DISCLOSURE APPENDIX CONTAINS ANALYST CERTIFICATIONS AND THE STATUS OF NON-US ANALYSTS. U.S. Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. 18 October 2010 Asia Pacific/South Korea Equity Research Airlines Korea Airline Sector INITIATION Not ready for descent Figure 1: KAL vs Asiana: international passenger yield and load factor trend 6.5 7.0 7.5 8.0 8.5 9.0 9.5 2007 2008 2009 2010E 2011E 70 72 74 76 78 80 KAL int'l pax yield (LHS) Asiana int'l pax yield (LHS) KAL int'l load factor (RHS) Asiana int'l load factor (RHS) (US cents) (%) Source: Company data, Credit Suisse estimates We initiate coverage of KAL (OUTPERFORM, 18% potential upside) and Asiana (OUTPERFORM, 23% potential upside). We are positive on the Korea airline sector and prefer Asiana going into 2011 on: 1) a continued solid demand outlook, especially in international passenger business, and 2) still attractive valuations, considering our high projected ROEs. Further passenger demand improvement likely, while cargo is stabilising. International passenger demand will remain strong in 2011 on: 1) further improvement in Korean outbound travel demand with continued economic recovery and Korean won appreciation and 2) increasing overseas travel demand in China, which we believe is a key growth driver for Korean carriers. On the supply side, we think KAL could face short-term capacity pressure given its large expansion plan, and industry supply is also likely to pick up from 2H11. Recent concerns about cargo looks overdone and we expect another solid round of demand next year, despite slowing YoY trend due to the high base in 2010. We prefer Asiana to KAL in the near term. Although KAL’s strategic focus on transit demand in transpacific routes (mainly China-North America routes) looks reasonable, we prefer Asiana to KAL in the near term on: 1) greater China exposure, 2) tighter load factor and yield outlook due to limited capacity expansion in 2011-12, 3) a higher focus on balance sheet improvement and 4) more attractive valuations with stabilising Kumho group-related risks. We initiate coverage of KAL with an OUTPERFORM and W85,000 (18% potential upside) target price and Asiana with an OUTPERFORM and W12,200 (23% potential upside) target price, based on 2011E target P/B of 1.7x and 1.6x, respectively, which is an up-cycle P/B multiple. Research Analysts Seungwoo Hong 822 3707 3795 [email protected]Sam Lee 852 2101 7186 [email protected]
Transcript
DISCLOSURE APPENDIX CONTAINS ANALYST CERTIFICATIONS AND THE STATUS OF NON-US ANALYSTS. U.S. Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
18 October 2010 Asia Pacific/South Korea
Equity Research Airlines
Korea Airline Sector INITIATION
Not ready for descent Figure 1: KAL vs Asiana: international passenger yield and load factor trend
■ We initiate coverage of KAL (OUTPERFORM, 18% potential upside) and Asiana (OUTPERFORM, 23% potential upside). We are positive on the Korea airline sector and prefer Asiana going into 2011 on: 1) a continued solid demand outlook, especially in international passenger business, and 2) still attractive valuations, considering our high projected ROEs.
■ Further passenger demand improvement likely, while cargo is stabilising. International passenger demand will remain strong in 2011 on: 1) further improvement in Korean outbound travel demand with continued economic recovery and Korean won appreciation and 2) increasing overseas travel demand in China, which we believe is a key growth driver for Korean carriers. On the supply side, we think KAL could face short-term capacity pressure given its large expansion plan, and industry supply is also likely to pick up from 2H11. Recent concerns about cargo looks overdone and we expect another solid round of demand next year, despite slowing YoY trend due to the high base in 2010.
■ We prefer Asiana to KAL in the near term. Although KAL’s strategic focus on transit demand in transpacific routes (mainly China-North America routes) looks reasonable, we prefer Asiana to KAL in the near term on: 1) greater China exposure, 2) tighter load factor and yield outlook due to limited capacity expansion in 2011-12, 3) a higher focus on balance sheet improvement and 4) more attractive valuations with stabilising Kumho group-related risks. We initiate coverage of KAL with an OUTPERFORM and W85,000 (18% potential upside) target price and Asiana with an OUTPERFORM and W12,200 (23% potential upside) target price, based on 2011E target P/B of 1.7x and 1.6x, respectively, which is an up-cycle P/B multiple.
Figure 4: Trend of Chinese visitors into Korea Figure 5: Transit as a % of total pax (IIA) vs passenger yield
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Source: KTO Source: IIA, Company data
Figure 6: KAL’s monthly FTK vs US ISM index Figure 7: Asia airlines (ex. China): P/B vs ROE
comparison (2011E)
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Source: DataStream, Company data Source: Company data, Credit Suisse estimates
18 October 2010
Korea Airline Sector 3
Not ready for descent Despite significant outperformance in the past 12 months, we believe it is too early to turn negative on the Korean airline sector due to: 1) the continued positive demand outlook in 2011, especially in international passenger business, and 2) still attractive valuations, considering our high projected ROEs.
Positive passenger demand outlook We believe international passenger demand will remain strong in 2011, due mainly to: 1) further improvement in Korean outbound demand on the back of continued economic recovery as well as a strengthening Korean won, and 2) increasing overseas travel demand in China, which we believe is a key growth driver for Korean carriers. We also think now is a good time to focus again on the China growth theme, given: 1) large growth potential in Chinese overseas travel demand with its improving consumer power, 2) further upside in Korean outbound travel demand heading into China, which is still 15% lower YTD than that in 2007, before the credit crisis, and 3) bigger upside for load factor increase, compared with the other major routes (Japan and North America). However, on the supply side, KAL could face capacity pressure in the short term, given its large expansion plan in the next few years, and industry supply would also pick up from 2H11.
Stabilising, but solid cargo demand Recent concerns on air cargo with weakening IT momentum is overdone, in our view. Due to a high base with unexpected strong results in a seasonally weak 2Q10, it may be challenging for Korean airlines to achieve YoY growth in cargo business next year. However, we expect more solid cargo traffic in 2011 on the back of: 1) slowing but still positive economic growth, 2) the improving global leadership of Korean IT brands, thus continued market share gain, and 3) structural improvement in air cargo demand, as customers reply more on Just-In-Time supply management.
Forex and fuel – key swing factors The KRW’s appreciation is positive for airlines, as it is a key macro driver for strong overseas travel demand. We assume 4.5% and 3.5% KRW appreciation to USD in 2010 and 2011, respectively, based on Credit Suisse’s bullish view on the KRW. Accounting for about 25-30% of revenue, fuel is the most important cost item for airlines. Hence, any drastic increase in jet fuel price is fatal, but we expect a stable trend in the near term based on Credit Suisse’s energy team’s crude oil price forecast, indicating 5.7% decrease in 2011 on the back of loose supply and demand outlook.
Prefer Asiana in the near term Although we like KAL’s leading position and reasonable strategic focus on rising transit demand in transpacific routes, we prefer Asiana to KAL in the near term due to the following reasons: 1) Asiana has consistently focused on China routes and is better positioned to benefit from China growth with higher revenue exposure; 2) Asiana’s international passenger yield and load factor will remain tight, while KAL may face capacity pressure due to aggressive expansion; 3) Asiana will focus on balance sheet improvement, whereas KAL needs to take higher interest cost burden due to large investments in the next few years; and 4) Asiana’s valuation looks more attractive at the current price.
We initiate coverage of KAL with an OUTPERFORM rating and a target price of W85,000 (18% potential upside) and of Asiana with an OUTPERFORM rating and a target price of W12,200 (23% upside), based on 2011E target P/Bs of 1.7x and 1.6x, respectively, which are up-cycle P/B multiples. Our regional airline P/B versus ROE profile suggests higher valuation attractiveness for Asiana with a target P/B of 1.9x, based on 2011 ROE of 28%, but we apply a 15% discount to reflect the potential risk of a Korea Express stake sale, which we think is unlikely in the near term.
Too early to turn negative on the Korea airline sector
We expect positive passenger demand outlook in both inbound and outbound businesses in 2011
YoY growth may be challenging due to high base in 2010, but the demand continues to remain solid
Forex and fuel outlook remains favourable for airlines
Asiana looks more attractive than KAL in the near term
18 O
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Ko
rea Airlin
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Asian airlines – valuation comparison Figure 8: Asia airlines – valuation comparison Country Bloomberg Share px Latest Mkt cap Target Upside P/B (x) ROE (%) EV/EBITDAR (x) P/E (x) Net Gearing (%)*
Average ex China 1.9 1.7 1.5 6 17 16 12.6 8.1 6.9 7.3 25.1 11.6 197 150 127
* Net Debt to equity, including capitalised operating lease
Note: Closing prices as of 15 October 2010.
Source: Company data, Credit Suisse estimates
18 October 2010
Korea Airline Sector 5
Positive passenger demand outlook We believe international passenger demand will remain strong in 2011 due mainly to: 1) further improvement in outbound demand on the back of continued economic recovery as well as a strengthening KRW, and 2) increasing overseas travel demand, especially in China, which we believe is a key growth driver for Korean carriers.
Figure 9: Korea: GDP growth vs international RPK growth
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Further upside to outbound passenger demand Despite the market’s recent attention to inbound and transit demand, outbound passenger business is still the most important to both Korean carriers, given its larger revenue contributions and better profitability due to higher ticket prices.
Figure 10: KAL and Asiana – international passenger traffic summary 2007 2008 2009 2010E 2011E 2012E
International pax yield (cents) 9.3 8.9 7.1 8.7 9.2 9.5
Korea GDP growth (%) 5.1 2.3 0.2 6.7 4.9 n.a.
Source: Company data, Credit Suisse estimates
Above-trend GDP growth to drive Korea overseas travel demand
Faster-than-expected economic recovery in Korea and thereby an appreciating KRW would be two important macro drivers to boost Korean overseas travel demand as well as outbound air passenger demand in 2010-11E, in our view. Like other countries, both GDP per capita and currency (the KRW to USD rate) have shown strong correlations with the number of outbound passengers. Based on GDP growth of 4.9% and 4.5% KRW appreciation versus USD in 2011, we expect further upside in the organic growth of Korean overseas travellers in addition to post-crisis recovery from early this year. According to our historical observation (Figure 12), the number of outbound passengers increases by 1.14% for every 1% appreciation in the KRW against the USD.
Outbound passenger business is still the most important for Korean carriers
Slowing, but still positive economic growth will encourage continued demand increase
18 October 2010
Korea Airline Sector 6
Figure 11: Korea: GDP per capita vs no. of overseas
travellers
Figure 12: Number of total outbound pax vs KRW/USD
(YoY changes, 1981-2009)
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As shown in Figures 13 and 14, average RPK (Revenue Passenger Kilo) growth-Korea GDP growth multiplier for KAL and Asiana is 1.70x for 1992-2009 and 1.74x for 1997-2009, respectively, and our RPK forecast for both companies in the 2010-2011E were based on each company’s historical average multiplier and new aircraft addition plan. KAL has large expansion plans in 2011-12, while Asiana does not due to its greater focus on balance sheet improvement.
