Description

Korean Electric Power Corp. (KEPCO) may be purchased for about 4x earnings and 0.6x book value (US utilities trade for about 15x earnings and 1.5x book value). The replacement value of the company’s generating assets is at least $55 billion, 60 percent more than the company’s current enterprise value. KEPCO owns other valuable assets, most notably the entire electric transmission and distribution infrastructure of South Korea. It is modestly levered, generates free cash flow and its ROE approaches 15 percent. Korea’s electricity generators are operating near peak capacity; electricity consumption in Korea increased by 5.8 percent during first half of 2004.

This idea was originally submitted by Round291 in December of 2003. Round’s write-up is excellent and is supported by an interesting thread; I will try not to repeat material covered in the previous write-up. Though KEPCO shares have appreciated substantially since then, the company remains a bargain.

Thesis
Electricity demand growth ensures that KEPCO’s regulators will continue to set tariffs high enough to generate money to fund capital expenditures and / or motivate investors to finance ongoing capital expansion. As this happens, one would expect KEPCO’s share price to appreciate to at least book value or replacement cost, which would represent 50 percent to 100 percent appreciation. Further deregulation of electricity prices, a stated goal of the government, is likely to result in additional share appreciation. In the meantime, KEPCO pays a divided and may be purchased at a fraction of replacement cost, which is remarkable for a monopoly business in a growing market.

Capital spending / electricity supply & demand
Our thesis is that KEPCO’s regulators will continue to allow KEPCO investors to earn a reasonable return on their investment because KEPCO needs to attract more investment, or generate enough cash flow, to meet the rising demand for electricity in Korea. To corroborate this premise, first consider that KEPCO has budgeted capital spending of 46.9 trillion Korean Won (about $44.5 billion) over the next five years to be financed by cash flow and debt. Why is so much capital spending needed? Electricity consumption in Korea has tripled since 1990; consumption increased 5.8 percent during the first half of 2004, the latest period for which data is available KEPCO’s nuclear and coal plants ran at 94 percent and 87 percent respectively of theoretical capacity during 2003; it is generally thought that a 15 percent capacity margin is necessary to maintain reliable service. KEPCO closes this gap with its marginal generating assets. Given electricity demand growth, Korea needs more generating capacity, hence the capital spending program.

Industrial and commercial users consumed 84 percent of the electricity produced in Korea during 2003. A constrained electricity supply has the potential to dampen Korea’s economic production, something that no government would want. Is demand growth in Korea about to wane? Over the short run, it is difficult to say, but to date, Korea’s per capita electricity consumption is less than half that of the USA. With this framework in mind, we will now move on to a brief discussion of KEPCO’s background and an examination of the leading explanations of why this company is so modestly valued.


Background: dis-integrating monopoly
KEPCO is the electric utility that services South Korea. The company owns all of South Korea’s electrical transmission and distribution infrastructure as well as most of the country’s generating assets e.g., KEPCO generated about 98 percent of Korea’s electricity in 2003.

Depending on how one counts its ownership, the Korean government owns 55 to 62 percent of KEPCO’s shares and is in the process of splitting the company into several autonomous pieces, a process the company refers to as privatization. The stated reason for the privatization is to “increase efficiency and induce foreign investment in Korea.” This process has moved in fits and starts since it began in January 1999. To date, KEPCO has been split into six operating subsidiaries.

The largest of the subsidiaries, KHNP, owns all of KEPCO’s nuclear and hydro generating assets and will be retained by the parent company along with Korea’s entire transmission and distribution infrastructure. The other five generating subsidiaries are to be spun-off in a process that will likely include share sales to the public for each subsidiary. During 2003, KEPCO tried sell KOSEP to a strategic buyer but abandoned the effort when it could not find a buyer willing to pay book value for the business.

Why is KEPCO so cheap?
The last time KEPCO’s shares traded above $12 was September of 2000, yet at $13.10, the company may be the cheapest electric utility in the world, trading at 4x earnings and a fraction of book value. The company is not facing a liquidity crisis, and is modesty levered compared to other electric utilities. During the course of our research, we came across several theories explaining KEPCO’s low valuation. Below we outline six theories together with our analysis of each.

1. Perceived regulatory uncertainty
In June 2004, the Korean regulators backed-away from their initial plan to spin-off KEPCO’s distribution assets into competing companies; the original plan to spin-off the generating assets remains in place. While the logic underlying the decision not to spin-off the transmission and distribution assets is reasonable (transmission and distribution assets are a natural monopoly, while generating assets lend themselves to a market-based system), there is a degree of uncertainty about how the regulatory environment will develop in Korea.

It is our observation that some degree of regulatory uncertainty is inherent in all electric utilities. Korea’s regulators are moving cautiously, and this gives us a degree of comfort, especially in view of the mess a few years ago in California as a result of ill-conceived regulatory initiatives. More importantly, Korea’s demand for electricity is growing rapidly e.g., electricity consumption has tripled since 1990 and was up 5.8 percent during the first six months of 2004. In this environment, new capital must be attracted (or generated) to build generating, transmission and distribution assets. While KEPCO’s capital requirements are sited as a negative by some analysts, we see this as a positive: the fact that new plant and equipment must be built to meet demand means that the Korean regulators must ensure a reasonable rate of return for investors in order to attract the necessary capital.


