S 30% 9:19 pm was the second most popular route in Dragonair's sched- More Turbulence? ule and accounted for 19-20 percent of its total passen- gers, Shanghai-Hong Kong was the most popular route After a few quiet years, there were signs that the status while Beijing-Hong Kong was third. quo might be changing again. It was reported that CNAC might merge with Air China and China Southwest Air- Global Opportunities and Challenges lines.' 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 Airline industry experts forecasted that by 2020, global property portfolio for a 51 percent stake in Air Macau, airlines would purchase 16,000 aircraft worth US$1,200 which principally provided a transit point for main- land- billion. It was estimated that infrastructure providers- Taiwan traffic until direct cross-strait flights would be airports and air traffic services-around the world permitted. would spend US$350 billion to accommodate the growth The extent to which this would affect Dragonair's post- in air traffic. Global aviation was the prime en- gine of tion in the merged group was of strategic importance to travel and tourism that at the beginning of the millennium Cathay and Swire. Should Cathay strike out on its own? contributed more than US$3,500 billion to the world economy, or 12 percent of the total. More than 190 Complicating the picture further, in 2001 China Eastern Airline joined the Asia Mile Travel Reward Programme, million jobs were generated by the global aviation which also includes Dragonair, Swissair, Japan Airlines, industry, or 8 percent of the world total. Capital invest- Japan Asia Airways, Asiana Airlines, and Qantas Airways. ment for travel and tourism was at US$733 billion a year, In March 2002 Cathay announced that its net profit more than 11 percent of the world total. This truly for 2001 fell 87 percent from the preceding year. Ac- represented an enormous potential market for all the cording to its chairman, James Hughes-Hallett, Cathay's global airlines. traffic had already been affected by the economic slow- Whether Cathay could repeat its winning formula that down in 2001 and with the sudden drop after September had proven successful in the Asian region depended not 11, 2001, the carrier was forced to cut back several only on the developments in the China market, but also routes. To attract customers back to flying, the airline on how effectively the company could address twomajor then discounted its fares severely. The reported net profit challenges: capitalizing on the benefits of globalization for 2001 was $84.7 million, down from $645 million the and growth without losing Cathay's local/ Asian identity previous year. and individuality; and forging rewarding relationships Adding salt to the wounds, the 2003 SARS (Severe with strong global partners without cannibalizing Acute Respiratory Syndrome) epidemic also hit the Hong Cathay's own market shares. Kong tourist traffic and Cathay Pacific hard. In May, The first challenge was essentially a "think global and with international travel to the mainland restricted and act local" issue. Through networks with global partners, SARS having spread to Taiwan, the airline recorded a Cathay could become connected with a number of major loss of US$5 million a day. markets around the world. However, it remained impor- Once the epidemic was under control toward the sec- tant for Cathay to reinforce "the Heart of Asia" brand im- ond half of 2003, travel resumed as China's rapid eco- age, anchored at Hong Kong city and conveniently linked nomic expansion continued apace. While high fuel prices with all major Asian cities. That image would provide a increased costs and reduced profitability, by March 2004 distinct advantage over other national flag carriers in the airline reported net earnings of US$167 million for Asia, even more than being known as Hong Kong's flag the year, higher than analyst expectations." carrier. During 2003 Cathay Pacific negotiated intensively The second challenge related to leveraging the rela- with Chinese authorities about getting direct access to tionships with Cathay's allied partners. Cathay joined three mainland destinations: Beijing, Shanghai, and Xia- with American Airlines, British Airways, and Qantas to men. Strong opposition came from Dragonair, where found Oneworld in February 1999, and soon the new al- Cathay held a minority stake, and from government-con- liance had doubled in size with the additions of Iberia, trolled airlines including China Eastern Air. In October Aer Lingus, and LanChile. By 2002 Oneworld airlines 2003 Cathay was finally granted a permit for takeoffs served 574 destinations in 134 countries and