EAsiana: RPK grow th/GDP grow th Av erage (1997-2009)
1997-2009 av erage: 1.74x
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Source: BOK, Company data, Credit Suisse estimates Source: BOK, Company data, Credit Suisse estimates
Recovery is not over yet, especially in Chinese routes
Although we are ahead of record-high earnings from the international passenger business of both KAL and Asiana in 3Q10, the total number of Korean outbound passengers from January to August 2010 was still 7.5% lower than that in the same period in 2007, a peak year before the credit crisis. More importantly, the number of Korean outbound passengers to China, on which we are very keen as a part of the China theme, was still 15.3% lower compared with that in 2007 (Figure 15). We understand 2007 was an exceptionally good year with strong macro support, especially KRW/USD rate of 929, the lowest in the past 10 years, but assuming higher GDP per capita in 2011 and continued KRW appreciation, we believe outbound passenger demand next year is likely to exceed that in 2007. Outbound, as a still more important RPK driver than inbound (Figure 16), its further recovery will directly improve both Korean carriers’ total RPK, together with steady growth trend in inbound.
The number of outbound passengers year to date still indicates upside, compared with that in 2007
18 October 2010
Korea Airline Sector 7
Figure 15: No. of outbound pax (Jan-Aug): 2011 vs 2007 Figure 16: Korea: inbound vs outbound vs KAL int’l RPK
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Source: Ministry of Justice (MOJ), KTO Source: MOJ, KTO, Company data
Downsizing domestic business in both carriers
For both the Korean carriers, domestic passenger business used to account for more than 10% of total revenues until 2004, but it has fallen continuously and is likely to reach below 5% in 2010, in our view. Both KAL and Asiana admit that domestic business is hard to make profits due to very low pricing by low-cost carriers (LLCs) mostly focusing on domestic routes and increasing competition with HSR (high speed rails) offering cheaper prices with better access to the cities. Korean HSR started its first operations back in 2004, when both KAL and Asiana’s domestic contribution started falling, and HSR will press the domestic airline business further with the opening of Daegu-Busan route in November this year. With the completion of the Daegu-Busan leg, it will take only two hours 18 minutes from Seoul to Busan compared to 55 minutes by air, which we believe is not much difference, given that the location of train stations is normally closer downtown compared to the airport, which is away from the city.
KAL and Asiana do not have detailed plan for domestic business for now, but both carriers will continue to reduce their domestic capacity at the parent level and shift some to their subsidiary LLCs, such as KAL’s Jin Air (not listed) and Asiana’s Busan Air (not listed), which only focuses on domestic and a few short-haul international routes. Given its very low revenue contribution and meaningless profit contribution at both carriers, domestic passenger business may not be an important part of the discussion about Korea airline sector.
China, a key growth driver Overseas travel in China: early stage of growth
With China’s increasing GDP per capita, indicating improving consumer power, we expect significant growth potential in Chinese overseas travel demand, which is the most important source of international passenger demand for the airline industry.
According to World Tourism Organisation, the number of Chinese overseas travellers will reach 100 mn in 2020, compared with 48 mn in 2009, indicating about 7% CAGR for the next 11 years. The number of overseas travellers versus GDP per capita for China and Japan proves that Chinese overseas travel demand is in the early stage of long-term growth, and we think it should be a key source of demand in the global travel industry on the back of the most promising economic growth in the world.
China has already experienced strong overseas travel demand growth. However, we believe it still has significant growth potential, given that its GDP per capita is only at
Both carriers continue to decrease domestic passenger capacity
We see significant growth potential in Chinese overseas travel demand
18 October 2010
Korea Airline Sector 8
around US$4,000, much lower than Japan’s in the early 1980s and similar to Korea’s in the late 1980s. Korea’s overseas travel demand achieved 26% CAGR from 1988 to 1996 when it peaked, with GDP per capita reaching US$12,761, before the Asian financial crisis in 1997 (Figure 11).
Figure 17: China: GDP per capita vs no. of overseas
travellers
Figure 18: Japan: GDP per capita vs no. of overseas
travellers
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Korea to benefit
As a neighbouring country, Korea is already benefiting from growing Chinese travellers, which will continue to boost inbound passenger demand for Korean airlines. The number of Chinese visitors into Korea reached 1.26 mn during January-August 2010, a 44.6% increase YoY, and this accounts for 22.0% of total foreign visitors, the second largest after Japan’s 33.9%. We believe this gap between China and Japan is narrowing further and China will take the first place finally, given that the country is still in the early stage of long-term growth.
Figure 19: No. of foreign visitors into Korea by countries Figure 20: Trend of Chinese visitors into Korea
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Korea is already benefiting from growing number of Chinese overseas travellers
18 October 2010
Korea Airline Sector 9
Increasing interest in Korea
According to a Korea Tourism Organisation (KTO) survey, most Chinese visitors came to Korea for shopping (1st) and witnessing fashion trends (3rd), besides the traditional reasons such as sightseeing (2nd) and historical remains (4th). We believe Chinese visitors’ interest in Korean culture and trends is increasing as a result of the significantly increased popularity of Korean culture, so called “Korean wave”, which attracts more Chinese to visit and spend in Korea.
From an economic perspective, as the popularity of overseas travel spreads among middle-income Chinese, Korea is on the radar due to its short distance, and thus costs lower than other destinations. A Nielsen survey in early 2009 reports that about 85% of Chinese who has no overseas travel experiences have plans for overseas travel within the next one year, and 64% of them prefer Asian countries due to the short distance.
Excluding Hong Kong and Macau, Korea has been consistently in the top three destinations of Chinese travellers, and from January to August of 2010, 1.26 mn Chinese visited Korea compared to 1.04 mn Chinese into Japan, according to the KTO and JATO, respectively. Given the worsening political relationships between China and Japan recently, we believe Chinese visitors’ preference for Korea will continue to rise.
Figure 21: Number of Chinese outbound travellers by destinations ('000 people) 2004 2005 2006 2007 2008
HK 1,300 1,353 1,433 1,614 1,756
Macau 749 848 989 1,277 1,552
Japan 102 112 128 146 156
Vietnam 78 85 51 92 146
Korea 70 84 110 131 137
Others 586 621 741 835 837
Total 2,885 3,103 3,452 4,095 4,584
Source: China National Tourism Administration
Easing visa requirement for Chinese visitors
Korea’s Ministry of Justice recently announced easing visa requirements for Chinese visitors to meet the Korean government’s goal of attracting more than 3 mn Chinese travellers per year from 2012. This change has been effective since 1 August 2010, and reflects the government’s effort to attract Chinese travellers away from other Asian destinations such as Japan and Thailand. It will take some time to check the real impact of the eased visa requirements, but the very active stance of the Korea government looks clearly positive for Korean airlines’ China related inbound business, in our view.
Figure 22: Change in visa requirements for Chinese travellers NEW OLD
Multiple Entry • Included lawyers, teachers, pension receivers, employees of Top 500 companies, and top college alumni.
• Expiry period extended to 3 years from current 1 year. • Required only two types of documents
• Only allowed for very high income levels, professors, gold card holders, etc
Double Entry • Newly created for multi-time visitors, who failed to achieve Multiple Entry
• Did not exist
Scope of “Family” • Extended to parents and parents in law of Multiple Entry visa holders
• Allowed to spouse and children of Multiple Entry visa holders
College student • Allowed to the students of a list of colleges selected by China government, regardless of wealth status
• Difficult to prove wealth status
Source: MOJ
China-Korea aviation capacity underutilised
Despite the generally accepted “strong China” theme, the Korean airline industry has experienced a pretty serious oversupply problem in the past few years in Korea-China route. As shown in Figure 23, Asiana (18%), having higher China exposure than KAL (10%), had
Korea has been one of the favourite countries for Chinese travellers
The Korea government is very active to attract more Chinese travellers
China routes offer the biggest upside for load factor increase
18 October 2010
Korea Airline Sector 10
seen a load factor deterioration since 2007, after the Korea and China government decided to double the number of traffic rights in that route, and the situation had become much worse than other routes during the credit crisis in 2009. However, with recent economic stabilisation, we believe now is a good time for the Korean airline industry to focus again on the China theme due mainly to: 1) the positive demand outlook set to grow in both inbound and outbound, 2) more potential upside in load factor improvement (still at around 65% level in 2Q10), compared with those of other major routes, and 3) limited supply growth at least in the near term. We believe this is positive for both Korean carriers, but Asiana will benefit more given its higher revenue exposure to the China route.
Figure 23: Asiana Airlines: passenger load factor trend of major international routes
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Transit demand: opportunity in the short to mid term We believe the growth of Chinese overseas travel demand is positive not just for short haul such as intra-Asia routes, but also for long haul such as Asia-Europe and transpacific (Asia-America) routes. According to the US Department of Commerce, the number of Chinese travellers into the US accounted for only 2.2% of total overseas travellers (excluding those from Canada and Mexico) in 2009, but the number has been increasing very fast at a five-year CAGR of 21% versus 3.6% for total overseas travellers. We think most airlines and airports are already keeping an eye on this trend, given its high growth potential.
Although Chinese travellers may prefer their national carriers like in other countries, given the insufficient aircraft line-ups, weak networks, and relatively low service quality of Chinese airlines, other Asian carriers including KAL aggressively enter the competition to secure transit passengers from China. Transit business is very important for KAL to be a firm regional carrier and is critical for its mid- to long-term growth and competitiveness. However, given the lower ticket prices of transits, increasing transit contribution may cause yield deterioration as shown in our historical observations (Figure 25).
Securing transit demand is important to KAL’s mid-term growth strategy, but it has downside risk in pricing in the near term
18 October 2010
Korea Airline Sector 11
Figure 24: Inbound transit pax by departure countries Figure 25: Transit as % of total pax vs passenger yields
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China JapanUS OthersChina as % of total (RHS)
(million) (%)
4
8
12
16
20
Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10
4
6
8
10
12
Transit as % of total pax (LHS) KAL - int'l pax y ield (RHS)
Asiana - int'l pax y ield (RHS)
(%) (US cents)
Source: Incheon International Airport (IIA) Source: IIA, Company data
Strengths of Incheon International Airport and KAL in capturing transit demand
1) Strong networks: Focusing on transpacific routes, the most important to Koreans strategically, Incheon International Airport (IIA) has the best balanced direct networks between Asia and North America, among major Asian airports. Despite Narita’s more coverage in North America and Chinese airports’ strength in Asia (mostly Chinese domestic airports), IIA still looks the most competitive in terms of coverage balance between the two regions. As shown in Figure 26, IIA covers 14 direct destinations in North America versus nine for the Chinese and Hong Kong airports, respectively, and 20 for Japan’s Narita. However, considering Narita’s insufficient coverage in Asia (45) compared with that of IIA (91), we think IIA’s network for transpacific routes is the strongest. Also, the still confusing aviation policy of Japan, regarding the key function of two major airports (Haneda and Narita), and the recent trouble with Japan Airlines (9205, ¥1, Not rated) will hamper Japan’s competitiveness as an Asian air transportation hub, in our view.
