Korean Air Project Final

Company Summary

Business OverviewCompany: Korean Air

SNU MBA Analyst Recommendation

Rating: GOOD

Date Established: March 1, 1969Area of Business: Passenger, Cargo, Aerospace, Catering, Hotel, In-Flight

Sales, LimousineFleet: 129 (As of September 30, 2010)

Route: Domestic: 13 Cities Intl: 38 Countries, 105 CitiesEmployees: 19,178

Operating Revenue: 9,393,700,000,000 WonOperating Result: Passengers: 20.41 Million Cargo: 1.57 Million Tons

Earnings OutlookBased on the current growth rate, we expect the FY10 revenue to rise by 15% and the operating costs to rise 8%. The net profit forecast will increase to KRW328 bill gain from a KRW393 bill loss the previous year. The reasons for these gains are: Demand for passenger seats will rise 9% compared to the previous year. This is based

on the GDP growths of each country according to their share of KAL revenue. The KRW will continue to gain value vs. the USD With KAL’s focus on increasing and improving their international business class

(estimated 48% of total revenue) we expect the profit margin and revenues to gain. The new development of a cargo hub based in China nearing completion will increase

productivity and utilization of KAL’s fleet and increase its freight capacity kilometers. The continuing growth of semiconductors, electronics, and automotive parts exports

should drive the outbound cargo loads. Good foresight and financial management by properly hedging fuel prices should

contain the rising operating costs.Potential RisksThere are several risk factors that could lead to a decline in the current growth rate of KAL: A relapse into an economic slowdown Catastrophic weather and natural disasters such as the Icelandic volcanic eruption Pandemic disease limiting the travel rate such as the swine flu Oil and fuel costs becoming instable due to turmoil in the middle east Rising tension of North and South Korea from regime change A decline in productivity of Korean companiesForecasts/Ratios

2009-Q1

2009-Q2

2009-Q3

2009-Q4

2010-Q1

2010-Q2

2010-Q3

2010-Q4

0

500,000

1,000,000

1,500,000

2,000,000

2,500,000

3,000,000

3,500,000Operating Revenues&Costs Op Rev

Op Costs

2005 2006 2007 2008 2009 2010

-35000-30000-25000-20000-15000-10000

-50000

50001000015000

29895725

180

-28762

-882

9750

EPSEPS

2007 2008 2009 2010

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

PE High/Low PE high

PE Low

Jul-0

8Sep-08Nov-08Ja

n-09M

ar-09

May-09Ju

l-09

Sep-09Nov-09Ja

n-10M

ar-10

May-10Ju

l-10

Sep-10Nov-10

0100002000030000400005000060000700008000090000

100000

4920038000 35600

54900

8200092000

Stock Price Stock Price

Analyst Team: Hae Ryun Kim, Eun Young Yang, Suh Joon Yoo, Robert Lee

Sell Hold Buy

2010Korean Air (KAL:003490) Financial Analyst Report

Strategy Analysis

Business Summary

Corporate OverviewKorean Air was first established on June 19, 1962 under the name, National Korean Airlines, by the Korean government and was then privatized on March 1, 1969, by Hanjin Group, one of the world’s largest transportation companies. Since its incorporation on March 1, 1969, the company’s shares have been offered for public ownership and all issued and outstanding shares are listed on the Korea Stock Exchange.

Korean Air started as a small regional airline, but currently the company offers air transportation to 117 cities in 39 countries with fleet of 129 aircrafts (as of July 31, 2010), being recognized as a global carrier with top ratings by travelers and critics throughout the world. It engages in the various domestic and international airline services with its main business residing in Air Transportation (Passenger, Cargo shipping, Maintenance service, Training service, Building lease) which generates approximately 96% of the total revenue. Its other business areas (Aerospace, Catering & In-Flight Sales, and Hotel & Limousine) accounts for the remaining 4%.

