Cathay Pacific Airways: China or the World?

Cathay Pacific is Hong Kong's privately owned interna- tional airline. As for most Hong Kong businesses, the 1997 takeover of Hong Kong by China created uncer- tainties that were difficult to anticipate and manage. The case details the situation before and after the takeover and shows the two basic strategic options available: go- ing global through alliances or focusing on the China market. It is a good case for studying how political fac- tors enter into strategic decisions.

On July 1, 1997, the British government relin- quished sovereignty over Hong Kong to the Chinese government. The Joint Declaration and the Basic Law of the Hong Kong Special Administrative Region (SAR) provided for Hong Kong to maintain a high de- gree of autonomy in aviation matters and "for the maintenance of the status of Hong Kong as a center for international regional aviation." Since the airline in- dustry was characterized by a high degree of govern- mental regulation, mainland Chinese support was critical to the solvency and growth of any flag-carrier airline. Could Cathay Pacific, a division of Britain's Swire Pacific, still have allies in the SAR government? Would its ownership interests now endanger its ability to penetrate the lucrative Chinese mainland market? Should Cathay aim to become a truly global carrier or another regional player?

Company Background

Cathay Pacific was founded in 1946 by an American, Roy

C. Farrell, and an Australian, Sydney H. de Kantzow. Al- though initially based in Shanghai, it soon relocated its air- line business in Hong Kong. Legend has it that Farrell and a group of foreign correspondents thought up the airline's unique name in the bar at the Manila Hotel. In 1948, the company was incorporated, and the Swire Group became its largest shareholder. In 1959, Cathay acquired Hong Kong Airways and became Hong Kong's flag carrier.

Over five decades Cathay had flown through numer- ous major political and economic crises in the region. Cathay had managed to thrive on each of these crises and grow bigger and stronger. By the mid-1990s, it had a fleet of aircraft that were among the youngest in the world, while its replacement program involved orders and options for US$9 billion in new aircraft. Cathay was now providing scheduled passenger and cargo services to 50 destinations around the world.

Marriage of Convenience

Despite these promising developments, the situation close to home was not nearly as encouraging for Cathay. WiththeChinesetakeover,Chineseairline operators

were likely to move into Hong Kong to compete head-on with Cathay. The China National Aviation Corporation (CNAC), the commercial arm of the regulatory Civil Avi- ation Administration of China, had carried on business operations in Hong Kong since 1978, the year when China began its phenomenal economic reform.

To address this potential threat, Swire made a series of strategic moves. Cathay was initially floated on the stock exchange in 1986, but prior to that the carrier was owned 70 percent by Swire and 30 percent by Hong Kong's largest bank, The Hong Kong Bank (HSBC). After the flotation, their respective holdings were diluted to 54.25 percent and 23.25 percent.

Maintaining a good relationship with key officials in China also remained of strategic importance for the fu- ture. So, in February 1987, China International Trust & Investment Corporation Hong Kong Limited (CITIC HK) sold a 12.5 percent stake in Cathay Pacific and thus became its second-largest shareholder. CITIC HK was a leading "red chip" company1 controlled by Beijing's China International Trust & Investment Corporation. This marked the beginning of a closer relationship be- tween Swire and the Chinese.

In the following decade, CITIC HK actively invested in strategic industries in Hong Kong. For instance, CITIC HK acquired Tylfull Company Limited in 1990 and later renamed it CITIC Pacific Limited, and it subsequently became the major holding and investment vehicle for CITIC HK. Over the next five years, CITIC Pacific acquired a major trading company, a 12 percent interest in Hong Kong's largest telecommunications company, a 10 percent interest in Hong Kong Air Cargo Terminals Limited, and 10-25 percent interests in Hong Kong's three cross-harbor tunnels.

Dragonair and the China Market

Since the inauguration of its Open Door policy in 1979, a rapid growth in economic activities has led to great de- mand for air travel throughout China. The outbound travel potential of 1.25 billion people and several hun- dred thousand foreign businessmen presented a huge po- tential windfall for the industry.

