Description

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To avoid confusion, I will clarify the action plan and stats upfront:
What are we buying?
COMPANY: Humax Holdings (KDQ:028080)----> HOLDCO
ASSET CLASS: Common Stock (Long)
Stock Price: KRW 14,200 per share (December 30, 2009)
Conservative Price/NAV (or PBR): 0.60

What are we NOT buying?
Humax (KDQ, 115160)-----> OPCO

Brief Reasoning:

Although
1) the Net Asset Value of the HOLDCO, as I will explain below in detail, is a derivative of the stock price of the OPCO and cash,
2) and, therefore, I will spend a good amount of time discussing the economics of the actual OPCO,

I want to clarify that I am still recommending a long position of the "HOLDCO,"
1) as HOLDCO provides sufficient cash floor when OPCO becomes completely worthless,
2) and the current valuation of HOLDCO at PBR=0.60 proves to be inherently cheap without any further appreciation of OPCO stock price.
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Here we go...!

I am recommending a spinoff arbitrage for a long position in the common stock of a South Korean set-top box manufacturer holding company, Humax Holdings Co., Ltd (Public, KDQ:028080).  Although I am aware that VIC.com recommends against international ideas for the applicant's first submission, the current margin of safety, the strong catalysts, and the overwhelmingly western market base of the Company(FY 2008 Geographic Revenue Breakdown: Europe 54%, US 9%, Japan 9%, Korea 11%, and Asia-Pacific/Other 17%)  make the investment idea a compelling buy regardless of regional expertise.

I believe I have found the Korean equivalent textbook example of Professor Greenblatt's spinoff arbitrage explained in his book, "You Can Be A Stock Market Genius."

   << Background & Spinoff Mechanics >>

Humax Holdings Co., Ltd, formerly Humax Co., Ltd, is a holding company of one of the leading companies in the world that engage in the manufacture and sale of digital set-top boxes, such as satellite set-top boxes, cable set-top boxes, and terrestrial set-top boxes, etc.

In August 7, 2009, Humax announced a spinoff.
The Company divided into two enitities:
Humax Holdings (in charge of "non-operational" investment activities), and
Humax (all the assets and liabilities pertaining to the original operations of Humax, which is the manufacturing and sales of Humax and its ODM set-top boxes)

-Spinoff Ratio

Humax Holdings (HoldCo) : Humax (OpCo) = 0.1830153 : 0.8169847

In other words, a single share owner of the "Pre-spinoff" HUMAX CO. now owns 0.18 shares of HOLDCO and 0.82 shares of OPCO.

Resulting new total shares for each company
HOLDCO:  5,126,800 shares
OPCO  : 22,886,157 shares

Relisting Date
HOLDCO: OCTOBER 30, 2009
OPCO: NOVEMBER 16, 2009

-Reason for spinoff

Whatever the supposed reason the Company announces, the motivation behind these recent spinoff practices in South Korea have been to increase the controlling stake of the controlling family/shareholder of the Company.  In complying with the Korean FTC regulations governing the capital structure, subsidiary shareholdership, cross-holding rules, etc, Korean conglomerates have chosen this method of "spinoff and equity swap" maneuver to optimize their objectives.  Since the method's successful execution by LG (one of Korea's biggest family controlled conglomerates) in the past, numerous companies followed suit to do the same thing.

As such, I will detail the spinoff mechanics in a diagram form.

-Spinoff Mechanics
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Phase 1 (Pre-spinoff HUMAX)

Mr. Byun Dae-Gyu and insiders -------------------------------> HUMAX
                                                                             14.6%
                

Note: Before the spinoff, Majority Shareholder (MSH), who are Mr. Byun Dae-Gyu and key insiders, had owned 14.6% of HUMAX
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Phase 2 (Spinoff)

Mr. Byun Dae-Gyu and insiders --------------------------------> Humax Holdings (HOLDCO)
                                |                                               14.6%                       |
                                |                                                                                 |11.38%                       
                                |                                                                                 |
                                |------------------------------------------------> Humax (OPCO)
                                                                  14.6%      
     
Note: The Company is spun off into two entities (Majority Shareholder (MSH), Mr. Byun Dae-Gyu and key insiders now own 14.6% of BOTH companies.)
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Phase 3 (Treasury stock "comes alive" to become HOLDCO's investment position of OPCO)

Mr. Byun Dae-Gyu and insiders ----------------------------> Humax Holdings (HOLDCO)
                                |                                          14.6%                            |
                                |                                                                                 |11.38%                       
                                |                                                                                 |
                                |-----------------------------------------------------> Humax (OPCO)
                                                                           14.6%      

Note: Before the spinoff, the pre-spinoff HUMAX had owned 11.38% of treasury stock (3,189,213 shares of pre-spinoff HUMAX). 
During the spinoff process, the HOLDCO took the entirety of the treasury. 

