Description

GS Home Shopping (KOSDAQ:028150) presents an opportunity to buy a leading home shopping business for less than 4x trailing EV/EBIT, with multiple drivers of future profit growth and a shareholder activist campaign in progress.

A majority of the VIC community should be familiar with QVC, a business that has been written up a number of times as part of one of John Malone’s Liberty tracking stocks.  For a detailed primer on the home shopping business model, readers can refer to clark0225’s write-up of Liberty Interactive Group from September 2015.

GS Home Shopping is the leading home shopping network in South Korea, with a 21% share of the mature TV shopping segment and a 29% share of the rapidly growing Mobile segment (measured against other home shopping companies).  The Company also holds interests in leading home shopping properties in Asia through JVs in China, India, Thailand, Vietnam, Indonesia, Turkey, Malaysia, and Russia.

GS Home Shopping was South Korea’s first home shopping network to launch in 1995.  Originally part of LG Group, the Company was separately listed as a subsidiary of GS Holdings in conjunction with a reorganization in 2004, in which the Koo family gained full control over LG Group and the Heo family gained control of GS Holdings.  During its history as a listed company, GS Home Shopping has not engaged in cross-holding, related party transactions or non-core investment activities that have historically plagued the Korean chaebols; the Company has remained a directly held subsidiary of GS Holdings focused on the operation of home shopping networks.  In 2011, the Company sharpened this focus by disposing of two cable networks inherited in the 2004 reorganization at roughly 30x EBIT:

http://m.pulsenews.co.kr/view.php?year=2010&no=570513

With a market cap of roughly KRW1,150 billion, net cash of roughly KRW750 billion, trailing EBIT in the core business of KRW100 billion, and JV investments in international markets worth KRW100 billion at cost, the stock is clearly cheap and is trading near the bottom of its historical valuation range. We believe that the stock deserves a fair valuation of at least 7x EV/EBIT, as the business will likely grow revenue and profitability over the next several years.

How did it get so cheap?

The stock briefly traded above KRW300,000 at the end of 2013 on the back of record profitability and a valuation of 10x EV/EBIT.  Over the subsequent two years, a number of developments resulted in a 30% decline in operating income and a contraction in share valuation:

·         The Company’s most profitable segment, TV Shopping, registered two straight 3% annual sales declines in 2014 and 2015.

o   TV Shopping market growth slowing due to shift to mobile – While total Home Shopping sales are growing at 10% annually, most of that growth is coming from the mobile segment and TV Shopping sales have been roughly flat since 2013.  A downward trend of terrestrial channel viewership will likely continue to pressure TV Shopping sales.

o   Increased competition – A 6^th player entered in 2012 and a 7^th government-owned player entered the market in 2015, reducing the market share of existing players.

o   Lack of “Mega hit” items

·         The Company’s sales mix has shifted to become more reliant on less profitable mobile sales, from 8% of gross sales in 2013 to 30% of gross sales in 2015.

o   While the mobile segment has been profitable from inception, operating margins are much lower, about 1% according to the Company, due to lower gross margins and higher customer acquisition costs.  EBIT margins are expected to remain low in order to capture more of the mobile growth opportunity.

o   GS has the highest mobile market share of TV Shopping competitors, but they are facing fierce competition from e-commerce players Coupang (backed by Softbank) and Ticketmonster (Groupon subsidiary). 

o   Mobile growth is clearly cannibalizing PC sales, but there is also some cannibalization of TV sales, as GS is encouraging viewers to make purchases through their mobile app, which has further pressured margins.

o   While the mobile segment has shared a good amount of the fixed cost base with TV shopping, it has been necessary to invest in additional IT infrastructure and may be necessary to invest further in warehouse infrastructure.

·         There was a confluence of bad industry data and bad news in 2015.

o   Weak consumer sentiment in South Korea due to record high household debt as a percentage of GDP contributed to a slump in retail sales growth in 2013-2014.

o   The MERS outbreak in the early summer of 2015 not only negatively affected offline retail sales but also home shopping, as some consumers were afraid even of contact with deliverymen.

o   In April 2015 there was a quality control scandal involving herbal pharmaceutical company Naturalendo Tech, which prompted GS Home Shopping to compensate customers for unconsumed NT products and consider making provisions for KRW43 billion of gross sales since 2012.

o   In March 2015 GS and 5 other home shopping channels were fined a total of KRW14 billion for unfair business practices by the Fair Trade Commission, essentially for exercising too much bargaining power over suppliers.

