Korea Airline Sector

Transcription

1 18 October 21 Asia Pacific/South Korea Equity Research Airlines Research Analysts Seungwoo Hong Sam Lee Korea Airline Sector INITIATION Not ready for descent Figure 1: KAL vs Asiana: international passenger yield and load factor trend (US cent s) (%) E 211E KAL int'l pax yield (LHS) KAL int'l load factor (RHS) Asiana int'l pax yield (LHS) Asiana int'l load factor (RHS) 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 211 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 211 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 21. 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 , 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, (18% potential upside) target price and Asiana with an OUTPERFORM and W12,2 (23% potential upside) target price, based on 211E target P/B of 1.7x and 1.6x, respectively, which is an up-cycle P/B multiple. 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.

2 18 October 21 Focus charts Figure 2: Korea: GDP per capita vs number of overseas travellers (million) (US$) E 211E Korea ov erseas trav elers (LHS) Source: KTO, DataStream, Credit Suisse estimates Korea GDP per capita (RHS) (Jan-Aug) 25, 2, 15, 1, 5, Figure 4: Trend of Chinese visitors into Korea (thousand) (%) 1,4 6 1,2 5 1, No. of Chinese visitors (LHS) YoY growth (RHS) Figure 3: Number of total outbound pax vs W/US$ (YoY change, ) YoY chg (%), no. of outbound pax y = x R 2 = Source: KTO, DataStream YoY chg (%), W/US$ rate Figure 5: Transit as a % of total pax (IIA) vs passenger yield (%) (US cents) Jan 2 Jan 3 Jan 4 Jan 5 Jan 6 Jan 7 Jan 8 Jan 9 Jan 1 Transit as % of total pax (LHS) Asiana - int'l pax y ield (RHS) -1 KAL - int'l pax y ield (RHS) Source: KTO Source: IIA, Company data Figure 6: KAL s monthly FTK vs US ISM index (%) Jan 2 Jan 3 Jan 4 Jan 5 Jan 6 Jan 7 Jan 8 Jan 9 Jan 1 KAL: FTK y oy grow th (LHS) US ISM index (RHS) Source: DataStream, Company data Figure 7: Asia airlines (ex. China): P/B vs ROE comparison (211E) 211 P/B (x ) 1.8 AirAsia EVA Air 1.6 CX CAL KAL SIA Asiana Quantas E ROE (%) Korea Airline Sector 2

3 18 October 21 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 211, 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 211, 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 27, 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 2Q1, it may be challenging for Korean airlines to achieve YoY growth in cargo business next year. However, we expect more solid cargo traffic in 211 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 21 and 211, respectively, based on Credit Suisse s bullish view on the KRW. Accounting for about 25-3% 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 211 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, (18% potential upside) and of Asiana with an OUTPERFORM rating and a target price of W12,2 (23% upside), based on 211E 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 211 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 211 YoY growth may be challenging due to high base in 21, 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 Korea Airline Sector 3

4 Korea Airline Sector 4 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 (%)* 15-Oct-1 Code currency price (US$ mn) Rating price (%) 29A 21E 211E 29A 21E 211E 29A 21E 211E 29A 21E 211E 29A 21E 211E KAL Korea 349 KS KRW 72,3 4,679 O 85, n.m Asiana Korea 256 KS KRW 9,9 1,568 O 12, n.m AirAsia Malaysia AIRA MK MYR ,113 O Cathay Pacific Hong Kong 293 HK HKD ,16 O China Airlines Taiwan 261 TT TWD ,549 O EVA Air Taiwan 2618 TT TWD ,749 O Malaysia Airlines Malaysia MAS MK MYR ,46 U Malaysia Airport Malaysia MAHB MK MYR ,94 O Qantas Australia QAN AU AUD ,441 O n.a. n.a. n.a Singapore Airlines Singapore SIA SP SGD ,967 O AOT Thailand AOT TB THB ,925 N Air China China 753 HK HKD ,278 N China Eastern China 67 HK HKD 5.4 6,225 U , China Southern China 155 HK HKD ,757 U Average Average ex China * Net Debt to equity, including capitalised operating lease Note: Closing prices as of 15 October October 21

