South Korea's aerospace industry, which has struggled to survive over the past decade, is faced with yet another round of challenges as it again tries to position itself as a top-tier manufacturer.
The country's two largest aerospace firms - Korea Aerospace Industries (KAI) and Korean Air (KAL) Aerospace - are planning a merger that could result in the rationalisation required for the struggling industry to achieve its long-time goal of becoming one of the top 10 aerospace exporters. But the companies overwhelmingly rely on domestic defence procurements and government-driven offset projects.
To survive, the new KAI has to succeed in its so-far unsuccessful attempt to export aircraft. The Korean government must continue to funnel most defence spending into KAI, invest in expensive new indigenous aircraft projects and resist pressure to spend scarce funds on other potentially more promising sectors.
Military products purchased by South Korea account for 80% of KAI's annual revenues, or roughly $720 million in 2003. Commercial sales account for about $180 million, mainly from KAI's Boeing-driven aerostructures business. KAL Aerospace has a similar aerostructures business, fuelled by offset contracts and accounting for roughly $100 million in revenues. Apart from this area, the two companies do not overlap because KAL's military business, which accounts for about $60 million in annual sales, is limited to maintenance and modification of Korean and US aircraft. KAI currently has no maintenance capability.
If the deal is completed next month as proposed, smaller KAL Aerospace, an in-house division of privately owned national carrier KAL, will gain control of KAI. KAL says it will initially operate KAI as a subsidiary, although eventually KAL Aerospace's assets should be injected into it.
In August, KAL signed a memorandum of understanding (MoU) with Daewoo Heavy Industries & Machinery covering the purchase of its 28% stake in KAI for between 102 billion won ($88 million) and 130 billion won. KAL later signed an MoU with KAI's two other dominant shareholders, Hyundai and Samsung, to issue new KAI shares to KAL for 130 billion won to give KAL just over a 50% stake and management control. Daewoo, Hyundai and Samsung merged parts of their aerospace divisions in 1999 in a government-backed rationalisation drive to create KAI. Each owns just over 28%, while local creditor banks own around 15%.
KAI projects it will more than triple its revenue base by 2010 to $3 billion, excluding any impact from the KAL merger.
"The majority of revenue should come from KT-1 and T-50 exports," says business development director T S Oh.
But exports of KAI's fast-growing military trainer product line have been slow to materialise. To date, KAI has exported only seven KT-1 primary trainers, the result of a counter-trade deal between Indonesia and South Korea that involved the swap of KT-1s for Indonesian Aerospace CN235s. A lack of exports is forcing KAI to shut down its KT-1 production line this quarter, after turning out 85 trainers for the Korean air force.
KAI hopes to re-open the line in two to three years by developing an armed variant called the KO-1. South Korea is looking at buying 20-40 of the type to replace its Cessna O-2s. Exports to Ecuador and Mexico are targeted, but no orders have been logged.
"Customers in different countries have different requirements. We are modifying the design to meet the requirements of these customers," says Oh.
Focus on production
KAI is now focusing on transitioning the T-50 advanced trainer programme into the production phase. KAI, which began test flying the new trainer last year and now has four prototypes in the air, expects South Korea to buy the first 25 T-50s by year-end. The country is expected to eventually purchase 50 T-50A advanced trainers and 44 lead-in fighter variants, known as the T-50B or A-50. KAI also hopes to sell a fighter variant known as the F-50 that is under study, but this Northrop F-5 replacement candidate will not be developed until about 2008.
The T-50 project, developed jointly with Lockheed Martin, is essentially designed to keep KAI afloat for the next decade, and perhaps longer if South Korea decides to replace its fleet of over 100 KAL-built F-5s with F-50s. This year alone Oh expects KAI to book over $1 billion in revenues from domestic T-50 sales. Production is expected to quickly ramp up to 1.5 aircraft a month, with deliveries beginning in late 2005.
KAI has the capacity to triple production and needs to export as many aircraft as it sells domestically to meet its expansion goals. For this to happen it must fend off competition in the export trainer market from more seasoned competitors, including BAE Systems, Embraer and Pilatus.
