LG Household & Healthcare (“LG H&H”) is one of the best companies in Korea and can be bought via its preferred shares for under 9x this year’s earnings.  LG H&H is a leading consumer products company focused on three areas - cosmetics, health and personal goods, and beverages – and has a CEO with a history of strong capital allocation.  The company has performed extremely well since the CEO took over 9 years ago – revenue has increased for 34 consecutive quarters and operating profit has increased for 36 straight quarters.  LG H&H’s common stock has averaged a P/E in the 30’s over that time, reflecting the consistent growth and strong competitive positioning; however in recent months the common shares have fallen significantly and now trade under 20x 2014 consensus earnings.  The prefs trade at a 55% discount to the common shares and I believe are the ideal way to invest in LG H&H as you get exposure to a very high quality company and the possibility of the discount closing over time as well.  I think there is a reasonable chance that the discount will close – the timing of that is unpredictable, but with a company of this quality I believe you will get paid to wait in the meantime.           

High Quality Business

LG H&H was spun out of what is now LG Corp in 2001 and initially struggled after the IPO.  In 2005 LG brought in an outsider CEO, Suk Cha, who spent 15 years at Proctor and Gamble in both Korea and the US earlier in his career and was educated in the US.  Mr. Cha instituted many Western-style practices at LG H&H, bought shares personally in 2005, repurchased ~5% of the float on behalf of the company in 2006, and has achieved excellent results as the table above shows.  He is widely regarded as one of the top CEO’s in Korea:     

http://www.4-traders.com/news/LG-HH-Chief-Suk-Cha-Named-the-2011-Best-Korean-CEO-for-the-3rd-Consecutive-Year-by-Asiamoney-Asi--14038143/

The company’s three divisions are each highly profitable and well positioned.  Cosmetics represent 38% of sales and 47% of operating profit.  LG H&H has 20% market share, second to Amorepacific.  Cosmetics revenue has grown every year since 2007 and operating profit has grown over 4x over that time. 

Health and personal goods represents 33% of sales and 32% of operating profit, and LG H&H has 34% market share across its major categories (soaps, shampoos, detergents, fabric softeners, toothpaste, etc.).  Both revenue and operating profit have grown every year since 2007 in this category. 

Beverages represent 28% of sales and 21% of operating profit.  The bulk of this segment is the result of LG H&H’s 2007 acquisition of the Coca-Coca bottling business in Korea.   That business was losing money at the time and LG H&H bought 90% of it for 287 billion Won.  Since then sales have increased 2.2x and the company generated 95 billion Won in operating profit last year.  Once again sales in this segment have grown every year since 2007. 

The company has historically been focused on Korea, but has successfully expanded into other countries in recent years.  International sales grew 50% in 2013 and now represent 22% of the company’s operating profit.  China, Japan, Vietnam, and Taiwan are the largest areas of focus, although the company has plans to expand in North America over time as well.      

Strong Capital Allocation

CEO Suk Cha has made several shrewd capital allocation decisions since taking over.  The buyback in 2006 was rare for a Korean company and a good use of capital as the stock is up over 6x since then.  As mentioned above the 2007 acquisition of the Coca Cola has resulted in great returns.  In 2009 the company bought a chain of cosmetics stores called Face Shop, whose revenues have more than doubled since the acquisition.  In 2010 they bought Haitai Beverage for a token amount while assuming the company’s debt – Haitai had shrinking sales and a 39 billion Won operating loss in 2009, but has since turned around and generated 8 billion Won of operating profit last year.  LG H&H bought two companies in Japan in 2011/2012 as well – Ginza Stefany and Everlike – and while it’s still early to judge those they are profitable thus far. 

