30 May 2018, Hong Kong – HNA Group’s Hong Kong Airlines (HKA) is reportedly tapping investors to raise funds through the issue of new shares and convertible bonds ahead of a potential IPO.
Hong Kong Airlines (HKA) seeks equity and bond investors
According to the Reuters - “HNA Group’s Hong Kong Airlines is considering an initial public offering in the “short to medium term” and tapping investors to raise funds through the issue of new shares and convertible bonds. It plans to raise about $350 million by selling new shares, expanding its equity base by 22%, according to the document dated April 2018. That would give the 12-year-old airline a pre-IPO valuation of about $1.6 billion, based on Reuters calculations. The company also wants to raise up to $550 million via convertible bonds or tradable bonds before the listing, the document showed. The bond issue will be at a coupon rate of 8-to-10 percent for a two-to-five year period, according to the document."
Implied valuation sought by Hong Kong Airlines (HKA) may look high
The implied pre-IPO equity valuation is about US$1.6 billion, according to Reuters.
This is equivalent to 25% of Cathay Pacific's current market cap of US$6.4 billion even though HKA's revenue amounts to only around 15% of Cathay Pacific's.
Cathay Pacific is turning around and we do not expect Hong Kong Airlines to be much more profitable than Cathay Pacific this year given HKA's aggressive expansion and high financial leverage.
Based on our estimates, a fairer equity valuation for Hong Kong Airlines would be US$1.1 billion but HKA could well attain a valuation closer to its ambitious target as we expect its share issuance to attract strategic investors with deep pockets.
BUT potential pre-IPO investors for Hong Kong Airlines (HKA) have deep pockets
In our view, these could include:
- Temasek Holdings/Singapore Airlines which have been interested in acquiring a North Asian carrier for more than a decade
- Cathay Pacific/Swire Group as a defensive strategy given Hong Kong Airlines' aggressive expansion plans
- Gulf carriers hungry for more connecting traffic such as Qatar Airways or Emirates
- Chinese carriers (such as Air China or China Southern Airlines) acquiring a stake in Hong Kong Airlines to enhance its market position in the Pearl River Delta region
Key value lies in Hong Kong Airlines’ prized slots and growing market share at Hong Kong International Airport
The key value of Hong Kong Airlines (HKA) lies in its 7% and growing market share out of Hong Kong International Airport whose barriers to entry are high with airport slot constraints until the new Three Runway System (3RS) is completed in 2024. Hong Kong Airlines has 10% of the airport departure slots out of Hong Kong International Airport.
Hong Kong Airlines also operates a younger aircraft fleet averaging only 6 years old, younger than Cathay Pacific’s 9 year-old fleet and has a lower cost structure than Cathay Pacific.
Chart: Number of flights per day at Hong Kong International Airport (2018)
Chart: Airline market share at Hong Kong International Airport (2018)
Historically a carrier serving only Asian routes, Hong Kong Airlines is now expanding rapidly into long-haul markets as it takes delivery of more wide-body aircraft
Traffic in the Asian region drives 60% of Hong Kong Airlines’ operations. Hong Kong Airlines’ top 3 markets in Asia are Japan (contributing 22% of its total traffic), followed by China (18%) and Thailand (7%) based on our estimates.
Hong Kong Airlines’ North American business has grown rapidly in recent times, accounting for a quarter of its operations. Australia/New Zealand is an important market too, accounting for 15% of HKA's business.
Chart: Hong Kong Airlines network coverage (2018)
Aggressive capacity expansion will dampen Hong Kong Airlines' passenger yields and profitability this year
The key risk is that Hong Kong Airlines’ capacity expansion looks too aggressive – it is growing capacity by 41% y/y currently.
This will put significant pressure on Hong Kong Airlines’ passenger yields and profit margins.
Moreover, fuel prices have risen significantly by 27% y/y this year and Hong Kong Airlines’ predominantly leisure traffic base is more price sensitive, making it harder to pass on the higher fuel costs completely to its customers.
Plans to nearly double Hong Kong Airlines' seat capacity based on existing aircraft orders
Hong Kong Airlines has 38 aircraft in service plus 31 aircraft on order. Given that most of its aircraft orders are wide-body planes, we expect Hong Kong Airlines’ total seat capacity to nearly double when all the new aircraft are delivered.
It could be challenging for Hong Kong Airlines to access sufficient new routes and frequencies to make money on as Hong Kong International Airport’s current slot constraints could impede HKA's growth strategy in the next 4 years (until the new 3RS is completed) and the available airport slots are sub-optimal.
Chart: Hong Kong Airlines Aircraft Fleet (2018)
In addition, Hong Kong Airlines faces stiff competition from the Chinese carriers as they continue to launch more direct flights between China and the rest of the world, bypassing the Hong Kong hub, and being able to secure China's traffic is crucial for HKA's growing long-haul operations.
Finally, there could be potential risks associated with the HNA Group, such as related party transactions.
See our previous report on a related company Hainan Airlines:
Independent Research Declaration: Crucial Perspective does not own any position in the equities featured in this report nor have we received any compensation for writing this report.
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