Figure 26: Number of non-stop destinations (major Asian airports) Beijing Shanghai Singapore Hong Tokyo
Incheon Capital Pudong Changi Kong Narita
Africa 0 2 0 3 2 1
Asia (a) 91 144 105 76 76 45
Europe 21 13 20 13 17 21
Latin America 0 0 1 0 0 1
Middle East 4 5 2 5 7 2
North America (b) 14 9 9 2 9 20
South Pacific 9 2 4 9 10 11
Total 139 175 141 108 121 101
(a) x (b) 1,274 1,296 945 152 684 900
Number of airlines 57 77 72 70 85 71
Source: Air Transport Intelligence
2) Location and flight time: Comparing the direct flight times, from Beijing and Shanghai to Los Angeles and New York, through each hub airport (Figure 27), we conclude that IIA and Japan’s Narita are more competitive than Hong Kong International Airport for the China-America route. In addition to that, IIA’s lower MCT (minimum connecting time) of 1 hour 10 minutes compared to Narita’s 1 hour 30 minutes (sourced from Official Airline Guide) also confirms its high efficiency as a hub airport.
IIA’s strengths as a regional air transportation hub will help Korean carriers to improve its regional presence
18 October 2010
Korea Airline Sector 12
Figure 27: Flight time from China to US, including transit Flight time (a) Flight time (b) Total flight time
Departure (hours) Transit (hours) Arrival (a)+(b)
Beijing Capital 2.0 Incheon 13.8 New York JFK 15.8
Beijing Capital 3.5 Tokyo Narita 12.8 New York JFK 16.3
Beijing Capital 3.3 Hong Kong 15.7 New York JFK 19.0
Shanghai Pudong 1.8 Incheon 13.8 New York JFK 15.7
Shanghai Pudong 2.7 Tokyo Narita 12.8 New York JFK 15.4
Shanghai Pudong 2.3 Hong Kong 15.7 New York JFK 18.0
Beijing Capital 2.0 Incheon 10.7 Los Angeles 12.7
Beijing Capital 3.5 Tokyo Narita 9.6 Los Angeles 13.1
Beijing Capital 3.3 Hong Kong 12.5 Los Angeles 15.8
Shanghai Pudong 1.8 Incheon 10.7 Los Angeles 12.5
Shanghai Pudong 2.7 Tokyo Narita 9.6 Los Angeles 12.2
Shanghai Pudong 2.3 Hong Kong 12.5 Los Angeles 14.8
Note: All flight times based on direct route, Source: KAYAK
3) Sufficient capacity at IIA: IIA already has enough capacity to function as a regional hub airport, dealing with maximum 44 mn passengers and 4.5 mn tonne cargo per year, but is working on the third expansion plan including the construction of terminal 2. With this W4.4 tn investment by 2015, IIA will be able to deal with maximum 62 mn passengers and 5.8 mn tonne cargo per year. Given IIA’s target number of passengers is 32 mn in 2011, we think the airport is ready to absorb increasing passengers in the China-America route. Also, with a 24-hour operation, IIA is currently able to deal with 410,000 aircraft movements per year versus Narita’s 220,000.
4) KAL is set to capture rising transit passengers, but short-term capacity pressure is likely: We think KAL is well positioned to capture Chinese transit passengers in the short to mid term due mainly to: 1) Incheon International Airport (IIA)’s competitiveness as a regional air transportation hub and 2) KAL’s relatively strong air craft line-ups compared with Chinese airlines. However, we suggest investors also keep in mind the risks of transit, such as: 1) low yield versus normal direct tickets and 2) mid- to long-term competition against Chinese airlines, which will be very challenging, in our view. In short, we believe secured transit demand will act as a good buffer to absorb the potential downside risk of load factor, especially while KAL aggressively expands its capacity in the next few years, but the impact on its yield (or profitability) should be negative, as shown in the historical trend (Figure 25).
Figure 28: No. of aircraft available for transpacific route
(2009)
Figure 29: Number of destinations: Asian carriers in
China and America
0
5
10
15
20
25
30
35
40
45
50
Air China CSA CEA KAL Asiana
B747 A340 B777
(units)
China (a) America (b) (a) x (b)
KAL 23 13 299
Asiana 21 5 105
Japan Airline 26 8 208
Air China 150 4 600
China Southern Airline 74 1 74
Cathay Pacific 14 5 70
Source: Company data Source: KAL, Asiana
KAL is well positioned to capture transit demand, but likely to face capacity pressure in the near term
18 October 2010
Korea Airline Sector 13
Transit is more important to KAL than Asiana, given its stronger networks in long haul and large aircraft expansion plans for the next two-three years. We believe KAL is well positioned to capture transit demand from China as: 1) Chinese airlines still have insufficient aircraft to compete with KAL in transpacific routes (Figure 28), 2) the Chinese government is not active on an open sky agreement with the US, while the demand is increasing, and 3) IIA will continue to support KAL with the strengths as a regional air transportation hub against other Asian airports. Also, KAL’s strong and balanced coverage of the destinations in China and North America will help the company gain market share in transit business, in our view.
New passenger supply does matter KAL may face capacity pressure in the near term
Although we are positive on the international passenger demand outlook in 2011, our view on the supply side is different based on each airline’s different capacity expansion plan. Including the addition of four units of A380s, we expect 7.9% average passenger seats growth for KAL in 2011, which is much bigger than Asiana’s 1.8%. We forecast that this will lead to an international passenger ASK (available seat kilo) growth of 8.8% for KAL and 2.0% for Asiana, but will result in lower international passenger yield growth for KAL (4.8%) compared with that of Asiana (6.3%) in 2011. We believe KAL’s near-term expansion should be a good investment for mid-term strategy to be a firm regional airline, but, in the short term, this will deteriorate its load factor as well as international passenger yield with potential increase of transit contribution.
Figure 30: Average pax seat growth (2011-12E) Figure 31: International pax ASK growth trend
Given the limited supply growth in 2010 amid a strong recovery in demand, we do not see any significant risk of oversupply this year. However, due to the aggressive expansion of Middle East airlines versus historical passenger traffic growth of only 5% on average, or 1.2x of global GDP, we believe potential industry oversupply is likely beginning 2H11.
Based on the existing order book, the delivery of the new capacity from the top-eight ME airlines will gradually increase and peak in 2014. The delivery for the rest of 2010 and 2011 is relatively mild, accounting for 6-7% of their existing fleet, compared with the above Asian carriers of 2-9%. However, 2012 onwards, we will see double-digit growth from ME carriers, with a peak of 22% in 2014 versus single-digit (and declining) growth from Asian carriers. Based on CS aerospace analyst Ross Cowley’s estimates, Boeing (BA, $70.11, OUTPERFORM, TP $95.00)’s and Airbus’ (not listed) total delivery will accelerate in 2011E-2014E, with delivery of more than 1,000 new aircraft per annum (Figure 32). On an aggregated seat basis, 2011E delivery will be equivalent to 8% of current global fleet (Figure 33).
KAL may face capacity pressure in the near term
We see a potential industry supply risk starting from late 2011
18 October 2010
Korea Airline Sector 14
Figure 32: Aircraft deliveries for Airbus and Boeing Figure 33: Delivery % of current fleet of top 8 ME and 11
Despite our positive view on KAL’s focus on transit demand from China, we see significant downside risk in this, in the mid to long term, as Chinese airlines should start focusing on longer-haul international routes given increasing competition with HSR (high speed rail) in their domestic business and their large aircraft expansion plans. Our China transportation team expects Chinese airlines to see competition from HSRs from 2H11 when another 2,000 km is put into operation and a significant threat in 2012 when a number of trunk lines come into full operation, with another additional 6,000 km. The team believes that the big-three Chinese airlines will see a potential domestic traffic loss of 6.1% in 2011 and 13.2% in 2012 to HSR, and pricing competition likely to spill over into international routes on the back of increasing capacity (see HSR, how big would the threat be?, published on 22 June 2010). We do not think this will happen in the near term, given the Chinese government’s passive stance on an open sky agreement as well as its worsening relationships with the US recently, but it can be an important risk to both Korean carriers, especially to KAL’s transit passenger demand in the mid to long term.
Figure 34: Additional operating length of China’s high
speed rails (including bullet trains)
Figure 35: Chinese airlines: potential domestic pax loss to
HSR, 2010-15E
-
1,000
2,000
3,000
4,000
5,000
6,000
2010E 2011E 2012E 2013E 2014E 2015E
(km)
9%
13%
8%
0
2
4
6
8
10
12
14
AC + SZ CEA + SA CSA + XM
Domestic traffic exposure (based on weekly flights)
(%)
9%
13%
8%
0
2
4
6
8
10
12
14
AC + SZ CEA + SA CSA + XM
Domestic traffic exposure (based on weekly flights)
Chinese airlines to increase competition in international routes, in the longer-term
18 October 2010
Korea Airline Sector 15
Stabilising, but solid cargo demand After the significant volume growth in 1H10, we expect air cargo for both KAL and Asiana to experience a smooth normalisation for the rest of 2010 and 2011. Monthly traffic data from both Korean carriers also support this view, with double-digit YoY growth in both traffic and yield during 3Q. Despite the cargo recovery starting from late 2009, both KAL and Asiana remain confident of delivering marginal positive YoY growth in 4Q10 based on the current booking ratio and we believe the IT sector’s performance including its potential restocking should be important to sustain this positive trend going into 1Q11. Besides the supply-demand situation, airlines’ profit-focused pricing policy helps the yield to remain strong during 3Q, in our view. According to the managements of both KAL and Asiana, after experiencing huge losses with yield collapse during the credit crisis, they decided to give the highest priority to profit, meaning that they will not operate loss-making air cargo anymore. We do not believe this strategy can be sustained without decent traffic support, but August-September cargo yields of about 30 US cents actually prove managements’ efforts on this, as the level is similar to that in March when cargo traffic started soaring.
Air cargo demand is slowing QoQ in 3Q10 after record-high results in a seasonally weak 2Q. However, we believe the recent concerns on the back of falling IT momentum are overdone, given resilient air cargo data in 3Q YoY, ahead of a seasonally strong 4Q and the improving global presence of Korean IT brands such as Samsung and LG. Even though YoY improvement may be challenging in 2011 due to the high base effect led by robust 2Q10 results, we are not negative on the cargo outlook next year, on the back of a solid IT outlook with a soft landing macro scenario.
Cargo is important to both Korean carriers KAL is well known as the largest air cargo carrier in the world, which is why cargo traffic has been one of the most important share price drivers. Cargo accounts for 28% of KAL’s 2009 total revenue, which is slightly lower than that of Taiwan carriers, while Asiana has 24% exposure, which is similar to that of Cathay Pacific (0293.HK, HK$21.90, OUTPERFORM, TP HK$23.00). We think the large cargo exposure of Korean and Taiwan carriers is due to both countries’ strength in global IT sector. We believe IIA’s global top tier air cargo traffic (2.3 mn tonnes in 2009, the second-largest in the world after Hong Kong International Airport’s 3.4 mn tonnes) is another key reason for the relatively large cargo exposure. Both the carriers do not disclose the profit contribution of cargo, but it should be more than that of revenue during good times as in 2010, given its higher operating leverage effect than passenger business.