2. High real rates of return on capital, but low regulatory returns.
Under traditional regulatory practice, regulators set electricity tariffs so that electric utilities can generate a “reasonable return” on the capital required to generate and deliver the electricity. As discussed above, Korea is in the midst of a transition from regulated power prices to some form of market based pricing; in the meantime, KEPCO management applies for rate increases and the Ministry of Commerce, Industry and Energy (MOCIE) makes the final determination, with input from the Ministry of Finance & Economy (MOFE) and the Korean Power Exchange, a recently formed bureaucracy to manage the development and purported deregulation of Korea’s electricity market.

In March of 2004, electricity tariffs were reduced by 1.4 percent. This came at a time when KEPCO’s fuel prices were increasing and just prior to the announcement that KEPCO’s transmission and distribution assets would not be spun-off. This downward adjustment was consistent with a change in MOCIE’s target for KEPCO’s rate of return on equity lowered in 2003 from 9.15% on to 7.53% and the target return on debt was lowered from 5.8% on debt to 5.3%. In theory, it looks as if KEPCO’s capital returns have gone from bad to abysmal, but the reality is quite different. KEPCO’s return on equity was 14.6 percent in 2003, 13.1% in ’02 and 13.5% in 2001, about twice the regulated target of 7.53 percent. How do we account for the difference?

Regulatory accounting vs. financial accounting. In the US, electric utilities keep two sets of financial statements: one for investors (GAAP) and the other for regulators. Rates of return are based on the Rate Base, a figure derived from a utility’s regulatory financial statements. Typically, the managements of regulated utilities lobby regulators to include as much in the rate base as possible, and the regulators make decisions (often appealed in court) regarding what to include and exclude from the rate base. As a result, in the US, a utility’s regulatory books often look quite different from its GAAP books.

We find a similar situation in Korea, with one technical difference, which is the cause of some misunderstandings. KEPCO’s books are based on Korean GAAP accounting, which is the starting point for the Korean regulators. The elements that go into the rate base, using KEPCO’s methodology and year-end 2003 numbers, are as follows:

- Net utility plant in service: $50.7 billion
- 2 months working capital, based on KEPCO formula: $2 billion
- Construction in progress: $9.2 billion
- Total rate base (plant + working cap + construction): $62 billion
- Debt: $22 billion
- Equity, for rate base purposes (rate base minus debt): $40 billion
- Korean book value: $36.6 billion
- US GAAP book value: $30.2 billion

The rate base equity figure is $10 billion greater than the US GAAP book value number. By implication a 7.53% return on $40 billion is equal to a 10% return on $30 billion. This is still 3% to 4% lower than the observed rate of return of 13% to 14.6%. This difference is explained by the differences of Korean GAAP and US GAAP when applied to the income statement. There are several small differences, some of which I’m still trying to understand, and one large difference: The depreciation and amortization number using Korean GAAP is significantly larger due to a one time write-up of assets in 1999; US GAAP didn’t permit the write-up of value of KEPCO’s property, plant and equipment. So, consistently applying GAP to both the numerator and denominator, one arrives at a reasonable rate of return.

One may argue that while KEPCO’s historical returns have been respectable, the Korean regulators may change the rules and restrict the company’s ability to generate reasonable returns in the future. After all, electricity is a political business, and there are more consumers of electricity in Korea than there are KEPCO shareholders. Three thoughts: 1) This may be said of every electric utility in the world. 2) To the extent Korea’s demand for electricity continues to grow and its generating capacity remains constrained, KEPCO’s regulators are likely to set electricity prices high enough to attract capital to build the required infrastructure. 3) Korea is deregulating and splitting-up KEPCO. As this process unfolds, KEPCO’s generating assets are likely to be able to sell power at market clearing prices. Purchasing these assets at a fraction of book value means that an investor has a significant cost-of-capital advantage over new competitors.

3. Fuel costs
Some have argued that rising fuel costs are likely to dampen KEPCO’s earnings, but the results through September 30, 2004 indicate that electricity tariffs were set in such a way that KEPCO will increase earnings in 2004.

KEPCO’s fuel prices have risen significantly: for the nine months ending 9/30/04 fuel costs were up 30 percent while revenues were only up 7 percent (please see exhibit in the Appendix for a comparison of the two periods). From these numbers, one would expect that the difference, 23 percent, would fall directly to earnings, or more precisely, would cause a loss. It has turned-out differently. KEPCO’s earnings actually increased 5 percent year-on-year. There are several contributing factors to this result including a new (lower) corporate tax rate in Korea, earnings from KEPCO’s hedging activities, falling interest costs and reduced costs attributable to KEPCO’s minority interests. Since rising fuel costs are known ahead of time e.g., KEPCO buys 74 percent of its coal under long-term contracts, we would suggest that KEPCO’s regulators successfully set electricity tariffs to compensate KEPCO’s investors, given the changing economics of the company’s business.

