Description

Which translate into net income as follows:

Briefly going over the businesses, tobacco is what matters most, being ~60% of group revenue, ~80% of group operating income. The business is split into domestic (1,800bn KRW sales) and international (1,030bn KRW sales) tobacco. Margins in the international business are about 600bps above the domestic business.

They had a monopoly in the domestic business until the late 90s when the market opened up, but the market share has been stable at around 60% in the last few years – since 2012, share has peaked at 62.3% and troughed at 59.1%, ending last quarter at 61.2%. The domestic market is ex-growth, with health warnings on packets and plain packaging coming into effect from the end of last year. Industry volumes have declined in the 2%-3% range over the last 5-6 years. KT&G have kept domestic revenues quite stable over that period, largely driven by mix increases – about 85% of volumes are in premium products, with that percentage increasing at a steady 1%-2% per annum.

The international business, as of 2016, was 57% Middle East & Central Asia, 17% China, the rest US, Southeast Asia, Europe and Africa. They sell marginally more sticks internationally now, but the ASPs are considerably lower, hence the lower revenue. Volumes have grown considerably in recent years, with revenues growing at a higher rate due to the mix effect seen domestically.

The ginseng business is ~25% of sales and ~13% of operating income (it is more of a typical FMCG business so the margin is mid-teens and of course cannot match the mid-40;s margins seen in the tobacco business). The business is mostly domestic (about 5% of it is exports), and the most recent data I could find on the Korean market size implies it was, at that time (2013) a ~1.1bn USD market, which would put their market share in the 60%+ range. It suffered a few years ago from weaker domestic demand, but has since bounced back strongly, growing 15% in 2015 and 20% in 2016. There’s no way it can grow that fast over the medium-term, but in my conversations with the company, they seem quite confident it can continue to grow mid single digits.

Like most tobacco businesses, this one is also very cash generative. Last year they generated ~1,500bn KRW of OCF and ~1,350bn KRW of FCF; for 2015 the numbers were 1,260bn KRW and 1,050bn KRW, respectively. The numbers were lower in the two years before that as profitability was depressed in the ginseng business and there was some inventory build in the tobacco business. My conversations with the company indicate that they can probably do about 1,000bn KRW of FCF this year (allowing for some elevated capex in the tobacco business), translating to an equity FCF yield of about 7% (and 8.5% on an EV basis). They will pay out about half of that in dividends – as for the rest, it will sit on the balance sheet – this is one of my issues with the company – I wish they would be a bit less “Korean” and not horde cash. I have mentioned it to the company a couple of times, and I am sure others have too, as they were criticised for it in the Q&A of the Q416 conf call. It is a company that would be a textbook case for an activist hedge fund really. Actually Icahn took a stake in the company way back when, and pressured the company into monetising a lot of property they owned but no longer needed following the privatisation.

Given a current share price of 104k KRW, 2017 EPS of ~8,400 KRW implies a very attractive P/E of 12.4x. International peers (I used PM US, MO US, BATS LN, 2914 JP, IMB LN, GGRM IJ in my peer group) trade on an average multiple of 19.1x, so you are buying at an attractive ~35% discount. To account for the company’s strong balance sheet, if one were to look at valuation on an EV/EBIT basis, KT&G trades on 7.8x 2017 EV/EBIT vs the same peer group on 14.8x, so you are buying at a ~47% discount.

Obviously, this is Korea, and probably everyone is aware of the corporate governance issues, so it will not trade in line with something listed in the US or the UK, but this 10y chart of the historical P/E discount vs. PM US, MO US, BATS LN, 2914 JP, IMB LN (couldn’t get the data for GGRM IJ) gives a sense for where we currently are in the “discount range” (chart is displaying in reverse date order for some reason - apologies):

So we are towards the lower end of the range.

The opportunity currently exists due to the introduction of plain packaging, anti-graft measures being stepped up a la China (which people feared would impact the ginseng business) and the introduction by PM of the iQOS product, which has been successful in Japan.

The plain packaging, I am not concerned about – basically you are selling to addicts and I don’t think they are that sensitive to the packaging. I don’t think reducing packaging reduces brand value that much, as people have a brand that they like and generally stick to it (in my experience).

The anti-graft measures have been in place for a while and certainly did not seem to impact revenue growth in Q416 (+19%) or in Q117 (+16%) – maybe I am not au fait enough about Korean culture, but who really buys someone a ginseng set to bribe some official to get a contract? The business seems to be much more driven by the strong brand and large increase in inbound tourism (duty free is a big part of the business).

The iQOS is more of a concern, but I think that it is in the price. To give some background, it is a product that heats the tobacco in a special device that you have to buy (for quite a bit, around 90 USD) and then charge after every pack of 20 “heat sticks” that you buy (for about 6 USD). The product was launched in Q315 in Japan, and has fairly quickly taken market share (see chart below from Morgan Stanley):

The product will launch in South Korea this year, and I think most of the share price move has reflected fears around it taking a lot of market share. I think that the market has basically discounted them losing about 1/3 of their domestic profits from competition from this product over time. At the moment, it is not clear that the product will have this kind of long-term impact in Korea. It could just be a fad in Japan (like blue e cigs). The tax treatment of the product may differ in Korea vs. Japan – see below from Morgan Stanley:

“In Japan, the iQOS has a huge tax advantage: a mere 17.6% of the device’s retail price is tax vs some 58.6% for tobacco—a gap of 41%pts. In Korea, the gap between the tax portions of retail prices for tobacco (64.6%) and e-cigarettes (26.6%) is also substantial at 38%pts. But if the tax rate for e-cigarettes rises to 40-51% through tax reform, that gap would narrow to 13-25%pts.”

KT&G could also come out with something to rival iQOS (they hinted at as much on the most recent conference call) if it does prove to be successful.

The way that I see it playing out is much like the VAT hikes from a couple of years back – in that case, the stock got killed when the news came out, as people feared that demand would be crushed by the price hikes. Of course, in reality demand is very price inelastic, so people were surprised by how resilient demand ended up being, and the shares eventually recovered. I see the same rough dynamic in this case – there is no immediate catalyst, but I see results over the next few quarters being better than many fear, and the company slowly clawing back some of its P/E discount to peers.

In terms of what the company is worth, I assume that iQOS does have some impact, and model them eventually losing a few percent of domestic market share. This should be offset somewhat by continued growth in the international business, which is higher margin, so I see operating income as being quite stable. I value the tobacco business on 11.8x my 2017 EBIT estimate (a 20% discount to global peers), which implies 14,700bn KRW of value. The ginseng business I value at 14x 2017 EBIT, again a ~20% discount to global peers to reflect the Korea listing and the lower margins (about 15% operating margins vs. global HPC generally in the high teens) – that business is thus worth about 2,700bn KRW. Adding the net cash and subtracting the capitalised group overhead, I think the equity is worth about 19,000bn KRW, or ~140k KRW/share, which implies about 35% upside.

In terms of downside protection, you have a very strong balance sheet with a net cash position, together with a 3.5% dividend yield. The free cash flow could actually support a dividend yield of 6%-7%, and it would not surprise me that much to see the company pressured into a more generous shareholder return policy a la Samsung.

Aside from the risk around the tobacco business, the only other risk to be aware of is the overhang risk from IBK’s ~7% shareholding. Risk weighting rules around equity holding will change in the next year or so, and IBK would potentially need to reduce their stake to avoid having to put aside capital against the holding – that being said, they are quite well-capitalised.

Catalyst

Earnings not as bad as people fear after the launch of iQOS

Outside chance the company is pressured into either dividend hikes or a buyback