Market OverviewKorean Air comprised of about 63% of the total Korean Airline market in 2009 with operating revenues consisting of KRW 9,393.7 billion and operating income consisting of KRW 133.4 billion. This was still an 8% decrease in its revenue, but an increase of 1.6% gross profit to KRW 1,413.7 billion as it reduced its flight expenses. This resulted in a better performance when compared to most other international airlines during this timeframe.

Competitive LandscapeThe Korean airline industry consists of approximately 5 million commercial passenger airlines. The major regional competitor is Asiana Airlines which controlled approximately 33% market share in 2009. In the international market, some of the main competitors are Cathay Pacific, Delta, and Air China. The Korean airline market is an oligopoly of competition between two major airlines, Korean Air and Asiana Airlines, but we cannot disregard the international airlines, which impacts on the total share of Korean passenger revenues. In addition, it is highly sensitive to the economic conditions, which has significant effects on the demand of two operation mainstreams: airline passenger demand and international cargo transportation.

Financial TrendsKorean Air (KAL) was valued at 78,000 Won on Oct. 1, 2010 which was an increase from the previous year. We can attribute this gain to the global economic recovery and the growing strength of the KRW to the USD. The economic stimulus has led to a recovery in cargo demand and an increase in the number of travelers. Despite the increase in fuel costs revenues, both cargo and passenger divisions have seen positive revenue streams.

Sub-Industry OutlookThe airline sub-industry appears to have a positive outlook. Traffic statistics at many carriers shows improving demand and increases in revenues for the first half of 2010. This trend is expected to continue as the economic conditions improve their way forward. In addition, with the passenger demand for travel increasing (whether it be for business or personal purposes), we should be able to see a turnaround and recovery from the previous two years which were impacted by the economic downturns.

Associated with the general economic downturns are the volatile fuel prices and the currency transaction and translation which the airline industry is highly exposed to. In fiscal 2008, this lead to negative performance along with higher COGS and operating profit fluctuations despite the operating revenue increases of 14% over the 2007 fiscal year-end. However, since fiscal 2009, the total fuel expenses decreased as the average price per barrel stabilized. This trend, along with the settlement of oil price zero-cost collar option contracts, is expected to ease cash usage throughout the group and positively influence operating profit for fiscal 2010.



Risk Analysis

Same-line industry competitionKorean Air continues to develop new routes in South America, Europe & Asia Pacific regions, targeting a larger international customer base. The overall size of domestic and international passengers had been an increasing trend for the last three years. In order to capitalize on the fast growing Chinese market for reliable cargo services, the company has continuously opened new routes and destinations within the Greater China area. Korean Air has also established a cargo terminal at the Tianjin Binhai International Airport, China, as a joint venture with Sinotrans Air Transportation Development to have a cargo hub to meet regional demands. With such diversified transportation services and increasing passenger levels, the subject borrower’s market position is considered to be superior to other competitors.

High exposure to jet fuel costs & foreign exchange rateDespite the positive turnaround in the economy and thus in fuel price and exchange rate, potential risks do exist in this area. For FY 2008, the soaring fuel price and loss on foreign currency transaction had imposed a great challenge for the subject airline, significantly reducing the year-end operating profits into negative margins. To mitigate ongoing risk factors, Korean Air now attempts to develop new selective destination/route(s) in high-potential market areas and to provide premium service, seating upgrades, and point-to-point services, especially in the long-term flight routes. These changes and upgrades will be performed on an annual basis. In order to hedge the exposure to changes in oil prices as it affects aircraft fuel, Korean Air has entered into oil price zero-cost collar option contracts, which consist of call-options in long positions, put-options in short positions and oil price swap contracts that are based on West Texas Intermediate. For FY 2009, the operating profits indicated a positive trend due to reduced risks for the weaker KRW and fuel price fluctuations. 2010 1Q exhibited a higher profitable operation with a 42% increase in total operating profit (2009’s $114 million to 2010’s $195 million). Net profit also increasingly turned into a positive margin to $206 million from overall gains on foreign currency exchange. Considering sufficient cash flows (interest coverage ratio of 3.01x as of 03/31/10) and reserved assets & net worth ($14,855M & $2,821M), the above risk factor can be mitigated. The current efficiency of the management team is also added benefit.