Pro-rata to the spinoff ratio,
3,189,213 shares * 0.1830153 =   583,674 shares of HOLDCO became 11.38% treasury shares of HOLDCO
3,189,213 shares * 0.8169847 = 2,605,538 shares of OPCO became Invesment Asset owned by HOLDCO (what I meant by "comes alive"; this portion alone currently accounts for KRW 48.2 billion)
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***********PHASE 3 IS WHERE THE CURRENT STRUCTURE IS!!!!*******************
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Phase 4 (Equity Swap of MSH's OPCO shares with HOLDCO's new issued shares)

Mr. Byun Dae-Gyu and insiders(MSH)
              |
              | 53.8% (Original spunoff owned by MSH 14.6% + Newly issued by HoldCo to MSH)
              |
Humax Holdings (HOLDCO)
              |
              | 25.98% (Spunoff treasury 11.38% + Investment In Kind from MSH14.6%)
              |
     Humax (OPCO)

Note:
1) As has been the case with other Korean conglomerates who also used the same practices in the past, MSH will give (Equity Swap) his 14.6% of OPCO shares to HOLDCO.  In exchange, MSH will receive newly issued HOLDCO shares in equivalent monetary amount.

2) Given the largely disparate size between the two companies,
the newly issued HOLDCO shares to MSH will increase his position from 14.6% to approximately 53.8% (contingent upon the final merger ratio). 
In turn, the HOLDCO will own 25.98%(=11.38+14.6) of OPCO.

--IMPORTANT--
3) ALTHOUGH CURRENT CORPORATE GOVERNANCE STRUCTURE IS AT "PHASE 3," THE MANAGEMENT MUST CONDUCT "PHASE 4" NO LATER THAN OCTOBER 30, 2011, AS KOREAN FTC RULES MANDATE THAT HOLDCOs MUST OWN AT LEAST 20% OF OPCO WITHIN 2 YEARS FROM RELISTED DATE (OCT. 30, 2009) TO QUALIFY AS A PURE HOLDING COMPANY ENTITY.
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RECOMMENDATION
As such, I believe that this is a Korean twist on a Greenblatt spinoff arbitrage on the HOLDCO (Humax Holdings), added with a downside protection due to the HOLCO's capital structure.

A conservative Price/NAV (or PBR) of HOLDCO trades around 0.60 despite its price appreciation since the last initial recommendation on December 5th, 2009.

    << Reasons to buy >>

  A. Outsiders don't want it:    
Institutions and outsiders may not want HOLDCO and put downward pressure on price because:
      a. Very small market cap for institutions (Market Cap: KRW 64.6 billion, equivalent of US$ 55.2 million)
      b. Original investors of Humax invested in Humax (OPCO), not the residual shell of cash and investments (HOLDCO), driving down prices regardless of valuation

  B. Insiders' incentive to pump up OPCO price will result in better valuation for HOLDCO:

      a. Insiders (MSH such as Mr. Byun and his cronies) currently hold a strong incentive to pump up the OPCO share price (to increase the per share value of their eventual Equity Swap -- their direct holdings of OPCO with newly issued HOLDCO shares) so that they will increase the shareholdership of HOLDCO in "Phase 4."
      b. The assets and the liablilties of HoldCo is very simple: with hardly any debt, the entirety of HoldCo's assets are just Cash (which is slightly below current market cap), miscellaneous Investment Assets, and 2,605,538 shares of OPCO in "Phase 3".  As such, the increase in the OpCo stock price will increase the HoldCo's net asset value. (Further discussion in later "Valuation" section)

  C. Share buyback of OPCO:
Not only do the insiders have the strong incentives to pump up the share price of OPCO, but they also have the tools to do so.  On the second day of the relisting of OPCO (Nov. 17, 2009), the Company anounced a share buyback, a total of 220,000 shares of OpCo, with daily purchase limitations of 22,000 shares.

  D. Spinoff structure reflected on FY 2009 10K: 
The spinoff was deliberately conducted on October 1, 2009, so that the two companies' newly spunoff structures are not reflected on the 3rd quarter 10Q, blurring the valuation for those who did not engage in proprietary research tracking down all past data.  As such, once the NEXT financial statement reflects all changes in the balance sheet, it will be clear to investors that they are buying HOLDCO shares current equal to or slightly above cash.