We expect a smooth stabilisation in cargo demand for the rest of 2010 and 2011
Cargo is important to both Korean carriers, but slightly more so for KAL
Source: Company data, Credit Suisse estimates Source: DataStream, Company data
Economic indicators remain in healthy territory US ISM peaked in early 2010, but has still stayed within positive territory (above 50). Both Korea and global GDP growth will obviously slow next year, but we do not expect any hard landing situation globally and for Korea. Having said that, cargo traffic growth is also likely to slow, but remain positive next year, in our view. Historical data proves that KAL’s cargo traffic increased during the most of the time period with US ISM above 50 (Figure 39).
Figure 39: KAL’s monthly FTK vs US ISM index Figure 40: GDP growth vs KAL’s FTK chg. (YoY)
-40
-30
-20
-10
0
10
20
30
40
Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10
30
35
40
45
50
55
60
65
70
KAL: FTK y oy grow th (LHS) US ISM index (RHS)
(%)
-10
-5
0
5
10
15
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
E20
11E
-20
-10
0
10
20
30
Global GDP growth (LHS) Korea GDP growth (LHS)
KAL: FTK chg (yoy) (RHS)
(%) (%)
-10
-5
0
5
10
15
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
E20
11E
-20
-10
0
10
20
30
Global GDP growth (LHS) Korea GDP growth (LHS)
KAL: FTK chg (yoy) (RHS)
(%) (%)
Source: DataStream, Company data Source: DataStream, Company data, Credit Suisse estimates
IT outlook: positive in 2011 IT is the most important single industry for air cargo demand and accounted for about 80% of total Korea exports through air transportation in 2009. Despite weakened IT momentum on the back of macro worries and thus share price correction among IT companies, our house view on Korean IT names remains positive heading into 2011 on the back of improving global leadership in core segments such as memory, panel, and handsets. The IT industry is now passing through a destocking phase due to the combination of aggressive restocking early this year and an uncertain economic outlook. However, we expect that restocking may start again when economic uncertainty is more stabilised.
18 October 2010
Korea Airline Sector 17
Figure 41: Exports through air transportation vs KAL’s cargo yield
Despite recent price weakness in both DRAM and NAND, our house view remains bullish on memory heading into 4Q, and especially for 2011, due to only modest supply growth complemented by new demand drivers. We think corporate PC upgrade, servers, smartphones, and tablets, which combined represent 46% of demand, are projected to grow 63%, and price elasticity would support content growth in 2011. From Korea’s perspective, as Samsung Electronics (005930.KS, W754,000, OUTPERFORM, TP W940,000) is set to gain further global DRAM market share (Figure 42), memory export should continue to have a positive impact on air cargo demand. We forecast Samsung’s bit growth for DRAM and NAND to be 66% and 80%, respectively in 2011.
Handset
The biggest event in the global handset market was the emergence of the smartphone led by Apple’s iPhone, which took the share of traditional handset makers, including Korean manufacturers. Unlike Samsung rapidly catching up in the smartphone trend, LG Electronics (066570.KS, W100,500, NEUTRAL, TP W91,500), the second-largest handset maker in Korea, had a bad year in 2011 due to its late entry in this field. However, given the low base in 2010 as well as price elasticity, we think handset may be able to deliver YoY growth, especially in terms of volumes. Regarding handset shipments of Korean brands, we expect 15% volume growth for SEC and 12% for LGE, respectively, in 2011.
Figure 42: Samsung Electronics’ rising share in the global
DRAM market
Figure 43: Handset revenue and ASP trend
0
5
10
15
20
25
30
35
40
45(%)
1Q04
4Q04
3Q05
2Q06
1Q07
4Q07
3Q08
2Q09
1Q10
4Q10
0
10,000
20,000
30,000
40,000
50,000
2005 2006 2007 2008 2009 2010E 2011E
0
50
100
150
200
SEC Rev (LHS) LGE Rev (LHS)
SEC ASP (RHS) LGE ASP (RHS)
(US$ mn) (US$)
0
10,000
20,000
30,000
40,000
50,000
2005 2006 2007 2008 2009 2010E 2011E
0
50
100
150
200
SEC Rev (LHS) LGE Rev (LHS)
SEC ASP (RHS) LGE ASP (RHS)
(US$ mn) (US$)
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates
SEC continues to gain market share in global DRAM industry
We expect positive growth in global handset shipments in 2011
18 October 2010
Korea Airline Sector 18
Display
Robust TV demand due to the combination of high popularity in new LED models and World cup effect was actually the most important driver of strong air cargo traffic in 2Q10. As the usage of air transportation is generally for either: 1) new models only produced in Korean plants (3D LED TVs in 2Q10) or 2) urgent delivery led by strong restocking, we believe it may be difficult to expect YoY growth after exceptional strength in 2Q10. However, given strong market leadership of Korean brands even in the weak season (Figure 44) and shortened product cycle, we think the air cargo demand from display industry will continue to remain solid. We expect 11% growth in LCD (including LED) TV shipments globally in 2011.
Figure 44: Utilisation at major panel makers in 3Q10 Figure 45: Global TV shipment trend
100
90
7070-8075-80
0
10
20
30
40
50
60
70
80
90
100
Samsung LGD* AUO CMI Sharp**
(%)
0
10
20
30
40
50
60
70
80
1Q04
3Q04
1Q05
3Q05
1Q06
3Q06
1Q07
3Q07
1Q08
3Q08
1Q09
3Q09
1Q10
3Q10
E
1Q11
E
3Q11
E
0
10
20
30
40
50
60
CRT LCD *PDP OthersLCD YoY growth (RHS)
(million units) (%)
0
10
20
30
40
50
60
70
80
1Q04
3Q04
1Q05
3Q05
1Q06
3Q06
1Q07
3Q07
1Q08
3Q08
1Q09
3Q09
1Q10
3Q10
E
1Q11
E
3Q11
E
0
10
20
0
10
20
30
40
50
60
70
80
1Q04
3Q04
1Q05
3Q05
1Q06
3Q06
1Q07
3Q07
1Q08
3Q08
1Q09
3Q09
1Q10
3Q10
E
1Q11
E
3Q11
E
0
10
20
30
40
50
60
CRT LCD *PDP OthersLCD YoY growth (RHS)
(million units) (%)
* From August, ** 50-60% on Sakaifab (Gen10)
Source: Company data, Credit Suisse estimates
* Including LED TVs
Source: Company data, Credit Suisse estimates
Global leadership of Korean brands continues to improve in TV and panel industry
18 October 2010
Korea Airline Sector 19
Forex and fuel: key swing factors KRW appreciation is positive As discussed earlier, a strong KRW has historically encouraged Korean outbound passenger demand as the number of overseas travellers has increased. We assume 4.5% and 3.5% KRW appreciation to USD in 2010 and 2011, respectively, based on Credit Suisse’s forecast indicating a strengthening KRW. Both KAL and Asiana do not disclose the exact portion of foreign currency denominated revenues and expenses, but, based on the discussion with management, we think KAL has a larger revenue exposure (60-65%) versus Asiana (40-50%) due to its stronger overseas sales networks, including a bigger transit business, while expense exposure is in a similar range of 60-70%. We believe Asiana’s expense exposure to foreign currency is higher than KAL’s, due to its greater dependency on operating lease, paid in USD. In terms of debt exposure, KAL has 57%, bigger than Asiana’s 32%, due to its greater dependency on financial leasing upon than aircraft purchasing.
Although KRW appreciation is clearly positive to both carriers, due to its lower earnings base and less exposure to overseas ticket sales, Asiana will benefit more than KAL, in our view. According to our sensitivity analysis (Figure 51), Asiana’s 2011 earnings rise 3.3% for every 1% KRW appreciation, versus KAL’s 1.9%. However, the degree of positive impact should be bigger than sensitivity results, as won appreciation is generally the most important macro driver of overseas travel demand (volume) increase.
We expect KRW appreciation in the near-term, which is clearly positive for outbound passenger demand increase
18 October 2010
Korea Airline Sector 20
Figure 49: FX sensitivity: KAL vs Asiana Base -1.0% -3.0% -5.0%
W/US$ (average) 1,103.8 1,092.7 1,070.6 1,048.6
KAL NP (W bn) 601.4 612.7 635.0 656.7
Chg from Base (%) 0.0 1.9 5.6 9.2
ASIANA NP (W bn) 370.0 382.3 406.8 430.8
Chg from Base (%) 0.0 3.3 9.9 16.4
Source: Credit Suisse estimates
Stable oil price outlook Fuel is the most important cost to airliners and comprised about 30% of airlines’ revenue in 2009 (Figure 52). Due to this large contribution to total expense and its high volatility, both Korean carriers could not deliver decent operating profits in 1Q-3Q08, when oil prices peaked, even under good economic condition before the credit crisis. We believe KAL’s bigger fuel cost to revenue ratio historically versus Asiana is due to the higher average age of their aircraft and less aggressive hedging ratio (19%) versus Asiana’s (30%). Given that KAL plans to add 10 A380s and B787s (well known for high fuel efficiency) in 2011-14, we think this gap will continue to narrow.
Figure 50: Fuel cost as % of revenue Figure 51: Crude oil vs jet fuel price forecast
20
25
30
35
40
45
50
2006 2007 2008 2009
CX SIA EVA
KAL Asiana
(% of revenue)
20
25
30
35
40
45
50
2006 2007 2008 2009
CX SIA EVA
KAL Asiana
(% of revenue)
40
50
60
70
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100
110
120
130
2005 2006 2007 2008 2009 2010E 2011E 2012E
WTI Jet Fuel
(US$ per bll)
Source: Company data Source: Bloomberg, Credit Suisse estimates
Credit Suisse energy team expects a 5.7% decrease in crude oil price (WTI) in 2011, on the back of a loose supply-demand situation. However, we assumed US$94 and US$97 per barrel for jet fuel prices in 2011-12, indicating 8% and 3% increases, respectively, to be conservative on the biggest swing factor for the cost side.
As shown in Figure 54, Asiana is less sensitive than KAL on fuel price, mainly due to its higher hedging ratio than that of KAL. However, any drastic fuel price increase should badly hurt the company’s operating results regardless of traffic demand, as was experienced back in 2008, before the credit crisis.
Figure 52: Jet fuel price sensitivity Base 1.0% 3.0% 5.0%
Jet fuel price (US$/bbl) 94.0 94.9 96.8 98.7
KAL NP (W bn) 601.4 578.8 533.8 488.7
Chg from Base (%) 0.0 -3.7 -11.2 -18.7
Asiana NP (W bn) 370.0 361.7 345.3 328.8
Chg from Base (%) 0.0 -2.2 -6.7 -11.1
Source: Credit Suisse estimates
Oil prices to remain stable in 2011, on the back of loose supply and demand
18 October 2010
Korea Airline Sector 21
Prefer Asiana in the near term We prefer Asiana to KAL in the near term due to: 1) greater China exposure, 2) a tighter load factor and yield outlook in 2011, 3) greater focus on balance sheet improvement and 4) more attractive valuations with stabilising Kumho group-related risks.