Growing Low-Cost airline marketWith increasing consumer demand in domestic and Asia Pacific routes, along with the increasing travel rate of younger generations, more practical and low cost carriers have created a new segment in the airline industry, leading to fiercer and wider competition among the airlines. In order to face this new trend and these rising challenges, Korean Air now manages Jin Air, a low-cost carrier which mainly flies short-term routes and targets younger generations.

Despite the various challenges it faces, Korean Air prepares well and mitigates through them by leveraging its core strengths and advantages which then generates positive output and growth. Korean Air visions itself as a ‘Respected Leader in the World Airline Community’, which they strive for through delivering its mission of ‘Excellence in Flight’ in the areas of operations, services, and Innovation. As shown through the successful breakthrough in 2009, Korean Air has now set a 10 year strategy which states its goal as achieving a revenue of KRW 25 trillion, an operating profit of KRW 2.5 trillion, and a ranking in the Global Top 10 airlines by year 2019. This will be accomplished through its competitive advantages: Strengthened Core Competencies, Customer Focused Service, Expansion of Business Sectors, and Advancement in Management System.



Accounting Analysis

Key Accounting PoliciesThe Company maintains its official accounting records in Korean won and prepares statutory financial statements in the Korean language in conformity with accounting principles generally accepted in the Republic of Korea (Korean GAAP).

Account Disclosure per 2009 Annual ReportProperty, aircraft and equipment, and related depreciation

“Depreciation of property, plant and equipment is provided using the straight-line method over the estimated useful life of the assets Property, aircraft and equipment are stated at cost less accumulated depreciation, except for certain assets which were revalued and are stated at revalued amount less accumulated depreciation. Maintenance and repairs are expensed in the year in which they are incurred. Expenditures which enhance the value or extend the useful life of the related assets are capitalized.”

Estimated useful life in years:Buildings 40Aircraft and engine 20Leased aircraft and engine 20Other aircraft parts 15Vehicles 6Others 6-15

Leases “The Company accounts for leases that transfer substantially all the risks and rewards incidental to ownership of assets as capital leases and leases other than capital leases as operating leases. The Company accounts for leases that transfer substantially all the risks and rewards incidental to ownership of Rental expenses for operating leases, which are expensed on a straight-line basis over the lease term, are charged to current operations as they become payable. The Company recognizes a capital lease as an asset and a liability in the statement of financial position at an amount equal to the fair value of the leased asset or, if lower, the present value of the minimum lease payments at the inception of the lease. In calculating the present value of the minimum lease payments, any residual value guarantee is excluded and the interest rate implicit in the lease is used as the discount rate. Leased assets are depreciated in the same manner as other assets through purchases. Minimum lease payments are apportioned between the finance charges and the reduction of the lease liability. The finance charges are allocated to each period by the effective interest rate method and recognized as an interest expense.”

Number of Aircraft Operating lease

Capital Lease

Own Total Operating Lease / Total

fleet

Korean Air 27 67 33 127 21.3%

Asiana 43 22 9 74 58.1%

Delta 213 93 677 983 21.7%

Cathay Pacific 29 49 48 126 23.0%





Key Accounts and Financial Statement Analysis

Property Plant and Equipment and related depreciation (PP&E)

PP&E is an important asset account for airlines as it accounts for a large part of their assets and consequently their related depreciation expense item accounts within their operating expenses. In addition, as operating expenses have an impact on Net Income, the various methods and estimates used in calculating depreciation amounts can vary among the firms in the industry. Compared to 2008 Korean Air’s Total Assets increased about 6% and most of this increase was primarily attributed to a 44% increase in Cash and an increase in PP&E. In 2009, Korean Air’s Net Property Plant and Equipment’s balance was 11,681,659 Mill KRW. This amount is about 69% of the Company’s total assets. The Depreciation Expense for the year was 758,231 Mill KRW and this amount is 8.49% of Operating Expenses. The table below shows that this percentage is reasonable to other airlines in the industry.

