Cathay at the Crossroad

The highly successful carrier faces what CEO Tony Tyler believes is its greatest challenge.

By Geoffrey Thomas
Air Transport World, December 2009, p.26

A CROSSROAD IS DEFINED AS A PLACE where a decision must be made, and Cathay Pacific Airways CEO Tony Tyler declares that aviation is once again at the crossroad. "We have been here before. We know it well, but this time the decisions are harder. In fact, we simply don't know which road to take," he reflects as he gazes out over Hong Kong Harbor from his downtown office. The fact that Cathay has not yet identified the best path forward is hardly a reflection on the airline's competence--anything but. It is a recognition that the industry's constant companion is the (possibly apocryphal) Chinese curse: "May you live in interesting times." Tyler muses that "the one thing I've learned during my airline career [is] that just when you think things couldn't get worse, they usually do." And "things" at Cathay are as bad as they ever have been.

In March the carrier reported an unprecedented reversal in fortune with its first annual loss in a decade, a record deficit of HK$8.56 billion ($1.1 billion) for 2008 that compared to a record net profit of HK$7.02 billion in 2007. It was a perfect storm result, suggests Tyler. Shrinking passenger and cargo demand combined with a HK$7.97 billion noncash loss on fuel hedging and a stunning collapse in yields attacked the airline from all directions. And while the headlines pointed the finger at fuel hedging, he is quick to point out that both CX and its Dragonair subsidiary recorded record operating losses as well. "This is for real," he laments. "Without trivializing it, hedging is not the main problem. It's the collapse in revenue."

In response, Tyler cut passenger capacity by 8% in April and appealed for voluntary unpaid leave for all employees. At the time he summed up the situation thus: "We anticipate an extremely challenging year in 2009, and a toxic combination of low fares, a big drop in premium travel, weak cargo loads, poor yields and a negative currency impact are making it more important than ever to preserve cash." The passenger capacity cut included a reduction of flights to 11 destinations, additional flights to Denpasar, Sapporo and Bahrain/Riyadh and a 13% cut at Dragonair, which suspended service to Fukuoka, Dalian, Shenyang, Guilin and Xi'an. Cargo capacity was lowered 11% with weekly freighter flights falling to 84 from last year's peak of 124. The decision to suspend those cities was tough, as CX had been adamant that tampering with the network structure was a last resort.

The leave scheme involved all 17,000 employees, each of whom was asked to take 1-4 weeks of unpaid time off before April 2010, with executives taking the most pain and also either forgoing any bonuses or having them significantly reduced. That medicine was required as the airline endured a 27% fall in revenue during the first six months of 2009 on the back of a 23% drop in passenger receipts and a 40% plunge in cargo billings. That led to a HK$1.2 billion outflow of cash from operating activities, causing the debt-to-equity ratio to rise from 0.69 to 0.81. Although CX posted a half-year profit of HK$812 million, this primarily was owing to HK$2.1 billion in unrealized mark-to-market fuel hedge gains. The underlying loss was HK$3.5 billion, versus HK$605 million in the year-ago period.

Tyler ponders the past 12 months and says he "cannot remember the industry being in such bad shape" in his 30 years of experience. "Yes recessions have hit now and then, but nothing like this one. Yes the Asian financial crisis hit us hard, but that was in Asia. Yes after 9/11 traffic collapsed, but mostly only on routes involving North America and Europe. This time it's global. It's passenger and cargo." And he is no pessimist--far from it. "In Hong Kong, optimism is a way of life, but so is pragmatism. We have been hardest hit because we, like our friends three hours south of here along with Japanese airlines, have a high degree of dependence on premium passengers, who we all know are staying at home in droves. And we don't have any domestic markets, which have generally remained quite resilient."

He notes that while the Chinese economy has weathered the financial storm remarkably well aided by some massive state intervention, international traffic in and out of the mainland is in the same deep trough as its global counterpart, which is borne out by tourist numbers down 90% at the Great Wall in June. Another factor is Asian airlines' heavy dependence on cargo. "In a good year cargo can account for as much as 30% of Cathay Pacific's revenue. Sadly, that will not be the case this year."

No Green Shoots

Tyler laughs off the suggestion that the airline industry is seeing so-called "green shoots" of recovery: "We're not seeing much of that kind of plant life ourselves, but there has been a stabilizing of the big drops in cargo and passenger numbers that we witnessed right up to the summer months of this year." Cathay's management views the "slight hints of recovery" as seasonal rather than structural. "I remain cautious. What I think is happening is a slow recovery effect exaggerated and amplified by seasonal factors." However, he says that "when the true recovery comes, Asia will lift more quickly."

While not being sure of which way the market will go or when the "true recovery" will arrive, Cathay is conducting a top-down analysis of its business and nothing is sacred, says Tyler. "We are looking at every aspect of our operation and we will have most of the work done by the end of the year." On the question of whether the changes recommended will be evolutionary or revolutionary, he suggests it is "too hard to say."

CX also will be looking at where the market is going and examining such things as the no-frills approach, particularly in the economy class product, and the various pay-for-what-you-want options for things such as seat allocation and exit row seats. Tyler is less concerned about the long-haul low-cost model than about regional infiltration from carriers such as AirAsia. In response, CX has been discounting the back end of its regional fleet. "I don't have the answer. We are doing okay so far but in the long term I am not sure."