5 18 October 21 Positive passenger demand outlook We believe international passenger demand will remain strong in 211 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 (%) (%) E 211E Korea GDP growth (LHS) KAL Int'l RPK growth (RHS) Asiana Int'l RPK growth (RHS) Source:BOK, Company data, Credit Suisse estimates 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 1: KAL and Asiana international passenger traffic summary E 211E 212E KAL International RPK growth (%) International pax yield (cents) Asiana International RPK growth (%) International pax yield (cents) Korea GDP growth (%) n.a. Outbound passenger business is still the most important for Korean carriers 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 21-11E, 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 211, 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. Slowing, but still positive economic growth will encourage continued demand increase Korea Airline Sector 5

6 18 October 21 Figure 11: Korea: GDP per capita vs no. of overseas travellers (million) (US$) E 211E Korea ov erseas trav elers (LHS) Source: KTO, BOK, Credit Suisse estimates Korea GDP per capita (RHS) 25, 2, 15, 1, 5, Figure 12: Number of total outbound pax vs KRW/USD (YoY changes, ) YoY chg (%), no. of outbound pax y = x R 2 = YoY chg (%), W/US$ rate Source: Korea Tourism Organization (KTO), DataStream As shown in Figures 13 and 14, average RPK (Revenue Passenger Kilo) growth-korea GDP growth multiplier for KAL and Asiana is 1.7x for and 1.74x for , respectively, and our RPK forecast for both companies in the E were based on each company s historical average multiplier and new aircraft addition plan. KAL has large expansion plans in , while Asiana does not due to its greater focus on balance sheet improvement Figure 13: KAL: RPK growth-gdp growth multiplier (x ) av erage: 1.7x Figure 14: Asiana: RPK growth-gdp growth multiplier (x ) av erage: 1.74x E 211E E 211E KAL: RPK grow th/gdp grow th Av erage ( ) Asiana: RPK grow th/gdp grow th Av erage ( ) Source: BOK, Company data, Credit Suisse estimates Recovery is not over yet, especially in Chinese routes Source: BOK, Company data, Credit Suisse estimates Although we are ahead of record-high earnings from the international passenger business of both KAL and Asiana in 3Q1, the total number of Korean outbound passengers from January to August 21 was still 7.5% lower than that in the same period in 27, 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 27 (Figure 15). We understand 27 was an exceptionally good year with strong macro support, especially KRW/USD rate of 929, the lowest in the past 1 years, but assuming higher GDP per capita in 211 and continued KRW appreciation, we believe outbound passenger demand next year is likely to exceed that in 27. 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 27 Korea Airline Sector 6

7 18 October 21 Figure 15: No. of outbound pax (Jan-Aug): 211 vs 27 (million) % % 1 Total Jan-Aug 27 Jan-Aug 21 Source: Ministry of Justice (MOJ), KTO China Figure 16: Korea: inbound vs outbound vs KAL int l RPK (thousand) 4, 3,5 3, 2,5 2, 1,5 1, 5 1Q4 2Q4 3Q4 4Q4 1Q5 2Q5 3Q5 4Q5 1Q6 2Q6 3Q6 4Q6 1Q7 2Q7 3Q7 4Q7 1Q8 2Q8 3Q8 4Q8 1Q9 2Q9 3Q9 4Q9 1Q1 2Q1 Total inbound (LHS) KAL Int'l RPK (RHS) Source: MOJ, KTO, Company data Total outbound (LHS) (million) 15, 14, 13, 12, 11, 1, 9, 8, Downsizing domestic business in both carriers For both the Korean carriers, domestic passenger business used to account for more than 1% of total revenues until 24, but it has fallen continuously and is likely to reach below 5% in 21, 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 24, 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. Both carriers continue to decrease domestic passenger capacity 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 1 mn in 22, compared with 48 mn in 29, 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. We see significant growth potential in Chinese overseas travel demand 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 Korea Airline Sector 7

