Daehan Flour 001130 KS
October 01, 2006 - 4:38pm EST by
gophar571
2006 2007
Price: 155,000.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 266 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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  • Discount to Tangible Book
  • Sum Of The Parts (SOTP)
  • Oligopoly
  • High Barriers to Entry, Moat
  • South Korea
  • Pricing Power
  • Insider Ownership
  • Analyst Coverage
  • Warren Buffett Personal Account

Description

Investment Overview

Daehan Flour Mills is an extremely cheap stock which is conservatively worth over 70% more than the public market value and trades at earnings and FCF yields of around 15%.  Daehan’s balance sheet has net cash and securities of ~W115bn (representing 45% of the market cap).  The stock is trading at 0.6x Price/Tangible Book, below 7x Price/Earnings, and approximately 3.0x EV/economic EBIT.  Its noteworthy that the recap potential is massive considering the stability of the business and high asset values, i.e., a buyer could probably finance a purchase of the company's entire market cap entirely with debt.

 

Our sum-of-the parts valuation (using an 8x EBIT multiple or 11x earnings given the ~27% tax rate) indicates an equity value of around W269,000 per share, meaning the stock is currently priced at a greater than 70% discount to fair value and possesses a huge margin of safety.

 

Interestingly, Daehan Flour is one of the few stocks that Warren Buffet has publicly stated that he purchased in Korea in recent times (see www.valueinvestorinsight.com; April 2006), saying “[Daehan Flour] has a 25% market share in wheat flour in South Korea.  Book value was 206,000 Won, the company had 201,000 Won in marketable securities and it was trading at 2x earnings.  Markets are clearly not efficient all of the time.” Interestingly, in Tweedy Browne’s recent book (The Little Book of Value Investing) Daehan Flour Mills is cited as a cheap stock too (unclear if they or Buffet still own or not).

 

Business and Industry Overview

Founded in 1952, Daehan grinds and processes purchased wheat into all-purpose flour, bread flour and cake flour at its two factories.

 

The flour industry in Korea is an oligopoly and Daehan Flour Mills has a 25% market share which has been stable for 10 years.  CJ Corp (a publicly-listed conglomerate) has a 25% market share and five other companies comprise the remaining 50% market share (including Youngnam, which is publicly-listed).  

 

There has been little change to the competitive dynamics of the Korean flour industry for several years: the number of companies competing in this industry was eight 10 years ago, now there are seven.  Barriers to entry are high because of high fixed capital requirements for storage facilities, equipment and terminal space at ports.

 

The flour market in Korea is a low growth market, with expected annual growth of 1-2% per year for the next several years.  Increasing disposable income in Korea combined with increasing preference for Western style food (pizza, pasta, etc.) is responsible for a multi-decade trend of increasing flour consumption per capita (notwithstanding a dip in 2001-2004).

 

Daehan and its peers were fined for price collusion in December 2005, but this appears to have had no lasting impact on prices/margins (Daehan’s appeal of the 12bn Won fine- which was paid in ‘05- is pending), and the company claims that its pricing policies remain unchanged (which is consistent with results post-fine).  In general, Korean flour mills price their products at a spread to wheat costs, and as all Korean flour mills buy wheat as a collective unit (led by Daehan and CJ), they know when competitors’ costs are changing, creating an unavoidable tacit collusion of sorts.

 

Daehan Flour usually ships flour to North Korea each year (usually humanitarian organizations, and the Korean government buys flour from the company and ships it to North Korea).  This amount is less than 1% of revenue, but with North Korea’s continued struggle with food shortages, shipments to North Korea are expected to grow.

 

There’s a good initiation report on the stock from February 2005 by Korea Investment and Securities.

 

Imports/Competition

The tariff on imported flour is 4.2% in Korea.  However, imports account for only ~2% of flour consumed in Korea (and have been relatively flat for years), primarily because imported flour needs to be kept completely free from moisture during transportation, which typically involves a long ocean journey.   Moreover, newly imported products also struggle to deal with quality requirements and existing domestic players’ strong long-term relationships with key customers.

 

Additional domestic competition in this industry is highly unlikely in the medium-term, given the low growth and high initial fixed costs.  Daehan’s long-term industry relationships, deep-water port berths and grain silos are strong competitive advantages that cannot be cheaply replicated.  Daehan has no major capex/expansion plans in the next few years (overseas expansion plans were apparently abandoned because a high IRR could not be guaranteed) and current competitors appear to have no major plans to expand their flour processing capacity in the near future.

 

Pricing

Over the last several years, Daehan Flour has demonstrated that it can raise flour prices slightly more than increases in wheat prices.  From 1997 to 2005, the company raised its domestic flour prices by 6.1% CAGR, and during the same period its annual imported wheat price rose 1.8%.