To capitalize on this opportunity, the Hong Kong Dragon Airlines (Dragonair, www.dragonair.com) was founded in 1986 by Hong Kong Macau International Investment Ltd., a company controlled by K. P. Chao. Mr. Chao was later joined by Y. K. Pao, but after Drago- nair's initially disappointing performance, the Pao family withdrew from Dragonair in 1989 and sold its shares back to the Chao family.

Realizing the need to acquire industry expertise in or- der to obtain better access to the Chinese market, Chao decided to invite the Swire Group and CITIC HK to be- come partners. In January 1990, Cathay Pacific and Swire Pacific acquired 30 percent and 5 percent respectively of Dragonair's issued capital. The cost to Cathay was ap- proximately US$38 million. The Chao family retained a 22 percent stake, while CITIC HK became the largest shareholder with 38 percent (increased to 46 percent in 1992). In 1992 Dragonair's shareholders were CITIC Pa- cific (46.15 percent), Cathay (30 percent), Swire Pacific (13.16 percent), and the Chao family (5.57 percent).

Cathay also entered into a management service agree- ment with Dragonair. As part of this move, some senior executives were transferred to Dragonair. Cathay trans- ferred its China routes, consisting of Shanghai and Bei- jing services, to Dragonair on April 1, 1990.

Because of the booming Chinese market, the first half of the 1990s was great for Dragonairin contrast to Cathay and the global airline industry. By 1992, Drago- nair was serving 13 cities in China and 4 cities in north and south Asia. It established itself as the preferred car- rier for passengers traveling to and from China. With ex- panding services and high load factors, Dragonair reported record profits in 1993. By 1994, it was provid- ing services to 14 cities in China and 8 cities elsewhere in Asia by a fleet of nine aircraft.

Of course, the mainland market was not without competition. Since the early 1990s, the Civil Aviation Administration of China (CAAC) had gradually decen- tralized the civil aviation rights to established regional airlines in order to stimulate air travel. In addition to Air China, the flagship carrier, new airlines included China Eastern (Shanghai based), China Southern (in Guangzhou), and China Northwest (based in Xian).

With China's entry into the WTO in 2002, air traffic between the mainland and other parts of the world was expected to increase even further. Given the compara- tively weaker Japanese and Southeast Asian economies, mainland destinations could become even more impor- tant. Apart from passenger service, the mainland was also expected to become more and more important on the cargo side.

Troubled Skies

Cathay's strategy of using Dragonair to crack the main- land market proved successful for a few years. Yet amidst such healthy progress, the potential of a threat was never far away. In 1992, CNAC had issued a warning by estab- lishing a wholly owned subsidiary, CNAC HK, to act as its commercial vehicle in Hong Kong. To strengthen its ties to Chinese interests, CNAC and China Travel Service Hong Kong Limited each became 5 percent shareholders of Cathay in 1992.

Furthermore, in March 1995 CNAC announced that it had applied for licenses with a new airline company to fly between China and Hong Kong, and Hong Kong and

Taiwan (a very profitable route for Cathay). Sensing that its worst nightmare might come true, Cathay protested by claiming a potential conflict existed if a Hong Kong air- line regulator was allowed to operate a carrier in Hong Kong. For instance, CNAC could easily promulgate rul- ings that favored itself while penalizing Cathay, or even rescind its primary landing slots in the new Hong Kong airport. Unfortunately, Cathay could not rely on Chris Patten, the colony's last British governor of the colony, to negotiate with China. In addition to being a "lame duck" ruler, his relationship with the Beijing government was strained due to some last-minute democratic reform mea- sures he had introduced.

In July 1995, Cathay announced a preliminary deal

with the Taipei Airlines Association to license a second carrier in both Taiwan and Hong Kong. The additional carriers were expected to be Dragonair and Taiwan's EVA Airways. The Chinese were not happy. The general manager of CNAC, Wang Guixiang, stated that Cathay was not authorized to negotiate the deal, and that laws were violated. No specific action was taken, however.

