Hong Kong-based Cathay Pacific Airways, Asia’s fourth-largest carrier by market capitalisation and Asia’s largest international airline, posted a worse-than-expected 60.8% fall in its 2011 full-year net profit of HK$5.5 billion (US$705.3 million) from 2010’s record-breaking full-year profit of HK$14.08 billion (US$1.8 billion), dent by soaring gross fuel costs which rose by HK$12.5 billion, or 44.1%, net of fuel hedging gains in the past year, as well as a 9-month consecutive decline in the world’s biggest cargo carrier’s freight traffic that began in April 2011.
The 2011 net profit of HK$5.5 billion was below analysts’ consensus of an earning of HK$5.82 billion, according to Reuters’ compilation of analysts estimates. The oneworld alliance member recorded a 2011 second-half profit of HK$2.7 billion (US$348 million), a steep 63% fall from 2010’s HK$7.2 billion second-half profit, primarily owing to the fact that the typical uptick in cargo traffic during the fourth quarter did not materialise in 2011. Profit margin plummeted dramatically from 15.7% to just 5.6%.
Revenue increased by 9.9% to HK$98.4 billion (US$12.6 billion) from HK$89.5 billion in the prior year, however, this was dwarfed by a 17.9% increase in the Cathay Pacific Group’s total operating expense to HK$93.7 billion from a year ago. Earnings per share (EPS) plunged by 60.9% from HK$3.571 a share in 2010 to HK$1.398 in 2011.
“We faced a number of major challenges in 2011 and we are still operating in a very challenging environment, particularly for our cargo business. However, the Cathay Pacific Group has a clear strategic focus and we are moving ahead with a number of initiatives that will make our airlines stronger and provide a better experience for our customers. For example, the Group is taking delivery of 19 new aircraft in 2012; we are introducing a new premium economy class product, new long-haul economy class seats and continuing with the rollout of our acclaimed new business class; we are improving our lounge facilities; and we are building one of the world’s most sophisticated cargo terminals in Hong Kong that is on track to open early in 2013. For Dragonair, we will add more aircraft, launch new products and introduce new destinations this year, all of which will improve connectivity and boost Hong Kong’s role as one of the world’s premier international aviation hubs,” Cathay Pacific chairman Christopher Pratt said.
However, these financial results masked Cathay Pacific’s strong underlying performance during 2011, and despite 2012 looks destined to be an even more challenging year than 2011, with surging fuel prices and softening economy class yields, Cathay Pacific is holding on tight and stands to benefit the most from a potential global economic recovery once it is on a self-sustained path as well as an increase in air travel demand buoyed by the burgeoning Chinese and Asia/Pacific economies.
For instance, the 2010 results were skewed by a HK$3.03 billion non-recurring gain from the sale of shares in Hong Kong Air Cargo Terminals Limited (Hactl) and Hong Kong Aircraft Engineering Company Limited (HAECO) and an exceptionally strong cargo demand as a result of inventories replenishing activities following the 2007-2009 global financial crisis. Had there not been these non-recurring gains, the company would have recorded a 50.1% fall in profits attributable to shareholders instead of a 60.8% fall being recorded.
Passenger revenue rose by 14.2% from 2010’s HK$59.4 billion to 2011’s HK$67.8 billion, on a 5.1% increase in passenger traffic, measured in revenue passenger kilometres (RPKs) to 101.6 billion and a 2.9% increase in the number of passengers carried to 27.6 million passengers. Capacity, measured in available seat kilometres (ASKs), rose by 9.2% to 126.3 billion, thereby leading to a 3% drop in the passenger load factor to 80.4% in 2011. The performance of passenger yields in 2011, measured in revenue per RPK, was superb with an 8.7% gain to a record-high of HK66.5 cents, even outperforming 2010’s HK61.2 cents and the second-highest passenger yield of HK63.5 cents recorded in 2008, despite capacity growth outstripping passenger traffic growth and a weakening yield picture in the economy class cabin, as well as a tampering off in the growth in premium traffic yield towards the end of the year.