Better China play Asiana has consistently focused on China routes and has 18% revenue exposure versus KAL’s 10%. Unfortunately, this large China exposure has affected it negatively since 2007 due to the China-Korea Aviation Agreement in 2006, which doubled the number of traffic rights in China routes. However, we think now is a good time to focus again on Asiana with the China growth theme, given the load factors of the other two major routes (North America and Japan) recently hit historical high on the back of rapid demand recovery in 2010, while China still shows relatively slow recovery (Figure 55). Based on IIA’s monthly traffic data, we expect significant improvement in China routes in the seasonally strong 3Q, but it still indicates the biggest upside potential in load factor increase, which will be filled with rising Chinese travellers into Korea as well as further recovery in Korean outbound passengers to China, in our view. We believe Asiana will benefit more than KAL for this China growth with larger revenue exposure and stronger direct networks.
Figure 53: KAL: Passenger revenue by routes (2Q10) Figure 54: Asiana: Passenger revenue by routes (2Q10)
America
34%
Europe
16%China
10%
Japan
14%
SEA
16%
Domestic
10%
America
21%
Europe
7%
Oceania
5%
China
18%
Japan
21%
SEA
18%
Domestic
10%
Source: Company data Source: Company data
Figure 55: Load factor comparison of major int’l passenger routes: Asiana vs KAL Asiana (%) KAL (%)
2Q07 2Q09 2Q10 2Q07 2Q09 2Q10
Japan 69.6 62.0 71.7 66.7 60.9 73.7
North America 88.8 76.1 87.1 81.0 73.4 83.7
China 65.7 51.1 64.6 61.1 54.1 72.5
Total 75.5 66.4 76.9 73.5 66.3 76.2
Source: Company data
Asiana has greater revenue exposure to China routes than KAL
18 October 2010
Korea Airline Sector 22
KAL’s aggressive expansion may cause pricing risk Although we think KAL’s mid-term strategy focusing on the increasing transit demand from China is reasonable, its large expansion in the next few years will be a pressure on passenger load factor as well as yield. KAL is well positioned to attract Chinese transit passengers with its strong network in transpacific routes and better aircraft line-ups than Chinese airlines; however, generally low transit ticket prices may cause margin deterioration in the near term. In contrast, Asiana’s conservative expansion plan may help the company’s load factor and yield remain tight in the near term. We forecast lower international passenger yield growth for KAL of 4.8% and 2.8%, compared with Asiana’s 6.3% and 3.5% for 2011 and 2012, respectively.
Figure 56: Yield and load factor comp: KAL vs Asiana Figure 57: Aircraft addition plan: KAL vs Asiana
KAL int'l load fac tor (RHS) Asiana int'l load factor (RHS)
(US cents) (%)
119 119 117 117 116 121 126119
127
146152
132
0
20
40
60
80
100
120
140
160
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
E
2011
E
2012
E
KAL Asiana
(units)
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates
Asiana’s focus on balance sheet improvement Although we like KAL’s investment plan to enhance its regional presence by securing transit demand for China-America route, the required financing cost for new aircraft addition still looks burdensome. Based on KAL management’s preference for financing leases to operating leases historically, we think that despite strong operating results, the company may not reduce its net debt to equity ratio in the next few years and the EBITDA interest coverage ratio will also deteriorate (3.6x in 2011 from 3.8x in 2010) with the rising pressure of potential interest hikes, going forward. Unlike KAL, Asiana is unlikely to expand its capacity aggressively until it introduces 30 A350s from 2016-19, due to its high focus on balance sheet improvement based on the agreement with creditors. We believe such a conservative investment could be a risk for Asiana’s mid- to long-term competitiveness, but it would help the company maintain a better shape in the near term given: 1) slowing economic growth after a strong recovery in 2010 and 2) the interest rate hike environment. We believe the limited capacity growth will make Asiana’s yield and load factor remain tighter than those of regional peers, including KAL. In the long term, the improved balance sheet of Asiana should also help the company to be more flexible in financing, which is very important to the airline business and withstand any potential downturn, in our view.
We expect potential capacity pressure for KAL in the near term
Asiana to focus strongly on balance sheet improvement under creditors’ control
18 October 2010
Korea Airline Sector 23
Figure 58: KAL: Net debt and interest coverage ratio Figure 59: Asiana: Net debt and interest coverage ratio
5,000
7,000
9,000
11,000
13,000
15,000
2007 2008 2009 2010E 2011E 2012E
1.0
1.5
2.0
2.5
3.0
3.5
4.0
Net Interest bearing debt (LHS)
EBITDA interest cov erage ratio (RHS)
(W bn) (x )
3,000
3,500
4,000
4,500
5,000
5,500
6,000
6,500
2007 2008 2009 2010E 2011E 2012E
-1
0
1
2
3
4
5
6
Net Interest bearing debt (LHS)
EBITDA interest cov erage ratio (RHS)
(W bn) (x )
Note: Net debt includes capitalised operating lease
Source: Company data, Credit Suisse estimates
Note: Net debt includes capitalised operating lease
Source: Company data, Credit Suisse estimates
Attractive valuation Further upside for Asiana, based on regional comparison
Despite a recent catch-up in the stock price performance, trading at 1.3x 2011E book value, Asiana still looks more attractive than KAL at 1.5x and regional peers average of 1.5x excluding China’s “Big 3” (Air China, CEA and CSA) (1.8x including China’s Big 3). Asiana’s high ROE of 28% versus KAL’s 17% and the regional peer average of 16% in 2011 also proves Asiana stock’s valuation merit among regional airline peers. Given that it deserves to benefit from an improving load factor and yield in the international passenger business next year, we prefer Asiana to KAL on both valuations as well as operating momentum heading into 2011.
Figure 60: Asia airlines (ex. China): P/B vs ROE
comparison (2011E)
Figure 61: Asia airlines: P/B comparison (2011E)
0.8
0.9
1.0
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
10 15 20 25 30
2011E ROE (%)
2011 P/B (x )
SIA
CX
Quantas
KAL
AirAsiaCAL
EVA Air
Asiana
4.3
2.6
0.0
0.4
0.8
1.2
1.6
2.0
CEA
Air C
hina
CSA
AirA
sia
Chi
na A
irlin
es
EVA
Air
Cat
hay
Paci
fic
KAL
Asia
na
Sing
apor
e Ai
rline
s
Qan
tas
Airw
ays
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates
Initiating coverage on KAL and Asiana with an OUTPERFORM
Our regional airline PB vs. ROE profile originally suggests a 2011E target P/B multiple of 1.9x for Asiana based on 28% ROE. However, as we apply a 15% discount to Asiana’s original target multiple to reflect the potential risk of Korea Express (000120.KS, W67,600, Not rated) stake sale, our target price of Asiana is based on 1.6x, which is in line with its
Asiana looks more attractive than KAL in terms of valuation
18 October 2010
Korea Airline Sector 24
average up-cycle P/B multiple. For KAL, we set our target P/B at 1.7x, which is in the higher range between +1 and +2 standard deviations of one-year forward P/B since 2003. Given KAL’s high operating profit margin as well as ROE compared with that during the last peak in 2007, we believe the stock deserves a higher up-cycle valuation multiple. We initiate coverage on KAL with an OUTPEFORM rating and a target price of W85,000 (18% potential upside) and Asiana with an OUTPERFORM and a target price of W12,200 (23% potential upside).
Figure 62: KAL: one-year forward P/B vs trailing ROE Figure 63: Asiana: one-year forward P/B vs trailing ROE
0.0
0.5
1.0
1.5
2.0
2.5
Jan 92 Jan 95 Jan 98 Jan 01 Jan 04 Jan 07 Jan 10
-80
-60
-40
-20
0
20
40
1 y ear fw d PB
Trailing ROE (RHS)
(X) (%)
0.0
0.5
1.0
1.5
2.0
2.5
Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10
-100
-80
-60
-40
-20
0
20
40
60
Trailing ROE (RHS)
1 y ear fw d PB
(%)(x )
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates
Figure 64: KAL: one-year forward P/B since 2003 Figure 65: Asiana: one-year forward P/B since 2003
0.0
0.5
1.0
1.5
2.0
Jan
03
Jan
04
Jan
05
Jan
06
Jan
07
Jan
08
Jan
09
Jan
10
-1
(x )
+2 STD
-1 STD
+1 STD
Av erage
0.0
0.5
1.0
1.5
2.0
Jan
03
Jan
04
Jan
05
Jan
06
Jan
07
Jan
08
Jan
09
Jan
10
+2 STD
+1 STD
-1 STD
Av erage
-2 STD
(x )
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates
Figure 66: KAL: one-year forward P/B vs operating margin Figure 67: Asiana: one-year forward P/B vs op. margin
-
0.5
1.0
1.5
2.0
2.5
Jan
92
-5
0
5
10
15
1 year fwd PB (LHS) OP margin (RHS)
(X) (%)
Jan
93
Jan
95
Jan
97
Jan
99
Jan
01
Jan
03
Jan
05
Jan
07
Jan
09
Jan
11
0.0
0.5
1.0
1.5
2.0
2.5
-10
-5
0
5
10
15
1 year fwd PB (LHS) OP margin (RHS)
(X) (%)
Jan
00
Jan
01
Jan
02
Jan
03
Jan
04
Jan
04
Jan
05
Jan
06
Jan
07
Jan
08
Jan
09
Jan
10
Jan
11
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates
18 October 2010
Korea Airline Sector 25
Asia Pacific / South Korea Airlines
Korean Airlines (003490.KS / 003490 KS)
Short-term capacity pressure ■ Initiating coverage with OUTPERFORM and target price of W85,000. We
like KAL’s strategic focus on transpacific routes, but think it may face capacity pressure in the near term given aggressive expansion in the next few years.
■ Well positioned to enhance its regional presence. KAL’s strategy to capture the rising transit demand in China-America routes looks reasonable and this should be a good stepping stone for KAL to be a prominent regional airline in Asia. We think KAL is well ready to attract Chinese transit passengers on the back of: 1) IIA’s competitiveness as a regional air transportation hub and 2) its relatively strong aircraft line-ups compared with Chinese airlines, as well as more competitive networks vs. regional peers.
■ Pricing risks in the near term due to large expansion. We believe its international passenger business may face a few challenges in the near term, such as: 1) load factor deterioration and a rising interest cost burden due to aggressive capacity expansion in 2011-12 and 2) downward pressure on yield due to a potential rise in transit contribution. Mid to long-term competition with Chinese airlines for transit demand should also be challenging, in our view. However, we think recent concerns on cargo are overdone, given a solid demand outlook with: 1) soft-landing macro situation and 2) the rising global leadership of Korean IT brands.