During early 1995 a great deal of speculation focused on Cathay's future and its shareholders' intentions. In September 1995, CITIC reduced its holdings in Cathay from 12.5 percent to 10 percent. Then in March 1996, CNAC was rumored to have sold its 5 percent stake in Cathay. Many investors considered these moves to indi- cate a vote of no confidence in Cathay and anticipated that a powerful Chinese company would soon replace Cathay as Hong Kong's flagship carrier.

On April 3, 1996, one of the most influential financial newspapers in Hong Kong reported that the Swire Group planned to sell its stake in Cathay. The report claimed that the Swire family had approached five potential buyers, among them United Airlines, Northwest, and Lufthansa. Although Peter Sutchthe Swire Group and Cathay's chairmancategorically denied the report, the rumor persisted.

In May 1996 these rumors were put to rest when the various parties announced a series of transactions that re- sulted in the following shareholder changes in the differ- ent companies:

CITIC Pacific increased its holdings in Cathay to 25 percent.

Swire Pacifics' was diluted from 52.6 percent to

43.9 percent.

2 "Beijing Is Buying Hong KongBut at Its Own Price," Business Week, May 13, 1996, p. 24; "Changing of the Guard," Asiaweek, May 10, 1996, p. 53.

3 China National Aviation Company Limited (CNACL) was incorporated in February 1997 to be the listing vehicle of CNAC Group. CNAC Group's 35.86 percent of Dragonair wasinjected into CNACL and an additional 7.43 percentwasacquiredfrom the Chao family and Peregrine International in a share swap agreement in October 1997 prior to its listing.

The CNAC Group (a holding company formed in 1995 by CNAC to control CNAC HK) acquired a

35.86 percent interest in Dragonair from CITIC Pa- cific, Cathay Pacific, and Swire Pacific.

After these transactions Dragonair's stakeholders were CNAC Group (35.86 percent), CITIC Pacific (28.49 percent), Cathay Pacific (17.79 percent), Swire Pacific (7.71 percent), and the Chao family (5.02 percent).

Industry insiders proclaimed the CNAC Group the deal's winner,2 since it gained control of Dragonair at only 7 times its estimated earnings for 1996. Also CITIC Pacific was able to acquire additional shares of Cathay at HK$11, 15 percent less than Cathay's share price before the announcement, without having to reduce its holding in Dragonair.

Shortly after the deal, Dragonair was granted the right to fly scheduled flights to Chengdu, Xian, Qingdao, Urumqi, and Chongqing. Swire Pacific expanded its air- craft engineering, airport cargo services, and car dealer- ship business in the mainland over the next couple of years.

Post-1997 Calm

Shareholdings in Cathay and Dragonair had been stable since the deal. By year-end 2001, CITIC Pacific held

25.6 percent in Cathay and 28.5 percent in Dragonair; Cathay held 19 percent in Dragonair; Swire held 45.6 percent in Cathay and 7.7 percent in Dragonair; and the listed subsidiary of CNAC Group held 43.3 percent3 in Dragonair.

By June 2001 Cathay was employing over 14,700 peo- ple in 30 countries and territories around the world, which helped position the carrier as "the Heart of Asia." The airline carrier owned 7 aircraft and leased 62 more, while its average passenger fleet age was 5.9 years, amongst the lowest of any major airline.

Exhibits 1A, B, and C show the mainland passenger traffic and commensurate share of the major carriers in recent years. Exhibit 2 shows passenger counts and Cathay's market share outside mainland China. By 2001 mainland traffic accounted for around 17 percent of all passenger traffic in and out of Hong Kong, and Drago- nair was able to maintain an impressive 31-36 percent of all mainland traffic. While Cathay's cargo volume dropped 9 percent during the first 11 months of 2001, Dragonair's cargo volume showed a 27 percent increase.4 Overall, mainland traffic was responsible for about 70 percent of Dragonair's business. In fact, this figure ac- tually understated its share since a large number of Drag- onair's Kaohsiung-Hong Kong passengers were in transit

4 "Dragonair Flies in Face of Recession," South China Morning Post,

January 17, 2002.