 
Daehan can raise its flour price slightly more than competitors, partially because over 50% of its revenue comes from wholesalers who sell Daehan’s products to users with relatively inelastic demand: restaurants, local bakeries, and other end consumers in supermarkets and groceries.  Competitors sell a greater percentage of flour directly to large institutional customers like Nongshim (the largest instant noodle maker in Korea) who exercise their buying power and whose demand is more sensitive to small price increases.

 

COGS

Of total operating costs, wheat represents about 60%, shipping 20%, and depreciation, labor, and selling expense account for the rest.  About half of Daehan’s clients are wholesalers and half are secondary processors, meaning that marketing and advertising costs are relatively low and predictable, as Daehan is not responsible for distribution.

 

Daehan imports about half of its wheat from the US and the remaining half from Australia and Canada.  Daehan purchases wheat about 3-5 months in advance of use, as part of a collective group of Korean flour processors.  When wheat and freight prices are elevated for a few months, Daehan usually raises its prices with a 3-6 month lag.  Wheat prices and futures curves can be found on Bloomberg.

 

Freight represents 20% of COGS, and when oil prices increase, shipping costs also tend to increase slightly.  BDIY Index on Bloomberg is one way to track freight rates, although note that Daehan’s freight rates are locked in for several months in advance, creating some stability.

 

The 25% appreciation of the Korean Won versus the US$ in the past four years has helped margins as Daehan Flour does not have to pass all cost savings on its wheat purchases and freight rates through to customers, especially for its consumer business.  Of course, you can short the Won if you view this as a major risk.

 

While one often hears many arguments why the Won is likely to appreciate against the US$ over the next 12 months (growing US trade deficit, efforts by the US to weaken its currency against Asian currencies, etc.), you can be agnostic on this issue and still find the stock extremely cheap and without substantial currency risk.  For example, if the Won weakened 10% and we assume that Daehan could only pass-through half of the additional cost (which all Korean flour mills would experience simultaneously, and which Daehan has consistently passed through entirely for several years now), this would change gross margins from ~26% to ~24%.

 

Affiliates

Daehan Flour has three affiliates which are accounted for as non-consolidated affiliates despite Daehan’s high ownership stake:

1)       Korea Silo (100% owned)- operates stevedoring and grain storage facilities.  Dec.  ’05 book value of 89bn.

2)       Korea Milk Product (67% owned) - makes animal milk substitutes.  Dec. ’05 book value of 12bn.

3)       Daehan Livestock & Feed (99% owned)- makes assorted feed for animals.  Dec. ’05 book value of 68bn.

Financials are available on an annual basis for each affiliate.

 

Valuation (in Korean bn Won; 945 Won = 1 US$)

Considering the operating track record, quality of the business and nature of the industry (non-capital intensive processor with 25% market share in stable demand, oligopolistic supply industry with high barriers to entry), we believe that 11x unlevered earnings is the minimum multiple that this business deserves.  The business could easily support a net debt to EBITDA ratio of 3x, which helps make it a great MBO/LBO candidate.

 

For ’06, we expect revenue of 242bn, gross profit of 62bn, EBIT of 32bn, EBITDA of 41bn, pre-tax income of 52bn and net income of 38bn.   D&A and capex are around 10bn Won.  3Q earnings should benefit from the appreciation of the Won in 2Q, although this is not a beat-the-quarter story (esp. when there’s no sell-side coverage right now).

 

Our sum of the parts valuation is:

Net cash: 52bn (42bn as of June 30; we assumed 10bn of free cash flow in 3Q)

Public securities: 58bn after-tax value (pre-tax value of 77bn; largely driven by value of its stake in major broadcaster, SBS)

Core Business:  263bn (11x earnings)

Korea Silo: 49bn (6.5x 2006 EBIT or 9x earnings plus net cash at 12/31/05)

Korea Milk: 10bn (6.5x 2006 EBIT or 9x earnings plus net cash at 12/31/05)

Daehan Livestock: 10bn (fraction of liquidation value, to be conservative)

    Total: 441bn Won

Shares outstanding (excluding 47k treasury shares): 1.64mm

Per share value: 269,000 Won

 

Its noteworthy that the last revaluation of Daehan’s land assets was done in 2001, whereas the company’s land in Incheon (where one of its factories is located) has appreciated substantially beyond its book value of 27bn Won based on all market indications.  The company has no plans to sell this land/re-locate the facility, so we don’t adjust for this.  In addition, the company’s Korea Silo affiliate owns a 19% stake in the Namseoul golf course for which we ascribe no value.  Thus, the price/book ratio of 0.6x is conservative.

