Cathay Pacific (293:HK) Fair Value: HK$14
Cathay Pacific (293:HK) Rating: Outperform
16 August 2017, Hong Kong – Cathay Pacific (293:HK) reported a net loss of HK$2.05B , its largest 1H loss in history, worse than our forecast (which was already more bearish than consensus) and much weaker than Singapore Airlines and other major Asian airlines’ performance. We expect Cathay Pacific to remain loss-making in 2H17 but turn around from 2018. Cathay’s market share remains strong and forward bookings suggest stronger passenger revenue growth going forward. However, given that its expensive fuel hedges are still in place until the end of 2018, Cathay will need to work harder to trim its non-fuel unit cost to improve its competitiveness. We recently upgraded Cathay Pacific from Underperform to Outperform as we believe much of Cathay’s weak earnings outlook is already priced in and its recovery from next year and a potential takeover by Air China could drive its valuations higher. It would make sense for Air China to acquire or merge with Cathay Pacific in the longer term with the combined carrier becoming the world’s largest cargo airline and second largest passenger airline. Here are our key takeaways from the 1H17 results and outlook from 2H17:
Financial performance weaker than Singapore Airlines and other major Asian airline peers: Cathay Pacific reported the largest deterioration in profit margins among the major Asian airlines that have reported 1H17 results so far. Cathay’s operating loss margin of 5.5% was much weaker than Singapore Airlines (SIA:SP)‘s 4.1% operating profit margin. ANA Holdings (9202:JP), Japan Airlines (9201:JP), EVA Airways (2618:TT) and China Airlines (2610:TT) also did better than Cathay Pacific. The Chinese airlines’ 1H17 financial results will only be announced in late August.
Chart: Major Asian airlines operating profit (loss) margin (1H17 and 1H16)
Largest 1H loss in history, worse than our forecast which was already more bearish than consensus estimates: Cathay Pacific’s poor financial performance came as no surprise to us but the magnitude of its loss was even larger than expected. Cathay Pacific reported a net loss of HK$2.05B in 1H17 versus its HK$353m net profit in 1H16. Excluding the major one-off items comprising of HK$498m cargo-related fine imposed by the European Commission, HK$224m staff redundancy costs, HK$586m gain from the disposal of Cathay’s entire interest in Travelsky Technology (696:HK) and HK$244m deemed partial disposal paper gain following the dilution of Cathay’s stake in Air China from 20.13% to 18.13% after the latter’s A share placement, Cathay Pacific’s recurring loss would have been even larger at around HK$2.2B in 1H17.
Chart: Cathay Pacific’s net profit/loss (1998 to 2017)
Chart: Cathay Pacific 1H17 results at a glance
The worst is nearly over, outlook to improve from next year: We have revised down our 2017 forecasts to factor in the higher than expected costs. We still expect Cathay Pacific to remain loss-making in 2H17, raising its full year net loss to HK$4.3B. However, we expect Cathay Pacific to turn around in 2018 with a small net profit of HK$377m and stronger net profit of HK$2.5B in 2019.
Market position in Hong Kong is still strong: Cathay Pacific’s market share at its Hong Kong hub is still strong at 50%, although down from 52% 3 years ago. This is lower than Singapore Airlines Group’s market share of 55% in Singapore but higher than EVA Airways/China Airlines’ 35%/30% market share in Taiwan and ANA Holdings/Japan Airlines’ 30%/22% market share in Japan. Hong Kong International Airport’s slot constraints provide barriers to entry until the new Three Runway System is completed in 2024.
Chart: Airline market share at home country hub (2017)
Revenue growth to pick up in 2H17: We expect Cathay Pacific’s passenger traffic growth to pick up in 2H17. Unearned transportation revenue rose 12% h/h in 1H17 which is encouraging. The benefits of Cathay’s Transformation programme will also start to kick in.
However, long-haul routes could continue to be a drag on earnings near term: Passenger yield pressure on long-haul routes to North America and Europe was particularly severe, down 8% and 7% y/y in 1H17. This is worrying as North America and European routes contribute around 45% of Cathay Pacific’s passenger revenue and competitor carriers around the region continue to add more capacity on these routes. In addition, based on the current planned flight schedules, Cathay Pacific is accelerating its seat capacity growth on European and North American routes by 13%, and 9% y/y respectively in 3Q17 which could drive further fare discounts to fill up the planes.
Cargo is the brightest spot: On a more positive note, Cathay’s cargo business has done extremely well: Cargo revenue rose 13% y/y in 1H17 and contributed 23% of Cathay’s total revenue in 1H17 versus 21% in 1H16. We expect this segment to be a larger revenue contributor as the global airfreight demand remains buoyant and as we enter the traditional peak cargo season in 4Q17. As the fourth largest cargo airline in the world, Cathay Pacific is highly leveraged to the improving cargo market.
Non-fuel unit costs need to be trimmed further to improve competitiveness: Cathay Pacific’s unit cost excluding fuel and one-off items rose 0.5% y/y in 1H17, mainly due to higher aircraft, depreciation and finance costs. This is disappointing and Cathay needs to work on bringing non-fuel unit cost lower in order to improve its competitiveness versus sector peers. Cathay Pacific still has expensive fuel hedges in place until the end of 2018 and as such, will have to work harder to trim its non-fuel costs down. Cathay Pacific’s fuel hedges are around US$30/bbl higher than Singapore Airlines’ on average.
No dividends but the risk of equity-raising is low: No interim dividend was announced for 1H17 which is in line with our expectations. Cathay’s net debt-equity rose from 90% to 104% but this is not too big a concern to us as Cathay’s financial leverage is similar to the Asian airline sector’s average.
An eventual marriage with Air China is likely: 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 Cathay Pacific 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. 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.
Chart: Combining Air China and Cathay Pacific’s operations (2016)
Share price downside is limited, potential takeover could drive stock rally: We recently upgraded Cathay Pacific from Underperform to Outperform as 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. We expect more investors to cover their short position in Cathay Pacific going forward. This could lead to a short squeeze as Cathay’s effective free float has been shrinking ever since Kingboard (148:HK) started to build up its stake in Cathay Pacific to 9%.
Chart: Cathay Pacific Airways – Shareholding structure
Chart: Cathay Pacific Airways – Crucial Perspective Scorecard
Chart: Cathay Pacific Airways – Financial Summary
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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