  E. Conspicuously aggressive coverage of Humax after relisting:
Ever since the relisting of the OpCo, they have been extremely aggressive in trying to pump up the OPCO shares by publishing numerous analyst reports, agressive 2009 4Q and FY 2010 earnings projections, and product sales success articles in Europe.
      a. Prudential Securities sets target price of OPCO at KRW 24,500 on the third day of its relisting (Nov 18, 2009) citing its top and bottomline growth of 25%+.  Also it cited that Humax (OPCO) will achieve 50% revenue gain in US market.
      b. In Nov 19, 2009, IBK Securities sets OPCO target price at KRW 20,000 also citing its top line growth and improved earnings due to increase HD set-top box demand. 
      c. Humax (OPCO) put on recommnended list by Daewoo and Hanhwa Securities.
      d. HMC Securities put target price of OPCO at KRW 26,000 (current price: KRW 18,500), citing its sales growth in time with the 2010 World Cup.
      e. In October 2009, UK consumer electroncis magazine, T3, chose Humax set-top boxes as one of the Best Consumer Products of 2009 in UK.

As such, regardless of whether any of the above recommendations are oh-so correct, as Prof. Greenblatt says, "by focusing on the motives of management," we can exploit it to our advantage.

  F. Senior Management Stock Options driving short term price hike:
Currently there are two rounds of management stock options outstanding:
      a. The first round set (currently in-the-money, with exercise price fixed at KRW 11,000 for both HOLDCO and OPCO) to expire in March 24, 2010.
      b. The second round set (currently out-of-the-money, with exercise price fixed at KRW 27,000 for both HOLCO and OPCO) to expire in March 20, 2011.

**BUT REMEMBER, WE ARE TRYING TO BUY HOLDCO. 
**THE FOLLOWING VALUATION SECTIONS SHOULD HOPEFULLY CONVINCE THAT CONCLUSION.

    << HOLDCO Valuation >>   Current Price : KRW 14,200

As I will detail in the below balance sheet, HOLDCO is a pure investment holding company, its major assets comprising of OPCO shares and cash.
As such, I believe that Price/NAV (or PBR) proves to be the most appropriate valuation metric for HOLDCO.

Humax Holdings (HOLDCO) Balance Sheet
        
               (Unit: KRW billion)
Cash                          54.7 (*1)
Investment Asset      66.0 (*2)  
----------------------------------------------
Total Assets            120.7
Tot. Li.                        12.8
----------------------------------------------
NAV                         107.9

Basic S/O                                                     5,126,800
Treasury                                                           583,674
MGMT Stock Option Outstanding                      7,311 (Company plans to grant options from treasury shares, not from new stock issuance)
Net S/O                                                          4,550,437 (=Basic S/O - Treasury + MGMT Stock Option assuming all outstanding becomes "in-the-money")
Stock Price                                         KRW      14,200
Market Cap                                        KRW        64.6 billion

Stock Price per share                     KRW 14,200
NAV per share                                 KRW 23,712         

Price/NAV (or PBR) =           0.60

Footnotes to each line item:

(*1) The latest financial statement that the Company released, which is that of 2009 3Q (Sep. 30, 2009), states that the spun off HOLDCO holds KRW 64.6 billion in cash.  Subsequently, on October 1, 2009, HOLDCO announced a KRW 9.9 billion cash investment to its subsidiary, Humax I&C.  Thus, to take this investment into account in the most recent balance sheet, I merely subtracted KRW 9.9 billion from KRW 64.6 billion and added that amount with 30% discount on the "Investment Assets" account.

(*2) Investment Assets of HOLDCO consists of three things:
    1) 11.38% (2,605,538 shares) of publicly traded Humax(OPCO) shares = KRW 18,500 * 2,605,538 = KRW 48.2 billion 
    2) Investment holdings of non-public subsidiaries, Humax Global and Humax I&C --> 30% discount from their BV = KRW 17.5 billion
    3) Miscellaneous non-public fixed assets, BV of KRW 0.3 billion ---> NEGLIGIBLE
       1) + 2) + 3) = KRW 66.0 billion

ALTERNATIVELY, WE CAN ALSO VIEW IT THIS WAY...
Stock Price per share                           KRW 14,200
Net Cash per share                               KRW    9,208  (this should serve as a theorectical stock price "floor")
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Residual per share                                KRW  4,992
OPCO investments per share              KRW 10,593  (KRW 18,500 * 2,605,538 shares / 4,550,437 shares)
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Net EV per share                                   KRW -5,601

This means that even if OPCO share price drops to KRW 8,718 per share (-53% drop from current price), we would have still bought the stock on Net Cash.