EXHIBIT 1aMainland China Passenger Statistics 2000/2001 (Passenger Arrival and Departure, 4/2000 to 3/2001)

Source: 2000/01 Annual Report of the Director of Civil Aviation, Hong Kong SAR Government.

TotalDragonairAir ChinaChina E.China N.China N.W.China S.China S.W.Errata

Behai23,85623,856 0

Beijing1,030,254467,828460,309102,114 3

Changchun8,5238,5230

Changsha59,14125,52133,620 0

Chengdu142,83468,35974,475 0

Chongqing67,78217,31650,466 0

Dalian78,47721,09840,22717,1520

Dayong20,91420,914 0

Fuzhou291,99262,014229,9780

Ganzhou

Guangzhou326,829326,829 0

Guilin189,90590,77499,131 0

Guiyang18,58818,588 0

Haikou135,06143,08991,972 0

Hangzhou243,682118,613125,0690

Harbin13,80213,8020

Hefei16,19816,1980

Jinan29,61829,6180

Kunming126,98242,32184,661 0

Lanzhou

Meixian15,25815,258 0

Nanchang22,18622,1860

Nanjing192,98195,57797,4040

Nanning28,23028,230 0

Ningbo81,98881,9880

Qingdao120,20742,40677,8010

Sanya135,95718,14360,29957,515 0

Shanghai-H1,507,430768,756738,335339

Shanghai-P2852850

Shantou99,69699,696 0

Shenyang23,09523,0950

Shenzhen54540

Shijiazhuang21,49621,4960

Taiyuan5,5065,5060

Tianjin50,08950,0890

Tunxi14,48514,4850

Wenzhou19,49419,4940

Wuhan70,6406,70463,936 0

Wuyishan

Xiamen294,665107,632187,027 6

Xian91,45123,48067,9710

Xuzhou

Yantai23,61023,6100

Zhanjiang8,2908,290 0

Zhengzhou22,58822,588 0

Mainland Total5,674,1192,019,631572,1751,481,957122,87167,9711,265,637143,529348

All destination32,612,3632,815,705572,1751,481,967122,87167,9711,287,632143,487

Transit1,206,6110000054,532 0

Transfer9,909,5961,124,053173,146643,66527,95233,784633,806 70,714

Mainland/All%17.4071.73100.00100.00100.00100.0098.29 100.03

Mainland %35.5910.0826.122.171.2022.31 2.53

EXHIBIT 1bMainland China Passenger Statistics 1999/2000 (Passenger Arrival and Departure, 4/1999 to 3/2000)

Source: 1999/2000 Annual Report of the Director of Civil Aviation, Hong Kong SAR Government.

TotalDragonairAir ChinaChina E.China N.China N.W.China S.China S.W. Errata

Behai23,64323,6430

Beijing919,543375,012423,092121,4390

Changchun8,3828,3820

Changsha52,90825,73427,1740

Chengdu114,33145,37968,952 0

Chongqing47,16513,72333,442 0

Dalian67,61321,45132,80213,3600

Dayong15,72915,7290

Fuzhou269,05738,066230,858133

Ganzhou

Guangzhou331,692331,6893

Guilin211,884105,700106,1840

Guiyang15,15715,157 0

Haikou159,74572,02087,7250

Hangzhou227,776107,40345120,3280

Harbin14,56114,5610

Hefei14,62114,6210

Jinan24,07924,0790

Kunming154,14060,0974793,9960

Lanzhou

Meixian15,54615,5460

Nanchang19,93519,9350

Nanjing160,88693,14967,7370

Nanning19,85219,8520

Ningbo73,8951,60472,2910

Qingdao99,37030,68468,6860

Sanya105,74348,65857,0850

Shanghai-H1,242,657559,703682,9540

Shanghai-P

Shantou107,391107,3910

Shenyang26,80926,8090

Shenzhen1271270

Shijiazhuang12,11812,1180

Taiyuan0

Tianjin47,98747,887100

Tunxi12,55112,5510

Wenzhou17,80417,8040

Wuhan59,9705,66154,3090

Wuyishan15,97215,9720

Xiamen276,779107,026169,7530

Xian71,64819,28952,3590

Xuzhou

Yantai21,79221,7920

Zhanjiang14,85014,8500

Zhengzhou19,44019,4400

Mainland Total5,115,1481,681,828515,9911,353,636111,77052,3591,281,777117,551 236