·         International investments not yet profitable in aggregate.

o   While the Company’s China JV is profitable with 20%+ revenue growth, all other international JVs are loss making.  As a result, the investments in aggregate have little impact on the P/L and there seems to be no valuation placed on the investments by the market.

·         The Company is hoarding cash.

o   An increased dividend in 2015 and share repurchases in 2012 and 2014 may be a positive sign of improved capital allocation, but the amounts were not large enough to address shareholder concerns over the Company’s growing pile of cash.  Although GS has not done anything to warrant mistrust, the market does not appear to be giving them full value for the cash, assuming they will make poor investments rather than distribute more to shareholders.

Why is it likely to revalue?

Following solid Q4 results, there are signs that the worst may be over operationally and profits may start growing again.  Furthermore, an activist shareholder movement has the potential to improve capital allocation and share valuations:

·         TV shopping could become more profitable as SO Commissions are renegotiated and competition stabilizes.

o   While competitive pressures in TV Shopping are unlikely to ease in the near term, commissions paid to some broadcast network operators were successfully negotiated downward in 2015, a trend that is expected to boost profitability in 2016 and beyond.

o   The impact of the entrance of a 7^th player on GS Home Shopping’s TV segment should be minimal.  The various Korean home shopping networks have been able to maintain their relative market share despite new entrants and have all remained profitable, likely due to high customer retention rates.

·         Mobile profitability is expected to improve as investment in growth slows.

o   The Company has suggested that mobile operating margins could be increased from 1% to 3% if they stopped investing in growth, which is at least two years out.  GS has thus far competed rationally by not competing directly on price or promotions, while e-commerce leaders Coupang and Ticketmonster have reported steep operating losses.  As mobile growth slows to 20-30% annually, the Company has stated that they are starting to focus more on profitability.

o   Thus far, the demographics of their mobile business has not substantially overlapped those of their TV Shopping business, with the mobile business customers tending to be more male and younger.  There is a ~25% product overlap between TV and mobile.

o   As mobile becomes a larger proportion of gross sales and PC sales are phased out, overall revenue growth should pick up.

·         Bad news is in the rearview mirror.

o   MERS and Natural Endotech were one-off events, and the FTC fines have not resulted in substantial changes to the industry.

·         There is potential for improved profitability from or monetization of international investments.

o   The Company’s best performing JV in China reported 25% revenue growth in 2015, and maintained profitability despite increased promotion expenses.  Plans for an eventual IPO would lead to better disclosure about financials and operations.  If the IPO were able to achieve the 3.5x EV/Sales valuation of one its direct competitors in China, Happigo, GS would record a 10x return on its $51.2m investment.  Given the Company’s current Enterprise Value of $300m, any valuation in between could have a significant positive impact on the Company’s share price.

o   The Company’s biggest loss-making JV in India has underwent a change of control in late 2014, and it appears that the new management is scaling back the business to focus on profitability.  Homeshop18 still boasts dominant market share at 48% vs. 20% for its closest competitor Star CJ (also a Korean JV).  IPO plans were shelved in 2014, but may be reconsidered following a successful turnaround.

o   The Malaysian and Vietnamese JVs, although relatively small compared to China and India, are growing revenue rapidly (100%+), and Vietnam broke even for the first time in 2015.

·         Shareholder Activism

o   It was reported on February 15^th that SC Fundamental has demanded that the Company double its annual dividend and repurchase 10% of its shares outstanding.  http://pulsenews.co.kr/view.php?year=2016&no=123115

o   SC Fundamental has had previous success in Korean activism on a smaller scale with Kukbo Design: http://www.valuewalk.com/2014/09/david-hurwitz-on-activist-investing-in-korea/

o   The ownership structure of GS Home Shopping should help SC Fundamental’s cause.  Foreign institutions own 35% of the Company vs. GS Holdings at 31.5%.  The largest Korean institution at 4.2%, National Pension Service, has a reputation for supporting minority shareholder demands for improved corporate governance.  This balance of power is perhaps what led the Company to more than double its annual dividend for 2014.

o   It is our understanding that the controlling family has better reputation in Korea than most concerning corporate governance, and they may respond favorably to shareholder demands around capital allocation.

Conclusion: 7x EV/EBIT based on analysts’ consensus 2016 EBIT of KRW115 billion would equal a share price of about KRW255,000, or about 30% upside from today’s price.  The downside appears to be well protected by cash and investments, and further upside could be unlocked if the Company heeds calls for improved capital allocation or if mobile profitability surprises to the upside.

Catalyst

Cash flow exceeds market cap in 3-5 years

Activist push for improved capital allocation succeeds, increased dividend yield and buyback

Mobile investment bears fruit

International businesses turn profitable and are monetized