On the cargo front, in the meantime, cargo revenue rose by 0.3% to HK$25.98 billion against a backdrop of plunging freight traffic for 9 months in a row, with freight traffic, measured in freight tonnage kilometres (FTKs), declining by 5.2% to 9.65 billion from a year ago whereas capacity, measured in available cargo and mail kilometres, increased by 6.9% to 14.4 billion, thereby leading to a 8.5% drop in cargo load factor to 67.2%. Remarkably, cargo yield increased by 3.9% to HK$2.42 per tonnage kilometre, second only to 2008’s record of HK$2.54 per tonnage kilometre.
Separately, Cathay Pacific finance director Martin Murray revealed in an analysts’ call the airline recorded a start-up loss of HK$1.7 billion for Shanghai-based Air China Cargo (ACC), in which Cathay Pacific has a combined 49% economic interest in the cargo joint venture.
In addition, Cathay Pacific has done a superb job in controlling cost, surging fuel costs notwithstanding. Cathay Pacific’s unit cost, measured in cost per available tonnage kilometre (CATK) without fuel, has stayed stagnant at HK$2.01, versus 2010’s HK$2.02 and 2009’s HK$2.00. This result was remarkable considering the airline’s passenger and cargo growth and Hong Kong’s 2011 inflation rate of 5.3%, Cathay Pacific’s unit cost has declined by at least 8.2% in constant terms over the last three years.
Premium economy to help improve profitability
Since unveiling its premium economy class in addition to its new long-haul economy class, Cathay Pacific has already sold more than 5,000 premium economy seats over the last few weeks, chief operating officer (COO) Ivan Chu told Bloomberg.
The premium economy class seat is a real upgrade over the economy class product, with wider seat pitch at 38 inches versus 32 inches for the new long-haul economy class seats, as well as 8 inches of recline versus 6 inches for the economy product. The design of Cathay Pacific’s premium economy seat was derived from Weber Aircraft’s model 6810, which was also the baseline design for American Airlines and Delta Air Lines’ regional first class and Korean Air’s regional business class, according to an Australian Business Traveller report.
“This is a business class seat for single-aisle aircraft which we’ve modified to suit widebody planes like the 777 and A330. Most premium economy seats are economy scaled up, but this is a true business class seat,” Zobiac Seats, Weber Aircraft’s parent company, vice president (VP) of sales and marketing Robert Funk was quoted as saying.
Moreover, a quick planned rollout of Cathay’s premium economy seats on its long-haul fleet should help improve its profitability by capturing the additional incremental revenue extracted.
Cathay Pacific plans to fit the premium economy class seats onto 48 aircraft by the end of this year, including 23 Boeing 777-300ERs, 17 Airbus A330-300s and 8 Boeing 747-400s; by the end of 2013, 87 aircraft, including 36 Boeing 777-300ERs and 26 Airbus A330-300s will feature the premium economy products.
Most importantly, the premium economy product bodes very well for Cathay Pacific’s profitability since the oneworld alliance member could utilise its strong revenue management system (RMS) coupled with price discrimination to extract consumer surplus from those who are willing and able to pay for a real upgrade to the premium economy product with better seats, food, beverages and services at a 50%-80% higher price than an economy class seat, but unwilling to pay for a business class seat that typically costs as much as 4 times the price of an economy seat.
Furthermore, Cathay Pacific could also employ its revenue management system (RMS) to limit any down-trading from business class while encouraging upgrading from economy class to premium economy class for those economy passengers who pay the standard full-fare. After all, premium economy class is designed for passengers with a higher price elasticity of demand against those price-inelastic business class passengers and the incremental revenue gain would offset any revenue loss from a trade-down from business class, as a price-elastic demand schedule implies a decrease in price would lead to a proportionately larger increase in the quantity demanded of the premium economy product.
“I think the yield improvement of premium economy won’t be the same by every week. So if you average it out in order to make it make sense, I think we need to have premium economy fares of about 1.5, but I think we’ll see a lot, in some cases we’ll see double the economy fares and some cases we may see very marginal gains. And the reasons for that in some markets the premium economy product is well-established, say to London where our competitors have it and it’s already a known well-established market, in some places where that product does not exist at all, it’s going to take some time for us to establish the market for premium economy,” Cathay Pacific director of corporate development James Barrington said in an analysts’ call discussing the full-year 2011 financial results.