■ Current valuation indicates 18% potential upside. Our target price of W85,000 is based on 2011E target P/B of 1.7x, which is the up-cycle P/B multiple in the higher range between +1 and +2 standard deviations since 2003. Trading at 1.5x 2011 book, we think KAL’s current valuation does not look demanding, especially after the recent correction on cargo concerns, but our preferred pick is Asiana on its better near-term outlook as well as higher valuation merit.
Share price performance
20000
70000
Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 Jun-10
60
110
160Price (LHS) Rebased Rel (RHS)
The price relative chart measures performance against the KOREA SE COMPOSITE (KOSPI) index which closed at 1902.29 on 15/10/10 On 15/10/10 the spot exchange rate was W1111.25/US$1
Well positioned to enhance its regional presence We believe KAL’s strategy to capture rising demand in China-America routes looks reasonable and this will be a good stepping stone for KAL to be a firm regional airline in Asia. KAL is well positioned to attract Chinese transit passengers due mainly to: 1) Incheon International Airport (IIA)’s competitiveness as a regional air transportation hub and 2) KAL’s relatively strong aircraft line-up compared with Chinese airlines. However, we believe the competition against Chinese airlines should be much more challenging in the longer term, given their aggressive capacity expansion plan and rising interest in international long haul routes, as their domestic competition is getting tougher due to oversupply in airlines, as well as increasing threat from high speed rails which continue to expand its network.
KAL plans large expansion from next year, which will add 10 A380s and B787s, respectively. As six units of each type of aircraft were scheduled to be delivered in 2011 and 2012, we forecast its average number of seats will increase 8% and 9% in 2011-12, respectively. We agree with the company’s mid-term strategic direction, given its high growth potential in transpacific routes on China demand, but near-term capacity pressure may not be avoidable, in our view.
KAL is well prepared to be a prominent regional carrier by capturing rising transit demand on transpacific routes
Pricing risks in the near term due to large expansion We believe KAL’s international passenger business may face a few challenges in the near term, including: 1) load factor deterioration and increasing interest cost burden on the back of aggressive capacity expansion and 2) falling yield due to potential increase of transit contribution. Large investment in the next few years looks reasonable for the company’s mid to long-term competitiveness, but this should be put near-term pressure on pricing given positive, but slowing, economic growth and industry supply set to pick up from 2H11.
Regarding cargo, we think recent concerns on the back of falling IT momentum is overdone and the demand in 2011 will remain solid due to improving global leadership of Korean brands and soft-landing economy situation. But, given high base driven by strong results in seasonally weak 2Q10, cargo may not achieve YoY growth next year, in our view.
Figure 70: KAL: Passenger load factor and yield trend Figure 71: KAL: Cargo load factor and yield trend
60
65
70
75
80
2005 2006 2007 2008 2009 2010E 2011E 2012E
80
85
90
95
100
105
110
115
Passenger load factor (LHS) Passenger yield (RHS)
(W/RPK)(%)
60
65
70
75
80
2005 2006 2007 2008 2009 2010E 2011E 2012E
80
85
90
95
100
105
110
115
Passenger load factor (LHS) Passenger yield (RHS)
(W/RPK)(%)
60
65
70
75
80
2005 2006 2007 2008 2009 2010E 2011E 2012E
200
250
300
350
400
Cargo load factor (LHS) Cargo yield (RHS)
(W/FTK)(%)
60
65
70
75
80
2005 2006 2007 2008 2009 2010E 2011E 2012E
200
250
300
350
400
Cargo load factor (LHS) Cargo yield (RHS)
(W/FTK)(%)
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates
Short-term capacity pressure is likely, given its aggressive expansion in the next few years
18 October 2010
Korea Airline Sector 28
Current valuation indicates 18% potential upside Our target price of W85,000 is based on a 2011 target P/B of 1.7x, which is the up-cycle P/B multiple in the higher range between +1 and +2 standard deviation of one-year forward P/B since 2003. Given its higher operating profit margins as well as ROE, compared with those during the last peak in 2007, we think the stock deserves a higher multiple. Our regional P/B versus ROE profile also suggests further upside on KAL trading at 1.5x 2011 book, especially after the recent correction on cargo concerns. However, given lower potential upside with a less positive near-term outlook, we prefer Asiana to KAL at current level.
Figure 72: One-year fwd P/B band Figure 73: One-year fwd P/B versus trailing ROE
0
10,000
20,000
30,000
40,000
50,000
60,000
70,000
80,000
90,000
100,000
Jan 92 Jan 95 Jan 98 Jan 01 Jan 04 Jan 07 Jan 10
0.5x
1.0x
2.0x
1.5x
0.3x
(W)
0.0
0.5
1.0
1.5
2.0
2.5
Jan 92 Jan 95 Jan 98 Jan 01 Jan 04 Jan 07 Jan 10
-80
-60
-40
-20
0
20
40
1 y ear fw d PB
Trailing ROE (RHS)
(X) (%)
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates
Investment risks Jet fuel price increase
As seen in 2007-08 period, any drastic fuel price increase could hurt company’s profitability very negatively regardless of the strength of traffic demand. Jet fuel cost accounts for about 31% and 29% of KAL’s total revenue in 2009 and 2010E, respectively, and our sensitivity analysis indicates that every 1% increase jet fuel price per unit will
We expect 18% potential upside from KAL’s current share price
18 October 2010
Korea Airline Sector 29
reduce 3.7% of net profits based on 2011 figures. We assume US$94 per barrel for 2011, indicating 8% increase YoY, which is conservative compared with Credit Suisse energy team’s oil price forecast indicating a 6% decrease in 2011.
KRW depreciation
We believe KRW appreciation will be a key positive macro driver for the increase of Korean outbound travel demand in the near term. However, in contrast, any unexpected KRW depreciation will negatively impact on our positive outlook on KAL’s international passenger demand. Our sensitivity analysis suggest every 1% KRW appreciation will hurt KAL’s net profit by 1.9%, but we think the real impact should be bigger, as the sensitivity does not reflect forex impact on traffic volume change. We currently assume 4.5% and 3.5% KRW appreciation to USD in 2010 and 2011, respectively.
Hard landing in economy
Given that air traffic growth is highly related to economic growth both for passenger and cargo business, we believe any hard landing situation in the global and Korea economy should directly affect air traffic demand negatively. Our traffic growth assumption is based on global GDP growth of 4.3% and Korea GDP growth of 4.9% in 2011.
18 October 2010
Korea Airline Sector 30
Financials Figure 76: Income statement (W bn) 2007 2008 2009 2010E 2011E 2012E
Total revenues 8,812 10,213 9,394 11,366 11,578 12,189
Domestic pax 585 602 489 530 521 507
International pax 4,632 5,352 4,973 5,760 6,232 6,673
Cargo 2,533 3,027 2,705 3,739 3,416 3,514
Others 1,062 1,232 1,227 1,336 1,409 1,494
Total expenses 8,175 10,312 9,260 10,144 10,417 11,009
Fuel 2,606 4,195 2,939 3,268 3,358 3,550
Labor 1,079 1,041 1,048 1,111 1,219 1,339
Depreciation 737 758 784 837 891 932
SG&A 1,353 1,464 1,268 1,391 1,418 1,493
Others 2,399 2,853 3,222 3,537 3,530 3,694
Operating profit 637 -99 133 1,222 1,161 1,180
Net interest gain (expense) -394 -438 -514 -544 -570 -599
Net forex gain (expense) -15 -1,853 480 117 212 171
To remain strong in 2011 ■ Initiating coverage with an OUTPERFORM and a target price of
W12,200. Despite significant outperformance in the past 12 months, we still see further upside for Asiana on the back of positive business outlook in the near term and valuation attractiveness.
■ 2011 to be as good as 2010. Unlike KAL, Asiana does not plan to increase its capacity aggressively in the near term and intends to focus more on balance sheet improvement based on its agreement with creditors. Such conservative investments could pose a risk to its mid- to long-term competitiveness, but we believe it will help Asiana’s passenger load factor and yield to remain tighter than KAL heading into 2011. We expect higher yield growth and a higher load factor for Asiana’s international passenger business than those for KAL.
■ Key beneficiary of the rising overseas travel demand in China. With 18% revenue exposure and a stronger network for China routes, we believe Asiana should be a key beneficiary of the rising overseas travel demand in China for the following reasons: 1) a persistent low load factor compared with the other major routes (Japan and North America), meaning higher potential upside and 2) a limited supply growth outlook due to the China government’s inactive stance on the open-sky agreement. The China routes should be a very important growth driver to both Korean carriers in future.
■ P/B versus ROE suggests 23% potential upside, after a 15% discount on the potential Korea Express stake sale. Trading at 1.3x 2011E book value with a 28% ROE, Asiana looks more attractive than KAL (1.5x P/B with 17% ROE) and the regional peer average (1.5x P/B with a 16% ROE) in terms of valuation. Our target price of W12,200 is based on a 2011 target P/B of 1.6x, an average up-cycle P/B multiple which is in line with our regional airline P/B versus ROE profile, including the 15% discount for the risk of the potential Korea Express stake sale.
Share price performance
2000
7000
Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 Jun-10
0
100
200Price (LHS) Rebased Rel (RHS)
The price relative chart measures performance against the KOREA SE COMPOSITE (KOSPI) index which closed at 1902.29 on 15/10/10 On 15/10/10 the spot exchange rate was W1111.25/US$1
* including capitalised operating lease; source: Company data, Thomson Reuters, Credit Suisse estimates
*Stock ratings are relative to the relevant country benchmark. ¹Target price is for 12 months. [V] = Stock considered volatile (see Disclosure Appendix).
2011 will be as good as 2010 Unlike KAL, Asiana does not plan to increase its capacity aggressively in the near term and it would like to focus more on balance sheet improvement based on the agreement creditors. We forecast only 2% growth in the average number of seats in 2011. Such a conservative investment could pose a risk to its mid- to long-term competitiveness, given the relatively lower entry barriers for short haul where Asiana currently has a large exposure. However, we believe this will help Asiana’s passenger load factor and yield to remain tighter than KAL’s, in the short term. We don’t expect any different trend in Asiana’s cargo business compared with that of KAL, which means our view remains positive on cargo next year despite slowing traffic due to the high base effect from 2010.
Asiana’s international passenger business to remain strong in 2011, on the back of a tight load factor and yield
Figure 81: Asiana: Passenger load factor and yield trend Figure 82: Asiana: Cargo load factor and yield trend
60
65
70
75
80
2005 2006 2007 2008 2009 2010E 2011E 2012E
85
90
95
100
105
110
Passenger load factor (LHS) Passenger yield (RHS)
(W/RPK)(%)
60
65
70
75
80
2005 2006 2007 2008 2009 2010E 2011E 2012E
85
90
95
100
105
110
Passenger load factor (LHS) Passenger yield (RHS)
(W/RPK)(%)
60
65
70
75
80
2005 2006 2007 2008 2009 2010E 2011E 2012E
200
250
300
350
400
Cargo load factor (LHS) Cargo yield (RHS)
(W/FTK)(%)
60
65
70
75
80
2005 2006 2007 2008 2009 2010E 2011E 2012E
200
250
300
350
400
Cargo load factor (LHS) Cargo yield (RHS)
(W/FTK)(%)
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates
Key beneficiary of China demand growth With 18% revenue exposure and stronger networks in China route, we think Asiana should be a key beneficiary of rising overseas travel demand in China for the following reasons: 1) its persistently low load factor compared with the other major routes (Japan and North America), meaning higher potential upside and 2) a limited supply growth outlook due to the China government’s inactive stance on the open-sky agreement. China route will be a very important growth driver to both Korean carriers in future. We also expect further potential upside in the number of Korean travellers to China, as the January-August 2010 figure is still 15% lower than that in 2007, before the credit crisis. Based on improving GDP per capita in Korea with continued Korean won appreciation, increasing overseas travel demand should continue to push up the load factor of China routes, going forward.