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SUMMARY on HOLDCO:
PBR             0.60
Net EV    KRW -5,601 per share
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Now, let's discuss the economics of OPCO (Humax) and why the -53% drop is unlikely and we can more likely expect the price to appreciate....

    << OPCO Valuation >>   Current Price : KRW 18,500

Brief Background

Humax is a leading Korean company that manufactures and distributes digital set-top boxes, such as satellite set-top boxes, cable set-top boxes, and terrestrial set-top boxes, etc.  A set-top box is a device that allows a television set to become a user interface to the Internet and also enables a television set to receive and decode digital television (DTV) broadcasts.  It is a device for television viewers who wish to use their current analog television sets to receive digital broadcasts.

The Company's revenue sources are internationally diverse (FY 2008 Geographic Revenue Breakdown: Europe 54%, US 9%, Japan 9%, Korea 11%, and Asia-Pacific/Other 17%).  It is expected to grow more rapidly in the US due to public policy mandates that required all TVs to be able to receive digital television signals.

DTV Benefits to Consumers
DTV is an advanced broadcasting technology that allows broadcasters to offer television with better picture.  Advantages of DTV over analog TV include:

-       Superior image resolution (detail) for a given bandwidth
-       Smaller bandwidth for a given image resolution
-       Compatibility with computers and the Internet
-       Interactivity (e.g. Video-On-Demnad)
-       Superior audio quality
-       Consistency of reception over varying distances

Public Policy
June 12, 2009 was the deadline for full power television stations to stop broadcasting analog signals.  As such, since June 13, 2009, all full-power US television stations have broadcast over-the-air signals in digital only.  This comes as a four-month delay passed by Congress pushing the original deadline from February 2009, citing that the original deadline would leave several million US viewers unprepared.  The US government explains that an important benefit of the switch to all-digital broadcasting is that it freed up parts of the valuable broadcast spectrum for public safety communications (such as police, fire departments, and rescue squads).  Also, some of the spectrum can now be auctioned to companies that will be able to provide consumers with more advanced wireless services (such as wireless broadband). (Source: www.dtv.gov)

Both Congress and the Whitehouse are in full support of the Digital TV transition.  On Jun 15, 2009, Congress passed legislation H.R. 2867: Digital TV Transition Fairness Act to smoothly facilitate the national transition to DTV.
(Link: http://www.govtrack.us/congress/bill.xpd?bill=h111-2867&tab=summary)

Governments of EU, Japan, and Korea have all followed suit and set a tentative all-out digital TV conversion deadline to be within the next few years.

   <<Company Competitive Advantage>>
Superior R&D (and conservative accounting through full R&D expensing):
With 49% of its total staff in R&D, made up of top researchers in the field of digital STB, Humax is the first Asian company to develop the European standard(DVB) digital set-top boxes. Equipped with technological know-how in a variety of CAS (Conditional Access System) and in-house middleware (software designed to run supplementary services), Humax possesses a diversified product line within the single digital set-top box focus. Building from this success and a proprietary patented technology, Humax is now introducing digital TV products with functions that excel its competitors.

Manufacturing Efficiency:
To ensure quality, delivery, and cost, Humax has been actively implementing new manufacturing techniques, such as Lean Production systems, cell line, or JIT (Just In Time).  It has also localized production to various regions to maintain continued price and product competitiveness. The company has not only localized manufacturing factories, but has also localized the production of parts in order to reduce parts purchasing and acquisition costs. While the technological design and engineering takes place in South Korea, the Company has positioned HQ-approved manufacturing facilities not only in South Korea, but also China, Poland, India, etc.  Moreover, establishing of a plant in Poland and with effective cooperation with outsourced production companies within Europe, Humax has continued to increase market share within the European market.