 

In terms of EV, we look at the net cash (52bn), market cap, excess cash at affiliates (26bn) and after-tax value of public securities (58bn).  This EV compares to an ’06 economic EBIT of 41bn (core business EBIT of 33bn plus affiliates’ EBIT of 8bn), meaning an EV/EBIT multiple of 2.9x.  Thus, while trading at 6.7x P/E and well below liquidation value, we believe the stock has substantially much more upside potential than downside risk over a 12-month period.

 

Activism in Korea

A new (Lazard-backed) fund called the Korea Corporate Governance Fund (KCGF), run by John Lee (who ran an $800mm Korea fund for Scudder for several years), recently made a big splash in the Korean stock market.  KCGF has stakes in several small-caps and attempts to influence the corporate governance of these companies by using public pressure (an extremely effective tool in Korea) if necessary.  Another corporate governance fund, backed by Allianz, has also been growing assets rapidly and has the same general approach, although it prefers to push companies behind-the-scenes.

 

On August 2006, KCGF announced that it owned over 5% stake of Daehan Synthetic (003830 KS), causing Daehan Synthetic to rise more than 200% (there’s a 15% daily up/down limit), as investors clearly believe that the company will be shamed/pressured into ‘doing the right thing’ with its excess cash, etc.

 

While its difficult to guess who will be the next activist ‘target’ in Korea, between the two corporate governance funds in Korea, Icahn/Steel Partners’ success with KT&G, and most recently, Hunter Hall’s (Australian activist fund) activist filing in Kolon Chemical, its clear that over-capitalized companies in Korea are receiving increasing attention from activists, and small-caps are becoming increasingly more shareholder-friendly/responsive to complaints about dividends and excess cash.

 

Thus, regardless of who John Lee picks next (a topic frequently discussed in the media), his actions should create a positive ripple through the Korean small-cap universe.

 

Current Ownership

Insider ownership has risen from 20% 3 years ago to 33% currently.  Non-Korean funds own ~18% (versus under 3% in early 2005).  Among the insiders, the Chairman (Jong Gak Lee, age 75) owns 14.6%. 

 

Under the Radar Quality

There has been no sell-side coverage on the stock for over a year now, but in talking to several food and beverage analysts in Korea, I believe there’s a good chance this will change soon.  A couple of the analysts seem to know the company but had declined to officially cover the stock because the company stopped taking sell-side analyst visits.  Now that the company is accepting analyst visits again, we are hopeful that coverage may be taken up by new and former analysts.

 

The financials and ratios on Bloomberg are currently screwed up for Daehan Flour, partly because of the 12bn Won non-recurring expense associated with the price collusion fine in December 2005.  Once this is straightened out (e.g., no longer in LTM earnings) and forward EPS estimates become available, it should be abundantly clear that this company is trading cheaply on every commonly cited valuation metric.

 

Unlocking Value

Free cash flow in the last few years has gone towards debt reduction.  Total debt was 75bn Won at June 30 compared to 165bn three years ago.  From 2Q03 to 2Q06, Daehan’s book equity rose from 328bn Won to 433bn Won, and its total liabilities declined from 217bn Won to 127bn Won.  We understand that management is no longer as eager to continue building up cash now that they have substantially more cash than debt, and they are aware that the 4-5% return on incremental cash on the balance sheet is not particularly attractive.

 

We also believe that the company may boost their annual dividend (current dividend yield is ~1.3%).  In the past, the company has tried to ensure that the dividend yield was similar to the yield on a bank deposit (average yield of over 3% in past 4 years), so its possible that they will materially increase the dividend at year-end, as a step in the right direction.

 

Conclusion

While Daehan Flour has a value trap element to it, with a 15% (unlevered) earnings yield and huge balance sheet/sum-of-the-parts value that the company has accepted is excessively conservative, I believe that you are more than adequately paid to wait for the business to get re-rated and/or for management to return more cash.  The risk of permanent capital impairment is extremely small here whereas the upside is substantial if Daehan trades to a normal multiple, or a catalyst emerges in more active Korean environment (LBO, shareholder pressure).

 
 
Nothing contained in this analysis shall be deemed to constitute investment advice or a recommendation to purchase, sell or otherwise transact in any security.  This analysis contains information from sources the author believes to be reliable, but the author cannot guarantee the accuracy of any such information.  The author undertakes no obligation to update or revise this analysis, whether as a result of new information, future events or otherwise.  The author owns share of the company, and may buy additional shares or sell shares at any time.   

Catalyst

Now that cash materially exceeds debt on the balance sheet, the company is contemplating increases in dividends and a share buyback.

Increasing shareholder activism in Korea is likely to lead to more investors pushing Daehan Flour to do the 'right thing' and for the cheapest, over-capitalized Korean small-caps to continue rising.
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