Despite the downturn, Cathay has continued to roll out its new interiors launched in 2006 across the fleet, with all aircraft to be fitted by year end. It also added some frequencies and new services, such as an additional four flights a week to Denpasar to meet summer demand, moving Sapporo from four flights a week to daily, making the Bahrain/Riyadh service daily and launching a weekly freighter service to Jakarta and Ho Chi Minh City and a three-times-weekly freighter service to Miami and Houston.

While it has made the headlines with deferrals, Tyler tells ATW that delivery of Cathay's 777-300ERs was renegotiated during the Boeing machinists' strike last year. "We have deferred the 777s by a cumulative 60 months," he notes. It has 19 777-300ERs to be delivered with seven in service. It also has parked seven 747s, including five freighters, along with four A340s at Victorville, Calif.

Although the delay in the 747-8F program would appear to be good news, he is unhappy that the order for 10 placed in November 2007 will be late. "We have planned this aircraft for our fleet as they are very good aircraft, but we will have to chop and change our aircraft, which is extremely inconvenient," he says. "We have always wanted the most efficient aircraft." To that end, CX retired the last of its 747F Classics this year, three years ahead of schedule.

The carrier has found the 747-400ERF's performance "impressive." It received three in 2008 and three more this year, completing its order for six, with the last one delivered in April being the final member of the 747-400 family. But new orders for larger passenger aircraft are off the radar. "We are not pursuing the A380 or 747-8I at the moment," Tyler says. However, CX is interested in smaller options such as the A350 and 787, and he suggests that if the A350 does what it says "on the box," it will be a great aircraft.

He dismisses suggestions that the downturn will drive consolidation. "Every time we plunge into crisis, the rallying cry goes up that it will all lead to consolidation within the industry. It never has yet and I don't think it will this time either. If anything, governments get even more protective of their national airlines in bad times than they are in good and many are happy to pour in taxpayers' money to keep them flying." He adds, "In an ideal world, real consolidation would lead to fewer but stronger airlines and a more competitive industry, but unless we tear up the rulebook governing international civil aviation, things are not going to change."

In a twist for Cathay, the return of Hong Kong to Chinese control in 1997 has allowed an "excellent" equity relationship with Air China to develop and more cooperation is in the pipeline, according to Tyler. The realignment with Dragonair consummated three years ago also has provided more cross-traffic than was anticipated. In September there was a further change in shareholdings, with CA taking its stake in CX to 29.99% and Swire Pacific lifting its share to 41.97%.

Tyler is adamant that Swire Pacific is committed to Cathay and will remain its largest shareholder. But he also recognizes that the airline's future lies in China, particularly Guangdong Province at Hong Kong's doorstep. "Guangdong Province has a population of 110 million--equal to that of Italy and Spain combined--and accounts for about one-third of China's exports and double those of India," he says. "And the GDP of both Guangdong's capital Guangzhou and Shenzhen, the city which borders Hong Kong, are each bigger than that of Vietnam."

He adds that 30 years ago when he arrived in Hong Kong, he was taken to the border and saw paddy fields. "Now those fields have become Shenzhen. It stands today as a towering metropolitan metaphor for China's extraordinary growth over that time . . . And 30 years ago only 3 million Chinese flew. Today, that number is 200 million and it will be 600 million in 20 years."

Cross-Straits Challenge

A downside for CX and Dragonair has been the opening of direct cross-straits flights between Taiwan and the mainland, although it is not as bleak as has been painted. While much of Taiwanese business has invested in China, companies often have branches in Hong Kong and thus triangulate their journeys. "We also have feed traffic through the Hong Kong hub to our other destinations in Southeast Asia, India and the Middle East. So all is not lost."

To handle the eventual increase in traffic, CX sees the need for a third runway at Hong Kong International and that currently is being evaluated. Significant air traffic control improvements for the Pearl River Delta are being rolled out. In October, changes to flight paths for the region were launched that saved the airline 8 min. on some flights. These improvements are through joint efforts with IATA and the Hong Kong Civil Aviation Department. In 2012, significant ATC improvements will be launched.

The largest market for Cathay from an ASK perspective is North America, which accounted for 27% of the total in 2008, a 24% jump on the prior year, followed by North Asia at 21%. The other major improver is Australia, New Zealand and South Africa, which increased 20% between 2007 and 2008 to account for 15% of capacity. In terms of turnover by origin of sale, Hong Kong and the mainland account for 41.5% of the total followed by Japan and Taiwan with 14.1%, North America (13.5%), Europe (12.3%), Southeast Asia and Middle East (11.5%) and Southwest Pacific and South Africa (7.1%).

A sobering perspective on how dramatic the reversal of fortune has been is the fact that in the first six months of 2008 the two airlines set a new interim passenger revenue record of HK$28.3 billion, up 34.8% (restated) on the same period last year. In the first six months of 2009, by contrast, passenger revenue slumped 22.9% to HK$21.81 billion and yield dropped 19.7% to HK49.7 cents while passenger numbers slipped 4.2% to 11.9 million.

Biggest hit was on North America services, which decreased 22.1% on an ASK basis, with North Asia--mainly Japan--sliding by 3.7%. Interestingly, all other markets increased, with Southeast Asia and the Middle East jumping 15.4%. On the cargo side, the first half of 2008 saw a rise of 6.8% to 828,399 tonnes, but in the corresponding period this year there was a drop of 15.3% to 700,693 tonnes.

Pondering the numbers, Tyler suggests that "the best we can say right now is the worst may be over and we have to face the fact that the business model that has served us so well for so long may need to be changed. We are possibly facing a new normal in the airline business." And that is a big statement from the world's most consistently profitable carrier that has become the industry standard for excellence.

ATW

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