YE 1999 Korean Air Asiana Delta Cathay Pacific

PP&E 11,681,659 2,457,557 23,775,800 9,770,750

Total Assets 16,919,272 5,814,972 50,662,000 17,003,500

PP&E / TA 69.04% 42.26% 46.9% 57.46%

Depreciation 785,986 205,433 3,402,370, 852,848

Total OPEX 9,260,327 4,123,907 33,031,100 9,323,930

Depreciation/OPEX 8.49% 4.98% 10.3% 9.15%

Off-balance sheet LiabilityAs of FYE 2009, there are pending litigations against Korean Air. It has been accused of price-fixing its cargo services and they are being investigated by the US Department of Justice. Furthermore, lawsuits have been filed against Korean Air regarding collusion.

Korean Air has also entered into aircraft purchase contracts as of Dec. 31, 2009 with companies such as Boeing. The amount of these purchase contracts is about 10,061,600 Mill KRW.



RevenueIn the airline industry, strong revenue levels need to exist in order to meet the high-levels of obligations. Per review of Korean Air’s income statement expenses, the higher expenses of 2008 are attributable to Jet Fuel costs of 4,195 Mill KRW, which took up about 40.7% of operating expenses. Additionally, lower 2009 revenues are due to lower Passenger and Cargo revenue which have been attributed to the H1N1 virus and the global economic crisis. 2009’s Passenger revenue was 5,469,948 Mill KRW and the Cargo revenue was 2,704,599 Mill KRW while 2008’s was 5,953,328 Mill KRW and 3,026,849 Mill KRW respectively.

Korean Won Millions 2009 2008Revenue 9,393,703 10,212,578

COGS 7,980,015 8,821,368Gross Profit 1,413,688 1,391,210

Operating Expenses 1,280,312 1,490,507Operating Income 133,376 (99,297)

Ratios 2009 2008% of COGS 85.95% 86.38%

% of Gross Profit 15% 13.62%% of Operating Expenses 13.63% 14.59%

Per analysis of Korean Air’s revenue through ratios, COGS and Operating Expenses have been fairly consistent over the past 2 years. Despite the Operating Loss in 2008, Korean Air has bounced back in 2009 and has had a good handle on cost control.

Korean Won Millions 2009 2008 2007Revenue 9,393,703 10,212,578 8,811,989

Total Expenses 9,260,327 10,311,875 8,175,152Operating income (loss) 133,376 (99,297) 636,837

Jet Fuel 2,938,700 4,195,100 2,606.4% Jet Fuel / Total

Expenses31.7% 40.7% 31.9%

Revenue 2008 2009Passenger 5,953,328 5,462,948

Cargo 3,026,849 2,704,599Others-revenues 1,232,401 1,226,156

Total Revenue 10,212,678 9,393,703% of Passenger Rev 58.29% 58.16%



Ratio Analysis

In fiscal year 2009, Korean Airlines recorded an ROE of -3.37% due to the airline industry slowdown associated with unfavorable economic conditions. However, Korean Air performed better than their competitors with a higher ROE than companies such as Asiana with a reported -35.5%. This ROE can be decomposed to three drivers, which are net profit margin, asset turnover and financial leverage.

Korean Airlines maintained its positive RNOA (0.69%) and remained more profitable than its domestic competitor, Asiana Airlines (-3.22%), in deploying its operating assets to generate greater operating profit. Its higher NOPM (1.12%), which shows how much it is able to keep as profit from recognized sales, was mainly caused from its premium pricing strategy as a leading company, efficient procurement in a duopoly market, and excellent cost management of its own maintenance subsidiary. Korean Airline’s operating asset turnover, NOAT, which shows how efficient to use its operating assets to generate sales (0.62), was slightly lower than Asiana’s (0.75).