8 18 October 21 around US$4,, much lower than Japan s in the early 198s and similar to Korea s in the late 198s. Korea s overseas travel demand achieved 26% CAGR from 1988 to 1996 when it peaked, with GDP per capita reaching US$12,761, before the Asian financial crisis in 1997 (Figure 11). Figure 17: China: GDP per capita vs no. of overseas travellers (million) (US$) Figure 18: Japan: GDP per capita vs no. of overseas travellers (million) (US$) , 5, 4, 3, 2, 1, , 4, 35, 3, 25, 2, 15, 1, 5, E 211E China ov erseas trav elers (LHS) China GDP per capita (RHS) Japan ov erseas trav elers (LHS) Japan GDP per capita (RHS) Source: China National Tourism Administration, DataStream, Credit Suisse estimates Korea to benefit Source: JATO, DataStream 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 21, a 44.6% increase YoY, and this accounts for 22.% 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 longterm growth. Korea is already benefiting from growing number of Chinese overseas travellers Figure 19: No. of foreign visitors into Korea by countries (thousand) (%) 8, 25 7, 6, 2 5, 4, 15 3, 1 2, 1, Japan China US Others China as % of total (RHS) (Jan-Aug) Figure 2: Trend of Chinese visitors into Korea (thousand) (%) 1,4 6 1,2 5 1, (Jan-Aug) No. of Chinese visitors (LHS) YoY growth (RHS) Source: KTO Source: KTO Korea Airline Sector 8

9 18 October 21 Increasing interest in Korea According to a Korea Tourism Organisation (KTO) survey, most Chinese visitors came to Korea for shopping (1 st ) and witnessing fashion trends (3 rd ), besides the traditional reasons such as sightseeing (2 nd ) and historical remains (4 th ). 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 29 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 21, 1.26 mn Chinese visited Korea compared to 1.4 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 (' people) HK 1,3 1,353 1,433 1,614 1,756 Macau ,277 1,552 Japan Vietnam Korea Others Total 2,885 3,13 3,452 4,95 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 212. This change has been effective since 1 August 21, 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. Korea has been one of the favourite countries for Chinese travellers The Korea government is very active to attract more Chinese travellers Figure 22: Change in visa requirements for Chinese travellers NEW Multiple Entry Double Entry Scope of Family College student Source: MOJ Included lawyers, teachers, pension receivers, employees of Top 5 companies, and top college alumni. Expiry period extended to 3 years from current 1 year. Required only two types of documents Newly created for multi-time visitors, who failed to achieve Multiple Entry Extended to parents and parents in law of Multiple Entry visa holders Allowed to the students of a list of colleges selected by China government, regardless of wealth status China-Korea aviation capacity underutilised OLD Only allowed for very high income levels, professors, gold card holders, etc Did not exist 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 (1%), had Allowed to spouse and children of Multiple Entry visa holders Difficult to prove wealth status China routes offer the biggest upside for load factor increase Korea Airline Sector 9

10 18 October 21 seen a load factor deterioration since 27, 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 29. 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 2Q1), 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 (%) Q1 3Q1 1Q2 3Q2 1Q3 3Q3 1Q4 3Q4 1Q5 3Q5 1Q6 3Q6 1Q7 3Q7 1Q8 3Q8 1Q9 3Q9 1Q1 Japan North America China Total International Source: Company data 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 29, but the number has been increasing very fast at a fiveyear 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 Korea Airline Sector 1

