Description

This one is for those who agree with Buffett’s notion that an investor’s scorecard is not computed using Olympic-diving methods.  If you like your stocks plain-vanilla and dirt-cheap take a look at AMOREPACIFIC Corp. shares (non-voting class) – rarely does it get any simpler and cheaper than this.

AMOREPACIFIC Corp. is the largest cosmetics company in South Korea boasting a stable cash-generative business, operating margins in high teens, and substantial excess cash on the balance sheet.  At the same time the company’s stock is selling for less than 2.4X NFY EPS and sports NFY dividend yield in excess of 6%.

AMOREPACIFIC dominates the South Korean cosmetics industry with a 35% market share, which is more than 3X larger than that of the next biggest competitor, and boasts four of the country’s five top-selling cosmetics brands.  The dominant position of the company’s brands is AMOREPACIFIC’s main competitive advantage.  Cosmetics businesses posses a remarkably high degree of continuity – as long as a company is #1 or #2 in the industry, it is likely to maintain and improve its position over time by taking market share from marginal players (absent a major managerial mishap).  The explanation of this phenomenon is quite simple:  most cosmetics end up on one’s face – which is a very personal place – so there is little incentive to switch from a well-known brand to a nameless brand just to save a couple of bucks.  A market leader’s ability to extract a healthy markup allows it to continuously solidify its position versus profit-strapped rivals.  Given AMOREPACIFIC’s market-leader status it is highly likely that the company will expand sales and profits over time at the expense of weaker competitors.  AMOREPACIFIC’s growth in South Korea will probably not exceed GDP growth by more than a couple of percentage points at best given the highly consolidated nature of the market, in which the Top 4 players account for over 60% sales.  At the same time AMOREPACIFIC may be able to add to its long term growth rate somewhat as the company expands overseas, particularly in Asia, where the high-growth/high-fragmentation nature of the markets offers AMOREPACIFIC an excellent chance to build a dominant franchise.  While the company’s main advantage is its dominant brands, AMOREPACIFIC has a number of other advantages that further enhance the company’s ability to compete:

1) Scale.  Being the largest player in the industry enables AMOREPACIFIC to:

a) Outspend all of its competitors on marketing, which helps maintain and enhance the image of the company’s brands;

b) Outspend all of the company’s competitors on R&D, which helps to continuously improve product quality;

c)  Have an unparalleled range of products, making the company a more attractive partner to its clients, such as department and specialty stores.

2) Superb financial condition.  AMOREPACIFIC’s cash-rich balance sheet should enable the company to take advantage of value-creating opportunities if they emerge.

AMOREPACIFIC has a highly qualified and operationally astute management team at helm.  The company’s Cornell-educated CEO Kyung-Bae Suh has worked for the company since the mid 1980s and took over the reigns from his father in 1997.  Mr. Suh was behind turning the company from a debt-laden bloated conglomerate, which included an insurance company and a baseball team, into a laser-like focused cosmetics company with a fortress-like balance sheet.  Over time the CEO has done a good job growing the company’s shareholder value, as he expanded AMOREPACIFIC’s market share from just 22% in 1997 to 35% in 2008 while also improving margins.  The CEO has an approximately 30% stake in the company and other insiders own approximately 20% of the firm.  While management appears to be carrying more cash on the balance sheet than seems to be warranted by the business’ needs, this overly conservative cash management policy is probably not a major risk factor in terms of capital allocation.  For one, management hasn’t done anything value-destructive with the capital in the past.  In addition, AMOREPACIFIC’s management is committed to returning at least 20% of profits to the shareholders each year via dividends.

VALUATION

Before reviewing the valuation section please keep in mind that the discussion pertains to AMOREPACIFIC’s non-voting class of shares, which are known as “preferred” shares in South Korea.  With the exception of voting rights these “preferred” shares are virtually identical to voting common shares in terms of ownership claims.  As insiders own a controlling stake in AMOREPACIFIC there is not much of a voting privilege that you get regardless of the share class you purchase.  (With that said I must point out that historically management has done the right thing for the shareholders for the most part.)

AMOREPACIFIC’s market capitalization net of cash and short-term financial instruments amounts to approximately KRW482 billion at the current stock price of KRW104,000.  The company should generate about KRW205 billion in profits next year, which results in NFY PE of just under 2.4X.  At the same time AMOREPACIFIC’s NFY dividend yield stands at just over 6%.  Given the high quality of the company’s business, it appears that AMOREPACIFIC’s stock is significantly undervalued at current levels.

Catalyst