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Morningstar | Uncertainties Around Geopolitical Tensions Weigh on Cathay’s 2019 Outlook. FVE Kept at HKD 12.20. See Updated Analyst Note from 13 Mar 2019

Our HKD 12.20 fair value estimate and no-moat rating are unchanged after Cathay Pacific Airways reported full-year earnings of HKD 0.60 per share, in line with management’s prerelease figures. While the market reacted positively to the announcement, presumably due to higher-than-expected supply growth guidance for 2019, we do not believe new supply will be matched by demand in the near term. Our long-term thesis for the carrier remains in place, but we think the first half of 2019 will be a challenge as geopolitical tensions and the strong U.S. dollar weigh on Cathay.

While management expressed confidence around bookings for Easter, they also admitted worries on maintaining the strong yield recorded in 2018. For 2019, we expect a 5% passenger yield drop, driven mainly by our oil price forecast that points to a 9% drop in Brent. Over the next couple of years, we remain optimistic about strong demand for Cathay’s premium cabin and believe it will offset some declines in yields. It is also worth noting that Cathay plans to grow overall available-seat-kilometers, or ASK, by 6.8% for 2019. If realized, this will be the fastest supply growth we have seen since 2008. While some of these new ASKs come from the reconfiguration of economy class on existing routes, we expect demand growth to trail that of supply, leading to a 100 basis points drop in the passenger load factor for 2019.

The group’s cargo business continued to improve during the second half of 2018, with revenue up 15% as a result of yield improvement. Although rising demand for specialist and more expensive cargo will continue, this segment is experiencing drastic load factor decline as result of geopolitical tensions between China and the U.S. Expectations around tariff hikes pulled forward shipments, resulting in much weaker expected cargo performance over the months to come. While we project the carrier’s cargo revenue to drop by 16% in 2019, our midcycle growth rate for the segment remains at 3%.

On the operating expenses side, Cathay’s unit cost (ex fuel and exceptional items) increased to HKD 2.16 from HKD 2.12, or a year-over-year increase of 1.9%. Much of the increase in unit cost was driven by investments in the Asia Miles program and ancillary cargo services, coupled with a one-time bonus payout for employees. Management's goal is to maintain unit cost flat for 2019 at least. Our valuation assumes a relatively flat ex-fuel unit cost over the next 10 years.

While China’s grounding of Boeing 737 MAX 8 is catching media headlines, Cathay is immune from the order given the absence of such a model in both its existing fleet and order book. To some extent, the carrier stands to benefit from the grounding as its major Chinese rivals have between 2% and 4% of their fleets composed of the Max 8. While we have not altered our forecasts based on this incident, the potential suspension of Max 8 deliveries for rivals can translate into opportunities for Cathay.