All destination29,598,7322,413,449515,9911,353,636111,77052,3591,294,594117,551

Transit1,306,0990000019,0000

Transfer8,547,449830,486146,087557,67721,16322,544633,00658,643

Mainland/All %17.2869.69100.00100.00100.00100.0099.01100.00

Mainland %32.8810.0926.462.191.0225.062.30

EXHIBIT 1cMainland China Passenger Statistics 1998/1999 (Passenger Arrival and Departure, 4/1998 to 3/1999)

Source: Annual Report (1998/99, 1999/2000, 2000/01) of the Director of Civil Aviation, Hong Kong SAR Government.

TotalDragonairAir ChinaChina E.China N.China N.W.China S.China S.W. Errata

Behai12,23712,2370

Beijing888,762328,957417,096142,7090

Changchun5,6405,6400

Changsha40,93125,46815,4630

Chengdu93,56835,66157,9070

Chongqing38,24411,97426,2700

Dalian69,44024,35535,2769,8090

Dayong0

Fuzhou197,82619,946177,8800

Ganzhou5050

Guangzhou327,594327,5940

Guilin174,59695,75078,8460

Guiyang10,76310,7630

Haikou175,84370,504105,3390

Hangzhou209,45689,964119,4920

Harbin7,9417,9410

Hefei12,54012,5400

Jinan17,78017,7800

Kunming97,08121,59175,4900

Lanzhou155155

Meixian14,07714,0770

Nanchang13,77113,7110

Nanjing138,22084,93853,2820

Nanning17,14417,1440

Ningbo71,58010,59960,9810

Qingdao79,38722,36957,0180

Sanya62,82738,12324,7040

Shanghai-H1,086,773453,642632,915216

Shanghai-P0

Shantou112,363112,3630

Shenyang26,12126,1210

Shenzhen0

Shijiazhuang4,1194,1190

Taiyuan0

Tianjin55,2635,32249,752189

Tunxi6,6846,6840

Wenzhou15,70415,7040

Wuhan50,2839,87240,4110

Wuyishan6,2896,2890

Xiamen274,557100,220174,3370

Xian58,98622,89436,0920

Xuzhou70700

Yantai16,65216,6520

Zhanjiang20,87220,8720

Zhengzhou21,94921,9490

Mainland Total4,534,0781,434,026506,2431,184,63987,63436,2471,189,89494,990 405

All destination27,595,9602,047,504507,7041,184,63987,63436,2471,207,32094,990

Transit1,443,56401921880014,6100

Transfer7,236,781656,403125,719436,46814,21912,988542,43537,392

Mainland/All %16.4370.0499.71100.00100.00100.0098.56100.00

Mainland %31.6311.1726.131.930.8026.242.10

EXHIBIT 2Passenger Statistics and Market Share of Cathay outside China (Top 20 Arrivals and Departures Destination, excluding Mainland)

Source: 1998-2001 Annual Reports of the Director of Civil Aviation, Hong Kong SAR Government.

2000-011999-001998-99

Total-ArCathay%Total-DpCathay%Overall %Total-ArCathay%Total-DpCathay%Overall %Total-ArCathay%Total-DpCathay