Basic S/O                                                          22,886,157
Treasury                                                                  220,000 (Announced to buyback 220,000 shares soon after relisting)
MGMT Stock Option Outstanding                          32,639 (Company plans to grant options from treasury shares, not from new stock issuance)
Net S/O                                                              22,698,796 (=Basic S/O - Treasury + MGMT Stock Option assuming all outstanding becomes "in-the-money")
Stock Price                                                KRW      18,500
Market Cap                                               KRW       419.9 billion
Net Debt                                                    KRW        39.5 billion
EV                                                              KRW       459.4 billion
Non-Operating Assets                             KRW        57.8 billion
Adjusted EV                                              KRW       401.6 billion

--EBITDA minus maintenance capex-- (hereinafter "FCF" for shorthand)
The company is well followed by numerous domestic and foreign brokerage houses, and also is engaged in aggressive IR after the recent spinoff.  Their 2009 and 2010 projected EBITDA minus maintenance capex (FCF) and their corresponding EV/FCF are as follows:

FCF          

Broker             2009          2010    (Unit: KRW billion)
HMC                 59            78
Meritz                57            66
Prudential         56            73
Daewoo            61            75
NH                     51            54

EV/FCF

Broker             2009          2010       Target Price (KRW)
HMC                6.8x          5.1x          26,000
Meritz              7.0x          6.1x          20,000
Prudential       7.2x          5.5x          24,500
Daewoo          6.6x          5.4x          20,000
NH                   7.8x          7.4x          19,000

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SO, WHY BUY HOLDCO INSTEAD OF OPCO?
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Despite all that is going well for Humax (OPCO) - namely, superior product technology, fair to low valuation, top-line growth prospects, management incentive to pump up OPCO shares - the nature of Humax's high-tech business and seasonal cashflow poses as a potential concern for me.  In retrospect, the future may not play out as rosy as we foresee it today.  Therefore, I fear for the OPCO's lack of downside protection relative to the HOLDCO's solid downside protection.

HOLDCO currently trades slightly above Net Cash with most of the OPCO holdings value unrecognized.  As mentioned above, even if OPCO's share price drops by 53%, we would have still bought the HOLDCO shares at the Net Cash floor.

Recap and Conclusion:
BUY HOLDCO FOR THE DOWNSIDE PROTECTION(Cash Floor) AND UPSIDE POTENTIAL(OPCO Value Recognition).

RISKS:
As mentioned above in the "Spinoff mechanics" section, "Phase 4" is an eventuality given that Korean FTC mandated that a holding company must own at leat 20% of its public subsidiary to qualify as a pure holding company entity.  As such, a potential shareholder dilution during the equity swap in "Phase 4" may be of a concern.  But the following table shows that however the future stock price plays out to influence the merger ratio for the equity swap, the current owner of HOLDCO is sufficiently covered by margin of safety.

There are roughly 9 possible scenarios that I foresee (Ups and Downs here by 50% from current price to test extremes)
(Units: KRW won)
HOLDCO: Up = 21,300; Same = 14,200; Down = 7,100
OPCO:   Up = 27,750; Same = 18,500; Down = 9,250

   HoldCo  :   OpCo     :    HOLCO PBR during and after Equity Swap                        
1)    Up         Down                  1.11                    
2)    Up         Same                  0.94    
3)    Up         Up                       0.84
4)    Same    Down                  0.83
5)    Same    Same                 0.74
6)    Same    Up                       0.70
7)    Down     Down                 0.55
8)    Down     Same                 0.55
9)    Down     Up                      0.56

1),2),3): if you currently have a position in HOLDCO, simply exit as value is realized. (In case of 1, potential buying opportunity in OPCO arises)

4): which is most unlikely given the above incentives and apparatus available to management, still hold your position even after the equity swap, so that you can enjoy an increased NAV/share with minimal share dilution.
(simultaneously, a potential buying opportunity in OPCO arises)

5): your NAV per share will decrease due to dilution so expect a potential downward price pressure after the equity swap and buy in more to average down. 
But even if you don't, you are still in the safe range.
(PBR 0.60 --> 0.74)

6),7),8),9): Increased NAV per share and thus better valuation (more margin of safety) (In case of 7,potential buying opportunity in OPCO arises)

Needless to say, if the anticipated equity swap never occurs, then the above HOLCO valuation holds true (see HOLCO VALUATION), providing a sufficient margin of safety, downside protection and potential upside gain.

Catalyst

- Outsiders' indiscriminate selling of HOLDCO without regard to valuation.
- Insiders' strong incentive to increase OPCO shares, which in turn will increase NAV/share of HOLDCO.
- Stock buyback of OPCO since relisting.
- Spinoff arbitrage still valid without equity swap ever occuring.
- Aggressive positive coverage of Humax soon after relisting.
- Management stock option incentives driving short-term price hike
- Stellar FY2009, 2010, 2011 performance of Humax driving the current multiples much lower.