Industry observers believe KAI faces long odds in convincing foreign militaries to purchase Korean aircraft and say there are few trainer competitions in the near term for KAI to even enter. KAI is mainly targeting small South-East Asian, Middle Eastern and South American governments.
"We're talking to many countries, but we have to wait for their decisions," Oh says.
KAI needs to secure additional work as soon as possible to keep its 3,200 employees busy. Industry observers say KAI faces an over-employment problem, with KT-1 production ceaseing, work of licence-built Lockheed Martin F-16s coming to an end and T-50 production not at full speed.
Industry observers believe KAL will make workforce reductions after it takes the reins from KAI, which has prompted stiff resistance and strike threats from KAI unions. Observers say KAI - or KAL if the merger goes through - will have to decide to either lay off up to 50% of their combined 4,800 employees or keep more employees than required to avoid labour animosity and the need to rehire workers in a few years when more work is expected to arrive. "If all the new programmes go as forecasted then they are not really overmanned," says an industry source. "But the thing is, nothing in Korea goes as scheduled. That's why the outlook looks so bad.
"Oh expects new business to be generated over the next few years from the procurement of maritime patrol aircraft (MPA) and an indigenous helicopter project known as the Korean Multi-role Helicopter (KMH). "We are preparing for many big programmes, such as KMH and MPA. Those are the major expansion streams of our business," he says.
But South Korea has not yet signed a contract for the MPA programme, which involves the refurbishment of eight ex-US Navy Lockheed Martin P-3B Orions. KAI and KAL have each bid for the work.
High hopes for KMHFor South Korea's aerospace industry, the KMH promises to be the T-50 of the next decade, with an expected procurement of up to 500 helicopters domestically and up to 500 exports (see P49). But the first helicopter will not be delivered until at least 2010 and the estimated $1.7 billion in development costs will have to be shared by several South Korean companies and government agencies. "During the development years revenues from KMH will be limited," Oh acknowledges.
KAI and its legacy companies have previously tried to expand into the helicopter sector, largely unsuccessfully. In 1996 Daewoo partnered with Poland's PZL-Swidnik on sales of its W-3A Sokol in Asia. But Daewoo/KAI sold only nine Sokols, including six to Daewoo, before the licensing agreement expired in April and an option to build Sokols in Korea was never exercised.
Further clouding their relationship, one of the KAI-sold Sokols crashed in January. KAI and PZL then decided to postpone any discussion on extending their partnership.
"We are looking for a way to resolve the accident amicably," Oh says. "After we resolve the accident issue, we'll talk about further sales.
"In 1997, Samsung forged a joint venture with Bell Helicopters to develop and build the SB427 light twin. But Samsung/KAI to date has only been able to sell three 427s, including two to Bell, and only two of these were built in South Korea. KAI is responsible for supplying the airframe/cabin for all 427s, including those sold and assembled by Bell, and for building helicopters sold in China, South Korea and elsewhere in South-East Asia.
Oh says the 427's inability to operate under instrument flight rules (IFR) has hampered sales. "Most customers prefer helicopters with IFR, so the market is limited," he says.
Bell and KAI are now in talks to jointly develop a new IFR version. "We're looking at the market to see if it is feasible," Oh says.
KAI's aerostructures business, meanwhile, has been hit by the downturn in commercial aircraft orders following the 11 September terrorist attacks. Oh says revenues have fallen, and are only now starting to recover. It remains unclear if this business will expand over the next decade.
KAI, however, has added three aerostructure contracts in the last year made possible by offset commitments from South Korea's purchase of 40 Boeing F-15Ks. KAI will supply Boeing with 737 vertical fins and horizontal stabilisers, which are larger than any of the commercial aircraft components KAI now manufactures (see chart). KAI has also begun building fuselages for Boeing AH-64 Apache helicopters and will from 2007 supply forward fuselages and wings for F-15s sold outside the USA. These deals give KAI's aerostructures business its first defence work.
KAL Aerospace's aerostructures business also fell by 50-60% after September 2001, but it too has added business in the past year, including Boeing 747-400 winglets and a section of Boeing 767 fuselage. Its maintenance business has also picked up since September 2001, with new contracts from the USA for Fairchild A-10 maintenance and modifications and Sikorsky UH-60 Black Hawk maintenance.