Amsterdam

106,070

37,898

110,481

43,592

Bangkok

1,345,684

420,444

31.24

1,319,170

431,730

32.73

31.98

1,299,522

407,658

31.52

1,274,008

407,049

31.95

31.73

1,215,237

383,644

31.6

1,159,801

367,575

Frankfurt

250,065

111,138

44.44

262,551

119,387

45.47

44.97

236,697

105,510

44.58

243,528

113,371

46.55

45.58

218,089

107,665

49.4

219,026

113,088

Jarkarta

161,405

89,732

55.59

152,220

72,777

47.81

51.82

103,215

6,103

65.01

96,274

55,499

57.65

61.46

Kaohsiung

513,787

0

0.00

516,696

0

0.00

0.00

469,518

0

0.00

470,330

0

0.00

0.00

392,958

0

0.0

399,215

0

Kuala Lumpur

435,516

189,980

43.62

371,474

161,793

43.55

43.59

385,368

167,398

43.44

322,920

141,139

43.71

43.56

335,643

145,377

43.3

276,060

115,976

London-

Heathrow

494,465

226,573

45.82

487,363

224,271

46.02

45.92

475,658

205,523

43.21

466,240

210,445

43.21

43.21

465,421

192,747

41.4

450,577

184,559

Los Angeles

245,266

168,665

68.77

270,406

183,909

68.01

68.37

214,922

142,048

66.09

236,103

156,274

66.19

66.14

261,029

171,537

65.7

275,990

182,356

Manila

776,505

430,693

55.47

769,373

427,195

55.53

55.50

810,450

419,990

51.82

806,732

421,352

52.23

52.03

745,508

422,730

56.7

747,140

418,403

Melbourne

142,336

72,488

50.93

128,418

70,923

55.23

52.97

117,500

62,684

53.35

106,742

64,709

60.62

56.81

106,346

65,053

61.2

106,829

66,770

Nagoya

117,501

75,871

64.6

124,734

78,977

New York-JFK

149,085

68,737

46.11

156,729

59,894

38.22

42.06

145,235

64,332

44.30

153,084

53,789

35.14

39.60

149,269

69,317

46.4

143,696

63,961

Osaka

351,712

151,518

43.08

372,402

162,389

43.61

43.35

317,411

120,484

37.96

333,599

129,710

38.88

38.43

322,543

127,328

39.5

353,231

142,796

Paris

189,381

111,443

58.85

190,528

108,219

56.80

57.82

184,750

103,142

55.83

185,360

102,092

55.08

55.45

177,085

103,496

58.4

178,966

103,003

San Francisco

249,511

79,728

31.95

260,580

78,277

30.04

30.98

238,112

72,451

30.43

243,095

71,595

29.45

29.93

188,825

21,854

11.6

191,708

20,091

Seoul

699,209

263,287

37.65

679,596

255,341

37.57

37.61

691,889

255,761

36.97

665,739

249,079

37.41

37.19

609,839

231,304

37.9

588,998

221,326

Singapore

1,002,700

274,861

27.41

989,294

277,760

28.08

27.74

868,703

251,902

29.00

856,370

250,166

29.21

29.10

851,249

221,300

26.0

813,193

225,880

Sydney

353,064

152,599

43.22

359,807

156,678

43.55

43.38

312,794

117,564

37.59

320,571

127,691

39.83

38.72

312,306

125,736

40.3

315,799

133,409

Taipei

2,750,185

1,103,747

40.13

2,753,021

1,079,719

39.22

39.68

2,409,636

965,592

40.07

2,417,417

969,515

40.11

40.09

2,085,455

946,686

45.4

2,133,184

954,707

Tokyo

954,541

333,706

34.96

920,085

317,923

34.55

34.76

865,889

280,051

32.34

822,980

263,365

32.00

32.18

834,800

287,447

34.4

791,283

262,761

Vancouver

287,090

146,912

51.17

301,246

158,067

52.47

51.84

260,951

130,572

50.04

274,331

141,473

51.57

50.82

271,624

137,756

50.7

262,662

137,969

Total Top 20

11,351,507

4,396,251

38.73

11,260,959

4,346,252

38.60

38.66

10,408,220

3,941,765

37.87

10,295,423

3,919,313

38.07

37.97

9,766,797

3,874,746

39.7

9,652,583

3,837,199

Top 20/All %

69.47

80.31

69.20

80.07

69.34

70.09

80.55

69.80

80.53

69.95

70.67

80.88

70.07

81.08

All destination

Direct and

transfer

16,340,279

5,474,187

33.50

16,272,084

5,428,191

33.36

33.43

14,849,826

4,893,361

32.95

14,748,906

4,867,138

33.00

32.98

13,820,909

4,790,816

34.7

13,775,051

4,732,659

Transit

603,265

0

0.00

603,346

0

0.00

0.00

653,090

0

0.00

653,009

0

0.00

0.00

721,753

0

0.0

721,811

0

Transfer

4,952,754

2,444,437

49.36

4,956,842

2,445,984

49.35

49.35

4,257,412

2,161,747

50.78

4,290,037

2,190,622

51.06

50.92

3,610,150

1,916,144

53.1

3,626,631

1,945,710

was the second most popular route in Dragonair's sched- ule and accounted for 19-20 percent of its total passen- gers. Shanghai-Hong Kong was the most popular route while Beijing-Hong Kong was third.

