Cathay Pacific and Air China - an ideal merger? May 2015

Cathay Pacific Airways and Air China hold significant minority stake in each other and speculation is growing over a full-blown merger between the two. Does a coming together of the flag carriers of Hong Kong and China make strategic sense?

Beijing-based Air China and Hong Kong-based Cathay Pacific already have very close ties — Air China has a 29.9% stake in Cathay Pacific and Cathay holds a 20.1% share of Air China, and the two airlines work closely with each other in everything from joint purchasing to maintenance.

On their own, each airline is a substantial operation. Air China is an immense carrier, with 25,270 employees at the mainline Air China and around 40,000 at the Air China group as a whole. Out of hubs at Beijing, Chengdu, and Shanghai they operate more than 330 routes to 159 destinations in 32 countries, of which 53 are international cities.

For calendar 2014 Air China reported a 7.9% increase in revenue to RMB 105.9bn (US $17.2bn), based on a 6.9% rise in passengers carried to 83m. Operating profit rose 76.4% to RMB 7.3bn and net profit increased 17% to RMB 3.8bn (US $618m) in 2014. That net profit came despite a net foreign exchange loss of RMB 360m (US $59m) in 2014, thanks to the depreciation of the yuan against the dollar. Air China — and other Chinese airlines — are vulnerable to a weaker yuan as most of their airline purchases are funded with dollar denominated debt, and they pay in dollars for leased aircraft and fuel purchased abroad.

Of the “Big Three” Chinese airlines (including China Southern and China Eastern — see Aviation Strategy, November 2014), Air China has consistently had the best results in recent years, and in large part that’s due to the massive advantages that being China’s flag carrier gives it. It has taken over in effect best of China’s plethora of smaller airlines under the government-mandated aviation industry consolidation plan, and also benefits from a large amount of official government travel within and outside the country.

Air China’s dominant position at Beijing airport was  handed to it free of charge by the government. Though China Eastern’s Shanghai and China Southern’s Guangzhou are significant foreign gateways, they don’t come close to Beijing’s importance;  as can be seen in the chart, xxx, Air China’s international RPKs as a proportion of all RPKs were 30.8% in 2014 (compared with 27.5% at China Eastern and 21.4% at China Southern).

Cathay Pacific operates to approximately 200 passenger and cargo destinations in around 50 countries, and in total the group employs 32,900, of which 22,500 work for Cathay Pacific Airways; (and with 15,900 of those airline employees based in Hong Kong). The group is listed on the Hong Kong stock exchange, and currently 45% of its shares are owned by conglomerate Swire Pacific, with Air China owning 29.9% and CITIC Pacific 1.98%.

In calendar 2014 Cathay Pacific Airways saw revenue rise 5.5% to HK $105.99bn (US $13.7bn), of which passenger revenue accounted for HK $75.7bn (up 5.4%) and cargo HK $25.4bn (up 7.35). Operating profit rose 18% to HK 4.4bn (US $572m) and net profit increased 18.8% to HK $3.45bn (US $444m).

In 2014 Cathay carried 31.6m passengers (a rise of 5.5% year-on-year), and a capacity increase of 5.9% (with new routes to Doha, Manchester and Newark as well as increased frequencies on existing routes) was met by a larger rise in traffic, leading to a 1.1 percentage point increase in load factor, to 83.3%.

John Slosar, Cathay Pacific chairman, says: "The overall improvement in our business in 2014 has continued in the first quarter of this year, and we are positive about the overall prospects for 2015. While we face growing competition in our passenger business, which makes it harder to maintain yield, overall demand remains strong and the outlook is positive."

Indeed Cathay saw a 1.8% fall in its passenger yield in 2014, to 67.3 Hong Kong cents (8.7 US cents). While LCCs have had a limited impact in the Chinese market so far, that’s clearly not the case in Asia as a whole. But from Cathay’s point of view, perhaps the greater threat comes from competition from the Gulf super carriers (even though Cathay has a codeshare deal with Qatar Airways).

