Cathay Pacific (293:HK) Fair value: HK$14.0
Cathay Pacific (293:HK) Rating: Outperform
Air China (753:HK) Fair value: HK$8.3
Air China (753:HK) Rating: Outperform
6 November 2017, Hong Kong – Qatar Airways’ acquisition of a 9.61% stake in Cathay Pacific (293:HK) from Kingboard Chemical Holdings (148:HK) is at a reasonable valuation of US$662 million and more importantly, a prized political win for the state-owned Qatar Airways that will bring renewed worldwide attention and perhaps more importantly, China’s attention to the Saudi-led blockade against Qatar.
This new development will also force Cathay Pacific’s existing major shareholders Swire Pacific (19:HK) and Air China (753:HK) to further evaluate the strategic direction and shareholding structure of Cathay Pacific.
We still maintain our view that a merger with Air China is more likely longer term as it would be too much of a financial strain on Qatar Airways to take over Cathay Pacific given Qatar Airways’ own massive aircraft orderbook. We analyze the implications:
FACING SAUDI-LED BLOCKADE, QATAR AND STATE-OWNED QATAR AIRWAYS HAVE URGENT NEED TO BROADEN GLOBAL FOOTPRINT
The Saudi-led economic and political blockage against Qatar does not seem to be ending anytime soon. In fact, Bahrain has made a fresh territorial claim against Qatar last Saturday. As predicted in our earlier report in June, the blockade has taken an immense toll on Qatar Airways.
Qatar and the state-owned Qatar Airways now face an even greater urgency to broaden their global footprint and network connectivity, boost international traffic feed to fill their fast-expanding aircraft fleet and need to demonstrate their financial strength to the world.
CATHAY PACIFIC STAKE IS A PRIZED POLITICAL WIN FOR REASONABLE US$662 MILLION PRICE
This is a prized political win for the state-owned Qatar Airways after it had to drop its plans to acquire a 10% stake in American Airlines (AAL:US). The acquisition of a major stake in a high profile carrier such as Cathay Pacific will bring renewed worldwide attention and perhaps more importantly, China’s attention to the Saudi-led blockade against Qatar.
Qatar Airways acquired its 9.61% stake in Cathay Pacific from Kingboard Chemical Holdings (148:HK) for a cash consideration of HK$5.16B (or US$662M). This implies a purchase price of HK$13.65 per Cathay Pacific share, a 3.4% premium to Cathay Pacific’s closing share price on 3rd November 2017. This values the Cathay Pacific stake at 1.0x Price/Book which is reasonable in our view. It is likely that Qatar Airways will even profit financially from its Cathay Pacific stake in the longer-term.
DO SYNERGIES EXISTS BETWEEN QATAR AIRWAYS AND CATHAY PACIFIC?
Qatar Airways and Cathay Pacific currently compete for connecting traffic and cargo on long-haul routes to Europe and North America which contribute 42% and 48% of their total passenger traffic respectively. Moving forward, the two carriers might work together in the areas of flight schedules coordination, cross-selling of tickets, cargo, catering and joint procurement.
Both carriers are similar in terms of the size of their aircraft fleet, number of daily flights and the scale of their passenger and cargo operations. Qatar Airways and Cathay Pacific are also part of the same global airline alliance – Oneworld.
Chart: Geographical distribution of Qatar Airways and Cathay Pacific’s passenger traffic by route region (2017)
Chart: Qatar Airways and Cathay Pacific – Key operating metrics (2017)
POTENTIAL CHINA MARKET ACCESS FOR QATAR AIRWAYS
Although Cathay Pacific is not the ideal partner to access the Chinese market, it is rare to find opportunities to invest in the major Chinese carriers and even more difficult to establish an airline joint venture in China. Therefore, investing in Cathay Pacific might very well be the next best option for Qatar Airways.
Cathay Pacific and Cathay Dragon operate flights to 21 airports in China accounting for 7% of its total passenger traffic versus only 6 airports that Qatar Airways flies to currently accounting for only 4% of its total traffic. Cathay Pacific has a 50% market share at Hong Kong International Airport versus Qatar Airways’ 0.8%.
