Aviation Ready to fly high Korea’s aviation industry offers an attractive long-term investment opportunity We believe Korea’s aircraft and parts industry is well-poised for exceptional long-term Overweight (Maintain) growth, supported by the stable expansion of the global civil aircraft market and the Korean government’s policy support. Domestic parts suppliers should step out of the shadows of Korea Aerospace Industries (KAI) and experience strong growth on their own Industry Report thanks to technological advances. Within a short time span, Korea has evolved into a August 27, 2015 manufacturer of parts, civil aircraft, and military aircraft. We believe the domestic development of civil aircraft will become possible within the next decade, aided by the accumulation of technology from manufacturing advanced fighter jets. Daewoo Securities Co., Ltd. We identify four potential areas of growth for the Korean aviation industry: 1) the [Shipbuilding & Machinery] manufacturing of civil aircraft parts, in which domestic suppliers should gain market share; 2) light-armed helicopters (LAH), light civil helicopters (LCH), and fighter jet (KF-X) Ki-jong Sung development projects, which are expected to commence this year, 3) maintenance, +822-768-3263 repair, and operations (MRO) for civil and military aircraft, and 4) the US next-generation [email protected] trainer program, known as T-X. Michael Yun KAI (047810 KS/Buy/TP: W143,000): Leader of Korea’s aviation industry +822-768-4169 [email protected] KAI is Korea’s leading aviation company, manufacturing civil aircraft parts (for Boeing and Airbus), as well as military aircraft, such as the T-50 and Surion. The company is also Ho-seung Lee at the center of Korea’s aircraft development projects, planning to develop and produce +822-768-4176 next-generation fighter jets and helicopters. In our view, the company is best positioned [email protected] to benefit from the government’s commitment to fostering the aviation industry. We believe KAI is primed to become a comprehensive aviation company encompassing not [Small Cap] only development and manufacturing but also modification and MRO. Technological Seung-hyeon Park advancements should help the company eventually tap into the development of civil +822-768-4194 aircraft. [email protected] ASTK (067390 KQ/Buy/TP: W49,000): A success story in aircraft parts ASTK is Korea’s second-largest aircraft parts supplier and is capable of producing civil aircraft fuselages. The company, which currently has an order backlog of W1.1tr, should gain increasing orders from Boeing, Airbus, and Lockheed Martin on the back of rising civil aircraft demand and growing outsourcing of parts production. The acquisition of Orbitech should help the company expand its order book, boost capacity, and reduce costs. Orbitech (046120 KQ/Buy/TP: W16,000): A combination of growth and stability Orbitech supplies aircraft parts, but also operates a nuclear energy business, which serves as its cash cow. We believe synergies with parent company ASTK will lead to increased orders and cost savings, allowing the aircraft business to swing to a profit in 2015. Road map of Korean aviation industry Source: KDB Daewoo Securities Analysts who prepared this report are registered as research analysts in Korea but not in any other jurisdiction, including the U.S. PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES & DISCLAIMERS IN APPENDIX 1 AT THE END OF REPORT. August 27, 2015 Aviation CONTENTS Civil aircraft market outlook 3 1. Market to expand at a CAGR of 5% over the next 20 years 3 2. Market trends: Expansion of global outsourcing 4 Military aircraft market outlook 6 1. Overview of KF-X project 6 2. Status of KF-X project 6 3. Impact of KF-X project 7 LCH/LAH development 8 1. Replacement of aging attack helicopters 8 2. KAI searching for LCH and LAH development partners 8 MRO market 9 1. Civil aircraft MRO market to expand 9 2. MRO business competition to intensify 10 T-X project 11 1. US to replace its jet trainers via the T-X program 11 3. Risks and expectations 11 Korean aviation industry 12 1. Overview 12 2. Domestic aviation industry’s supply chain and recent trend 13 3. Domestic aircraft industry’s history and technological trends 14 4. Overseas technology trends 16 Global peer valuation 19 Korea Aerospace Industries (047810 KS) 22 ASTK (067390 KQ) 29 Orbitech (046120 KQ) 36 KDB Daewoo Securities Research 2 August 27, 2015 Aviation Civil aircraft market outlook 1. Market to expand at a CAGR of 5% over the next 20 years According to Boeing, the global civil aircraft market will see demand for 38,050 new aircraft over the next 20 years, with the total value of those new deliveries estimated at US$5.7tr. Notably, airline passenger traffic and cargo traffic are expected to grow at respective CAGRs of 4.9% and 4.7%—higher than the annual average global GDP growth estimate of 3.1%—creating a favorable environment for the civil aircraft market. In