Family ties weigh on Korean Air Lines
KIM JAEWON, Nikkei staff writer
SEOUL -- The South Korean national carrier Korean Air Lines is flying high. The airline reported record quarterly earnings in the period to September on the back of rising passenger and freight demand combined with low fuel costs. But the skies are not completely clear for KAL, which is burdened by allegations of corporate mismanagement and reputational issues related to its founding family.
The airline's problems came to a head in September as its 10 board directors split over the management's desire to rescue Hanjin Shipping, a troubled affiliate, by providing a loan of 60 billion won ($54 million). KAL chairman and CEO Cho Yang-ho and three other executive directors backed the plan, saying it was needed to resolve logistical chaos caused by Hanjin Shipping's decision to file for receivership in late August, which put the company in the hands of a Seoul district court. Six external directors were opposed, arguing that KAL had no legal responsibility to help the sinking shipping company.
After five meetings, the board approved the plan on Sept. 21, but attached a condition requiring Hanjin Shipping to offer account receivables of the shipping line as collateral. "Tensions were running deep in the boardroom," said a source familiar with the matter, who asked not to be named.
The boardroom conflict illustrates how KAL's management is vulnerable to risks stemming from its founding family and substantial shareholder Cho and his family. Such risks can damage the company's earnings and tarnish its reputation, which is critical to its passenger business, analysts said.
Hanjin Shipping has weighed on KAL's performance since it came under the airline's wing in June 2014. Even though KAL has posted robust revenue figures for the last few years, its profits have been undermined by its exposure to the shipping company, in which it owns a controlling stake.
Both companies have operated under the umbrella of the Hanjin Group all along, but when the holding company's founder Cho Choong-hoon passed away in 2002, the airline was inherited by his eldest son Cho Yang-ho and the shipping line was handed over to his third son Cho Soo-ho.
Cho Yang-ho decided to acquire a 33.2% shareholding after a request from Choi Eun-young, Hanjin Shipping's then-chairwoman, who is his sister-in-law. Hanjin Shipping was suffering a liquidity crisis caused by weak global demand. To save the shipping line, KAL sold its 28.4% stake in S-Oil in January 2015, raising 2 trillion won. Market watchers said that was an unwise decision since the partnership with S-Oil, a South Korean company majority-owned by the Saudi Arabian oil company Saudi Aramco, gave the airline a secure source of fuel supplies for its aircraft.
KAL was left with a total loss of 825 billion won related to Hanjin Shipping over the past three quarters, equivalent to about 90% of its operating profit during the same period. KAL said the loss reflects a write-off of the value depreciation of Hanjin Shipping and that it now considers that value to be zero under accounting terms since the company is under court protection. The airline faces a further financial risk in relation to a fresh 60 billion won loan provided in September, though covered by collateral.
Shares in Hanjin Shipping spiked 24.8% to 998 won on Oct. 31 when the government announced a 6.5 trillion won support package for the country's shipping and shipbuilding industries. However, the price dropped 13.2% the next day after it emerged that Hanjin Shipping was not on the list of beneficiaries. The company's shares closed the week ending Nov. 4 at 865 won, up 8%. For the year, they are down 76%.
Analysts said that risks from Hanjin Shipping are affecting KAL's corporate value. "KAL has been undervalued in the market due to the risks of its exposure to Hanjin Shipping," said Kim Choong-hyun, an analyst at Mirae Asset Daewoo Securities.
The airline's market capitalization is far behind its regional rivals. At about $2 billion it dwarfs its smaller domestic rivals -- Asiana Airlines and Jeju Air -- but is valued by the market at less than one sixth of Air China. It also lags other mainland Chinese, Japanese, and Hong Kong competitors.
Fixed income investors are also wary of the risk. A plan to issue perpetual bonds failed in October as investors asked for higher yields to reflect risks relating to Hanjin Shipping's problems. KAL has a very high debt-to-equity ratio -- above 900% in September -- compared with Asiana Airlines' 684% and Hong Kong-based Cathay Pacific Airways' 72.8%.
Choi, who now heads the real estate and restaurant company, Eusu Holdings, poses another reputational threat to the company because of an investigation into alleged insider trading in connection with Hanjin Shipping's financial problems. Investigators are considering claims that she avoided losses of 1 billion won by selling her family's 0.39% stake in Hanjin Shipping for 2.7 billion won in April, a few days before the company filed for debt rescheduling program led by creditors.
A group of minority shareholders have since launched an online chat room, vowing to take legal action against Choi. "We invested in the company, but Choi left Hanjin Shipping by selling all of her stake. She should be accountable for this," the group, known as Hanjin Minority Shareholders & Solidarity, said in a statement.
