Korean Air: short-term problems; long-term promise? September 2009

Following a massive loss in 2008, Korean Air recently announced a 10–year strategic plan designed to double revenue and grow its fleet by more than 50% over the same period. But can Korean Air deliver such ambitious growth, particularly given the problems it faces in the short–term?

Korean Air’s 10–year plan came about following a period in which the airline’s revenue increased from Korean Won (KRW) 7.2 trillion (US$5.5bn) in 2004 to KRW 10.2 trillion (US$7.8bn) in 2008, yet its profitability declined steadily from a 7.2% net margin in 2004 to -19% in 2008 (and with passengers carried by Korean Air in 2008 falling 4% to 21.9m).

There are many factors behind this fall in profitability, but key among them are fuel prices and foreign exchange rates. Korean Air’s fuel bill has increased from KRW 1.58 trillion (US$1.2bn) — accounting for 28.6% of total operating costs — in 2004 to KRW 4.19 trillion (US$3.2bn) — or 47.6% of costs — in 2008. With only 15% of fuel consumption hedged in 2008, the airline inevitably suffered heavily from the fuel price rise, reporting a massive loss of KRW 1.96 trillion (US$1.5bn) in 2008.

However, foreign exchange rates — and specifically the KRW/US dollar rate — play a more fundamental role in the company’s profitability than even fuel prices do. The majority of the carrier’s revenue is generated inside South Korea and thus is paid in KRW, but Korean Air’s fuel bill, aircraft rental, insurance and some financing expenses are all paid in US dollars. The first three expenses account for nearly 52% cent of total operating costs, and so when the fuel price soars and the KRW depreciates — which happened in 2008 — Korean Air is hit twice over.

On the other hand, Korean Air benefits when fuel prices fall and the KRW stays relatively stable and strong – which happened in the fourth quarter of 2008, when the carrier made an operating profit of KRW 22.6bn (US$17.2m). Since then the carrier has experienced both fuel price and KRW exchange rate falls, and in the first half of 2009 Korean Air’s fuel expenses fell by 40.1% — though the airline still recorded an operating loss of KRW 127.3bn (US$96.7m).

Profitability question

Korean Air is also affected by the impact of the KRW/US dollar rate when translating its foreign currency transactions and reserves onto its financial results. While the airline reported a 163% increase in non operating gains in 2008, the effect of foreign currency translations lost the airline a staggering KRW 2.4 trillion (US$1.8bn). Conversely, the carrier’s net profit of KRW 78.5m (US$0.1m) in the second quarter of 2009 was derived from foreign currency benefits totalling KRW 477.8bn (US$363.1m) that offset an operating loss of KRW 127.3bn (US$96.7m) as well as other non–operating losses. This fluctuation of exchange rates and non–operating results makes it very difficult to judge Korean Air’s financial health merely by profitability, and a more accurate assessment can be drawn from the airline’s debt–to–equity ratio. Over the past five years this has risen from 261% at the end of 2004 to 534% in June 2009. Before 2008 the ratio stayed stable at around 240% — which allowed the airline to raise considerable debt in times of distress — but increasing fuel bills and investment activities in 2008 resulted in a cash outflow of KRW 688.7bn (US$523m) that year, and this had to be financed by increased debt, thus pushing up the debt–to–equity ratio.

Ordinarily this wouldn’t be too much of a problem since South Korea is renowned for close ties between corporations, government and banks. Despite the global credit crunch, the carrier secured US$196m in short–term loans and US$53.8m in long–term loans from Korean banks in 2008, and in the same year the airline also issued US$858.9m in bonds at annual interest rates of at least 5%, the majority of which will mature in 2011. However, the Korean financial markets were hit hard by the global financial crisis in the second half of 2008, and Korean Air has recently had to turn to foreign financial institutions for further liquidity, such as mandating Naxitis for a 777–200ER refinancing and using Export–Import Bank financing for a 777–300ER delivery in mid–2009.

The deterioration of the carrier’s financial position raises questions about its ambitious new 10–year plan, which aims to double its annual revenue to KRW 25 trillion (US$19bn) and grow the fleet by 50% to more than 180 aircraft.

The fleet currently stands at 119 aircraft (see table, above), of which 44 are long–haul passenger aircraft and 17 are dedicated cargo aircraft. This reflects the geography of the country, because by being based in the southern half of the Korean peninsula and bordering the sea of Japan, the Yellow Sea and North Korea, South Korea is in effect isolated from continental Asia – which means that medium–and long–haul air transport is vital for the country.

An added natural advantage for Korea’s airlines is the country’s position to the east of the continent, which means that it is closer to the US west coast than almost all major rivals. This has encouraged Korean Air to develop a hub–and–spoke network connecting the East Asia market via Incheon airport to routes onto North America, and despite ongoing global recession the number of international passengers transferring at Korean airports increased from 6.9m in 2007 to 7.1m in 2008, demonstrating the resilience of the Korean transfer market. In 2008 the country recorded 36.5m international air passengers (including origin & destination and transfer passengers), 38% of whom were transported by Korean Air. This compares with 16.8m domestic passengers in South Korea (in 2007, the last year for which figures are available).

