Cathay withdraws 2H16 profit guidance, implying a much worse 2H16: Thecompany has said overcapacity and strong competition is putting particular pressureon its passenger business, with continued shortfalls in revenue compared withforecasts and heavy pressure on yield. Against this background, it is no longerexpected that the company's 2H16 results will be better than those of 1H16.
　　Business update – worse than expected: The implied 2016 earnings forecasts arewell below market expectations, and we expect the 2H16 result to be worse than1H16, despite 3Q16 being the peak season. It's been less than two months sinceCathay issued its previous profit guidance. So what's changed We think there hasbeen intense pressure on passenger yields in recent months after the introduction ofan Airport Construction Fee （HKD70-180 per departing passenger） at HKIA in August2016. We estimate about 50% of traffic carried by Cathay Pacific represents transitpassengers, therefore the carrier would have to lower prices in order to retain thistraffic and maintain satisfactory load factors.
　　Forecast significant losses in 2017e: Given the much worse-than-expectedpassenger yield erosion, we have substantially reduced our FY16/17 EPS forecaststo HKD-0.10/-0.71 from HKD0.78/0.40, respectively. We now forecast the companywill report significant losses in 2017e, given a large undesirable fuel hedge position（51% of fuel usage hedged at USD90/bbl）， expected intense competition fromChinese and other global airlines, and structural negatives such as the AirportConstruction Fee （August 2016） and a 17-19% hike in landing and parking expensesat HKIA （September 2016）； these will be effective for the whole of 2017.
　　Downgrade to Reduce from Hold, cut TP to HKD10.0 from HKD12.5 on expectedlosses: Yield erosion continued as expected but the decline is worse than we anticipated.
　　We forecast the company to report negative ROEs in 2017-18, and therefore we think thecompany's shares will trade near historical trough levels in terms of one-year forward P/Bratios. We apply 0.7x （from 0.8x previously） to our one year forward book value （2017ebook value）， which yields a new target price of HKD10.0, which implies 8% downside.
　　We downgrade Cathay to Reduce from Hold because of the deteriorating businessenvironment and a muted outlook in 2017-18e. Upside risks: 1） significant operationefficiency improvements; 2） resilient yields; 3） lower-than-expected fuel hedge losses ifthe oil price surges; 4） potential government support or subsidies.