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Cathay Pacific Airways (0293.HK) - Still on the way toward recovery

Monday, August 24, 2009

4878

Cathay Pacific Airways(293)

Recommendation on 24 August 2009
Recommendation	BUY
Price on Recommendation Date	$11.440
Target Price	$13.600

Weekly Special - 603179.CH Xinquan

Summary

Cathay Pacific's revenue in 1H09 dropped 27% y/y impacted by economic recession. But benefited by cost decline of 32% y/y, it reported positive profit of HK$812million. While it is worth noting that excluding the booked profit of fuel hedging of HK2.07billion, 1H09's operating profit really finished with a loss of HK$765million.

Weak demand resulted in decline both in L /F and yield while we expect Cathay Pacific will record 50% less in its fuel cost for the full year in FY09.

Latest data imply slowing of traffic decline. But competition is getting fiercer, suggesting a hard recovery in full. Recent purchase of 12.5% stake by Air China is positive for Cathay's exposure to the bustling domestic air market. We give it 10% premium cautiously based on 1.16x P/B and 12m TP of HK$ 13.6, 19% up from the present price, rating Buy.

HK$812 million profit is only on book

Cathay Pacific Airways is the major air line company in HK. It has advantageous location and has a fleet of 154 aircrafts in operation. In 2007 attributed to its merge with Dragon Airline and share investment in Air China, the Company's performance in 2007 had a large jump of 72% to HK$7billion. In 2008, however, it reported loss of HK$8.56billion dragged by fuel cost inflation and great loss in fuel hedging.

Its revenue in 1H09 dropped 27% y/y impacted by economic recession. But benefited by cost decline of 32% y/y, it reported positive profit of HK$812million compared to losses of HK$760million in 1H08. EPS stood HK cent 20.6, no dividend (the second time).

While it is worth noting that excluding the booked profit of fuel hedging of HK2.07billion, 1H09's operating profit really finished with a loss of HK$765million, less HK$730million than the loss of 1H08, EPS of HK$-0.194, in line with our expectation.

If Cathay Pacific qualified for the real cash payment of about HK$2.87billion resulted from the fuel hedging and relative taxes, then the underlying loss would have been HK$-3.47billion in 1H09, still at the bottom period.

Weak demand resulted in decline both in L /F and yield

The global recession in 1H09 still weigh on traffic and yield extremely for airlines. The Downturn in Cathay Pacific's key markets has been deep and sustained and has sharply reduced passenger and cargo revenue.

Though passenger volume only decline 4%, the average air fare is dragged greatly by a fall in premium business and fiercer competition in economy class. Combined with unfavorable foreign currency movements, its passenger revenue, 70% of its total, dropped 23% y/y with yield down 19.7% y/y and passenger L/F fell by 1.5pts to 78.5%.

Cargo business was even worse impacted by the continuous fall in air cargo demand of the world. A 14.1% y/y drop in ATK hasn`t been compensated by a 15.3% decline in cargo volume, as a result the cargo L/F decreased by 0.2 pt. Yield and revenue dropped 32.8% and 39.5% respectively.

Fuel price drop leads cost per ATK cut of 26%

The Company reported fuel expense drop of 56% supported by average fuel price decline of 51% and fuel consumption decline of 8%. Combined with the profit of HK$2.07billion resulted by fuel hedging, it finally reported a positive book performance. The proportion of fuel expense dropped to 23% in the total operational cost from the 50% in 2008.

Its cost per ATK dropped 26% y/y to HK$2.57, but increased 4.8% to HK$1.98 excluding the fuel factor, mainly led by increased depreciation due to new aircraft deliveries since the Company accelerated the replacement of the older with the new fuel-efficient fleets.

Fuel price bottomed up in Feb. 09, and surged from the 2Q with May recording the biggest monthly rise in 10 years, yet were still lower than the peak in July, 08 after a 50% rise from the bottom. Carriers thus get out of the woods. We expect Cathay Pacific will record 50% less in its fuel cost for the full year in FY09. However, it may still face the trouble of oil price rebound once the economy recovers.

Hedging loss rely on future fuel price trend

Fuel hedging may reduce the negative impact brought by fuel price fluctuation. But some carriers encountered big loss in 2008 for their unwise strategy of hedging concerned for hedging cost. According to the management, Cathay Pacific hedged 30% of fuel in the next 12Ms.

From its report, if the oil price is at a level of HKD 45 per barrel in the coming three years, then the Company will be required to pay a total of about HKD 1.4 billion to settle the contracts. But if the average oil price is approximately HKD 75 per barrel, there will be no further net cash impact, and the mark to market losses of HKD 7.6 billion in 2008 would be released in subsequent periods. We forecast that there's very little possibility that the global oil price splash again, then the Company's hedging loss will likely be released gradually.

2H09 outlook: possible to bottom but hard to recover in full

Latest data imply slowing of traffic decline. But with premium passengers turning to economic seats, competition is getting fiercer, suggesting a hard recovery in full.

Dragged by weak economy, H1N1, and direct flight between Taiwan and mainland China, the Company saw business wave from the late in May. its passenger traffic dropped 9.9% in July, accumulating -5.1%; but its cargo improved, with volume extricating from double digits fall in June and narrowing to -3.7% y/y in July.

The management denied equity financing in the near future for the Company has sufficient cash to cover working capital need and acknowledged to continue replacing old aircrafts with new fuel-efficient ones.

We expect some time is needed before the whole market recovers to the level before the crisis. Recapitalization could not be ruled out if the market demand or fuel cost continues to worsen.

Risks

Impact by recessed global economy, bearish of aviation demand may go beyond expectation;

As the company holds a large short position in USD, USD appreciation will bring exchange losses;

Hedging loss will further enlarge due to global crude oil price fluctuations;

Crisis such as terrorism, flu and wars;

Air fare war.

Valuation

Technically, the stock price has strong correlation to HSI at 0.95 in coefficient, and has increased c. 40% in the past six months or 65% from the bottom this year, mainly supported by the positive recovery expectation. At present, it bounds within the range of HK$9.95 and HK$11.5, from which it will go up once breaks though the platform.

As for valuation, based on its P/B trend in the past nine years, we think 0.9x-1.4x is its reasonable PB range for stable growth and 1.8x as the upward prospect. Recent purchase of 12.5% stake by Air China is positive for Cathay's exposure to the bustling domestic air market. Given the good reputation and strong competitiveness, the Company is reasonable to have some premium. We give it 10% premium cautiously based on 1.16x P/B and 12m TP of HK$ 13.6, 19% up from the present price, rating Buy.

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