Global Opportunities and Challenges

Airline industry experts forecasted that by 2020, global airlines would purchase 16,000 aircraft worth US$1,200 billion. It was estimated that infrastructure providers airports and air traffic servicesaround the world would spend US$350 billion to accommodate the growth in air traffic. Global aviation was the prime en- gine of travel and tourism that at the beginning of the millennium contributed more than US$3,500 billion to the world economy, or 12 percent of the total. More than 190 million jobs were generated by the global aviation industry, or 8 percent of the world total. Capital invest- ment for travel and tourism was at US$733 billion a year, more than 11 percent of the world total. This truly represented an enormous potential market for all the global airlines.

Whether Cathay could repeat its winning formula that

had proven successful in the Asian region depended not only on the developments in the China market, but also on how effectively the company could address two major challenges: capitalizing on the benefits of globalization and growth without losing Cathay's local/Asian identity and individuality; and forging rewarding relationships with strong global partners without cannibalizing Cathay's own market shares.

The first challenge was essentially a "think global and act local" issue. Through networks with global partners, Cathay could become connected with a number of major markets around the world. However, it remained impor- tant for Cathay to reinforce "the Heart of Asia" brand im- age, anchored at Hong Kong city and conveniently linked with all major Asian cities. That image would provide a distinct advantage over other national flag carriers in Asia, even more than being known as Hong Kong's flag carrier.

The second challenge related to leveraging the rela- tionships with Cathay's allied partners. Cathay joined with American Airlines, British Airways, and Qantas to found Oneworld in February 1999, and soon the new al- liance had doubled in size with the additions of Iberia, Aer Lingus, and LanChile. By 2002 Oneworld airlines served 574 destinations in 134 countries and territories, with more than 8,500 flights every day. Further, the eight member airlines were expected to benefit by almost US$1 billion in 2002 by virtue of the various relation- ships amongst them: revenue generation, protection and feed, and savings from joint purchasing and shared air- port and city facilities.

More Turbulence?

After a few quiet years, there were signs that the status quo might be changing again. It was reported that CNAC might merge with Air China and China Southwest Air- lines.5 The resulting group would have total assets of ap- proximately HK$52.9 billion and a fleet of 118 aircraft. Also, the listed arm of CNAC Group swapped its rental property portfolio for a 51 percent stake in Air Macau, which principally provided a transit point for main- land-Taiwan traffic until direct cross-strait flights would be permitted.

The extent to which this would affect Dragonair's posi- tion in the merged group was of strategic importance to Cathay and Swire. Should Cathay strike out on its own? Complicating the picture further, in 2001 China Eastern Airline joined the Asia Mile Travel Reward Programme, which also includes Dragonair, Swissair, Japan Airlines, Japan Asia Airways, Asiana Airlines, and Qantas Airways. In March 2002 Cathay announced that its net profit for 2001 fell 87 percent from the preceding year. Ac- cording to its chairman, James Hughes-Hallett, Cathay's traffic had already been affected by the economic slow- down in 2001 and with the sudden drop after September 11, 2001, the carrier was forced to cut back several routes. To attract customers back to flying, the airline then discounted its fares severely. The reported net profit for 2001 was $84.7 million, down from $645 million the

previous year.6

Adding salt to the wounds, the 2003 SARS (Severe Acute Respiratory Syndrome) epidemic also hit the Hong Kong tourist traffic and Cathay Pacific hard. In May, with international travel to the mainland restricted and SARS having spread to Taiwan, the airline recorded a loss of US$5 million a day.