Questions have also been raised about Choi's ability to manage the shipping company. She had no jobs before taking the helm in 2007, one year after her husband Cho Soo-ho -- who was chairman of Hanjin Shipping -- died from lung cancer. Choi, 54, studied English literature at the University of the Sacred Heart in Tokyo.
There is also another family member who has hurt the company's image -- the so-called "nut rage princess," Cho Hyun-ah, also known as Heather Cho, who ejected cabin crew from a KAL aircraft at New York's John F. Kennedy International Airport in 2014 after a row over the way in which she was served macadamia nuts.
Cho, the eldest daughter of KAL's chairman, and a former vice president of the airline, served three months in jail in 2015 for violating South Korea's Aviation Security Law before being released with a suspended 10-month prison term after an appeal. A further hearing is pending in the Supreme Court. The 42-year-old mother of twin boys has not been seen in public since her release.
In spite of these distractions, KAL has performed strongly in 2016. Helped by rising passenger demand and low fuel prices, the airline posted its biggest quarterly operating profit in the third quarter to September at 447.6 billion won, up 35% from a year earlier. Revenue increased by 5% to 3.06 trillion won, and net profit rose to 428 billion won compared with a net loss of 510 billion won.
Analysts said the earnings signaled that the airliner is emerging from a difficult period and predicted that revenue passenger kilometers, a key aviation metric, may have expanded 6% for domestic services and 8% for international passenger routes in the quarter. The exact figures are due to be announced in mid-November.
The stellar third quarter results followed an improved second quarter, in which KAL's revenue passenger kilometers rose 8.5% to 780 million kilometers for domestic routes and 6% to 17.9 billion kilometers for international routes from a year ago, according to data from Samsung Securities.
KAL has also recently performed well in freight services, thanks at least in part to the collapse of Hanjin Shipping and the recall of Samsung Electronics' flammable Galaxy Note 7 devices, according to the International Air Transport Association, an aviation industry body.
IATA said that some "unique factors" have worked in favor of KAL, "such as the rush replacement of Samsung Galaxy Note 7 devices during the month, as well as the early impacts of the collapse of the Hanjin marine shipping line at the end of August."
KAL was the world's third-largest player in cargo business last year with 7.7 billion freight ton kilometers in international routes, behind only Emirates' 12.5 billion and Cathay's 9.9 billion.
Analysts disagree about the extent to which KAL faces growing competition from low-cost carriers, or LCCs, which had a 57.4% market share in domestic flights and 24.1% in international flights in August, according to Mirae Asset Daewoo Securities. KAL's LCC unit, Jin Air, offers cheaper options to customers and targets tourists, while Korean Air focuses on premium demand. Jin, set up in 2008, has grown to be the second-largest LCC in South Korea, behind Jeju Air, with a fleet of 22 aircraft, compared with KAL's 158.
"We maintain the buy opinion [for KAL shares] because KAL has been relatively free from competition [with low cost carriers] thanks to its focus on long-haul routes," said Kim Young-ho, an analyst at Samsung Securities. However, Shin Ji-yoon, an analyst at KTB Securities, said KAL is "struggling to battle with LCCs in routes to Japan, China and Southeast Asia."
There is agreement, however, that the airline faces tough challenges in its long-haul passenger business. "More and more foreign players from Asia and the U.S. offer trans-Pacific routes via Incheon [South Korea]. All of them are threating to bite into KAL's market share," said Shin.
In particular, Shin said that young customers who speak English tend to use non-South Korean airliners that offer cheaper fares, while older passengers stick to the national carrier, preferring its Korean language communications and services.
Trans-Pacific routes are the largest revenue source for the company, accounting for 30% of revenue in the second quarter, followed by European routes with 18% and Southeast Asian routes with 16%, according to data from the company.
Buoyed by recent strong results but facing the long shadow of reputational issues and market challenges, especially in long-haul traffic, KAL may be at a crossroads, needing to make difficult decisions quickly about its links with Hanjin Shipping and the influence of family shareholders and managers over the company's direction.
There may be lessons in the group's successful experience in overcoming a safety crisis after a few crashes and other deadly incidents in the 1980s and 1990s, including the downing of a KAL Boeing 747 by the Soviets over the Sea of Japan in 1983. The company responded with a focused and sustained strategy, standardizing its regulations and manuals, and investing more than 100 billion won every year in safety-related sectors.
No deaths have been reported for the last 17 years, making Korean Air one of the safest airlines in the world with insurance rates globally above only Cathay Pacific, according to the carrier. The improvement has fully justified Korean Air's marketing slogan -- Excellence in Flight. What the company needs now is excellence in management.