Cathay v Dragonair: a battle for the skies

Alysha Webb reports on the public fight taking place between Cathay Pacific Airways and partner-turned-rival, Dragonair, over flights into China

It has all the elements of a Shakespeare play - an ambitious offspring, a powerful parent, a sinister relative, and even nationalistic fervour. Maybe a play will be written one day about the route dispute between Cathay Pacific and Dragonair, but it will have to wait months for the final outcome. In mid-March, the two sides finished arguing their case before Hong Kong�s Air Transportation Licensing Authority (Atla); in mid-April, Atla ruled that Cathay could fly the routes. But that won�t be the last word; the Chinese Government will have the final say.

What should have been a simple quid pro quo - Dragonair acquiescing to Cathay�s request to fly three mainland routes, after Cathay did not protest Dragonair�s application to fly the Hong Kong-Taiwan route - has turned into a lengthy and sometimes acrimonious battle over the mainland skies. The outcome has the potential to bolster, or call into question, the success of the �one-country-two system� experiment of mainland rule over Hong Kong, and the success of China�s move to separate business and government.

The drama began in January, when Cathay Pacific, Hong Kong�s premium international airline, applied to fly three popular mainland routes - Hong Kong to Beijing, Shanghai and Xiamen. Cathay stopped flying the routes in 1990, when it invested in Dragonair. Though some mainland-based airlines already fly those routes, most business passengers fly Dragonair, which, according to ING analyst, Philip Wickham, �has really benefited from being the businessman�s airline�. So why pursue the routes now? Like most China markets, airline travel is showing robust growth at a time when other countries are lagging. According to the Civil Aviation Administration of China (CAAC), in 2002, departures from China to international destinations soared 22.3% to 19.77m, compared to 2001. Other foreign airlines are already boosting their flights to China. Lufthansa added three new weekly non-stop Munich-Shanghai flights in late March, to make a total of seven, and KLM added two Shanghai-Amsterdam flights to make five. Cathay doesn�t want to be left behind. �In the long run, linking routes to China is critical to our whole strategy as an international airline,� said director of corporate development, Tony Tyler. �It will be increasingly difficult to be a network player if we can�t fly to this huge, fast-growing strategic market right on our doorstep.� Cathay also claims that flights to the mainland are crucial to maintaining Hong Kong�s future as a leading aviation and logistics hub, and that a strong home carrier with network connectivity can attract more traffic through the hub. Of course, Dragonair is also Hong Kong-based, but has a much smaller fleet and flies within Asia. �Cathay�s brand strength and product offering is significantly better,� said HSBC analyst, Mark Webb. For example, Cathay has TV screens on every seat, and its frequent flyer miles can be redeemed on a global network.

Earnings-wise, the routes are no big deal for Cathay but a huge deal for Dragonair. ING estimates that Cathay�s net profit would be boosted by a mere HK$67m in fiscal year 2004 by adding the routes. For 2002, Cathay posted a six-fold rise in net profit to HK$3.98bn. In contrast, HSBC estimates that Dragonair�s earnings before interest tax would fall by US$79m, or 28%, if Cathay wins the routes. Dragonair�s net profit rose 60% on-year in 2002 to HK$540m, but the disputed routes account for 50% of Dragonair�s total revenue. Hence Dragonair�s refusal to return a favour to Cathay Pacific.

The nature of Hong Kong�s route licensing system laid the foundation for this dispute, and the complicated ownership structure and history of the two airlines involved make the outcome hard to predict. Since the mid-1980s, Hong Kong has practised a one-route, one-airline policy for Hong Kong-based airlines, though �there has always been flexibility in the policy� taking into consideration the traffic demand, consumer choice and Hong Kong�s overall economic interest,� the Hong Kong Government told accounting & business. The policy was effectively abandoned, however, when Dragonair was granted permission to fly the Hong Kong-Taipei route.

Policy to blame

Dragonair blames the policy for its current situation. The airline only entered the Hong Kong aviation scene in 1985, by which time Cathay had already acquired �most, if not all, of the viable, valuable routes� and �had nowhere to go except the secondary routes in mainland China and region. The policy also led to great financial difficulties for the small, new entrant, leading to its change in shareholding in 1990,� Dragonair told accounting & business.