Once the epidemic was under control toward the sec- ond half of 2003, travel resumed as China's rapid eco- nomic expansion continued apace. While high fuel prices increased costs and reduced profitability, by March 2004 the airline reported net earnings of US$167 million for the year, higher than analyst expectations.7

During 2003 Cathay Pacific negotiated intensively with Chinese authorities about getting direct access to three mainland destinations: Beijing, Shanghai, and Xia- men. Strong opposition came from Dragonair, where Cathay held a minority stake, and from government-con- trolled airlines including China Eastern Air.8 In October 2003 Cathay was finally granted a permit for takeoffs

5 "CNAC Looks for Boom after Merger," South China Morning Post,

March 1, 2002.

6 "Hong Kong: Loss at Airline," New York Times, March 7, 2002,

p. W1.

7 Ien Cheng, "Cathay Pacific rebounds, after SARS Outbreak,"

Financial Times, March 11, 2004, p. 1.

8 Nicholas Ionides, "Dragonair Fights Cathay Pacific China License," Flight International, April 29, 2003, p. 10.

three times weekly. Access to Shanghai and Xiamen was still denied, however.

In September 2004, with important democratic elec- tions in Hong Kong upcoming, the Chinese government further liberalized access to mainland cities from Hong Kong, although not directly to Cathay. The main question involved the role of a large new airport outside of Guangzhou, just north of Hong Kong. The giant Baiyun International Airport had opened in August about 80 miles up the Pearl River from Hong Kong, in direct com- petition with the huge new Chek Lap Kok airport outside Hong Kong, which had opened in July 1998. The move to preserve Hong Kong's status as the entry hub into China was seen as a political move by the Chinese authorities to reduce the pressure for greater democracy in the former British colony.9The pact also reaffirmed the limits on in- ternational access to Hong Kong destinations, limiting foreign competition and solidifying Cathay Pacific's sta- tus as the Hong Kong flag carrier.

In 2007 Cathay Pacific posted a 71.8 percent increase in profit, taking advantage of booming growth in Asia and defying the impact of historically high oil prices. The sharp jump in Cathay's profit during the year, well be- yond the expectations of analysts of more than HK$7 bil- lion, or US$900 million, followed similar performances from other major regional carriers including Qantas and Singapore Airlines. Driving the good times of the airline industry was a leap in passenger volume, in particular business travelers, as Asian economies enjoyed robust economic growth. Demand from business and first-class passengers was particularly strong.

But industry executives and analysts were concerned

about dark clouds on the horizon from a softening U.S.

economy and a weaker performance in cargo traffic. While the growing business Cathay had in the aviation powerhouse of China was a significant plus, some 60 percent of its business comes from outside China, expos- ing it to a global slowdown. Still, the results confirmed the benefits of Cathay's acquisitions in Chinathe 2006 takeover of Dragon Air, which had an extensive network of connections between Hong and the mainland, and a stake in Air China.10 Those acquisitions, which had now produced their first full-year contribution to the results, were already having a positive impact on the business of the Cathay Pacific Group.

Discussion Questions

1.Given the political complications, how attractive is the China mainland market? How would you evaluate the threat from Baiyun? What if China's economic expan- sion slows down?

2.What strategic alternatives are there for Cathay to de- velop the mainland market? Should it rely on Drago- nair, develop new alliances, or continue to go it alone?

3.How should Cathay develop and market its global im- age without diminishing its local/regional identity as the Hong Kong (and China) carrier?

4.Should Cathay focus on China by attempting to develop it further or instead focus on the overall global market?

9 Keith Bradsher, "Deal Preserves Hong Kong's Hub Status,"

New York Times, September 9, 2004, p. W1,7.

Source: This case was prepared by EddieYu,associateprofessorat the City University of Hong Kong, and Anthony Ko, associateprofes- sor at the Open University of Hong Kong, and revised by Paul Kolesa.