A super-merger

If the two airlines do merge, they will form an immense airline, whether measured in terms of aircraft, routes or employees.

The fleet compatibility appears good, with Cathay’s long-haul fleet complementing Air China’s mixed short and long-haul aircraft. The mainline Air China fleet totals 331, comprising 119 A320 family aircraft, 49 A330s, 124 737s, 30 777s and nine 747s. The order book is 199 aircraft — 61 A320 family aircraft, four A330s, 10 A350s, 87 737-800s, two 747s, 15 787s and 20 Comac C919s. Cathay's mainline fleet is smaller, at 122 aircraft, including 43 A330s, 10 A340s, two 747s and 67 777s. On order are 48 A350s and 24 777-9Xs.

The Cathay Pacific group also owns Hong Kong Dragon Airlines (100%) and AHK Air Hong Kong (60%). Hong Kong Dragon Airlines — which uses the brand name Dragonair — operates 41 A320 family and A330 aircraft on passenger and scheduled services to around 50 destinations throughout Asia, while Air Hong Kong is a joint venture with DHL Express, and offers cargo services to 12 Asian destinations with a fleet of 13 A300Fs and 747Fs.

Shanghai-based Air China Cargo is a joint venture between Air China and Cathay Pacific, (in which the former owns 51% and the latter 25%) that operates 14 freighters. However, the carrier had struggled over the last few years and the shareholders had to inject new funding in 2014, though the airline saw stronger levels of business last year, helped by lower fuel prices and increasing levels of international trade, eventually managing to make a small profit for the full year after significant losses in 2013. The two airlines also have a ground handling joint venture to provide services at Shanghai’s two international airports, Hongqiao and Pudong.

The problem in merging the fleets would come in scaling back the orders imposed on Air China by the Chinese government. For example, operationally Cathay Pacific would be highly unlikely to want Comac aircraft in a combined fleet, though the political reality may be that Cathay might have to swallow the order in order to keep on the right side of the powerful Chinese air ministry. Perhaps more of a concern are the 31 widebody aircraft on order at Air China, given the 72 widebodies that Cathay has already in its order book. Any rationalisation would again have to be agreed with the Chinese government, though of course the extent of scaling back of widebody orders will depend on the new strategy for a combined airline.

An obvious strategy

The strategic rationale for the merger is the untapped potential for Chinese passengers, both internally and on international routes; Cathay would dearly love Air China to feed passengers into its long-haul network.

China has a population of 1.3bn, but according to statistics from the Civil Aviation Administration of China for 2013 (the last full year figures it has released), Chinese airlines carried 360m passengers, which equates to 0.27 trips per person per year. That’s a figure that will grow fast as China’s economy keeps on expanding — although the Chinese economy has slowed in the last few years, it’s still expanding at around 7-8% per annum, which far outstrips anything western economies are currently delivering.

According to Boeing, Chinese domestic passengers will grow at an AAGR of 6.6% over the 20 year period to 2033, while Airbus is even more bullish, forecasting that domestic Chinese passengers will grow by an average 7.1% per annum over the next 20 years (see chart, xxx) — and that “by 2033 the Chinese domestic market will be more than 60% larger in terms of passenger than today’s largest market, the US”.

Network benefits

Within China, Air China’s current focus is on maintaining its dominant position at Beijing and building up its secondary hubs at Shanghai and Chengdu, while internationally the strategy is to grow routes to Europe and North America; this year Air China forecasts it will carry 88.5m passengers, an increase of 6.6% on 2014.

For Cathay, after concentrating on growing capacity and routes into North America over the last year or two, the focus for future growth is Europe; in 2016 A350-900s and then -1000s start arriving, which Cathay will use “for secondary European points”. In December 2014 Cathay launched a non-stop route between Hong Kong and Manchester, while this year routes to Zürich and Düsseldorf (September) are being added.

While Cathay and Air China expanded their codeshare in November last year, to two more internal Chinese routes, a merger would allow a substantial readjustment of schedules and networks, in order to provide greater feed into Cathay’s long haul flights.