LEASING OPPORTUNITIES FOR QATAR AIRWAYS’ EXCESS AIRCRAFT CAPACITY
Its Cathay Pacific stake could also provide leasing opportunities for Qatar Airways’ excess aircraft capacity. Recall Qatar Airways wet-leased aircraft and cabin crew to 20%-owned British Airways when its staff went on strike back in June 2017. Qatar Airways also plans to provide widebody and narrowbody aircraft to 49%-owned Meridiana. For more details on Qatar Airways’ excess aircraft capacity, please refer to our earlier report:
THE KEY RISK FOR QATAR AIRWAYS IS THAT MINORITY EQUITY INVESTMENTS HAVE HISTORICALLY BEEN CHALLENGING IN THE AVIATION INDUSTRY
Qatar Airways has historically been focused on growing organically and only started to invest in foreign carriers in recent years. Qatar Airways has a 20% stake in International Consolidated Airlines Group (IAG:LN) which it first invested in January 2015, a 10% stake in LATAM Airlines (LTM:US) completed in December 2016 and a 49% stake in AQA Holdings which is the parent company of Meridiana, Italy’s second largest airline completed in October 2017. Qatar Airways had mentioned plans to acquire a 10% stake in American Airlines earlier this year but this did not materialize.
Minority equity investments in airlines have historically not been value-accretive for most airlines globally due to the lack of management control which limited the level of cooperation and synergies that could be reaped. Qatar Airways’ neighbour Etihad Airlines and its major competitor Singapore Airlines have historically been victims of this.
Therefore, it is essential for Qatar Airways to actively influence Cathay Pacific’s management decisions and strategies and push for the two historical competitors to work together to boost each other’s traffic feed and pursue other synergies.
MAJOR SHAREHOLDERS SWIRE PACIFIC, AIR CHINA & QATAR AIRWAYS HAVE DIFFERENT CORPORATE CULTURES AND CONFLICTING INTERESTS
We expect Qatar Airways, unlike Kingboard, to be a much more vocal shareholder. Qatar Airways is likely to attempt to influence Cathay Pacific’s management decisions and long-term strategy. Cathay Pacific will now have three major shareholders with vastly different corporate cultures, potentially conflicting interests and strategic focus – Swire Pacific (19:HK), Air China and Qatar Airways. Even without a Board seat, Cathay’s management is still obliged to meet and engage Qatar Airways given its meaningful stake.
This may not necessarily be favourable for Cathay Pacific if it results in sub-optimal decision-making as it is undergoing a 3-year Transformation programme. Moreover, Air China and Qatar Airways have non-economic political interests given that they are state-owned enterprises. In addition, Air China is a member of Star Alliance while Qatar Airways and Cathay Pacific are part of the Oneworld Alliance.
CATHAY PACIFIC’S LOW EFFECTIVE FREE FLOAT OF 15.4% WILL NEED TO BE ADDRESSED
Cathay Pacific’s effective free float is too low. Excluding Swire Pacific, Air China and Qatar Airways’ strategic stakes in Cathay Pacific, the remaining publicly traded float is only 15.4% of Cathay Pacific’s total shares outstanding effectively. This is much smaller than Singapore Airlines’ public float of 44%. This could result in lower trading liquidity for the stock going forward.
Chart: Cathay Pacific Airways new shareholding structure
THIS NEW DEVELOPMENT COULD PUSH AIR CHINA TO MERGE WITH CATHAY PACIFIC SOONER RATHER THAN LATER
This new development could test Air China and Cathay Pacific’s relationship and partnership as Qatar Airways would want Cathay Pacific to work more closely with Qatar Airways. Consequently, this could push Air China to merge with Cathay Pacific sooner rather than later.
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 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).
Similarly, Qatar Airways may also consider whether it should increase its stake in Cathay Pacific. We still maintain our view that a merger with Air China is more likely as it may be a financial strain on Qatar Airways to take over Cathay Pacific given Qatar Airways’ massive aircraft order book.
It will cost at least another US$4.6B for Air China and US$5.9B for Qatar Airways to take over Cathay Pacific after taking into account their respective 29.99% and 9.61% stakes in Cathay Pacific based on Cathay’s current share price.
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
In comparison, Qatar Airways and Cathay Pacific are similar in terms of their current aircraft size and the scale of their passenger and cargo operations. Combining Qatar Airways and Cathay Pacific would elevate them to become the fourth largest passenger airline, overtaking Emirates, and the largest cargo airline in the world, overtaking Federal Express, in terms of passenger and cargo traffic with a total fleet size of 398 aircraft.
Chart: Combining Qatar Airways and Cathay Pacific’s operations
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