11 18 October 21 Figure 24: Inbound transit pax by departure countries (million) (%) (Jan- Aug) Figure 25: Transit as % of total pax vs passenger yields (%) (US cents) Jan 2 Jan 3 Jan 4 Jan 5 Jan 6 Jan 7 Jan 8 Jan 9 Jan 1 China US China as % of total (RHS) Japan Others Transit as % of total pax (LHS) Asiana - int'l pax y ield (RHS) KAL - int'l pax y ield (RHS) 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 2 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 (925, 1, Not rated) will hamper Japan s competitiveness as an Asian air transportation hub, in our view. IIA s strengths as a regional air transportation hub will help Korean carriers to improve its regional presence Figure 26: Number of non-stop destinations (major Asian airports) Beijing Shanghai Singapore Hong Tokyo Incheon Capital Pudong Changi Kong Narita Africa Asia (a) Europe Latin America 1 1 Middle East North America (b) South Pacific Total (a) x (b) 1,274 1, Number of airlines 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 1 minutes compared to Narita s 1 hour 3 minutes (sourced from Official Airline Guide) also confirms its high efficiency as a hub airport. Korea Airline Sector 11

12 18 October 21 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. 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. 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. Beijing Capital 2. Incheon 1.7 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 1.7 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 215, 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 211, 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 41, aircraft movements per year versus Narita s 22,. 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). KAL is well positioned to capture transit demand, but likely to face capacity pressure in the near term Figure 28: No. of aircraft available for transpacific route (29) Figure 29: Number of destinations: Asian carriers in China and America (units) China (a) America (b) (a) x (b) KAL Asiana Japan Airline Air China China Southern Airline Cathay Pacific Air China CSA CEA KAL Asiana B747 A34 B777 Source: Company data Source: KAL, Asiana Korea Airline Sector 12

13 18 October 21 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 211, our view on the supply side is different based on each airline s different capacity expansion plan. Including the addition of four units of A38s, we expect 7.9% average passenger seats growth for KAL in 211, 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.% for Asiana, but will result in lower international passenger yield growth for KAL (4.8%) compared with that of Asiana (6.3%) in 211. 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. KAL may face capacity pressure in the near term Figure 3: Average pax seat growth (211-12E) (%) E 212E Figure 31: International pax ASK growth trend (%) E 211E 212E KAL Asiana KAL Asiana Source: ASCEND, Credit Suisse estimates Industry supply also pick up from 2H11 Given the limited supply growth in 21 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 214. The delivery for the rest of 21 and 211 is relatively mild, accounting for 6-7% of their existing fleet, compared with the above Asian carriers of 2-9%. However, 212 onwards, we will see double-digit growth from ME carriers, with a peak of 22% in 214 versus single-digit (and declining) growth from Asian carriers. Based on CS aerospace analyst Ross Cowley s estimates, Boeing (BA, $7.11, OUTPERFORM, TP $95.) s and Airbus (not listed) total delivery will accelerate in 211E-214E, with delivery of more than 1, new aircraft per annum (Figure 32). On an aggregated seat basis, 211E delivery will be equivalent to 8% of current global fleet (Figure 33). We see a potential industry supply risk starting from late 211 Korea Airline Sector 13

14 18 October 21 Figure 32: Aircraft deliveries for Airbus and Boeing Figure 33: Delivery % of current fleet of top 8 ME and 11 Asian airlines (No. of aircrafts) E 211E 212E 213E 214E 215E Boeing Airbus Rising competition from Chinese airlines Global seat delivery as % of current fleet 2H Source: ASCEND, Credit Suisse estimates 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, km is put into operation and a significant threat in 212 when a number of trunk lines come into full operation, with another additional 6, km. The team believes that the big-three Chinese airlines will see a potential domestic traffic loss of 6.1% in 211 and 13.2% in 212 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 21). 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. Chinese airlines to increase competition in international routes, in the longer-term Figure 34: Additional operating length of China s high speed rails (including bullet trains) (km) 6, Figure 35: Chinese airlines: potential domestic pax loss to HSR, 21-15E (%) 14 13% 12 5, 1 9% 8% 4, 8 6 3, 4 2, 2 1, AC + SZ CEA + SA CSA + XM - 21E 211E 212E 213E 214E 215E Domestic traffic exposure (based on weekly flights) Source: Credit Suisse estimates Source: Credit Suisse estimates Korea Airline Sector 14