addition, we believe that the oil price downtrend will positively affect the market in the medium to long term, as the attendant fall in jet fuel prices should improve the earnings and purchasing power of airlines. (Jet fuel accounts for the highest proportion of airlines’ expenses.) Of note, small- and medium-sized aircraft (single-aisle and small wide-body) are seeing the fastest demand growth in the global market due to 1) rising emerging market demand, 2) the growing adoption of highly efficient aircraft, and 3) the growth of low-cost carriers (LCCs). Over the next 20 years, the proportion of small- and medium-sized aircraft will likely reach around 70% of the overall civil aircraft market (50% for single-aisle and 22% for small wide-body). Figure 1. New aircraft and global airline networks Figure 2. Overview of key aircraft market indicators (%) Average annual growth rate: 2015-2034 6 4.9 5 4.7 4 3.1 3 2 1 0 Global economic growth Passenger traffic Cargo traffic Source: Boeing, KDB Daewoo Securities Research Source: Boeing, KDB Daewoo Securities Research Figure 3. Global aircraft market breakdown Figure 4. Civil aircraft market outlook by size ('000 units) 40 2014 2034 Civil aircraft MRO 31 34% 30% 30 [Civil aircraft market] (2010) 20 20,910 units (2013) -> 42,180 units (2033) W396bn 14 10 6 4 Components/ 2 3 3 3 Combat aircraft 1 1 equipment 12% 0 24% Large wide- Medium wide- Small wide-body Single aisle Regional jets body body Source: Korea Aerospace Industries Association, KDB Daewoo Securities Research Note: 2013 and 2033 figures refer to total number of aircraft in operation Source: Boeing, KDB Daewoo Securities Research KDB Daewoo Securities Research 3 August 27, 2015 Aviation 2. Market trends: Expansion of global outsourcing The aircraft industry environment is oligopolistic and closed. Traditionally, the industry has been dominated by the US and Europe, with Boeing and Airbus, in particular, controlling the global civil aircraft market. And the combined market share of the top 10 makers stands at more than 80%. However, major aircraft makers are gradually increasing their global outsourcing of sections/parts/materials production, as: 1) Boeing and Airbus currently enjoy order backlogs of more than five years thanks to surging aircraft demand; 2) outsourcing can cut production costs; 3) parts makers are reducing the burden of new aircraft development for aircraft makers via risk- sharing programs; and 4) parts makers have bolstered their competitiveness on the back of defense offset agreements (in which the seller of a product or service agrees to buy products or services from its client as an inducement). In the past, Boeing outsourced 35-50% of 737 parts production. For the recently developed 787 model, the percentage has increased to 70%. In addition, the company has modified its supply chain by forging partnerships with vendors capable of providing entire integrated sections (similar to modules). Airbus also plans to increase the proportion of non-EU-sourced parts from 31.5% in 2009 to 40% in 2020. Table 1. Changes in Boeing’s parts outsourcing strategy 737 (past) 787 (current) % of parts outsourcing 35-50% 70% Relationship with parts suppliers Based on conventional supply contracts Strategic partnerships with tier-one vendors Roles of parts suppliers Parts development and production Section development and production No. of parts suppliers Several thousand Around 50 strategic partners Supply contract type Fixed-price contract with delay penalties Risk-sharing partnership Assembly operations 30 days for final assembly Three days (assembly of complete sections) Source: Airway News, KDB Daewoo Securities Research Figure 5. Boeing 737 supply chain (past) Figure 6. Boeing 787 supply chain (current) Source: Boeing, KDB Daewoo Securities Research Source: Boeing, KDB Daewoo Securities Research KDB Daewoo Securities Research 4 August 27, 2015 Aviation Figure 8. Airbus attempting to raise percentage of non-EU Figure 7. Boeing 787 Dreamliner supply chain overview parts to 40% by 2020 Source: Boeing, KDB Daewoo Securities Research Source: Airbus, KDB Daewoo Securities Research KDB Daewoo Securities Research 5 August 27, 2015 Aviation Military aircraft market outlook 1. Overview of KF-X project The KF-X project is a program that aims to develop an advanced multirole fighter for the Republic of Korea Air Force (ROKAF) based on domestic aerospace technology. The program is targeting production of a 4.5-5G fighter to replace Korea's aging F-4D/E Phantom II and F-5E/F Tiger II aircraft (243 units in total). The government is targeting the introduction of 120 fighter aircraft in 2025. KF-X is Korea’s largest weapons project, bearing total costs of around W30tr (including R&D expenses of W8.7tr). 2. Status of KF-X project In July 2014, Korea’s Joint Chiefs of Staff decided to equip the KF-X with two engines, pushing back the year of deployment to 2025 and bumping up the total R&D budget from W6.4tr to W8.7tr.