“But my gut feeling is on long-haul, ultra long-haul flying, there’ll be a tremendous incentive to trade up from economy to premium economy for a small surcharge and very little concern from our point of view about people trading down. So we see minimal dilution from the business class cabin and a segmentation of the economy class cabin where we’ll pull out all the high-yielding stuff and be able to charge more than a lot of efficiency in our economy class seats,” Barrington reiterated.
And the “intelligent misuse” of long-haul aircraft, as Cathay executives put it on situations where long-haul aircraft are deployed on regional routes instead of sitting on the ground before their deployments on long-haul routes the next trip, would ensure Cathay Pacific capture the growing middle class in China and Asia/Pacific as their incomes soar and these Asian economies continue to grow despite an anaemic global economic recovery.
“Premium economy was obviously designed to give extra comfort for long-haul passengers to trade people up at a surcharge yet to be determined by the market, but 30% of our long-haul capacity operates in the region, so we’ll be operating a significant quantity of premium economy product in the region. We haven’t yet worked out how to price that, but I think if you look at the way which ancillary revenue works with both us and our competitors, everybody has moved away from one price for every seat and we offer, if you’re flying to London in an all-economy configuration, there’s a significant premium people are prepared to pay for exit-row seats and for aisle seats, and I think we’ll probably try to operate that kind of model for premium economy in the region. But we haven’t determined that yet. So at the moment, in the short term you’re going to ride the premium economy at probably economy rates, but I think beyond the very short term, you should expect to pay some kind of premium whether it’s through Asia Miles or through price, it’s yet to be determined,” Barrington commented.
Meanwhile, settling on 4-class and 3-class layouts onboard the carrier’s Boeing 777-300ER fleet enables Cathay Pacific to optimise the use of its fleet and deploy the right aircraft to the right market. In doing so, not only could Cathay boost its revenue streams by removing first-class seats that have low local demand and earning incremental revenue from the business and premium economy classes instead of having a low first-class uptake rate, it could also enable Cathay to deploy the 3-class 777-300ERs to new destinations in the emerging economies first while giving it a tremendous amount of flexibility to up-gauge it to a 4-class 777-300ER later as the market evolves and matures.
Cathay Pacific’s 3-class 777-300ER with its New Business Class, Premium Economy and New Economy Class features 340 seats, dubbed “77D” in the global distribution system (GDS) and which comprises 40 New Business Class seats, 32 Premium Economy Class seats and 268 New Economy Class seats, whereas its 4-class 777-300ER with the first-class product, dubbed “77H” in the GDS, will feature 6 First Class and 53 New Business Class seats, as well as 34 Premium Economy and 182 New Economy Class seats, according to an Airline Route report.
“The plan is to keep first class, in simple terms, that’s not quite like simple as this: but I think half of our 777 long-haul fleet will have 4 class: First, Business, Premium Economy [and Economy] and half of it will be 3 class. There’s clearly market demand for first class, New York, London, Los Angeles and clearly there’s some markets that don’t and then there’re those in the middle,” Barrington said.
“At the moment the plan is roughly 50:50, there’s no plan to get rid of First Class. And we definitely plan to be a full service, 4-class operator to all the markets where there’s sufficient demand for first class but the ones in the middle will, places like Toronto, Chicago, possibly San Francisco, Vancouver, we’ll just sort of wring out the benefit of fleet simplicity, versus matching exact supply with demand,” Barrington stressed.
On the Boeing 747-400, dubbed “74K” in the global distribution system (GDS), it will feature 4-class in a 359-seat configuration, comprising 9 First Class seats, 46 Business Class seats, 26 Premium Economy Class seats and 278 New Economy Class seats, an Airline Route report said, whereas the 3-class A330-300 with the New Business Class, Premium Economy Class and New Economy Class, dubbed “33G”, will feature 38, 28 and 175 seats in the respective cabins, Airline Route said..