The company's business, however, has steadily shrunk since KAI was created in 1999 because KAI was given a "right of first refusal" on all new Korean military aircraft projects. As a result KAL has been unable to bid for any project and its military aircraft manufacturing line shut down two years ago after the delivery of the last licence-built Black Hawk to the South Korean army.
KAL Aerospace has since lobbied the government to drop its "sole-source policy" that puts KAI at an advantage on military programmes, says its president, Suh Sang-mook. But the company has been unsuccessful and does not expect any change soon, helping to push it towards a deal with KAI.
"I tried to lobby, and I said that the sole-source policy is not a good policy for the long term. We have to compete," Suh says. "I tried for two to three years, but unsuccessfully." KAL was especially interested in pursuing a prime role on KMH with long-term partner Sikorsky.
"The reason KAL is interested in taking over KAI is KMH," says an industry official. "They could never have it if they stay out, they could only be a subcontractor to KAI."
Lobbying for maintenance
Meanwhile, the official says KAI has been lobbying the government for its first military aircraft maintenance contract, putting further pressure on KAL to reconsider joining KAI. KAL was pressured in 1999 by the government to fold its manufacturing unit into KAI but it declined, claiming its aerospace business was financially stronger than those of Daewoo, Hyundai and Samsung.
Suh says KAL first looked at acquiring Daewoo's shares two years ago, when the conglomerate approached it saying it wanted to sell out of KAI, but KAL concluded that having only a minority holding "cannot change KAI's culture or capability".
"KAI has been divided by three companies on the leadership, so we felt they need strong leadership. If not, the company cannot be [successful]," he adds.
"Taking 51% of the company is easy - we can buy Daewoo stock, and some of the portion of the others, but that cannot help KAI. KAI needs cash, so we decided we would have to put cash into KAI so we can make 51% of KAI's stock. We know they need cash. They are trying to borrow money every day," Suh says.
KAL expects the takeover to be formally completed by year-end, after it completes an expected six to eight weeks of due diligence. It is not certain the deal will be completed and not all of KAL's takeover efforts have gone smoothly. There were initial difficulties in talks with Hyundai and Samsung, while KAI unions have vehemently opposed the takeover.
But Suh is not worried about KAL Aerospace's future if the deal collapses. "We will survive," he insists. "We can survive with the maintenance work and with the commercial work. My division has been very, very healthy for the last seven years, and we made profits.
"Suh does not like to think of "what ifs", saying of the takeover: "It must be done. We have been in this business for 26 years so we have more experience - more knowledge on various types of aircraft."
Attracting foreign funds
Suh says KAL is already working to bring foreign funds into KAI soon after the takeover and this could lead to between $200 million and $300 million coming in from abroad. He believes rationalising the local manufacturing sector will lead to more foreign subcontracts and possibly a foreign equity partner, which KAI has wanted for a long time.
"There are a couple of companies - big companies - who want to invest in KAI if Korean Air takes leadership of the company," he says, declining to reveal names.
Companies in the USA and Europe believe the market in South Korea in 20 years will grow, he says, "so they are very, very keen about commercial and military [growth prospects] in Korea. So they would like to participate in this company," he adds.
In May 1999 a BAE Systems/Boeing consortium was selected over several candidates as KAI's preferred investment partner with a 35% stake. But talks with BAE Systems and Boeing collapsed several months later, reportedly over the degree to which they would have control over major company decisions and over KAI's valuation. Just over a year later, KAI's main creditors agreed to accept their minority stake in exchange for writing off sizeable debts.
Since then KAI has continued working to improve its financial position, but it remains weak. KAL, in announcing its MoU with Daewoo in August, said it planned to "turn around KAI into one of the key players in the aerospace industry by giving it a new competitive edge".
It added: "As a dominant stockholding figure, Korean Air plans to improve KAI's management conditions as early as possible with its 25 years of experience and know-how in the aerospace industry. KAI has been experiencing difficulties due to the lack of market presence in the commercial aviation field and an absence of strong management leadership. In addition, the investment duplication of the Korean aerospace industry has led to concerns such as weakened competitiveness in the international market and ineffective use of national resources."
Source: Flight International