15 18 October 21 Stabilising, but solid cargo demand After the significant volume growth in 1H1, we expect air cargo for both KAL and Asiana to experience a smooth normalisation for the rest of 21 and 211. 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 29, both KAL and Asiana remain confident of delivering marginal positive YoY growth in 4Q1 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 3 US cents actually prove managements efforts on this, as the level is similar to that in March when cargo traffic started soaring. We expect a smooth stabilisation in cargo demand for the rest of 21 and 211 Figure 36: Cargo demand and yield summary E 211E 212E KAL FTK growth (%) Yield (cents) Asiana FTK growth (%) Yield (cents) Korea GDP growth (%) n.a. Air cargo demand is slowing QoQ in 3Q1 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 211 due to the high base effect led by robust 2Q1 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 29 total revenue, which is slightly lower than that of Taiwan carriers, while Asiana has 24% exposure, which is similar to that of Cathay Pacific (293.HK, HK$21.9, OUTPERFORM, TP HK$23.). 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 29, 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 21, given its higher operating leverage effect than passenger business. Cargo is important to both Korean carriers, but slightly more so for KAL Korea Airline Sector 15

16 18 October 21 Figure 37: Cargo exposure comparison (29-1E) (%) CAL EVA KAL CX Asiana SIA Figure 38: KAL: monthly FTK vs avg. share price (YoY) (%) (%) Jan 3 Jan 4 Jan 5 Jan 6 Jan 7 Jan 8 Jan 9 Jan E Monthly FTK yoy (LHS) Monthly Avg. shr price yoy (RHS) Source: DataStream, Company data Economic indicators remain in healthy territory US ISM peaked in early 21, but has still stayed within positive territory (above 5). 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 5 (Figure 39). Figure 39: KAL s monthly FTK vs US ISM index (%) Jan 2 Jan 3 Jan 4 Jan 5 Jan 6 Jan 7 Jan 8 Jan 9 Jan 1 KAL: FTK y oy grow th (LHS) US ISM index (RHS) Figure 4: GDP growth vs KAL s FTK chg. (YoY) (%) (%) E 211E Global GDP growth (LHS) Korea GDP growth (LHS) KAL: FTK chg (yoy) (RHS) Source: DataStream, Company data IT outlook: positive in 211 Source: DataStream, Company data, Credit Suisse estimates IT is the most important single industry for air cargo demand and accounted for about 8% of total Korea exports through air transportation in 29. 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 211 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. Korea Airline Sector 16

17 18 October 21 Figure 41: Exports through air transportation vs KAL s cargo yield (US$ mn) (US cents) 3, 25, 2, 15, 1, 5, 1Q4 3Q4 1Q5 3Q5 1Q6 3Q6 1Q7 3Q7 1Q8 3Q8 1Q9 3Q9 1Q Semiconductor Handsets Display Computer Others KAL Cargo y ield (RHS) Source: KITA Memory Despite recent price weakness in both DRAM and NAND, our house view remains bullish on memory heading into 4Q, and especially for 211, 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 211. From Korea s perspective, as Samsung Electronics (593.KS, W754,, OUTPERFORM, TP W94,) 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 8%, respectively in 211. SEC continues to gain market share in global DRAM industry 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 (6657.KS, W1,5, NEUTRAL, TP W91,5), the second-largest handset maker in Korea, had a bad year in 211 due to its late entry in this field. However, given the low base in 21 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 211. We expect positive growth in global handset shipments in 211 Figure 42: Samsung Electronics rising share in the global DRAM market (%) Q4 4Q4 3Q5 2Q6 1Q7 4Q7 3Q8 2Q9 1Q1 4Q1 Figure 43: Handset revenue and ASP trend (US$ mn) (US$) 5, 4, 3, 2, 1, E 211E SEC Rev (LHS) LGE Rev (LHS) SEC ASP (RHS) LGE ASP (RHS) Korea Airline Sector 17