territories, with more than 8,500 flights every day. Further, the eight s "CNAC Looks for Boom after Merger," South China Morning Post, member airlines were expected to benefit by almost March 1, 2002. US$1 billion in 2002 by virtue of the various relation- "Hong Kong: Loss at Airline," New York Times, March 7, 2002, ships amongst them: revenue generation, protection and p. W1. feed, and savings from joint purchasing and shared air- "len Cheng, "Cathay Pacific rebounds, after SARS Outbreak," Financial Times, March 11, 2004, p. 1. port and city facilities. Nicholas lonides, "Dragonair Fights Cathay Pacific China License," Flight International, April 29, 2003, p. 10. three times weekly. Access to Shanghai and Xiamen was economy and a weaker performance in cargo traffic. still denied, however. While the growing business Cathay had in the aviation In September 2004, with important democratic elec- powerhouse of China was a significant plus, some 60 tions in Hong Kong upcoming, the Chinese government percent of its business comes from outside China, expos- further liberalized access to mainland cities from Hong ing it to a global slowdown. Still, the results confirmed Kong, although not directly to Cathay. The main question the benefits of Cathay's acquisitions in China-the 2006 involved the role of a large new airport outside of takeover of Dragon Air, which had an extensive network Guangzhou, just north of Hong Kong. The giant Baiyun of connections between Hong and the mainland, and a International Airport had opened in August about 80 stake in Air China. Those acquisitions, which had now miles up the Pearl River from Hong Kong, in direct com- produced their first full-year contribution to the results, petition with the huge new Chek Lap Kok airport outside were already having a positive impact on the business of Hong Kong, which had opened in July 1998. The move to the Cathay Pacific Group preserve Hong Kong's status as the entry hub into China was seen as a political move by the Chinese authorities to Discussion Questions reduce the pressure for greater democracy in the former British colony." The pact also reaffirmed the limits on in- ternational access to Hong Kong destinations, limiting 1. Given the political complications, how attractive is the foreign competition and solidifying Cathay Pacific's sta- China mainland market? How would you evaluate the us as the Hong Kong flag carrier. threat from Baiyun? What if China's economic expan- In 2007 Cathay Pacific posted a 71.8 percent increase sion slows down? in profit, taking advantage of booming growth in Asia What strategic alternatives are there for Cathay to de- and defying the impact of historically high oil prices. The velop the mainland market? Should it rely on Drago- sharp jump in Cathay's profit during the year, well be- pair, develop new alliances, or continue to go it alone? yond the expectations of analysts of more than HK$7 bil- 3. How should Cathay develop and market its global im- lion, or US$900 million, followed similar performances age without diminishing its local/regional identity as from other major regional carriers including Qantas and the Hong Kong (and China) carrier? Singapore Airlines. Driving the good times of the airline 4. Should Cathay focus on China by attempting to develop industry was a leap in passenger volume, in particular it further or instead focus on the overall global market? business travelers, as Asian economies enjoyed robust economic growth. Demand from business and first-class " Keith Bradsher, "Deal Preserves Hong Kong's Hub Status," New York Times, September 9, 2004, p. W1,7. passengers was particularly strong. But industry executives and analysts were concerned about dark clouds on the horizon from a softening U.S. Source: This case was prepared by Eddie Yu, associate professor at the City University of Hong Kong, and Anthony Ko, associate profes- sor at the Open University of Hong Kong, and revised by Paul Kolesa.L S till 29% 0 9:20 pm Case Study No 01 Cathay Pacific Airways China ( . . . were likely to move into Hong Kong to compete head-on (13.16 percent), and the Chao family (5.57 percent). with Cathay. The China National Aviation Corporation Cathay also entered into a management service agree- ment with (CNAC), the commercial arm of the regulatory Civil Avi- Dragonair, As part of this move, some senior executives were ation Administration of China, had carried on business transferred to Dragonair, Cathay trans- ferred its China routes, operations in Hong Kong since 1978, the year when China consisting of Shanghai and Bei- jing services, to Dragonair, on began its phenomenal economic reform. April 1, 1990. To address