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MARCH 2019

Week 10

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Hong Kong Airlines outlook

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March 8th 2019

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Will there be a political or aviation solution? Investor must define a future and untangle HKA from HNA. Read More »

There is growing likelihood HNA will sell HK Express without requiring the investor to also purchase Hong Kong Airlines (HKA). The full-service airline is in the middle of a growth period, requiring the investor to decide what direction to take. The investor could resume growth and capital injection. Or the investor would have to make some cuts with associated financial implications.

Likely investors can be categorised as providing a political solution or an aviation partnership. One theory is that a consortium of Hong Kong or mainland Chinese conglomerates buy HKA as a favour to or to seek status with the central government in Beijing, which is watching proceedings at HNA, the large conglomerate that is almost a de facto state-owned enterprise.

Another theory is that a foreign airline would invest in HKA, presumably for market access. The network appeal of HKA depends which region the investing airline is from. Foreign ownership is not capped in Hong Kong, but airlines must have their principal place of business in the city.

An airline or blue-chip conglomerate may be unable to complete due diligence. Cathay Pacific was reported to be interested in HK Express and HKA. Cathay’s official statement only said it was in active discussions with HK Express.

Singapore’s investment fund, Temasek, was reported over many months to be interested in a minority HKA stake. Temasek never confirmed speculation while media reports said Singapore Airlines, majority owned by Temasek, was not involved.

Making Hong Kong Airlines a sustainable business is challenging. There is a view that prior to long-haul expansion, the regional network was sound and could be made profitable. The counter-point is that the leap needed in future cost reductions could only be achieved with long-haul flying, which has lower costs and brings efficiencies to the rest of the operation.

There is generally consensus that Hong Kong can eventually support two full-service long-haul units, although not necessarily close in size. There is an argument HKA’s growth is too soon, but the counter-argument is that a long-term network needs to be built now.

Whichever the direction, HKA’s management and IT could be over-hauled, delivering significant enhancements. Sister HK Express was able to leave its TravelSky platform for Navitaire. HKA wanted to use Amadeus but HKA’s management from HNA was concerned about political implications from leaving state-owned TravelSky.

HKA’s long-haul challenge is the critical regional Asia feed to support the network. HKA started Ho Chi Minh and Manila flights to feed its North America network, but HKA lacks feed in key cities such as Singapore, Kuala Lumpur and Jakarta. HKA wanted to partner with other airlines but airlines did not want to feed HKA’s long-haul network. Singapore Airlines was interested in codesharing until realising it was for HKA’s North America network.

HNA’s cash constraints hit as HKA was part-way through expansion. HKA’s resulting liquidity issues have seen the airline trim its network. Ending service to Australia (Cairns and Gold Coast) was logical due to more favourable flights from partner Virgin Australia.

The recent cancellation of Auckland is partially because there was no feed from London, where HKA planned to fly. London was due to be a JV route with Virgin Atlantic, but the British carrier apparently walked away as HKA was inexperienced in offering fair JV terms. HKA also mooted flying to New York, and received extra-bilateral traffic rights for Toronto, both of which are shelved.

HKA has scheduled frequency reductions for its Vancouver and San Francisco services. This week its only other North American destination, Los Angeles, saw service decline from daily to four weekly in September and October. This is the peak travel period for corporate markets, and underscores HKA has not penetrated high-yielding business travellers.

Economy class and leisure travellers in a premium cabin cannot sustain HKA. Even in the leisure segment, HKA’s positioning is not well understood. Hong Kong tends to segment Cathay as full-service and HK Express as low-cost, but HKA is sometimes thought of as a budget airline from mainland China with free baggage and meals. It has not helped that HK Express has developed a largely well-received local brand.

As a result of HKA’s decreased North American flying, some regional Asian flights could be reduced as they will no longer be needed to fill long-haul.

HKA’s reductions and cancellations run the risk of losing slots since airports generally require a flight to be operated 80% of the time in order for the airline to retain the slot. HKA may want to be more aggressive with service reductions, but does not want to lose slots. There are questions if Hong Kong would support HKA’s long-term vision by preserving slots that fail to be used 80% of the time.

One silver lining is that decreased long-haul flying frees up aircraft to serve regional Asia markets at a time the area is in peak season, such as around Mid-Autumn festival. This flying, to existing or new regional destinations, could help preserve slots.

The fleet is already under-utilised. Three A330-200s have been inactive: B-LNF has not flown since 2 September 2018, B-LHB has not flown since 22 November 2018, and B-LND has not flown since 31 January 2019. A320 B-LPK has not flown since 21 February 2019, according to Flightradar24 data.

It has been asked if liquidity issues are affecting HKA’s fleet, and if it is reducing maintenance costs by intentionally grounding aircraft to remove parts, including an engine, for the rest of the fleet.

A HKA spokesperson says: “The engine defect issues on two of our grounded A330 aircraft require a longer time to address due to limited spare engine resource[s] worldwide. We plan to restore our A320 aircraft back into service by April.” HKA’s A330s use either Rolls-Royce or Pratt & Whitney engines.

HKA’s A330-200s could exit the airline, giving some scale advantage as there are three sub-fleets of A330-200s. The sub-fleets – all with a different business class seat – could be seen as another example of HKA’s inefficiencies, but also the result of HKA wanting to quickly procure aircraft for growth.

It would be relatively logical to return the A330-200 fleet: the active fleet is already reduced from 11 to eight, the -200 is the smallest widebody, and a number of the aircraft are leased from HNA or HNA-owned lessors, making it easier for them to be returned.

There are growing issues with the portion of HKA’s fleet that is from non-HNA lessors. HKA received a lawsuit from AerCap/ILFC and Wilmington Trust, a trustee for assets managed by AerCap. Other lessors say the industry was spooked by a lawsuit from HNA to Hong Kong Airlines Consultation Services, owned by a former HKA director. Some lessors interpreted the lawsuit as HNA no longer guaranteeing HKA.

The lawsuit was especially notable due to the aircraft involved: US$13 million for four A350s and $6m for two 737-800s. HKA does not operate 737-800s. The aircraft in question were apparently sub-leased to Hainan Airlines for six years. It is unclear if Hainan Airlines was paying HKA on time for the aircraft. But conversely, HKA may not be promptly paying for aircraft owned by HNA-related companies.

Regarding the lawsuit, a HKA spokesperson says: “Hong Kong Airlines is at the final stage of negotiation with the aircraft lessors to address the issue.”

A330 and A350 fleet additions have been put on hold. It has been asked if HKA has stopped paying fuel and other expenses at certain outports, such as in China, where HNA can accumulate the debt. A HKA spokesperson says, “We have also been communicating regularly with our service providers on outstanding matters.”

In addition to defining a future for HKA, investors must also untangle HKA from HNA. HKA’s 2014 IPO prospectus stated that HNA Tourism accounted for 25% of passenger revenue, the single largest source. An undisclosed portion was for block seats that HNA Tourism guaranteed to pay for, with or without passengers. HNA Aviation accounted for 15% of cargo revenue, also the single largest source at the time.

In 2013, 83% of passenger revenue was from travel agencies. Of that portion, 66% was from agents based in mainland China.

More recently, HNA’s Hainan Airlines has been growing internationally from Shenzhen, taking some of the catchment market that HKA was going to rely on.

HKA is said to be asset-light, liability-heavy.

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