Idea of the Week: Cathay Pacific Turning Losses into Profits! Attractive bond yields of 5.6%

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Highlights:

Company Background

Cathay Pacific (referred to as "Cathay") was established in 1946 and is Hong Kong's flagship airline. The company is currently listed on the Hong Kong Stock Exchange (stock code: 293.HK) with a market capitalization of approximately HK$52.4 billion.

Cathay's business includes passenger air travel, air cargo services, catering, laundry, and ground handling. Its subsidiaries include Hong Kong Express Airways (a low-cost airline) and Air Hong Kong (a cargo airline).

Cathay operates a total of 225 aircraft, including both passenger and cargo planes, and holds a market share of about 50% in the Hong Kong aviation market in terms of passenger capacity.

Recovery in Passenger Numbers and Turning Losses into Profits

Cathay's main source of revenue comes from its passenger transportation business, which accounts for 63% of its total revenue. Cargo and other services contribute 29% and 8% of the total revenue, respectively. Subsidiaries Hong Kong Express Airways and Air Hong Kong generate around 6% and 4% of the company's revenue (see Chart 1).

Chart 1: Cathay’s Revenue Distribution

Following the lifting of quarantine requirements by the end of September 2022, the number of passengers in Hong Kong began to recover. Currently, monthly air passenger traffic has reached approximately 60% of pre-pandemic levels. This has led to a significant increase in Cathay's revenue in the 1H2023, with a YoY growth of 135% to HK$44 billion, approaching pre-pandemic levels (see Chart 2).

After three years of losses, Cathay has successfully turned a profit, recording a net profit of HK$4.3 billion. Although the net profit includes the one-time gain from the sale of a 1.9% stake in Air China, excluding this HK$1.9 billion gain, the company still has a net profit of around HK$2.4 billion. This is higher than the 2019 level, reflecting its continued improvement in operational performance.

Chart 2: Revenue and Net Profit Trend

Strong Demand for Passenger Transportation is Expected to Boost Operating Performance

Cathay Pacific's passenger transportation business experienced a significant rebound in the first half of 2023, with available seat kilometers (ASK) growing over four times YoY, and revenue passenger kilometers (RPK) growing over five times YoY (see Chart 3). (*ASK is the number of available seats multiplied by the distance travelled, serving as a measure of passenger-carrying capacity. RPK refers to the number of revenue paying passengers multiplied by the distance travelled. It is a unit measuring passenger transport volume.) Additionally, the passenger load factor reached 85.7%, surpassing the 82.3% recorded in 2019, indicating strong passenger demand.

Chart 3: Passenger Business Metrics

During the pandemic, Cathay Pacific had to reduce flight routes, frequencies, and staff due to insufficient demand. In 2020, the company also ceased operations of its subsidiary, Cathay Dragon, in order to reduce costs. As a result, available seat kilometers (ASK) experienced a significant decline of 4.5 times, leading to a decrease in the company's passenger carrying capacity compared to previous years.

However, considering the slower recovery pace of the aviation industry in Asia compared to other parts of the world, Cathay's recovery in the 1H2023 and its market share in Hong Kong, there are signs of sustained recovery for the company. This is expected to drive its business performance.

Fuel Hedging Reform and Improved Fuel Risk Management

One of the factors contributing to Cathay Pacific's perceived mismanagement was its high fuel hedging ratio and misjudgment of oil price trends in 2015 and 2016, resulting in investment losses of approximately HK$8 billion in two consecutive years (see Chart 4). However, starting in 2017, the company initiated a corporate transformation plan to reform and control fuel hedging, leading to a successful turnaround from losses to profits in 2021 and 2022.

Fuel costs are a significant cost in airline operations. Cathay's fuel costs as a percentage of total operating expenses decreased from a high of 39% in 2013 compared to peers to 21% in 2022. This indicates a lower sensitivity to fuel price fluctuations and reflects the company's improved cost control and fuel risk management.