2009 Korean Air Asiana Cathay Pacific DeltaRNOA 0.69% -3.22% 6.48% -0.62%

NOPM 1.12% -4.27% 6.32% -0.90%NOAT 0.62 0.75 1.03 0.68

NOPMxNOAT 0.69% -3.22% 6.48% -0.62%

Its spread, which signifies the economic effect of borrowing, was negative (-0.98%) because the return on operating assets (0.69%) was lower than the cost of borrowing (1.67%). Asiana airlines’ significantly negative ROE(-35.05%) is magnified by the high extent of financial leverage(579%) relative to its equity base and negative spread (-5.50%).

2009 Korean Air Asiana Airlines Cathay Pacific DeltaROE -3.37% -35.05% 11.85% -221.09%

RNOA 0.69% -3.22% 6.48% -0.62%FLEV 415.70% 579.12% 64.80% 7245.76%

SPREAD -0.98% -5.50% 8.28% -3.04%

2006 2007 2008 2009 2010 2011 2012-1

0

1

2

3

4

5

Ratios ROE

RNOA

FLEV

SPREAD

As Korean Airlines increased its liabilities to maximize its equity based return in 2007, its spread turned negative due to the economic recession, and operating profit marked its worst performance as ROE indicated -53.67% and debt increased. But ROE is expected to turn positive (14.69~16.34%) from 2010 because of its aggressive strategy of purchasing new air fleets and developing more international routes during this economic recovery.

　 2006 2007 2008 2009 2010E 2011E 2012EROE 8.26% 0.25% -53.67% -3.37% 16.34% 14.69% 15.33%

RNOA 3.12% 0.56% -0.55% 0.69% 4.14% 4.40% 4.50%FLEV 1.97 1.99 2.92 4.16 3.83 3.30 2.86

SPREAD 2.61% -0.15% -18.21% -0.98% 3.19% 3.12% 3.78%



Valuation

Discounted Cash Flow Valuation Method

Cost of Equity = 7.07% Net Income = ₩ 752,211.00

Net Income without interest income from cash= ₩ 719,640.00 Growth rate in Net Income = 2.05%

Equity Reinvestment Rate for high growth phase= 13.68%The dividends for the high growth phase are shown below (upto 5 years)

2010 2011 2012 2013 2014Expected Growth Rate 2.05% 2.05% 2.05% 2.05% 2.05%Net Income ₩ 734,407.00 ₩ 749,477.00 ₩ 764,856.00 ₩ 780,551.00 ₩ 796,568.00Equity Reinvestment Rate 13.68% 13.68% 13.68% 13.68% 13.68%FCFE ₩ 633,940.00 ₩ 646,948.00 ₩ 660,223.00 ₩ 673,771.00 ₩ 687,597.00Cost of Equity 7.07% 7.07% 7.07% 7.07% 7.07%Cumulative Cost of Equity 107.07% 114.64% 122.74% 131.42% 140.71%Present Value ₩ 592,080.00 ₩ 564,331.00 ₩ 537,883.00 ₩ 512,674.00 ₩ 488,647.00

Present Value of FCFEs in high growth phase = ₩ 4,245,941.00

Present Value of Terminal Equity Value = ₩ 783,112.00

Value of equity in operating assets = ₩ 5,029,054.00

Value of Cash and Marketable Securities = ₩ 890,400.00

Value of equity in firm = ₩ 5,919,454.00

Value per share = ₩ 87,651.07*Notes. Accounted for the losses in historical FX translations as an anomaly for future projections.The basis for the valuation was based on historical data utilizing incomes, cash flows, asset fluctuations, and market valuesWe have assumed a 3.5% risk free rate and have use the Beta value 1.19 as listed by the Korea Exchange as of June30, 2010.

Due the instability of the economy during this recovery period, there were some challenges in formulating an accurate model of growth with the amount of fluctuations in data. Although this discounted cash flow model, based primarily on data collected from July 01, 2009 to June 30, 2010, still provided a favorable estimate, we believe that the growth for Korean Air has an even higher potential with the strategic approach they are endeavoring to execute. To reflect this perspective, below are some further trend reports.

