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Record Cathay profit clouded by worries over jet fuel prices

For Cathay Pacific, 2010 was a year of superlatives. Last year Cathay and its Dragonair subsidiary carried 26.8 million passengers, up 9 per cent from 2009 and more than in any other year in the company's history.

And passengers were only half the story. The airline also carried a record 1.8 million tonnes of freight, up a handsome 18 per cent from the year before.

Even better, Cathay's aircraft were fuller last year, both of passengers and cargo, and customers were paying more. Passenger yields - the price paid for every kilometre flown - were up 20 per cent, while cargo yields climbed 25 per cent.

The result of all this booming traffic was a 34 per cent increase in revenues and a near 150 per cent rise in the airline's operating profit. Add in the profit on the sale of its stake in aircraft maintenance company Haeco and a couple of other one-off gains, and Cathay notched up net profits last year of a record HK$14 billion, tripling 2009's figure.

Announcing the company's results yesterday, an understandably pleased chairman Christopher Pratt declared that Cathay is now 'probably the world's most profitable airline'.

Pratt's boast may hold good only until the end of the month, when Air China announces its own 2010 results. But even if Cathay's profits are eclipsed, the Hong Kong airline's bosses will still have plenty of reason to cheer. With an 18.7 per cent stake in its mainland rival, Cathay stands to benefit handsomely from the expected surge in profits at Air China.

Flushed with success, Cathay's management yesterday announced plans to hire 2,300 new staff this year, as well as buy 25 new aircraft and lease a further two, bringing its total order book to 91 planes.

Yet despite all the buoyancy on show yesterday, there is still one thing that has notably failed to take off lately: Cathay's share price.

Although the stock rose 4.5 per cent yesterday in response to the company's earnings announcement, Cathay's shares have underperformed the broader Hong Kong market over recent months, falling almost 20 per cent since the beginning of December.

Part of the reason investors are so gloomy is that Cathay is unlikely to repeat last year's growth in its freight business, which was boosted by United States companies rebuilding their inventories of Asian-made goods following the financial crisis.

But the big dampener for sentiment is fuel prices. At an average price for 2010 of US$94 a barrel, jet fuel costs made up a hefty 36 per cent of Cathay's entire operating expenses last year. Since then the turmoil in the Middle East has pushed prices up sharply, and yesterday jet fuel was quoted in Singapore at just under US$130 a barrel.

If prices remain at these elevated levels for much longer, Cathay's business will begin to suffer. The airline has hedged around a third of its fuel requirements for this year, and can hope to cover some of the extra expense of the rest through increased fuel surcharges levied on customers.

But experience from the last fuel price spike, in 2008, teaches that higher surcharges soon eat into passenger demand.

According to HSBC analyst Mark Webb, if the jet fuel price averages US$120 a barrel over 2011, the increase in surcharges could cut expected passenger growth in East Asia outside China this year by half.

Demand growth from China will be more robust. But even so, higher costs and weaker passenger growth will eat into Cathay's profitability this year, knocking more than HK$3 billion off the airline's 2010 operating profit.

It's a painful scenario. But things may not turn out quite as black as they have been painted. If fears about a squeeze on Middle East oil supplies abate soon, then the current spike in jet fuel prices could prove short-lived.

But even if fuel prices remain elevated, Cathay will still be in a relatively strong position compared with its competitors.

The airline will continue to benefit from double-digit passenger growth in China. Meanwhile Cathay, with its strong branding and high proportion of business and first-class travellers, will be less affected by high fuel prices than its low cost rivals around the region, whose budget passenger traffic will be hit disproportionately hard by higher fuel surcharges.

As a result, trouble for the Asian airline industry as a whole could once again promise to strengthen Cathay's competitive position in the region, just it did in 2008 and 2009.

Given that, Cathay's shares may still prove to be a good buy. The stock is currently trading at an attractive valuation compared to many of its Asian competitors, and although there is likely to be turbulence in the short term, the prospects for future gains look promising.

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