Valuation of the Cathay Pacific Dragon Airline Merger

background music
(right click to download: the CX/KA merger song)
source: "I actually like this song", video


The much anticipated HK airline merger has been speculated for over a year. Final bits of difference kept delaying the public announcement. CX called off a planned press conference on Thursday evening. However, according to CX insider note, the deal was finally reached by the 5 parties at the top floor of Pacific Place on Thursday night.

Update: Deal is finally announced
  • 1) CX to pay HK$12.29bn in total, in cash and new stocks
  • a) KA valued at HK$10bn
  • b) CX will pay Citic and CNAC a total of HK$8.22bn for 82.2% share, ending up with 100% KA in total (KA will keep its brand for at least 6 years)
  • c) CX will pay HK$4.07bn to buy another 10% of CA. CX will end up with 20% CA in total
  • 2) CNAC will acquire 10.16% CX share with 5.39bn, presumably using the cash it received from selling KA/CA
  • 3) CX and CA will form a cargo JV, which will be based in Shanghai
  • 4) CITIC share in CX will be reduced from 25.4% to 17.5%
  • 5) CNAC will hold 7.34% CX, and none in KA
  • 6) Swire to maintain control of CX in future under side agreements
Kong Chan suggested a couple simple ways to valuate Dragon Airline.

His "Method 1" deaverages the profits from 3 categories, passenger, cargo and 'others'. He suggested we could use benchmarking and look for comparables. In addition, he thought it is possible to adjust the benchmarking ratios using capacity and load factors using simple ratios.

There are a couple problems about that.
  1. Usually it is easy to find revenue split, but very difficult to find profit split. Especially for airlines. Because, apart from a few cargo planes, most of the cargos actually go into the belly of the passenger planes. (A main reason why CX does not fly to Hawaii. no cargo to fill) Now how do you allocate the cost to cargo?
  2. Load factor and profit is a highly non-linear relationship. e.g. a company can be just breaking even at load factor of 65%, while the profit at 90% load would be 5 times as much as that at 80%. That is why airlines tend to fill their last seats at deeply discounted coach tickets, since there is very small incremental cost.

His "Method 2" is a highly level benchmarking using comparables. That sounds a simpler job. However, I believe for KA, CX is a much closer comparable than CA. In fact, KA is almost a clone out of CX, as many of the staff were cross-trained back in the honeymoon years.


Applying CX's multiples (PE, PB, etc) to KA's corresponding numbers (and adjust for asset/debt) should yield the fair market value for KA, fairly accurately. Those numbers should be published when the transaction becomes official. (Kong Chan worries about data availability and compromised on the elss accurate methods.)

However, "fair market value" is what KA should sell for in an IPO. It is the price for you and me. For CX, the value is much larger. And Citic/CNAC know this. CX needs to pay the premium for

  1. Elimination of a competitor. No more price cutting in China routes. No more bickering on route expansion, hence saving management resources and time to market. Price premium for all ex-HKG flights (both CX and KA, in particular those that overlap)
  2. Synergy: lower cost in maintaining the China outports, PEK/TPE/SHA/XMN, feed traffic LAX-HKG-China, better utilization for both passenger and cargo due to larger scale, consolidation of HKG base and corporate overhead, etc.
  3. Potential growth: assuming KA's routes (developing Asia and China) will grow faster than CX's more matured markets (Europe, Japan Australia and N America)
  4. Other intangible (and tangible) benefits: getting into China market for CX, the leverage inside oneworld alliance, etc.

So the transaction price should reflect some 30-80% of this premium, depending on the bargaining power. It looks likely it will be on the high side, as we know CX eagerly wants the China routes.

This is good news for CX and KA. But bad news for consumers in HK. Monopoly is never a good thing for consumers.

p.s. Bloggers seems to have some technical glitches recently. I could not put this into his comment field.


Sun Bin said...

One strange point of the deal:
The deal also results in Air China offering to privatize China National Aviation Co. Ltd. (CNAC) (HKSE:1110.HK - News), which is the largest shareholder in unlisted Dragonair, at HK$2.80 a share, a premium of 42 percent over its last trading price.

This explains why CNAC share jumped but CA share was sluggish ann even dipped a little.

Sun Bin said...

CX press announcement

Sun Bin said...

Detailed filing to HKEX of the deal

Cathay Pacific Airlines said...

Hong Kong-based airlines Dragon Air and Cathay Pacific Cargo have been awarded the Skytrax World Airline Awards for this year. Its a great thing that they both merged.