Growing China demand to be helpful to Asiana, which has 18% revenue exposure to China routes
18 October 2010
Korea Airline Sector 35
Figure 83: Quarterly revenue by routes Figure 84: China route – quarterly revenue vs % of total
0
100
200
300
400
500
600
700
800
1Q01
1Q02
1Q03
1Q04
1Q05
1Q06
1Q07
1Q08
1Q09
1Q10
Domestic Japan SEA China
North America Europe Oceania
(W bn)
0
20
40
60
80
100
120
140
1Q01
3Q01
1Q02
3Q02
1Q03
3Q03
1Q04
3Q04
1Q05
3Q05
1Q06
3Q06
1Q07
3Q07
1Q08
3Q08
1Q09
3Q09
1Q10
5
10
15
20
25
China China as % of total
(W bn) (%)
0
20
40
60
80
100
120
140
1Q01
3Q01
1Q02
3Q02
1Q03
3Q03
1Q04
3Q04
1Q05
3Q05
1Q06
3Q06
1Q07
3Q07
1Q08
3Q08
1Q09
3Q09
1Q10
5
10
15
20
25
China China as % of total
(W bn) (%)
Source: Company data Source: Company data
Stabilised Kumho group risk During the credit crisis, the former Kumho group faced liquidity problems as it had aggressively participated in big M&As such as Daewoo E&C (047040.KS, W12,250, UNDERPERFORM [V], TP W9,500) and Korea Express acquisitions, with high leverage including the putback options for financial investors (FIs). Eventually, the group failed and most of its core affiliates including the acquired entities are now under the control of creditors and FIs (Figure 87). Asiana is also under creditor control through Kumho Industrial (002990.KS, W4,840, Not rated) and, early this year, there was actually some news flow regarding Asiana’s potential capital reduction by creditors, which was carried out for other former Kumho affiliates except Kumho Petrochemical (011780.KS, W73,800, Not Rated). However, the current situation is much better for Asiana, as its operations have successfully turned around with cyclical strength in addition to a successful W150 bn bond issuance in August 2010, despite the ongoing group restructuring.
Figure 85: Kumho Group structure under creditors’ control
Park family and related parties
Kumho Petrochem
(Treasury: 19.7%)
Kumho Tire (under capital
reduction process)
KDB Life Insurance *
Asiana Airlines
24.0%
58.2%
44.6%
14.0%
Korea Express
Daewoo E&C
Creditors & FIs excluding KDB
0.5%
KDB
24.0%
12.2%
85.0%
33.5%
4.5%
2.8%
5.6%
0.7%
1.0%
40.9%
Kumho Industrial
Source: FSS, Company data
Kumho group-related risk has stabilised, as most of problematic affiliates are now under creditors’ control
18 October 2010
Korea Airline Sector 36
We believe it is very unlikely that either management or the creditors of Asiana will decide to dispose of Asiana’s stake in Korea Express at the current market price in the near term. Kumho group restructuring may take some time, in our view, given that the creditors hold a significant stake in three major former Kumho affiliates including Daewoo E&C, which the creditors have failed to sell. We believe Korea Express may not be a high priority in this entire restructuring, and we also do not think the creditors would want to speed up a Korea Express stake sale, as: 1) the potential loss from the asset disposal could be a burden on Asiana’s balance sheet, which is delivering one of the best operating performances among all the former Kumho affiliates; and 2) Korea Express’s logistics business generally shows a high correlation with the macro economic conditions, meaning a further recovery is likely with a soft landing economy. However, we have applied a 15% discount to Asiana’s 2011 target P/B multiple (based on a regional P/B versus ROE profile) to reflect the potential risk of a Korea Express stake sale.
Our preferred pick in Korea airline sector Trading at 1.3x 2011E book value with 28% ROE, Asiana has valuation merit compared with KAL at 1.5x P/B at 17% ROE and the regional peer average of 1.5x P/B and 16% ROE. Our target price of W12,200 is based on a 2011 target P/B of 1.6x, the average up-cycle P/B multiple between +1 and +2 standard deviations of a one-year forward P/B since 2003. This is also in line with our regional airline P/B versus ROE profile including 15% discount to reflect the risk of potential Korea Express stake sale. With group-related risk stabilising and a better business outlook, we prefer Asiana to KAL at current levels.
Figure 86: One-year fwd P/B band Figure 87: One-year fwd P/B versus trailing ROE
0
2,000
4,000
6,000
8,000
10,000
12,000
14,000
Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10
0.7x
1.0x
2.0x
1.4x
0.4x
(W)
0.0
0.5
1.0
1.5
2.0
2.5
Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10
-100
-80
-60
-40
-20
0
20
40
60
Trailing ROE (RHS)
1 y ear fw d PB
(%)(x )
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates
Figure 88: One-year fwd P/B band since 2003 Figure 89: One-year fwd EV/EBITDAR trend
0.0
0.5
1.0
1.5
2.0
Jan
03
Jan
04
Jan
05
Jan
06
Jan
07
Jan
08
Jan
09
Jan
10
+2 STD
+1 STD
-1 STD
Av erage
-2 STD
(x )
4
9
14
19
Jan
00
Jan
01
Jan
02
Jan
03
Jan
04
Jan
05
Jan
06
Jan
07
Jan
08
Jan
09
Jan
10
1 y ear fw d EV/EBITDAR Av erage
(x )
Av erage since 2000 = 8.9x
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates
Korea Express stake sale is unlikely in the near tern, in our view
Asiana is our preferred pick in the Korea airline sector heading into 2011
18 October 2010
Korea Airline Sector 37
Investment risks Jet fuel price increase
As seen in 2007-08 period, any drastic fuel price increase could hurt Asiana’s profitability very negatively regardless of the strength of traffic demand. Jet fuel cost accounts for about 31% and 27% of Asiana’s total revenue in 2009 and 2010E, respectively, and our sensitivity analysis indicates that every 1% increase in jet fuel price per unit will reduce 2.2% of net profit based on 2011 figures. We assume US$94 per barrel for 2011, indicating an 8% increase YoY, which is conservative compared with Credit Suisse energy team’s oil price forecast indicating a 6% decrease in 2011.
KRW depreciation
We believe KRW appreciation will be a key positive macro driver for the increase of Korean outbound travel demand in the near term. However, in contrast, any unexpected KRW depreciation will negatively impact on our positive outlook on Asiana’s international passenger demand. Our sensitivity analysis suggests that every 1% KRW appreciation will hurt Asiana’s net profit by 3.3%, but we think the real impact should be bigger, as the sensitivity analysis does not reflect forex impact on traffic volume change. We currently assume 4.5% and 3.5% KRW appreciation to USD in 2010 and 2011, respectively.
Hard landing in economy
Given that air traffic growth is highly related to economic growth both for passenger and cargo business, we believe any hard landing situation in the global and Korea economy should directly affect air traffic demand negatively. Our traffic growth assumption is based on global GDP growth of 4.3% and Korea GDP growth of 4.9% in 2011.
Kumho group restructuring related risks
Given: 1) successful bond issuance recently during the Kumho group restructuring and 2) strong turnaround in operating results, we do not see a high likelihood that creditors insist on capital reduction for Asiana Airlines in the near term. However, any drastic decision for the sale of Asiana’s stake in Korea Express may cause a burden on Asiana’s balance sheet, considering Asiana’s low equity base and quite large gap between the book value and market value of Korea Express’ stake. We applied a 15% discount on Asiana’s target P/B to reflect this potential risk.
18 October 2010
Korea Airline Sector 38
Financials Figure 90: Income statement Year-end 31 Dec (W bn) 2007 2008 2009 2010E 2011E 2012E
Total revenue 3,650 4,261 3,887 5,039 5,073 5,211
Domestic pax 267 303 256 252 247 242
International pax 1,873 2,225 2,058 2,685 2,819 2,915
Cargo 896 1,088 952 1,347 1,231 1,266
Others 614 646 621 756 777 789
Total expenses 3,479 4,314 4,124 4,423 4,475 4,623
Fuel 1,008 1,574 1,216 1,351 1,392 1,470
Labor 448 482 477 501 549 596
Depreciation 241 264 207 227 214 216
Others 1,782 1,994 2,223 2,345 2,320 2,340
Operating profit 172 -53 -237 616 599 588
Net interest gain (expense) -107 -212 -191 -164 -143 -136
Net forex gain (expense) -10 -247 87 56 38 25
Others 60 247 -40 0 0 0
Pre-tax profit 114 -265 -381 509 493 477
Income tax 8 -37 -114 117 123 119
Net profit 106 -227 -266 391 370 358
EBITDA 414 213 -29 844 813 805
EBITDRAF 711 279 437 1,269 1,226 1,213
Operating margin (%) 4.7 -1.2 -6.1 12.2 11.8 11.3
Net profit margin (%) 2.9 -5.3 -6.9 7.8 7.3 6.9
EBITDA margin (%) 11.3 5.0 -0.7 16.7 16.0 15.5
EBITDRAF margin (%) 19.5 6.6 11.2 25.2 24.2 23.3
Source: Company data, Credit Suisse estimates
18 October 2010
Korea Airline Sector 39
Figure 91: Balance sheet Year-end 31 Dec (W bn) 2007 2008 2009 2010E 2011E 2012E
As of close of business on 15 October 2010, Credit Suisse Securities (Europe) Limited, Seoul Branch performs the role of liquidity provider on the warrants of which underlying assets are Korean Airlines and holds 9,819,460 of warrants concerned. These may be covered warrants that constitute part of a hedged position.