this potential threat, Swire made a series of Because of the booming Chinese market, the first half of the strategic moves. Cathay was initially floated on the stock 1990s was great for Dragonair-in contrast to Cathay and the exchange in 1986, but prior to that the carrier was owned 70 global airline industry. By 1992, Drago- nair was serving 13 percent by Swire and 30 percent by Hong Kong's largest cities in China and 4 cities in north and south Asia. It established bank, The Hong Kong Bank (HSBC). After the flotation, itself as the preferred car- fier for passengers traveling to and their respective holdings were diluted to 54.25 percent and from China. With ex- panding services and high load factors, 23.25 percent. Dragonair, reported record profits in 1993. By 1994, it was Maintaining a good relationship with key officials in providing services to 14 cities in China and 8 cities elsewhere China also remained of strategic importance for the fu- in Asia by a fleet of nine aircraft. ture, So, in February 1987, China International Trust & Of course, the mainland market was not without competition. Investment Corporation Hong Kong Limited (CITIC HK) S Since the early 1990s, the Civil Aviation Administration of sold a 12.5 percent stake in Cathay Pacific and thus became China (CAAC) had gradually decen- tralized the civil aviation its second-largest shareholder. CITIC HK was a leading rights to established regional airlines in order to stimulate air "red chip" company? controlled by Beijing's China travel. In addition to Air China, the flagship carrier, new International Trust & Investment Corporation. This airlines included China Eastern (Shanghai based), China marked the beginning of a closer relationship be- tween Southern (in Guangzhou), and China Northwest (based in Swire and the Chinese. Xian). In the following decade, CITIC HK actively invested in With China's entry into the WTO in 2002, air traffic between the strategic industries in Hong Kong. For instance, CITIC HK g mainland and other parts of the world was expected to increase acquired Tylfull Company Limited in 1990 and later even further. Given the comparatively weaker Japanese and renamed it CITIC Pacific Limited, and it subsequently So Southeast Asian economies, mainland destinations could became the major holding and investment vehicle for become even more important. Apart from passenger service, CITIC HK. Over the next five years, CITIC Pacific the mainland was also expected to become more and more acquired a major trading company, a 12 percent interest in important on the cargo side. Hong Kong's largest telecommunications company, a 10 percent interest in Hong Kong Air Cargo Terminals Troubled Skies Limited, and 10-25 percent interests in Hong Kong's three cross-harbor tunnels. Cathay's strategy of using Dragonair to crack the main- land market proved successful for a few years. Yet amidst such healthy Dragonair and the China Market progress, the potential of a threat was never far away. In 1992, CNAC had issued a warning by estab- lishing a wholly owned Since the inauguration of its Open Door policy in 1979, a su subsidiary, CNAC HK, to act as its commercial vehicle in Hong rapid growth in economic activities has led to great de- Kong. To strengthen its ties to Chinese interests, CNAC and China mand for air travel throughout China. The outbound travel Travel Service Hong Kong Limited each became 5 percent potential of 1.25 billion people and several hun- dred ed shareholders of Cathay in 1992. thousand foreign businessmen presented a huge potential Furthermore, in March 1995 CNAC announced that it had windfall for the industry. applied for licenses with a new airline company to fly between To capitalize on this opportunity, the Hong Kong Dragon China and Hong Kong, and Hong Kong and 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 Taiwan (a very profitable route for Cathay). Sensing that its percent stake, while CITIC HK became the largest worst nightmare might come true, Cathay protested by claiming shareholder with 38 percent (increased to 46 percent in a potential conflict existed if a Hong Kong air- line regulator 1992). In 1992 Dragonair's shareholders were CITIC Pa- was allowed to operate a carrier in Hong Kong. For instance, cific (46.15 percent), Cathay (30 percent), Swire Pacific CNAC could easily promulgate cul- ings that favored itself while penalizing Cathay, or even rescind its primary . The CNAC Group (a holding company formed in landing slots in the new Hong Kong airport. Unfortunately, Cathay could not rely on Chris Patten, the 1995 by CNAC to control CNAC HK) acquired a colony's last British governor of the colony, to negotiate 