On the other hand, Cathay Pacific said it plans to have the New Economy Class on 63 aircraft by the end of 2013, which is a significant improvement over the airline’s existing fixed-back shell seats with additional cushioning, a touchscreen in-flight entertainment system (IFE) with Wi-Fi trials to be conducted later this year, as well as a bigger seat width at 18.1 to 18.5 inches versus 17.45 to 18.5 inches on the existing shell seats, more recline at 6 inches and a nice, small hook for storing personal items below the personal television screen.
The airline said it is currently reviewing options on economy class seats on its regional fleet, which Aspire Aviation‘s sources at the Asia’s biggest international carrier said is very likely to retrofit the regional fleet with the fixed-back shell seats coming from the long-haul retrofitting programme, thereby providing a renewal of the carrier’s regional product at minimal investment.
“We are reviewing our options for the CX regional fleet and we will make a proper announcement when more concrete details are available,” Cathay Pacific spokeswoman Carolyn Leung said.
Separately, the airline said it will have 50 aircraft retrofitted with the New Business Class seats by the end of 2012 and 63 by the end of 2013, which the well-received New Business Class products are already featured on 15 aircraft at the end of 2011.
Outlook, Asian focus
After having a challenging year in 2011 with the devastating Japanese earthquake in March, the flood in Thailand, the Middle East political upheavals, 2012 looks even more challenging with soaring fuel costs and the weak cargo demand, while stabilised, may not pick up again until the second half of this year, contingent upon the global economic recovery and the resolution regarding the bottomless European sovereign debt crisis, of which a combination of the €440 billion (US$575 billion) temporary European bailout fund, the European Financial Stability Facility (EFSF) and the permanent one, the €500 billion European Stability Mechanism (ESM) would create a war chest sufficient in calming global financial markets.
Cathay Pacific currently plans for a 7% growth in passenger capacity, measured in available seat kilometres (ASKs), against an anticipated 6% growth in passenger traffic, measured in revenue passenger kilometres (RPKs), its finance director Martin Murray told industry analysts.
This enables Cathay Pacific to retain flexibility in future growth in its passenger business, as adding capacity later once the global economic recovery is on a self-sustaining path would not be fast enough to realise the revenue gains from the astounding pace of growth spurred by a burgeoning Chinese economy, primarily owing to the inelastic nature of supply in the airline business.
Make no mistake, growing capacity, while lowering the unit cost by reaping the benefits from economies of scale, growing it much faster than the growth in passenger traffic would put undesirable pressure on passenger load factor and hence yields, as the law of diminishing marginal products dictates.
However, the anticipated 1% shortfall between the growth in passenger traffic and passenger capacity is a comfortable scenario which balances the need of capacity discipline and the retaining of flexibility in future growth nicely.
Furthermore, Cathay Pacific’s strategy on focusing on Asian growth for the time being before the European economy eventually recovers and launching routes to secondary European destinations such as Munich, Barcelona on the Airbus A350-900 whose first delivery is scheduled to take place in late 2015, is unquestionably the sound and correct one.
For instance, Dragonair, Cathay Pacific’s wholly-owned subsidiary, plans to add 4 new Airbus A320s and 2 Airbus A330-300s aircraft this year, as well as restoring routes to Xian and Guilin, and is likely to launch routes to new destinations in Thailand and South Korea such as Busan “very soon”, Aspire Aviation‘s sources at Cathay Pacific said.
“Asia’s economies are better than the rest of the world’s at the moment. Traffic around the Asian points is good, we think that’s a pretty good strategy for this year,” Cathay Pacific chief executive John Slosar said in a Bloomberg interview.
Meanwhile, Cathay Pacific’s strong balance sheet enables it to enjoy relatively cheap loans at low interest rates for its fleet renewal programme, with its balance sheet remaining extremely healthy despite a 0.15 times increase in its net debt-to-equity ratio from 0.28 times in 2010 to 0.43 times in 2011.
