Chinese puzzle: Interview with Philip Chen, Cathay Pacific Airways

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Photography by Kevin Phillips

Cathay Pacific Airways chief executive Philip Chen's trademark grin belies the fact that he and his team have just pulled together an intricate and highly sensitive six-way deal

In June last year, Cathay Pacific Airways chief executive Philip Chen was in Paris for the IATA annual general meeting and looking forward to travelling on to London to address the Aviation Club.

He expected the prestigious speaking engagement would be "one of the major events in my career", but a newspaper report that a deal to radically reshape Hong Kong's aviation sector was nearing completion sparked a media frenzy, forcing Chen to drop everything and rush home.

The deal, which would give Cathay long sought-after access to the fast-growing China market through a takeover of fellow Hong Kong-based carrier Dragonair and an increased stake in Air China, had been under discussion for more than two years. Final terms were negotiated in the following days and it would unquestionably become the biggest event in Chen's career.

Codenamed Constellation, the first talks had begun several years earlier and they eventually involved six companies, each of which was named after a star in a bid to keep the negotiations secret.

Chen, who was promoted from chief operating officer in January 2005 to become the first ethnic Chinese chief executive of Cathay, was deeply involved in the negotiations, but he is careful not to give the impression that the deal was his doing alone or that his ethnicity helped bridge the cultural divide. Those who know Cathay's way of working would back up such a statement - the airline is not run in a top-down manner and given the complexity of the deal relationships were smoothly worked in China by many members of the senior management team.

Chen says the first talk of such a deal began before Cathay agreed in the second half of 2004 to take a 10% stake in Air China as part of the Chinese flag carrier's initial public offering.

The groundbreaking agreement that was ultimately finalised saw Cathay, which already had a minority stake in Dragonair, purchase the 82.2% that it did not own for HK$8.2 billion ($1.1 billion) from Air China-owned China National Aviation (CNAC), fellow China-backed company CITIC Pacific, Cathay's biggest single shareholder Swire Pacific, and a handful of minority shareholders.

Complex share dealings

Air China and CNAC at the same time acquired a combined 17.5% of Cathay from CITIC and Swire for HK$5.4 billion, while Cathay acquired more shares in Air China for HK$4.1 billion, lifting its stake to nearly 17.5%. Swire remains Cathay's biggest single shareholder with 40% and management control, while CITIC is the second-largest with 17.5%.

Although the shareholding links remain complicated, why the agreement is so important for Cathay is simple. While it is the de facto flag carrier of Hong Kong - a Special Administrative Region of China since 1997 - Cathay had for years been frustrated in its attempts to boost its presence in China - ironic for an airline that was originally based in Shanghai before it was moved to Hong Kong in 1946. Dragonair has an extensive China network, however, and the takeover, which was fully completed late in September, gave Cathay instant access to more than 20 Chinese cities.

Analysts almost universally labelled it a deal that Cathay had to do, otherwise it risked being sidelined in a growing market that it cannot ignore. Cathay, a consistently profitable airline with a reputation for strong management and smooth top-executive succession moves, admits that it paid a "fair price" for Dragonair, but says it was well worth it.

Chen, who joined Cathay in 1977 in one of the early intakes of local staff by UK-backed parent company Swire, says a long-term benefit will be the strengthening of both Beijing and Hong Kong as the two main Chinese aviation hubs.

"It is very important for Cathay Pacific because Cathay Pacific has since 1997 changed into a hub operator and we are really expanding the hub operation over Hong Kong," Chen said in an interview at Cathay City, its headquarters building at Hong Kong International Airport.

"One major area obviously that we needed to strengthen was the mainland China market, and with Dragonair and Air China that will definitely give us the opportunities and the network in China, which is absolutely key.

"This deal enhances Beijing and Hong Kong. I am sure there will be a few other major hubs in China, but to link Beijing, which is our capital, to Hong Kong, which is the number one commercial city, is a very important thing."

Cathay and Air China are, meanwhile, enhancing co-operative ties and are now codesharing between their home bases. They are also looking at a cargo joint venture in Shanghai and have expanded cross-training initiatives. Chen says none of the parties involved see it as a problem that Air China has elected to join Star Alliance while Cathay is a founding member of oneworld.

New synergies

Change has, meanwhile, been taking place at Dragonair to create new synergies between Hong Kong's two main airlines. Chen boasts that the integration has been one of the smoothest ever in the airline business and despite cutting 5% of Dragonair's workforce when the deal was completed, there will be growth for both carriers as a direct result of joining forces.

It is a return to the past in a way, as Cathay and Swire had control of Dragonair through much of the 1990s. Chen, in fact, ran the smaller carrier on secondment between 1994 and 1997 - a fascinating time in Hong Kong's history. During that period China-backed CNAC and CITIC were in a high-stakes fight among themselves as well as with Swire - a well-established conglomerate with strong UK colonial roots - for control of the local airline sector in the lead-up to China's mid-1997 takeover of Hong Kong from the UK.

Dragonair was launched by local investors in 1985 as a competitor to Cathay, which fought vehemently against its establishment. While Cathay failed in its often vicious attempt to block Dragonair from taking off, the new player soon fell into financial difficulty.

Cathay and Swire then took control and made Dragonair, which at the time only had narrowbody aircraft, the exclusive operator to China. With hindsight, it may have been a mistake for Cathay and Swire to give up all China routes, as they were later pressured to give up control of Dragonair to CNAC to prevent it from launching a competing airline, leaving Cathay with no China services. As part of that 1996 deal, CITIC increased its Cathay holding to 25%.

Dragonair then worked to forge its independence and even fought publicly against Cathay's bid to return to China. Cathay eventually won rights to serve a handful of major Chinese cities, but with limited frequencies.

