Description

We’re presenting a small-cap South Korean developer, which we believe is an attractive opportunity. South Korea recently tightened mortgage lending regulations, so fewer people qualify and the market is facing difficulties. It has also removed some tax incentives used by real estate investors, including foreigners. Possibly due to this environment, this apartment block developer and construction company's stock appears to be cheap while decent quality. It is trading at close to net cash level while generating cash, remained profitable historically and helmed by an owner-operator. Monthly trading volume ranged from 900k-2.4m shares (c. $3-8m) and float is 33%.

Background and business overview

Dongwon is a KOSDAQ listed developer headquartered in the port city of Busan, South Korea. It is engaged in the development of residential real estate and construction. The first division focuses on developing and selling residential units. The construction business is engaged in domestic engineering and construction works for schools, residential and commercial buildings, terminals, roads and others for the needs of government and private works.

The company was founded in 1975 and according to various reports it has remained profitable in its existence. The last time it issued equity was in 1998. The main business areas are Busan, Gyeongnam and other metropolitan areas in Korea. Over the past 5 years the company has been in the top 3 developers in Busan and is in the middle of the pack by national standards based on backlog.

The company was founded by entrepreneur and philanthropist Bok-Man Jang (장복만), who is an owner-operator and still the CEO of the company. Furthermore, one of his sons Ho-Ik Jang (장호익) is also involved and one of the directors of the company. Insiders hold just under 60% of the stock (CEO holds mostly indirectly) and during 2018 insider ownership increased by roughly 2%. To note, one of those holding companies has pledged its stake as collateral to a 1-year loan and it's about 9% of the company.

For the full year of 2018 the company generated KRW608bn (approx. $520m) in sales, which is roughly evenly split between the housing and constructing businesses. Since 2010 revenues are up 6 fold, EBIT (KRW160bn, or $140m in 2018) up 16x, while net income up 15x in the same period.

The development business peaked in 2015 when revenues reached KRW416bn (c. $360m) and has been declining since. Due to cost cutting in the development business and the increase in construction projects the company has been able to offset the general decline while profitability actually increased. Worth noting that if the housing downturn deepens the construction business could help the company stay in the black, however wouldn’t support the entire market cap. Given the diverse nature of the construction business we expect it to be fairly resilient.

Furthermore, the company has been looking to expand the development business internationally, with first country to set foot in is Vietnam (first MOU has been signed already last year with more to follow), with plans to build projects for housing, offices, factories etc, first in the capital Ho Chi Minh City, then other cities in Vietnam and further in SE Asia. Additionally, the company is also expanding its business to Seoul, looking mostly for maintenance projects at this stage.

Macro background

Korea has been experiencing a real estate boom and the government has applied various measures but struggled to keep housing costs under control. The average price of a home in the capital in October was KRW650.2m ($557,000), according to the government real estate monitor (24 times the city's average annual salary). The government is attempting to cool the market with a number of measures, the latest of which was announced in October. The ministry is enforcing caps on the presale prices of apartments in designated areas, mostly in Seoul, where prices have increased significantly over the past year. The effect on Busan-based Dongwon is likely to be mostly indirect. In another move meant to slow the rise of housing prices, in 2018 the government increased the rate of tax paid by owners of multiple homes, also affecting foreign property investors. Interest rates are still kept low. However, according to industry surveys people expect prices to continue to rise and the last attempt at price limits on certain apartments from 2007-2015 failed.

The concern is that while demand for new units is strong, supply of new completed units have exceeded new household formations for several years in a row.

To put affordability in context see these two charts below (first as of 2018 and the second during 2012-18). The Housing Opportunity Index is a measure of housing affordability expressed as the percentage of homes considered affordable for a family earning the median income. Lower number indicates a higher quantity of homes that can be afforded by median income families, and vice versa (100 means that the median income families can purchase 100% of the houses in the area). Seoul is the obvious odd one out while Dongwon’s key markets (Busan, Gyeongnam etc) are generally more affordable. Busan’s score is similar to Dallas, TX and the Korean national average is almost equal to the US.