Cathay Pacific still has 14 aircraft for delivery for the remainder of this year at press time, comprising 3 747-8Fs, 5 Airbus A330-300Es, 4 777-300ERs and 2 Airbus A320-200s, excluding another 2 A320s which Cathay agreed to lease in January. Cathay Pacific has 96 aircraft orders on its backlog.
However, due to skyrocketing fuel prices, Aspire Aviation believes Cathay Pacific will withdraw the 21 gas-guzzling Boeing 747-400s and 11 Airbus A340-300s in its fleet much faster, of which the de facto 747-400 replacement, the 777-300ER, burns 22% to 24% less fuel per tonnage kilometre than the 747-400s, yet has a considerably larger revenue cargo volume. While retiring its 747-400 and A340-300 fleets faster would lead to a spike in the depreciation and maintenance cost items on Cathay Pacific’s balance sheet, the benefits of doing so, with 22% less fuel burn and considerably larger revenue cargo volume, in addition to a smaller economy class cabin which enables Cathay to reduce discounting on the back-end of the aircraft, apparently outweigh the cost of doing so.
“Basically the 777s of which we’ll have a fleet of 50 and the 350-900 ordered that we’ve already announced are, by and large, a mixture of replacements for 747s and 340s, but also allowing us some opportunity for growth. The speed at which we phase out the 747s and 340s is still flexible and that puts us in quite a strong position, I think, to an event of high fuel price and a low market demand, phase the less fuel efficient aircraft out earlier or in the event of a low fuel price and high demand, keep them going for longer. So I can’t really be specific about the plan to exit them, but I think by 2016 and 17, I think you should assume that all of our 747s and 340s have pretty much exited the fleet and we have a fleet of 777s, 350-900s, and potentially -1000s as we already haven’t confirmed any orders for those yet, so that’s the fleet side of it,” Cathay Pacific director in corporate development James Barrington explained.
Looking ahead, Cathay Pacific will start evaluating very large airplanes (VLAs), including the 747-8I Intercontinental and Airbus A380 later this year, with the 747-8I suiting Cathay’s frequency-based business model better, in addition to a larger revenue cargo volume, the sellable cargo space left after fully loading passengers’ luggage. The A380 has a total cargo volume of 5,875 cubic feet and a revenue cargo volume of 2,995 cubic feet, whereas the 747-8I has a total cargo volume and revenue cargo volume of 6,345 cu. ft. and 3,895 cu. ft., respectively (“Cathay Pacific stays on the course of expansion“, 2nd Jan, 12).
“We are going to look at the large aircraft again later this year. That’s the kind of flexibility premium customers value. Anything from one hour to 16 hours, we have the aircraft to do that. Now, after a certain point, you have done as much of that as you can do and it’s natural that down the line you will be looking at bigger aeroplanes,” Cathay Pacific chief executive John Slosar said in an Orient Aviation interview.
Crucially, Cathay Pacific has a lot of options regarding its future fleet, and need not rush to order any very large airplane (VLA) against a backdrop of economic volatility and declining profitability, and could easily exercise its purchase rights for 20 Boeing 777-300ERs for deliveries between 2015 and 2017, as well as options for 10 Airbus A350s to be exercised no later than 2016. This could enable Cathay obtain early availability for big twins such as 777-300ERs or A350-1000s, before deciding on bigger airplanes such as the 407-seat 777-9X that burns 21% less fuel on a per seat basis and has a 16% lower cash operating cost (COC) per seat than the 365-seat 777-300ER with a range of around 8,000 nm (nautical miles), or the 467-seat 747-8I Intercontinental and 525-seat Airbus A380 superjumbo (“Boeing develops 777X to challenge Airbus A350“, 9th Feb, 12).
“We focus on offering global connectivity and maintaining high flight frequency on trunk routes for maximum schedule flexibility to passengers. The fleet mix – A330s, 777-300ERs and future A350s – suits our business model perfectly,” Cathay Pacific spokeswoman Carolyn Leung said.
“The 777-300ER and the A350-900 will be at the core of our long and ultra haul fleet. We will continue to evaluate all available aircraft models for our fleet needs and are not ruling out larger aircraft, including A380s or Boeing 747-8, but this is subject to aircraft needs,” Leung elaborated.