18 October 2010
Korea Airline Sector 40
Companies Mentioned (Price as of 15 Oct 10) Air China (0753.HK, HK$10.94, NEUTRAL [V], TP HK$8.00) AirAsia (AIRA.KL, RM2.36, OUTPERFORM, TP RM2.70) Airports of Thailand (AOT.BK, Bt40.25, NEUTRAL [V], TP Bt45.00) Asiana Airlines (020560.KS, W9,900, OUTPERFORM, TP W12,200) AU Optronics (2409.TW, NT$30.85, OUTPERFORM, TP NT$35.00) Boeing (BA, $70.11, OUTPERFORM, TP $95.00) Cathay Pacific (0293.HK, HK$21.90, OUTPERFORM, TP HK$23.00) Chimei Innolux Corporation (3481.TW, NT$40.75, OUTPERFORM [V], TP NT$44.00) China Airlines (2610.TW, NT$23.80, OUTPERFORM, TP NT$23.00) China Eastern Airlines - H (0670.HK, HK$5.04, UNDERPERFORM [V], TP HK$2.20) China Southern Airlines - H (1055.HK, HK$5.58, UNDERPERFORM [V], TP HK$3.00) Daewoo E&C (047040.KS, W12,250, UNDERPERFORM [V], TP W9,500) EVA Air (2618.TW, NT$28.45, OUTPERFORM [V], TP NT$28.60) Japan Airlines (9205, ¥1, NOT RATED) Korea Express (000120.KS, W67,600, NOT RATED) Korea Kumho Petrochemical (011780.KS, W73,800, NOT RATED) Korean Airlines (003490.KS, W72,300, OUTPERFORM, TP W85,000) Kumho Indistrial (002990.KS, W4,840, NOT RATED) LG Display Co Ltd. (034220.KS, W41,250, OUTPERFORM, TP W50,000) LG Electronics Inc (066570.KS, W100,500, NEUTRAL, TP W91,500) Malaysia Airlines (MASM.KL, RM2.27, UNDERPERFORM, TP RM1.40) Malaysia Airports (MAHB.KL, RM5.87, OUTPERFORM, TP RM6.80) Qantas Airways (QAN.AX, A$2.87, OUTPERFORM, TP A$3.70) Samsung Electronics (005930.KS, W754,000, OUTPERFORM, TP W940,000) Sharp Corp. (6753, ¥835, NEUTRAL [V], TP ¥850, MARKET WEIGHT) Singapore Airlines (SIAL.SI, S$16.22, OUTPERFORM, TP S$18.50)
Disclosure Appendix Important Global Disclosures Seungwoo Hong & Sam Lee each certify, with respect to the companies or securities that he or she analyzes, that (1) the views expressed in this report accurately reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report.
See the Companies Mentioned section for full company names. 3-Year Price, Target Price and Rating Change History Chart for 0753.HK 0753.HK Closing
Price Target
Price
Initiation/ Date (HK$) (HK$) Rating Assumption 29-May-08 X 22-Jun-10 8.44 7.2 X 16-Aug-10 8.78 8 7
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Korea Airline Sector 44
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See the Companies Mentioned section for full company names. Price Target: (12 months) for (0753.HK) Method: Our 12-month target price of HK$8.0 for Air China is based on 2.0x 12-month forward P/B, which is at its historical average of price-to-book. Its profitability in 2006E and 2007E is likely to be adversely affected by high jet fuel prices. Thus, the usual earnings-based valuation methodology used for airlines stocks, such as forward enterprise value to earnings before interest, taxation, depreciation, rental, amortisation and forex gain/loss (EV/EBITDRAF) is not applicable, in our view. Risks: Risks to our 12-month target price of HK$8.0 for Air China are 1) high jet fuel price (accounts for 37% of its total operating expenses); 2) airfare discounting due to growing competition; 3) overcapacity with more new aircraft to be delivered in the next 2-3 years; and 4) slower economic growth of China. On the other hand, we believe the peaking of jet fuel price and further RMB appreciation are positive catalysts of the stock. Price Target: (12 months) for (020560.KS) Method: Our W12,200 target price on Asiana Airline is based on 2011 target PB (price to book) of 1.6x, which is average upcycle PB mutiple, between +1 and +2 standard deviation of PB since 2003. Regional airline PB vs. ROE (return on equity) profile also suggest target PB of 1.6x at 32% ROE after 15% discount on potential Korea Express stake sale. Risks: Key risks of our W12,200 target price on Asiana includes 1) higher than expected jet fuel price increase, 2) unexpected Korea won depreciation, 3) any hard landing situation in macro economy and 4) potential stake sale in Korea Express as a part of Kumho group restructuring. Price Target: (12 months) for (0670.HK) Method: Our 12-month target price of HK$2.20 for China Eastern Airlines - H is based on 2.5x our 12-month forward P/B, which is at its historical average of price-to-book plus the potential premium from the introduction of strategic investor. Its profitability in 2006E and 2007E is likely to be adversely affected by high jet fuel prices. Thus, the usual earnings-based valuation methodology used for airlines stocks, such as forward enterprise value to earnings before interest, taxation, depreciation, rental, amortisation and forex gain/loss (EV/EBITDRAF) is not applicable, in our view. Risks: Risks to our 12-month target price of HK$2.20for China Eastern Airlines - H include: 1) high jet fuel price (accounts for over 34% of its total operating expenses); 2) airfare discounting due to growing competition; 3) overcapacity, with more new aircraft to be delivered in the next 2-3 years; 4) extremely high gearing for the capex on aircraft purchase; 5) growing competition with both domestic and international airlines, as there will be more 'open-sky' initiatives in its main hub, Shanghai; and 6) failure to get strategic investor. On the other hand, we believe the peaking of jet fuel prices and further RMB appreciation will be positive catalysts for the stock. Price Target: (12 months) for (1055.HK) Method: Our 12-month target price of HK$3.0 for China Southern Airlines - H is based on 0.93x our 12-month forward P/B, which is at its historical average of price-to-book. Its profitability in 2006E and 2007E is likely to be adversely affected by high jet fuel prices. Thus, the usual earnings-based valuation methodology used for airlines stocks, such as forward enterprise value to earnings before interest, taxation, depreciation, rental, amortisation and forex gain/loss (EV/EBITDRAF) is not applicable, in our view. Risks: Risks to our 12-month target price of HK$3.0 for China Southern Airlines - H include include: 1) high jet fuel price (accounts for 32% of its total operating expenses); 2) airfare discounting due to growing competition; 3) overcapacity, with more new aircraft to be delivered in the next 2-3 years; 4) extremely high gearing for the capex on aircraft purchase; and 5) growing competition with both domestic and international airlines, as there will be more 'open-sky' initiatives in its main hub, Guangzhou. On the other hand, we believe the peaking of jet fuel prices and further RMB appreciation will be positive catalysts for the stock. Price Target: (12 months) for (047040.KS) Method: Our 12-months target price of W9,500 for Daewoo E&C is based on a sum-of-the-parts valuation, which we have a target earnings before interest, tax, depreciation and amortisation (EBITDA) of 7x in 2012E for the target net asset value (NAV) of the company's core construction business.
18 October 2010
Korea Airline Sector 45
Risks: Risks to our W9,500 target price on Daewoo E&C include: Slowing housing market and introduction of price cap on new housing are major concens for Daewoo's core operation, while earnings from houisng business currently constitutes more than half of the company's overall gross profit. Meanwhile, the ruling shareholder and the management's strong motivation to boost share price provides an upside risk to our valuation. Price Target: (12 months) for (003490.KS) Method: Our W85,000 target price on Korea Airlines is based on 2011 target PB (price to book) of 1.7x, which is an upcycle PB mutiple, in the higher range between +1 and +2 standard deviation of PB since 2003. Risks: Key risks of our W85,000 target price on Korean Air includes 1) higher than expected jet fuel price increase, 2) unexpected Korea won depreciation and 3) any hard landing situation in macro economy. Price Target: (12 months) for (034220.KS) Method: Our W50,000 target price for LG Display is based on a price-to-book (P/B) multiple of 1.6 times (LGD's historical mid cycle P/B) and a book value (BV) of FY10 to reflect: 1) confirmations of the directional improvement 2) LGD's increasingly clear leadership in the regional TFT-LCD sector. Risks: Primary risks in reaching our current target price of W50,000 for LG Display may stem from: 1) any unforeseen supply growth in the market, 2) any delay in the planned execution of the company's cost reduction measures, and 3) any unforeseen changes in end demand depending on the price-demand elasticity of TV demand globally given TFT-LCD related products are still at an early phase of adoptions by consumers. Price Target: (12 months) for (066570.KS) Method: Our W91,500 target price for LG Electronics is based on the sum of each divisional fair value estimate attained from the target enterprise value-to-earnings before interest, tax, depreciation, and amortisation (EV/EBITDA) multiple applied to 2H10+1H11 divisional EBITDA. Our choice of the sum of parts for our valuation stems from the observations that: 1) each of LG Electronics' divisions shows very distinct earnings characteristics and cycles, and 2) accordingly, each division deserves a different target multiple. We refrenced the EV/EBITDA multiple of Whirpool in the US, 4.6x for its appliance division, Thomson Multimedia in France, 2.8x for its display & media division, and Kyocera in Japan, 6.2x for its telecoms division, which are adjusted for the multiple differences between each respective market and Korea. Risks: Potential risks in reaching our current target price of W91,500 for LG Electronics stem from: 1) overall macro environment given consumer-oriented product nature of the company, 2) any unforeseen changes in supply/demand dynamics of key products (especially in handsets and display products), and 3) foreign exchange changes given its export driven earnings nature. Price Target: (12 months) for (005930.KS) Method: Our 12-month target price of W940,000 for Samsung Electronics is derived from using the average value per share which is calculated by applying the historical mid cycle 1.8x price-to-book to average FY10 and FY11 book value per share estimates. Risks: Potential risks to our 12-month target price of W940,000 for Samsung Electronics are: slowing consumption in developed countries, due to macro concerns and rising interest rates, as well as won appreciation. Rising competition from new entrants in the company's key business area, NAND flash, could increase pricing competition, and market dominance may also have a negative impact on our earnings estimates. Please refer to the firm's disclosure website at www.credit-suisse.com/researchdisclosures for the definitions of abbreviations typically used in the target price method and risk sections.
See the Companies Mentioned section for full company names. The subject company (0753.HK, 020560.KS, 1055.HK, 047040.KS, 034220.KS, 066570.KS, 005930.KS) currently is, or was during the 12-month period preceding the date of distribution of this report, a client of Credit Suisse. Credit Suisse provided investment banking services to the subject company (0753.HK, 020560.KS, 1055.HK, 047040.KS, 034220.KS, 066570.KS, 005930.KS) within the past 12 months. Credit Suisse has managed or co-managed a public offering of securities for the subject company (1055.HK, 034220.KS) within the past 12 months. Credit Suisse has received investment banking related compensation from the subject company (0753.HK, 1055.HK, 047040.KS, 034220.KS) within the past 12 months. Credit Suisse expects to receive or intends to seek investment banking related compensation from the subject company (0753.HK, 020560.KS, 1055.HK, 047040.KS, 034220.KS, 066570.KS, 005930.KS) within the next 3 months. Important Regional Disclosures Singapore recipients should contact a Singapore financial adviser for any matters arising from this research report.
The analyst(s) involved in the preparation of this report have not visited the material operations of the subject company (0753.HK, 020560.KS, 0670.HK, 1055.HK, 047040.KS, 003490.KS, 034220.KS, 066570.KS, 005930.KS) within the past 12 months.
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18 October 2010
Korea Airline Sector 46
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18 October 2010 Asia Pacific / South Korea
Equity Research
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