Korean Air has also been helped by the sustained industrialisation and modernisation carried out by South Korean governments over the past four decades, which have focused on export–oriented and high–tech and high value–adding industries such as electronics, telecommunications, automobile production and shipbuilding. However, South Korea’s export reliance also has a downside for Korean Air, leaving it relatively exposed to global economic volatilities — as evidenced by the carrier’s fall in international passenger revenue of 17.7% and in cargo revenue of 28.7% in the first half of 2009.

Korean Air’s dependence on international markets is at least helped by an increasing number of liberalised air service agreements signed between South Korea and other countries. By the summer of 2009 the government had signed passenger ASAs with 19 countries and cargo ASAs with 31 countries. The passenger agreements are mainly with countries in the Asia/Pacific region and the Americas, while the cargo agreements include these regions plus selected EU member countries.

Given this background, Korean Air is focusing on building up its medium- and long–haul fleet and has outstanding orders for six A330–200s, 10 A380–800s, 10 777- 300ERs and 10 787–8s. The A380–800s will be deployed on hub–to–hub routes such as Seoul to New York, while the 787–8s are for long, thin routes and the 777–300ERs will fill in routes between these categories. Given Incheon’s hub position, the large medium and long–haul fleet and the myriad of open skies agreements, it’s not surprising that Korean Air serves more destinations in America and Asia than any other airline,resulting in 30.2% cent and 12.9% respectively of its passenger revenue coming from the North America and Southeast Asia routes.

On routes to Europe and the Middle East, however, given its eastern Asian location Korean Air is at a disadvantage to its continental Asian rivals, and so the airline concentrates on direct routes to secondary cities — such as Munich and Milan — which attract some transfer traffic throughout Asia.

Korean Air appears to be retreating from the domestic market, whose revenue contribution has decreased steadily from 17% of total passenger revenue in 2004 to 10.5% in 2008. That’s due partly to the emergence of Korean LCCs (such as Air Busan), which had a 28% domestic market share by mid–2009, up from 2.2% in 2006, and partly to a contraction in the domestic market, which has fallen from 22.5m passengers in 2000 to 16.8m passengers in 2007.

To defend its domestic position Korean Air established LCC Jin Air in July 2008, offering premium service at low fares via four leased 737–800s and a Cessna 208 Caravan. Together with route restructuring efforts, this move helped Korean Air record a 2.7% increase in domestic passenger revenue in 2008 even though passengers carried fell 6.1%.

Much more of a priority for Korean Air than the domestic market is its cargo business, where it traditionally has high volumes and load factors — 9bn ton kilometres and 74% respectively in 2008. The airline has seven 747–8Fs and six 777–200LRFs on order, and is also committed to converting 10 of its 747- 400s to freighters. While the single most important market is North America (accounting for 40.7% of cargo revenue), Korean Air has been trying to strengthen business in China and Southeast Asia, and in late 2007 it launched Tianjin–based Grandstar Cargo International Airlines in co–operation with China’s Sinotrans Air Transportation Development Co and Korean investors.

The future

Perhaps even more important is Korean Air’s plan to take advantage of South Korea’s open skies agreement with Uzbekistan by developing the country’s Navoia airport as a central Asian cargo hub by 2018, where it will connect cargo flights from Korea, China and Southeast Asia through to the Middle East and Europe. If successful, this would reduce Korean Air’s reliance on the North American cargo routes, and thus this will be a key focus for the airline over the next decade.Despite a net income of KRW 78.5bn (US$59.7m) for the first–half of the 2009 financial year, there’s little doubt that Korean Air is fighting for survival through the current recession. Its cash and cash equivalents of KRW 494.5 billion (US$375.8m) as at the end of 2008 will hardly sustain it through the next two years, particularly as there is KRW 1.94 trillion (US$1.5bn) of short–term borrowings and bonds to pay off in the same period. However, Korean Air will struggle to secure refinancing at anything other than high interest rates, which will pile up further problems for the future.

However, if the carrier can somehow refinance at reasonable terms then its long term expansion plans do make strategic sense. Though its cargo business faces strong competition created by the merger of All Nippon Cargo and Japan Airlines’ cargo divisions as well as the tie–up of Air China and Cathay Pacific in cargo, it is being pro–active via expansion in China and the new hub in Uzbekistan. The impending “Free Trade Agreement” between South Korea and US — which is awaiting US congressional approval — may also be crucial to its cargo fortunes, and the US government estimates the deal will add around $10bn in annual exports to South Korea.

But perhaps it is the long–haul passenger business that will be the key to the airline’s long–term success, and Korean Air will need to place new capacity carefully as markets are opened up by ASAs signed by the government. The airline’s revenue generated from first and business class services only accounted for 19.5% of total passenger revenue in 2008 (a percentage far below its Western peers) and so if Korean Air can add capacity and increases its premium traffic a few percentage points as well, then its future may well be bright – always assuming it can get through the difficult next 18 months or so.