On the cargo front, there is a glimmer of hope after 10 months of consecutive declines in cargo traffic since April 2011 which ended in February with a 2% increase in freight traffic, measured in freight tonnage kilometres (FTKs), as well as the commencement of sale of Apple Inc’s iPad 3. Cathay Pacific currently plans for a 7% growth in freight capacity, measured in available cargo and mail kilometres, downgraded from the 17% and 10% growth targets set at the end of 2011.
“On the cargo capacity, we currently got a planned 7% increase, we could go up as much as 17% increase, so there’s quite a lot of flex in our system. We don’t have any aircraft parked at the moment, so we got good flexibility in the system,” Cathay Pacific director in corporate development James Barrington said.
“In the event that the market picks up, we have got quite a lot of flex in our capacity to put more capacity on and in the event the market goes down, we’ve 30% of our cargo volume on the bellies of our passenger aircraft, and so we’ll simply match supply with demand by reducing the amount of flying of our freighters.
“But predicting what the cargo market, the air cargo market is going to do, it’s very difficult. But our fundamental belief is that Hong Kong and China will remain the production centre of the world. If you’re setting up a cargo business anywhere in the world, it’s pretty hard to find a better place than Hong Kong and also Shanghai where we have a JV cargo operation with Air China. And so when that cycle comes back, we’ll have the infrastructure with the new cargo terminal, joint venture with Air China and the underlying capacity to take advantage of a market that returns,” Barrington commented.
Indeed, Cathay Pacific would be the biggest beneficiary once the now stabilised but still weak cargo market recovers, given its freight network connecting all the major worldwide cargo markets with all the interior points in China via Hong Kong, as well as via its Air China Cargo (ACC) joint venture (JV) in Shanghai. By limiting its cargo capacity growth to 7% while maintaining spare capacity of up to 17%, Cathay Pacific could respond to a potential cargo market upturn quickly and realise a handsome profitable growth in the cargo market.
And despite the aforementioned upfront start-up loss recorded at the Air China Cargo (ACC) joint venture (JV) in the competitive Shanghai cargo market with China Eastern’s China Cargo Airlines and HNA Group’s Yangtze River Express, the growth of manufacturing industries in the Yangtze River Delta, coupled with a dual cargo hub strategy with Cathay Pacific Cargo in Hong Kong capturing demand from the Pearl River Delta (PRD), this positions Cathay Pacific very well to reap the most benefits over the long term, despite the significant short-term challenges.
In the meantime, Cathay Pacific director in corporate development James Barrington said in an analysts’ call that the airline has yet to make a firm decision regarding the withdrawal of the Boeing 747-400 BCF (Boeing Converted Freighter) fleet, a decision of which will only be made upon the maintenance milestone is reached. Aspire Aviation thinks Cathay Pacific will eventually decide to replace its 747-400 BCF fleet with the 777-200F freighter fleet, primarily owing to the very significant cash outlays involved in the 747-400 BCF’s maintenance and its fuel inefficiency, which burns 24% and 15% more fuel than the 777-200F and 747-400F freighters on a typical 3,000 nautical miles (nm) trip, respectively.
The 777-200F freighter can perform the 747-400 BCF’s missions comfortably and efficiently, of which the former can fly 4,900 nautical miles (nm) with 102 tonnes of payload whereas the 747-400 BCF has a range of 4,091 nm with 107.8 tonnes of payload.
In conclusion, Cathay Pacific is ready for an eventual economic upturn, with its significant product investments in the roll-out of its New Business Class, Premium Economy Class and New Economy Class, lounge upgrades, a sparkling cargo terminal that will lower the cargo handling cost and boost the cargo handling efficiency when it enters into service in 2013. After all, in the difficult airline business where margins of error are as thin as the air in 40,000 feet, it is those who have the long-term visions with a prudent financial and operational management succeed. Cathay Pacific, an extremely well-managed airline, has achieved this before and it is going to surprise the sceptics and naysayers again in the future.
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