Chart 4: Fuel Hedging and Expenses

Ample Liquidity and Stabilizing Credit Situation

In terms of credit, Cathay Pacific had a total available liquidity (including cash, short-term investments and undrawn credit facilities) of HK$28.9 billion in 1H2023, representing a 45% increase compared to 2019. This reflects the company's efforts to maintain more abundant liquid funds to address unforeseen economic impacts following the pandemic. It is worth noting that cash and short-term investments also saw a significant increase of 64% to HK$24.1 billion in 2019. The cash/ short-term debt ratio improved to 2.5 times, indicating that the company has not only relied on external credit facilities but has also increased internal funds to enhance its own liquidity.

Overall, the company's liquidity position is strong, with sufficient available liquidity to cover all short-term liabilities (excluding contractual liabilities), totaling approximately HK$28.2 billion.

In the past two and a half years, Cathay Pacific has been actively reducing its total debt by about 20%. At the same time, its cash and short-term investments have increased by approximately 26%, which has resulted in a decrease in net debt (see Table 1). The net debt ratio has decreased by 11 percentage points to 92%, and the net debt/EBIT ratio has decreased from 16.1 times in 2022 to 5.6 times, which is still not particularly ideal but shows significant improvement.

Furthermore, the company has an interest coverage ratio of 7.5 times, indicating a strong ability to meet interest payments. Based on the gradual recovery of air passenger traffic, it is expected that the company's profitability and balance sheet will continue to improve, indicating a stabilizing overall credit situation.

Table 1: Cathay’s Credit Metrics

Aircraft and Equipment Collateral and Good Government Relations Bring Financing Advantages to Cathay Pacific

The airline's planes and equipment can be used for financing through secured loans. As of the end of June 2023, only 63% of Cathay Pacific's planes and related equipment (with a book value of HKD 47.9 billion) were used as collateral for secured loans and other borrowings. This means that there are still some unencumbered assets that can be used to obtain secured loans when needed, indicating that the company still has a certain financing capacity.

On the other hand, Cathay Pacific has a good relationship with the Hong Kong government. In 2020, when the company's passenger volume dropped by nearly 80% and faced operational difficulties, the Hong Kong government provided a commitment of HK$27.3 billion in assistance to the company. The assistance included HK$19.5 billion in preferred shares and HK$7.8 billion in bridge loans to help the company overcome its operational challenges. The Hong Kong government also stated that the assistance was provided because Cathay Pacific has a certain impact on the economic development of Hong Kong as an international city, reflecting the company's importance in the government's eyes. The government may be willing to lend a helping hand to the company when necessary, bringing it financing advantages.

Bond Investment

Currently, we have one Cathay Pacific bond available for trading on our platform. The bond has a maturity date of August 2026. The following table provides some other details:

Table 2: Cathay Pacific Bond Information

The issuer and this bond do not have any credit ratings. The current yield to maturity is 5.6%. Considering the company's current credit situation and its relationship with the Hong Kong government, we believe its credit status is comparable to peers with a lower investment-grade rating. Furthermore, this bond has a higher yield compared to similar bonds with similar maturity among its peers, making it attractive to investors.

Corporate Risk

The company announced its plan to purchase 38 aircraft in eight installments, with delivery scheduled for 2029. Although this expense can amount to HKD 57.4 billion and may affect its liquidity and repayment capability, most of the amount will only be paid in 2029. Therefore, the impact on the repayment of the 2026 bonds is limited.

While Cathay Pacific's sensitivity to fuel price fluctuations has decreased, investors need to note that the airline industry is inherently highly seasonal and operates with a certain level of uncertainty. Geopolitical risks and volatility in fuel prices can still impact the company's operations and debt-servicing ability.

Currently, the company can still issue bonds in the public market. However, if this financing channel is affected, it will further increase the cash flow pressure on the company and weaken its ability to raise funds through refinancing.

Conclusion

As Hong Kong has lifted quarantine requirements, the number of local passengers has gradually recovered. This has allowed Cathay Pacific to successfully turn losses into profits, and there is hope that it will drive its business performance.

With the improving operational capacity, the company has a healthier cash flow, and its overall credit situation is stabilizing.

The yield to maturity of Cathay Pacific's 2026 bonds is 5.6%. Considering the company's current credit situation and its relationship with the Hong Kong government, we believe its credit status is comparable to peers with a lower investment-grade rating. Furthermore, this bond has a higher yield compared to similar bonds with similar maturity among its peers, making it attractive to investors.

Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

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