Description

Overview

Based in South Korea, AmorePacific is the leading cosmetic/beauty producer with 28 brands and a 40% market share in South Korea (LG Household is second with a 20% market share). AmorePacific earns 30% of its revenues abroad in China, Europe, America and other Asian countries. The company was founded in 1945 by Suh Sungwhan. AmorePacific is still family controlled today and the son of the founder, Kyung-bae, has been the CEO since 1997.

AmorePacific has two listed companies because of a holding company restructuring in 2006. They are AmorePacific Corp (APC) and AmorePacific Group (APG). APC owns 23 of the 28 brands in the portfolio, while APG has a 32.2% economic interest in APC and owns the other 5 brands as well as some non-material legacy assets. Despite, two separate listed companies, they are run as one and Kyung-bae is the CEO of both. Additionally, both listed entities, have common and preferred shares outstanding. The preferred shares are the “standard” Korean preferred shares that have the same economic ownership as common shares, a higher dividend, and no voting rights, yet trade at wide discounts to the common shares.

We own the AmorePacific Group Preferred (002795). APC and APG’s common stocks trade at equal valuations on EV/Sales, P/E, etc. However, APC’s preferred stock trades at a 37.0% discount to the common while, APG’s preferred stock trades at a 55.3% discount to the common.

Recent tensions between South Korea and China over North Korea have been a major contributor to ~25% stock price decline over the past 12-13 months. The recent share price decline and the discount to common produces an attractive valuation for the preferred shares at a valuation of 10.4x EV/NOPAT (Q1 2017 TTM).

Company

AmorePacific based in South Korea competes in the luxury, premium and mass market categories. They market their products through 28 brands and they project that their five leading brands will soon make up 40% of total revenue. They have products ranging from beauty care, perfume, hair, oral, etc. Their products are distributed through many channels. Up until a few years ago, door-to-door sales, which started in 1964, had been the major selling channel. More recently, as door-to-door sales have declined, duty free and online stores have emerged. In addition, they have specialty stores, department stores, and larger market stores (like Target). In their online channels, they sell through sites like Tmall and maintain their own sites as well. The company is very focused on organic growth and does not do many acquisitions.

The company has enjoyed strong and consistent margins and high returns on capital due to its focus on quality products and the structural advantages of being the market leader. As the largest player, they can spend more money on R&D and advertising than any of their peers which helps protect their market position and ensure they have the best products on the market. Additionally, they have a very strong brand image which has allowed them to enter foreign markets despite being a small player in those markets and not enjoying the same advantages they do in their domestic market. 

Management

AmorePacific is run by Kyung-bae, 53, the son of the founder. At the time he took over as CEO in 1997 the core beauty business was strong, but the company had ventured into unrelated businesses such as construction and stock brokering. Under his leadership, AmorePacific has sold off the unrelated businesses and focused on its core beauty business. From 1997 to 2016, market share has increased from 22% to 40%, sales have compounded at 11.7%, and operating income has compounded at 13.4%. Kyung-bae owns 55.7% of APG’s common shares and 10.7% of APC’s common shares. Additionally, Kyung-bae is known to personally test all the company’s products.

China

Government tensions between China and South Korea have impacted the beauty industry in South Korea. While sales in China account for 19.3% of APC’s sales in 2016, duty-free store (DFS) purchases made by Chinese tourists in South Korea count as domestic sales. According to IR, DFS sales are ~40% of domestic sales. Additionally, ~70-80% of DFS sales are by Chinese tourists. Thus, China is closer to ~40% of sales. Earlier this year, China banned travel groups to South Korea which has hurt AmorePacific’s and the industry’s DFS business. In Q2 2017, where they felt the travel ban for the entirety of the quarter, sales were down 16.5% YoY. Our view, is while this certainly hurts near term sales and earnings, this is a temporary problem that will resolve over time.

Valuation

We value APG on a look through basis of its proportional ownership of APC plus its ownership in its own businesses. On a look through basis, its ownership of APC accounts for 62% of sales. At the end of Q1 2017, we calculated TTM NOPAT (look through adjusted for ownership levels) to be 348B KRW assuming a 25% tax rate. There are 83.289M shares outstanding. The common share price is 126,500 KRW and the preferred share price is 56,500 KRW. Thus, the implied market value of buying the preferred is 4.706T KRW. Additionally, the company has a net cash position (look through, again) of 1.059T. We therefore calculate that EV/NOPAT is 10.5x which we find to a be a very compelling valuation for a company that is owner-operated, high ROIC, growing, and has barriers to entry. For reference, the EV/NOPAT of the common shares is ~28x and the average forward P/E across its peers is 24.6x.

While the tourist ban is in effect, earnings will decrease, however, we view this multiple to represent normalized earnings.

Catalyst

Easing Tensions with China

Closing Valuation Gap between Preferred and Common in Korea – Although the gap has persisted for decades, recent increased attention towards corporate governance in South Korean could be a catalyst for closing the gap. Samsung has bought back its preferred shares and closed the gap from a 38% discount 5 years ago to a 10% discount in January 2017 (currently back to a 20% discount today).