Cathay's China Crisis

The Hong Kong airline can't remain aloof from the market share war taking place over the border.
At Closing, February 23rd
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Hong Kong's political activists aren't the only ones who fear the long arm of the Chinese state these days. Airlines are getting in on the act too.

Shares in Cathay Pacific fell as much as 5.6 percent to their lowest level in seven years Thursday after the company junked its forecast for second-half profit and said it was carrying out a "critical review" of its business. Blame competition from over the border.

Mainland China's big three state-owned airlines have been adding planes and routes at a rapid clip in recent years. Along with HNA-controlled Hainan Airlines, they've been chasing a domestic market that Airbus forecasts will grow almost fourfold between 2015 and 2035 and an international one that has already turned China into the world's biggest exporter of tourists.

Too Much of a Good Thing

Cathay Pacific has been trying to cut its rate of capacity growth. That's no use when the competition is surging

Source: Bloomberg

If that sort of market growth sounds like good news for Cathay, think again. Boom times can be as fatal to airlines as busts, because when the competition raises capacity too quickly it drives down everyone's prices.

As Gadfly warned in August, airlines in China and Hong Kong are suffering from a brutal bout of ticket price deflation. Passenger yield -- which measures how much a carrier earns for flying a single passenger one kilometer -- has slumped across the board. In their most recent reporting periods, the 7 cents and 6.8 cents revenue per passenger kilometer that Cathay and Hainan Airlines were getting was barely more than the 6.7 cents received by Juneyao, an upmarket budget airline that by rights should be making considerably less.

Crash Landing

China's full-service airlines have been engaged in a race to the bottom on passenger yields

Source: Bloomberg

Note: RPK=revenue passenger kilometers, ie. flying a single passenger for a single kilometer.

In theory, that deflation should be offset somewhat by the rapidly falling price of jet fuel, but Cathay's been hit on that front as well. Its state-owned rivals have enjoyed the full benefit of plummeting oil prices because they don't hedge, while Cathay's hedging policy has been an expensive failure.

The options for airlines caught in this vise aren't attractive. Keeping ticket prices low offers no respite from the climate of marginal or negative profits. Putting them back up or cutting capacity just encourages passengers to fly with the competition instead, adding to Hong Kong's existential sense of marginalization relative to an ebullient mainland.

Cathay still has some cards up its sleeve. Shuffling its aircraft orders would stop the bleed from capital spending while a restructure of the fuel hedge book, or possible higher oil prices, could turn some of those losses back into profits.

You Need Your Hedge Examined

Cathay Pacific's fuel hedging losses have overtaken its operating income and remain stubbornly high

Source: Bloomberg, company reports

Note: Negative hedge loss figures indicate a gain from contracts.

The carrier could raise cash by selling off stakes in its catering, ground-handling or frequent-flier programs, though its substantial cargo business isn't likely to attract investors in a weak market for air freight.

It might also have some supporters in the form of controlling shareholder Swire and Hong Kong's government, which showed its willingness to go into bat for the local hero in rejecting Qantas's attempt to set up a low-cost carrier in the territory last year.

Either way, Cathay can't remain aloof from the market share war playing out in China. Transit passengers make up about half its traffic, according to HSBC analyst Jack Xu, so Cathay is embroiled in this battle whether it wants it or not. Fasten your seat belts.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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    David Fickling in Sydney at

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