay Pacific.
Kingboard and affiliates have been amassing Cathay Pacific’s shares and their stake in the airline has risen to 8.34% as at 30 June 2017. Based on Cathay Pacific’s current share price, Kingboard Chemical Holdings and affiliates’ 8.34% stake in Cathay Pacific is worth HK$4.0B, amounting to 11% of its Kingboard Chemical Holdings’ own market cap.
Kingboard Chemical’s core business is in Laminates, PCBs, chemicals & magnetic products and property development sectors which are completely unrelated to the aviation sector which raises questions on the real motivation behind its investment in Cathay Pacific. Meanwhile, Kingboard has so far made a paper gain of around HK$200m from its financial investment in Cathay Pacific shares based on the current share price.
Chart: Kingboard Chemical Holdings revenue breakdown by business segment (2016)
UPGRADE TO OUTPERFORM, FAIR VALUE HK$14
Following Cathay Pacific’s recent release of its 1H17 operating statistics, we have updated our 2017-2019 earnings forecasts, mainly to factor in lower passenger traffic and yield assumptions, higher cargo traffic and yields, restructuring charges and unit cost savings.
We forecast Cathay Pacific to incur a net loss of HK$1.5B in 2017 and dividend payments are unlikely this year as it undergoes restructuring. We expect Cathay Pacific to turn around with a small net profit of HK$852m in 2018 and significantly higher net profit of HK$2.5B when its expensive fuel hedges have rolled over.
We value Cathay Pacific Airways at HK$14 which is based on 1.0x P/B, a slight premium to the HK$13 valuation derived by our Gordon Growth valuation model assuming ROE of 5% and 0% long-term growth and our estimated “liquidation” value assessment for Cathay Pacific to factor in the potential M&A interest.
Chart: Cathay Pacific Airways Limited – Crucial Perspective Scorecard
Chart: Cathay Pacific Airways Limited – Financial Summary
Chart: Cathay Pacific Airways Limited – Gordon growth valuation model
Chart: Cathay Pacific Airways Limited – Estimated “liquidation” value
Note: Stocks with upside of more than 10% based on our fair value are assigned an Outperform rating. Stocks with downside of more than 10% based on our fair value are assigned an Underperform rating. Stocks with upside or downside of less than 10% based on our fair value are assigned an In-line rating. These are Crucial Perspective’s proprietary rating classifications and by no means serve as investment recommendations.
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