18 18 October 21 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 2Q1. As the usage of air transportation is generally for either: 1) new models only produced in Korean plants (3D LED TVs in 2Q1) or 2) urgent delivery led by strong restocking, we believe it may be difficult to expect YoY growth after exceptional strength in 2Q1. 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 211. Global leadership of Korean brands continues to improve in TV and panel industry Figure 44: Utilisation at major panel makers in 3Q1 (%) Samsung LGD* AUO CMI Sharp** * From August, ** 5-6% on Sakaifab (Gen1) Figure 45: Global TV shipment trend (million units) (%) Q4 3Q4 1Q5 3Q5 1Q6 3Q6 1Q7 3Q7 1Q8 3Q8 1Q9 3Q9 CRT LCD * PDP Others LCD YoY growth (RHS) * Including LED TVs 1Q1 3Q1E 1Q11E 3Q11E Korea Airline Sector 18

19 18 October 21 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 21 and 211, 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 (6-65%) versus Asiana (4-5%) due to its stronger overseas sales networks, including a bigger transit business, while expense exposure is in a similar range of 6-7%. 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. We expect KRW appreciation in the nearterm, which is clearly positive for outbound passenger demand increase Figure 46: KAL: foreign currency exposures (%) Figure 47: Asiana: foreign currency exposures (%) Rev enue Operating ex pense Interest bearing debt * Rev enue Operating ex pense Interest bearing debt * Korean w on Foreign currency ** Korean w on Foreign currency ** * 2Q1 / ** Mostly US Dollar Source: Company data * 2Q1 / ** Mostly US Dollar Source: Company data Figure 48: ROE and earnings: Bottom line vs ex. FX E 211E 212E W/US$ (average) 1, ,99 1,277 1,156 1,14 1,65 KAL ROE (%) NP (W bn) , NP ex. FX (W bn) Asiana ROE (%) NP (W bn) NP ex. FX (W bn) 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 211 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. Korea Airline Sector 19

20 18 October 21 Figure 49: FX sensitivity: KAL vs Asiana Base -1.% -3.% -5.% W/US$ (average) 1,13.8 1,92.7 1,7.6 1,48.6 KAL NP (W bn) Chg from Base (%) ASIANA NP (W bn) Chg from Base (%) Source: Credit Suisse estimates Stable oil price outlook Fuel is the most important cost to airliners and comprised about 3% of airlines revenue in 29 (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-3Q8, 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 (3%). Given that KAL plans to add 1 A38s and B787s (well known for high fuel efficiency) in , we think this gap will continue to narrow. Oil prices to remain stable in 211, on the back of loose supply and demand Figure 5: Fuel cost as % of revenue (% of revenue) Figure 51: Crude oil vs jet fuel price forecast (US$ per bll) CX SIA EVA E 211E 212E KAL Asiana WTI Jet Fuel Source: Company data Source: Bloomberg, Credit Suisse estimates Credit Suisse energy team expects a 5.7% decrease in crude oil price (WTI) in 211, on the back of a loose supply-demand situation. However, we assumed US$94 and US$97 per barrel for jet fuel prices in , indicating 8% and 3% increases, respectively, to be conservative on the biggest swing factor for the cost side. As shown in Figure 54, Asiana is less sensitive than KAL on fuel price, mainly due to its higher hedging ratio than that of KAL. However, any drastic fuel price increase should badly hurt the company s operating results regardless of traffic demand, as was experienced back in 28, before the credit crisis. Figure 52: Jet fuel price sensitivity Base 1.% 3.% 5.% Jet fuel price (US$/bbl) KAL NP (W bn) Chg from Base (%) Asiana NP (W bn) Chg from Base (%) Source: Credit Suisse estimates Korea Airline Sector 2