However, it’s not all about Hong Kong. There is a capacity issue at Hong Kong airport, and Cathay was at the forefront of a campaign to build a third runway — which the Hong Kong Executive Council approved in March this year at an estimated cost of HK $141.5bn (US $18.2bn). But Ivan Chu, Cathay Pacific’s chief executive, points out that the airport “will reach capacity well before a third runway could be built, which is of great concern when we are seeing increasing competition from other rapidly expanding hubs in the region."

A tie-up with Air China, therefore, would not only provide mainland Chinese feed into long-haul routes out of Hong Kong, but equally importantly in the short-and medium-term would give the merged entity space to expand international routes at Chinese airports, and in particular from Beijing.

The downsides

There are potential problems with a merger too — Cathay Pacific is a founder member of oneworld (which does not have a mainland Chinese member), while Air China is a member of Star. There would also be much haggling over the respective values of the airlines; Cathay’s market cap as of mid-May was HK $78.5bn (US $10.1bn), while Air China’s (it’s listed on the Hong Kong, Shanghai and London stock exchanges) as of mid-May was HK $121.2bn (US $15.6bn). However, given the surprises that might be unveiled when Air China’s books are opened to due diligence and/or a potential “discount” due to anticipated ongoing interference by the Chinese government, market caps may only be the starting point for negotiations regarding the relative values, rather than the definitive end point.

The respective workforces too may be wary of a merger, particularly if Cathay staff believe that over the long term unified pay and conditions may gravitate to mainland Chinese levels rather than that of an international company based in Hong Kong. Relations between unions and management at Cathay aren’t great anyway; in December 2014 the Hong Kong Aircrew Officers' Association instructed its 2,000 pilot members at Cathay to work-to-rule after failure to agree a new three-year pay deal, and that action continued until this May, when a new deal was agreed between the two sides.

From the Air China side, there will be apprehension as to the improved practices that Cathay Pacific would inevitably bring to the Chinese flag carrier. Cathay has been making significant cost savings over the last years, with a focus on retirement of old aircraft. James Barrington, Cathay Pacific’s director of corporate development, says that: “Pretty soon our fleet will be all 777s, all 748 freighters, and soon to be A350- 900s and 1000s — all of which are new technology aircraft with a fuel burn per kilo somewhere between 10% and 20% of their forerunners of A340s and 747s. So that is an efficiency that's now built into the underlying cost of operating the aircraft.”

Cathay also works hard to maximise utilisation — it claims to have “the third highest utilisation of 777-300ERs in the world; number three — at about 16 hours a day”. Barrington adds: “If we operated our fleet only 12 hours a day, we'd need 13 more aircraft and have to spend another couple of billion US dollars. Fleet utilisation is a pretty major driver”.

Cathay has also refreshed its cabin product across the entire fleet over the last few years, with new business class, premium economy, and economy classes accompanied by upgraded lounges across its international network — and upgrading Air China’s product would be another area that Cathay might want to contribute to post a merger.

Overall, a merger between Air China and Cathay Pacific makes sound strategic sense — and despite the inevitable squabble the shareholders of the two companies will have over respective stakes in a merged entity, the market appears to agree. The Cathay share price (see chart, above) has risen substantially over the last seven months, from under HK$14 as at October 2014 to around HK$20 as at mid-May; similarly, over the same period Air China’s shares have risen from under HK$5 to more than HK$9 today. While those share price increases must be due partly to the impressive results both airlines posted for 2014, it’s also a reflection that both sets of shareholders see a prospective merger as being beneficial to their interests.

If (or when) a merger does occur, it will be interesting to see what Swire Pacific, the current 45% shareholder in Cathay, does post-merger. The Swire Group dates back to the 18^th century, has long invested in the Chinese market and tends to be a long-term stakeholder in businesses. It is likely that Swire will back a deal in order to unlock long-term value, but if it starts selling shares at any point following a merger, that would be a major signal that things aren’t going to plan.