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Morningstar | Despite Cathay's Unexpected Jump in Profit, We Are Maintaining FVE at HKD 12.2.

No-moat Cathay Pacific released a profit alert on Feb. 20, guiding a net profit of approximately HKD 2.3 billion versus Morningstar’s estimate of HKD 893 million. This implies the airline made roughly HKD 2.6 billion in the second half of the year. While we applaud the carrier’s efforts in turning profitable after two years of losses, our long-term assumptions for Cathay are unchanged based on this announcement. As a result, we are maintaining our fair value estimate of HKD 12.20 on the operator and await full-year results for more strategic commentary and greater financial disclosure.

The carrier’s passenger business benefited from a 4% capacity expansion that was matched by a similar level of demand in the second of 2018. At the same time, higher fuel prices during the period allowed Cathay to increase prices and further lift Cathay Pacific’s passenger and cargo yields, while reducing its hedging losses on fuel. We believe strong cargo performance also boosted the firm’s earnings for the second half, as the U.S.-China trade war has pulled forward shipments in anticipation of higher tariffs to be imposed by both countries.

Going into this year, we believe passenger capacity will continue its track of expansion, due mainly to the reconfiguration of economy class, from nine-seat to 10-seat rows on some of the Boeing 777 aircraft. However, with our expectation for oil prices to pullback and Brent to average USD 60 per barrel within the next five years, the carrier’s yields are set to face pressure. Our current fair value estimate for Cathay Pacific implies a midcycle operating margin of 8% and a free cash flow margin of 5%.