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Morningstar | The Worst Is Over for Cathay; FVE Lifted to HKD 12.20

We are raising our fair value estimate for no-moat Cathay Pacific Airways to HKD 12.20 from HKD 11.60 as the company continues to show signs of solid recovery. First-half operating profit was HKD 697 million versus an operating loss of HKD 1,704 million for the year-ago period, above our estimate. Strong passenger yield, at 7.6% year-over-year growth, came on the back of a negligible 0.5% drop in load factor. Cathay’s cargo business (around 24% of overall revenue) remains robust, with revenue for the segment up 23% as a result of a robust 16% yield improvement. We raised our projected passenger revenue per available seat-kilometer for 2018 and the following years, in concert with Cathay Pacific’s first-half finish and our latest outlook. Cathay shares are trading at a slight 3% discount to our fair value estimate, and we recommend that investors wait for a wider margin of safety before buying this high-uncertainty stock.

On the passenger side, the carrier posted yield improvements for all six of its major operating regions. Strong growth was partially driven by 3.2% capacity expansion, namely with the introduction of new routes and increased frequencies on existing routes. At the same time, the carrier added a significant amount of capacity to its European routes. We think this is a sensible move, especially during a time when many Chinese airlines are prioritizing profitability over international expansion. However, given that traffic volumes in Europe have yet to catch up with the added capacity, we remain wary of the potential benefits these routes will bring to the group’s bottom line. Demand for Cathay’s premium cabin has also been strong in the first half, and we believe it will continue to drive additional revenue opportunities.

We now forecast Cathay Pacific’s passenger revenue to grow at an average of 4% over the next 10 years as the carrier continues to add capacity at a moderate rate. We see passenger yields rebounding in the near term and remaining at around HKD 0.56 over the long term. We also estimate that passenger load factors will hover between 84.6% and 85.1% throughout our explicit forecast period.

Cathay’s cargo operation is on track for recovery thanks to growing e-commerce shipments out of Asia, leading to demand outgrowing capacity added. Rising demand for specialist cargo and movement of higher-value goods will strengthen the yields on the cargo side. We now project the carrier’s cargo revenue to grow at an average of 4.8% over the next 10 years, driven by moderate capacity expansion, improving yields, and stabilizing load factor.

On the cost side, we are seeing cost-cutting efforts beginning to bear fruit. The group’s reorganization efforts have led to some reduction in unit staff cost. On the other hand, underlying cost per available tonne-kilometer (excluding fuel and exceptional items, and adjusted for foreign currency) grew by merely 3.3%, slower than the capacity expansion of 3.7% during the first half of 2018. While we remain optimistic regarding Cathay’s devotion to cutting costs, some of the cost savings will inevitably be passed onto the end consumers, given that the carrier operates in an industry that is highly exposed to low switching costs and price transparency.