Korean Prefs Generally

RH121’s write-up of Daelim from a month ago has an overview of Korean prefs broadly ((https://www.dropbox.com/s/7muigwutqtnp6gy/000215.pdf), which I would point to for a detailed background of the space.  To summarize, Korean prefs generally have an equal claim on earnings as common shares, and typically pay out a higher dividend, but do not receive voting rights.  They are very close to being equivalent to common shares from an economic perspective, yet trade at very large discounts – the average today is around 44%.  That level of discount is an outlier relative to other markets where similar preferred shares exist – for example in Germany, Italy, and even Russia, discounts are significantly smaller today (single digits on average). 

I believe there is a reasonable chance that discounts will close in the coming years.  The biggest reason is that in the past year Korean prefs have started to receive increased attention from the investment community.  Li Lu pitched the idea at the Value Investing Congress last year, it’s been mentioned recently in places like The Manual of Ideas and Grant’s Interest Rate Observer, and a US-based hedge fund (Weiss Asset Management) launched a closed end fund listed in London to focus purely on the opportunity set (WKOF).  Andrew Weiss, the PM, spoke at Ira Sohn in London a few months ago: http://www.valuewalk.com/2013/10/andrew-weiss/.  The Weiss fund has around $180 mm in assets and trades at a 10% premium to book value. This public attention on the space is a big positive – discounts on average have narrowed in the past year – and I believe that is likely to continue going forward. 

The Korean regulator also announced last year that some of the smallest prefs would be up for delisting given their lack of liquidity.  One company, Hyundai Mobis, responded to that ruling by tendering for its prefs at an ~18% premium to their price at the time.  This was small but a good sign that prefs aren’t completely disregarded by local management teams.  Finally there is a positive trend regarding shareholder protections generally in Korea – the FT quoted Andrew Weiss at the Ira Sohn conference as saying ‘…if regulations on the way through now pass, South Korea will soon have the “best shareholder rights in the world”’ (http://www.ft.com/intl/cms/s/0/e70c47b2-42db-11e3-8350-00144feabdc0.html). 

Even if discounts for the entire pref universe don’t narrow, there is a chance that it could narrow for LG H&H in particular.  The table below shows the 20 most liquid Korean prefs and you can see that it has one of the widest discounts, despite being one of the best companies on the list.  It would not take a huge re-rating to lead to a good outcome – for example if the underlying company and common shares increase in value at 8%/year, and three years from now the discount is 40%, the prefs would deliver a total return of almost 70%.

Potential Risks

• Capital allocation - Korean companies overall don’t have a great track record of capital allocation – while LG H&H has been an outlier in recent years that may not continue forever
• Difficult to trade – you have to register to buy shares in Korea.  Ju Kim at Samsung Securities ([email protected]) is a helpful resource on that front
• M&A risk - in theory, prefs could get hurt in an M&A scenario, although to my knowledge that has never actually happened
• North Korea conflict – always a non-zero risk unfortunately, although you could hedge that out with indices or CDS if you are particularly worried about it
• Illiquid – while LG H&H’s common shares are very liquid the prefs only trade around $300 K/day
• Debt – the company does have some debt, but not an irresponsible amount in my opinion (debt/EBITDA around 1.7x)
• Insider sales – Suk Cha has sold about 2/3 of his common shares since 2008, including a sale in Q4 of last year.  He still owns about $9.3 mm of common shares.  Interestingly he owns ~$2.7 mm worth of prefs personally and has been a net buyer since 2008 (albeit small).  His stake in the prefs is about 0.7% of the outstanding shares, while his stake in the common shares is closer to 0.1%

Summary

Overall I believe an investment in LG H&H’s pref shares provides an investor with exposure to a very high quality company at a cheap price, with several ways to win over the next few years.  Any combination of the common shares performing well, Korean prefs generally getting more attention, or LG H&H’s discount narrowing on its own should result in attractive returns from current levels.  While I think the Korean pref space generally is interesting, in many cases a good outcome is dependent upon the discount narrowing.  In the case of LG H&H, while that would certainly be nice, I don’t believe it’s necessary given the underlying strength of the business, which I’m quite happy to own a stake in while waiting for that to occur.