In Q3 2019 there was a frenzy among developers to launch as many units for pre-sale as possible before the price caps kick in. Dongwon didn’t have any such surge but housing sales were down 42% and gross margin was down to 14% from 50% last year.

In 2007, housing supply soared with a high number of unsold units in 2008-2009. During the period 28 of the top 100 construction companies filed for either court receivership or workout plans led by creditors. Dongwon suffered earnings declines but didn’t lose money.

Given the success of both the development and construction businesses the company generated ample cash and since 2014 has been in net cash position, which swelled to KRW359bn ($308m) by the last quarter. This is roughly equal to the current market cap, which provides adequate margin of safety. Furthermore, book value increased over 3x between 2010 (KRW751bn or $645m; Q3’19) and the company currently trades for less than half of book value. We believe both provide adequate margin of safety in a prolonged housing downturn. ROE averaged 15% since 2010. Net cash less all liabilities is approx. 55% of market cap.

Valuation

The share price has increased 6x since the end of 2010, yet the company is very cheap on most metrics, likely driven by the general downturn. However, we believe this general attitude doesn’t reflect the diverse (and fairly resilient) nature of the business, the move to more contracted/pre-sold work and the able owner-operator at the helm of the company. While the macro might not look perfect we’re comfortable that the company is doing enough to offset the decline by various expansions and that there is sufficient margin of safety given the significant net cash position.

Dividends have increased each year since 2012. Last year the dividend payout was KRW185/sh for a 4.5% current yield.

Dongwon has always traded at a low multiple that may be attributable to limited float, family control and the perception that real estate development and construction deserve a low multiple (which hasn’t stopped the stock from its 5.5x return in 10 years). The market is also not giving Dongwon credit for its cash balance. Brokers are valuing the company at 5x earnings for a KRW7,000/sh price target while ignoring the net cash balance of almost KRW4,000. Based on their own earnings forecasts the FY21 net cash balance should stand at around KRW7,000.

The KOSDAQ index is down about 26% over the last two years. Further, real estate developers and construction companies are out of favor. Dongwon reported a quarterly 9% sales decline and EBIT was down 60% but is down a bit less than KOSDAQ probably because of its already cheap valuation. Doosan Engineering & Construction is a similar-sized construction company down over 50% in the timeframe. HDC Hyundai Development Company is a peer that was created through a spin-off in 2018 from conglomerate HDC Group and its stock is down about 50%, trading at roughly its net cash value also. However, it recently decided to diversify by investing roughly double its market cap in struggling Asiana Airlines. Daewoo E&C is more infrastructure construction focused but yet is down 30%.

Insiders

Insiders have been good at timing the market, selling high in 2005-2007, buying back at lower prices 2009-2012, selling at higher again 2013-2014 and buying again in 2018. That being said trading didn't pay off and compared to buy-and-hold they are worse off by about KRW11bn. That's assuming trading profits were their objective. It might not because they may have had cash needs or had superior returns available elsewhere. The negative is that insiders hold fewer shares now than in 2005 (by 10.9m). The volumes they have sold have greatly exceeded those they have bought. The positive is that buy-and-hold generally still works in compounding stocks even if insiders think they are smarter than that. Also, 2018 had strong insider buying at KRW4,020/sh but then stopped. We'd have to go back to 2014 to see the last time insiders sold a share.

Capital allocation

Dongwon is a family-controlled and run business that hasn’t suffered from temptations to do things with other people’s money. It has stayed in its industry without diversification or acquisitions. Capital has been allocated within management’s circle of competence and book value has compounded at 13.5% since 1998 (the last equity raise).

Risks

Further deterioration of South Korean housing market and additional government measures.

Capital allocation e.g. expansion to Vietnam or new projects somewhat outside of their bread and butter. So far the company has been conservatively managed.

Catalyst

Continued execution in the face of a difficult housing market, growth of the construction business and selective new projects outside of key areas.