Here�s where it gets complicated. Cathay Pacific is arguably a representative of pre-handover, colonial Hong Kong. It is 45.85% owned by old-time British Hong Swire Pacific Ltd, but also 25.5% owned by CITIC Pacific Ltd, a so-called red-chip company (as Hong Kong-listed companies with strong mainland ties are known). Dragonair is 43.29% owned by red-chip China National Aviation Corp, whose mainland-based parent company has strong government links. Additionally, Citic Pacific owns 29.35% of Dragonair, Cathay Pacific owns 17.79%, and Swire Pacific owns 7.71%. The complicated overlapping ownership structure arose in 1990, when Cathay invested in Dragonair to save it from bankruptcy. But CNAC expressed a desire to have a Hong Kong-based airline in the run up to the 1997 return of Hong Kong to mainland rule, and Cathay complied by selling down its stake. Cathay still retains a board seat, however.

Dragonair�s argument against awarding the licences to Cathay rests on several assertions. Firstly, that there is no unmet demand on the routes. Dragonair and the mainland carriers �have been piling [on] frequencies,� Olivia Lin, Dragonair�s general manager for planning and international affairs told Atla. Load factors on the routes are already low. For 2002, Shanghai was at 66%, Beijing 56% and Xiamen 58%. Dragonair CEO, Stanley Hui, also claimed his airline�s development was retarded by the 1990 agreement, which determined that Dragonair would focus on the mainland and Cathay on international routes. Indeed, Dragonair paid Cathay Pacific some HK$140m in management fees over the last 14 years to ensure co-ordination, he said.

Just in case the economic arguments fail, Dragonair is also claiming that, under the Basic Law governing relations between Hong Kong and Beijing since the handover, Atla cannot grant licences for the routes because they involve mainland destinations. In any case, though Atla awards the licenses, the right to actually fly the routes must be granted in consultation between the Hong Kong Special Administrative Region Government and the mainland Government, based on a confidential arrangement.

More than just money is involved in this drama. �In the airline industry, nationality issues still come into consideration,� said Wickham. And the route dispute pits a representative of Hong Kong�s former colonial rulers against a Chinese company. �If Cathay wasn�t owned by Swire, there probably wouldn�t even be these issues,� said Wickham. Dragonair�s desire to been seen as equal to its former parent may also play a role. �There is an element of pride,� said a Hong Kong-based analyst at a European investment bank, who asked not to be named. �Dragonair wants to be able to prove it can run a serious regional airline.� Along with the Hong Kong-Taipei route, Dragonair also applied to fly to Bangkok, Seoul, Manila, Tokyo and Sydney.

Though Atla granted Cathay the right to fly the routes in April, the final decision on whether or not Cathay gets to fly the three routes rests with the Chinese Government, as aforementioned - which, it could be argued, has a vested interest in the outcome. China is working to get the Government out of business management. The separation of asset ownership and regulation is part of the ongoing restructuring of China�s aviation industry to help accomplish that, pointed out ING�s Wickham. So Atla�s ruling should be the final say. But other issues overlap, such as the impact awarding the routes might have on mainland-based carrier China Eastern, which also flies these routes. China Eastern figures centrally in the Government�s plan to restructure CAAC into three main groups centred around China Eastern, China Southern and Air China.

CNAC declined to comment. �We are waiting until the matter is resolved to issue an official statement because this is a very sensitive matter,� a spokeswoman told accounting & business. No matter what the outcome, however, CNAC has already taken a hit. In February, HSBC downgraded its stock from add to sell.

And now, all the airlines are facing a much bigger problem than a route dispute. The spread of Severe Acute Respiratory Syndrome (SARS) in Hong Kong, China and the rest of the world, has already caused a drastic two-thirds or worse decrease in passenger traffic for the carriers, despite a reduction in flight frequency. Cathay issued a first-ever profit warning in mid-April, and ING downgraded the airline�s earnings estimates by 25% in 2003 and 10% in 2004. On mainland routes, the problem looks to get worse before it gets better. Beijing is only now facing up to the severity of the problem, and new SARS cases are reported daily from China�s inland provinces.

Alysha Webb is a business journalist based in Shanghai.