2000 2001 2002 2003 2004 2005 2006 2007 2008 20090.00

4.00

8.00

12.00

16.00

20.00

EV/EBITDA EV/EBITDA

Forecasting and Recommendations

We recommend that Korean Airlines is a good company for investment and long term growth. Korean Airlines has hit record EBIT values in the first quarter of 2010 and continued with a strong second quarter. Although we do see the growth rate



normalizing slightly, we believe that it will remain strong. We believe that the fluctuations in the market value and earnings are non-volatile in nature especially when compared to the industry and the economy so we can have assurance that the growth is substantiated by Korean Air’s strategy and management. We expect that the demand for passenger travel will exceed prior expectations allowing Korean Air for more growth with the release of their newly purchased planes. The less predictable market for cargo services may be an issue and may be affected by the ongoing filing against them for collusion and price-fixing, but we believe that they will be able to bring stability because of their strong market share and plans for expansion in China.

The criteria for our recommendation are based on the earnings forecasts vs. the potential risks. The key factors investor should keep an eye on the status of the economic recovery, the Korean manufacturing and export industry, the continuity of Korean Airline’s growth and expansion execution, and fuel prices. The risks to our valuations are mainly due to the Korean economy and the value of the Won. Investors should also make note of the upcoming requirement to change to the IFRS accounting principles which could affect the way Korean air accounts for their assets drastically changing the values of their ROA and other ratios. These factors may impact their stock market value and share price in the short term.

In summary, we believe Korean Airlines as a company has had strong performance especially when compared to their main competitors like Asiana Airlines. We find no reason to believe that this trend will not continue for the next several years. Korean Airlines aggressive strategic growth plans should move them into a position to acquire even more market share both in passenger and cargo sectors.



Appendix

Operating Results

Operating Results (based on 2009 IATA standards

Operating Revenues

Employees (Total 19,178)

Financial Statements







Exhibit 1

Korean Airline Industry Analysis: Porter’s Five Forces



Rivalry Among Existing Firms

Oligopoly: Two dominant players within Korean market (Korean Air & Asiana Airlines)

Industry Potential: Continuously growing market due to increasing demand in personal and business travelers resulting from economic developments

Cost Leadership & Differentiation: 1) Turnover management and low fare based on seasonality, routes 2) Investment in brand image, superior service quality 3) High fixed operating costs

Threat of New Entrants

Low fare/cost carriers: 1) High cost of entry in airline industry had reduced the threat of entry by competitive companies in the past, however, business model offered by low fare carriers exploited lower segment of the market via market price and provided a foundation for entry of low cost carriers such as Jin Air and Jeju Air 2) No-frill

International fliers: 1) With increasing demand in traveling to international destinations, international fliers with strong brand names are entering the Korean passenger market 2) Expansion of alliances and frequent flier programs opens the entrance of diverse fliers to enter

Threat of Substitute Products

Customer price sensitivity: Growing demand for low fare/cost carriers especially within domestic routes

On-ground transportation: 1) Improving technology (i.e. promptness, expansion of routes) of on-ground transportation such as train (i.e. KTX) and buses 2) Convenience and easy access compared to flight transportation

Bargaining Power of Suppliers

Fuel & Oil Prices: Single largest airline cost expenditure item Boeing & Airbus: low bargaining power as airliners are mostly dominated by

Boeing and Airbus Others: labor, raw materials, travel agents

Bargaining Power of Buyers

Elasticity of air travel: Casual travelers elastic to economic conditions whereas business travelers are more inelastic

High consumer demand in quality: excellence in service, convenience, and comfort important especially in long distance routes

Flexible, switching buyer demand: Low fare carriers who offer no frill flights in return for discounted fares reshaping the airline industry as result of more options for buyers

Documents

Korean Air Project Final