Going for growth

The fact that Cathay and Dragonair moved apart in the post-1997 environment was probably damaging to both, leading to missed opportunities. But that has all changed now. With Cathay in full control of Dragonair, the two carriers are working quickly to make up for lost time.

Chen says that although nearly 200 jobs were cut at Dragonair and its Bangkok services were dropped, there is plenty of growth to be had. Dragonair has already introduced new routes to Phuket in Thailand and Busan in South Korea, for example, which would not otherwise have been commercially viable.

"Cathay Pacific already had a lot of interline revenue pumped into Dragonair, but it is obviously different if you have the same ownership and obviously total integration. You can already see the benefits," he says.

"At the same time we can have lots of other connections. Even though Dragonair is run as a separate company, the connectivity has improved tremendously, which enables us, for example, to start services like Phuket. How many Hong Kong people go to Phuket? It's not that many and not enough to have a daily flight. And how many people go from Phuket to Hong Kong? Even fewer. But now we can mount a daily flight from Hong Kong to Phuket because we can feed from Europe, from Japan, even from China, thereby also giving Hong Kong customers the convenience of a daily flight."

Chen, a youthful looking 51 who works relationships well, chooses his words with politician-like care to avoid controversy and is rarely seen in public without his trademark grin, says there are more new services to secondary destinations in Asia that will be launched by Dragonair as a result of the deal. The airlines have also begun codesharing to China and other parts of Asia, while Dragonair will soon become a member of oneworld.

It is too early to claim real revenue enhancements, as the deal's completion came just ahead of the peak year-end travel period, which would have been strong for both airlines anyway. But "we are starting to see the increased connections", says Chen, and analysts do see revenue growth in the years ahead as a direct result of the integration.

Cathay agreed as part of the deal to retain Dragonair's brand for at least six years and Chen says there are no plans to eliminate it or fold the smaller carrier's main operations into Cathay. Dragonair's expanding cargo operations will also remain separate, he adds.

Birthday celebrations

The Dragonair acquisition and the increased Air China stake were obviously milestones for Cathay in 2006, during which it celebrated its 60th birthday, but Cathay itself has been growing steadily. Its fleet now comprises more than 100 aircraft, all widebodies, compared with fewer than 60 less than a decade ago. The group fleet - comprising that of Cathay, Dragonair and Air Hong Kong, which is a regional freighter operator 60%-owned by Cathay and 40%-owned by DHL - now comprises 144 aircraft.

With new Boeing 777-300ERs, plus additional Airbus A330-300s and Boeing 747-400ER freighters on order, as well as more used 747-400 passenger aircraft and 747-400BCFs that are being converted from passenger to freighter configuration, the group fleet will increase to around 180 aircraft by 2010.

Chen said at the airline's management conference in December that based on annual growth of 5%, the fleet will grow to 240 aircraft by 2016. He will not be drawn on whether that is the actual fleet-size target being worked towards, but says that as Cathay continues to grow so quickly things must be done differently within the rapidly changing organisation. No longer is it the almost family-like business that it used to be.

"What I am telling the management team is that there are things we have got to think through differently," says Chen. "It is a very different organisation when you have 1,000 cabin crew. When I was running Dragonair I basically knew the names of all the cockpit crew, but it's obviously impossible to do that in Cathay Pacific now. We have over 2,000 cockpit crew and 7,000 cabin crew. So you have got to prepare to best embrace the future. Many of the things we have done in the past may not be the same things you want to do in the future. The values don't change, but in the way of working you've got to find smarter ways of doing things."

One area where Cathay is continuing to innovate is in its aircraft cabins, taking a big step forward with a new long-haul product that will be rolled out in the coming months. It will initially be retrofitted on its 747-400s and then introduced on new 777-300ERs that start arriving in September.

The new first- and business-class products will provide increased privacy and lie-flat seats. Cathay will at the same time become the first airline to have a seat in economy class with a "fixed back" design similar to a mini business-class seat, allowing passengers to recline without their seatback leaning into the knees of the person behind.

Cathay will also introduce more new passenger routes in the years ahead, but more importantly will look to boost frequency to existing destinations. In Chen's view the airline needs to "fly for dough, not for show", meaning it will only go to destinations that help keep it profitable.

The fleet will also continue to grow, but Chen says there are no immediate plans to order additional aircraft as Cathay has enough due to enter service over the next few years to meet capacity requirements. This will come as a setback to Airbus, which for years has been trying to convince Cathay to order the A380, given that it operates more than 20 747-400s.

Local competition

Cathay is, meanwhile, keeping a close eye on new home-based competitors. Hong Kong now has three new players: long-haul, low-fare operator Oasis Hong Kong Airlines as well as China-focused Hong Kong Airlines and Hong Kong Express, both of which are part owned by China's Hainan Airlines.

Oasis has been getting the most attention for its recent launch of services between Hong Kong and London Gatwick, but it is perhaps Hong Kong Airlines that Cathay will need to watch most closely. Hong Kong Airlines has bold growth plans that will see it adding many new Boeing 737-800s serving more points in China and elsewhere in Asia. It also plans to eventually move into the long-haul market.

"Hong Kong is not a closed place," says Chen. "Hong Kong has more than 70 or 80 airlines already flying in - that is a huge number linking Hong Kong to more than 140 destinations. Competition is something that we accept and we support, as long as it is fair. As long as Hong Kong's interest is protected, as long as Hong Kong's interests and Hong Kong peoples' assets are not compromised, we accept competition, we embrace it and we support it."

In Chen's view, 2006 was a defining year for Cathay and one that he says saw the creation of "one of the world's strongest airline groups". But he adds that the key is to keep an eye on where it will be in the future.

"If we are now in 2016 and evaluating what we did in 2006, what would you say? That is how we have to think."