35.86 percent interest in Dragonair from CITIC Pa- with China. In addition to being a "lame duck" ruler, his cific, Cathay Pacific, and Swire Pacific. After these transactions Dragonair's stakeholders were relationship with the Beijing government was strained due to some last-minute democratic reform mea- sures he CNAC Group (35.86 percent), CITIC Pacific (28.49 had introduced. percent), Cathay Pacific (17.79 percent), Swire Pacific In July 1995, Cathay announced a preliminary deal (7.71 percent), and the Chao family (5.02 percent). with the Taipei Airlines Association to license a second Industry insiders proclaimed the CNAC Group the carrier in both Taiwan and Hong Kong. The additional deal's winner,? since it gained control of Dragonair, at carriers were expected to be Dragonair and Taiwan's only 7 times its estimated earnings for 1996. Also CITIC EVA Airways. The Chinese were not happy. The general Pacific was able to acquire additional shares of Cathay at manager of CNAC, Wang Guixiang, stated that Cathay HK$11, 15 percent less than Cathay's share price before was not authorized to negotiate the deal, and that laws the announcement, without having to reduce its holding were violated. No specific action was taken, however. in Dragonair During early 1995 a great deal of speculation focused Shortly after the deal, Dragonair was granted the right on Cathay's future and its shareholders' intentions. In o fly scheduled flights to Chengdu, Xian, Qingdao September 1995, CITIC reduced its holdings in Cathay Urumqi, and Chongqing. Swire Pacific expanded its air- from 12.5 percent to 10 percent. Then in March 1996, craft engineering, airport cargo services, and car dealer- CNAC was rumored to have sold its 5 percent stake in ship business in the mainland over the next couple of Cathay. Many investors considered these moves to indi- years cate a vote of no confidence in Cathay and anticipated that a powerful Chinese company would soon replace Post-1997 Calm Cathay as Hong Kong's flagship carrier. On April 3, 1996, one of the most influential financial Shareholdings in Cathay and Dragonair had been stable newspapers in Hong Kong reported that the Swire Group since the deal. By year-end 2001, CITIC Pacific held planned to sell its stake in Cathay. The report claimed that 25.6 percent in Cathay and 28.5 percent in Dragonair the Swire family had approached five potential buyers, Cathay held 19 percent in Dragonair; Swire held 45.6 among them United Airlines, Northwest, and Lufthansa. percent in Cathay and 7.7 percent in Dragonair; and the Although Peter Sutch-the Swire Group and Cathay's listed subsidiary of CNAC Group held 43.3 percent3 in chairman-categorically denied the report, the rumor Dragonair persisted. By June 2001 Cathay was employing over 14,700 peo- In May 1996 these rumors were put to rest when the le in 30 countries and territories around the world various parties announced a series of transactions that re- which helped position the carrier as "the Heart of Asia." sulted in the following shareholder changes in the differ- The airline carrier owned 7 aircraft and leased 62 more, ent companies: while its average passenger fleet age was 5.9 years, CITIC Pacific increased its holdings in Cathay to amongst the lowest of any major airline. 25 percent. Exhibits 1A, B, and C show the mainland passenger Swire Pacifics' was diluted from $2.6 percent to traffic and commensurate share of the major carriers in recent years. Exhibit 2 shows passenger counts and 43.9 percent. Cathay's market share outside mainland China. By 2001 mainland traffic accounted for around 17 percent of all 2 "Beijing Is Buying Hong Kong-But at Its Own Price," Business passenger traffic in and out of Hong Kong, and Drago- Week, May 13, 1996, p. 24; "Changing of the Guard," Asiaweek. gait was able to maintain an impressive 31-36 percent of May 10, 1996, p. 53. all mainland traffic. While Cathay's cargo volume China National Aviation Company Limited (CNACL) was dropped 9 percent during the first 11 months of 2001, incorporated in February 1997 to be the listing vehicle of CNAC Dragonair's cargo volume showed a 27 percent increase.* Group. CNAC Group's 35.86 percent of Dragopak was injected Overall, mainland traffic was responsible for about 70 into CNACL and an additional 7.43 percent was acquired from percent of Dragonair's business. In fact, this figure ac- the Chao family and Peregrine International in a share swap agreement in October 1997 prior to its listing. tually understated its share since a large number of Drag onair's Kaohsiung-Hong Kong passengers were in transit ""Dragonair Flies in Face of Recession," South China Morning Post, anuary 17, 2002