It is also important to remember that commodities such as KEPCO’s fuels are priced in dollars; a significant portion of the commodity price appreciation over the last 18 months has been the result of dollar inflation. For companies that generate revenues in currencies other than the dollar, they will only feel the price increase to the extent that it exceeds the amount the dollar falls against the currency they receive for their goods and services.


4. Government share ownership / governance
While some argue that the Korean government’s majority ownership of KEPCO is a negative, it may be a positive because it reduces the likelihood of dilution and, by law, the government is unlikely to divest significant shares. The Korean government directly owns 27 percent of KEPCO’s shares; it owns and additional 27 percent of KEPCO shares through its ownership of the Korean Development Bank. In addition, the Resolution & Finance Corporation and the National Pension Corporation are quasi-governmental organizations, so depending who is counting, the government owns between 54% and 62 percent of KEPCOs shares.

The large share ownership by the Korean government presents a couple of problems, including the specter of share overhang and the fact that the Korean government has non-economic motives regarding its KEPCO investment.

Regarding share overhang, the KEPCO Act requires that the Korean government own at least 51 percent of KEPCO’s shares. For purposes of the KEPCO Act, the government’s ownership currently stands at 54 percent. In addition, about half of the government’s ownership is being used to strengthen the balance sheet of the Korean Development Bank. Given these facts, it seems unlikely that the government would consider reducing its ownership in the foreseeable future because selling more than 3 percent of their position would require an amendment to the KEPCO Act. The KEPCO Act also reduces the likelihood that shareholders will be diluted by new stock offerings because a significant new offering would require the government to invest more money into KEPCO to keep their ownership over 51 percent. As mentioned above, future capital spending is to be financed by cash flow and debt offerings.

As the majority shareholder, the Korean government chooses KEPCO’s president, auditor and directors. Buying shares in KEPCO means that one is in partnership with the Korean government. The government makes for an odd partner because it is not in it for the money. In fact, there is even a provision in the KEPCO Act which allows KEPCO to withhold dividend payments to the government while paying dividends on shares held by others. We have no opinion as to Korean politics, but note that with rising demand for electricity and constrained capacity, the Korean government must continue to respect outside investors’ need to make an adequate return on capital. If not, the government will need to finance new power projects out of its own coffers.

5. Northern exposure
South Korea abuts North Korea, one of the most despotic and economically depressed countries in the world. Some analysts point to KEPCO’s proximity, and hence vulnerability, to North Korea as an explanation for why its shares should trade at a discount. While initially satisfying, this argument does not holdup on closer examination.

A look at a map shows that most of Japan is within easy striking distance of North Korea, yet Japanese utilities are valued at about three times more than KEPCO. Also, in the event that North Korea does something irrational, investments in Japanese equities will certainly fall, as will investments in US equities.

Maybe a greater risk to KEPCO shareholders is the possibility that the two Koreas are reunited, given the incredible expenditures which would be required to integrate North Korea with the South. History indicates that entrenched despots tend to perpetuate the status quo.

6. Other factors
There are at least three more factors that may explain KEPCO’s modest price: 1) The chaebol’s reputation for ruthlessness; 2) Korean political stability; and 3) KEPCO’s ability to manage growth. Having said this, KEPCO is not a chaebol, Korea’s young democracy is functioning and to date, KEPCO’s management has effectively managed growth.

Chaebol reputation. The Korean economy is dominated by a handful of family managed companies known as the chaebol e.g., Samsung, Hyundai, LF, SK, Hanjin etcetera. The chaebol are notorious for abusing minority shareholders; as noted in a recent survey on Korea published by The Economist:

The chaebol may have shaped up their operations but they remain unaccountable to outside shareholders, whom they often swindle by manipulating their subsidiaries’ finances.

It appears that things are getting better. The chaebol have been restructured since the 1997 financial crisis. Half of the 30 largest chaebol in 1996 have gone out of business while foreign investment in the chaebol has increased from 15 percent before the crisis to 36 percent in 2003. One may argue about the appropriate discount to assign the chaebol’s, but KEPCO is not a chaebol. To our knowledge, there is no evidence of minority shareholder abuse by KEPCO.

Political stability. Korea is a fledgling democracy. Its third elected president, Roh Moo-hyun, was elected in December 2002 to a single five-year term. The National Assembly impeached him in March of 2004; the constitutional court reinstated Roh on May 14th, 2004. While some may fret about the uncertainty which accompanied the impeachment process, and for that matter, the inherent uncertainty of the democratic process, Korea’s political system seems to be working.

Growth management. Probably the biggest risk to an investment in KEPCO is the company’s ability to continue to manage growth. The nightmare scenario is that they overbuild; we don’t know how to handicap this risk other than to note that they have effectively managed tremendous growth over the last 15 years. Should the company sell at a discount because of its prospects for growth? Possibly, but we view the potential for earnings growth as a positive, especially when we are not asked to pay for it.

Currency exposure
An investment in KEPCO includes a bet that the KRW will appreciate vis-à-vis the dollar. In addition to the fact that KEPCO is a Korean company and its shares are denominated in KRW (a currency exposure which may be hedged) KEPCO’s profitability, at least in the short run, (In the medium term, electricity tariffs are likely to be adjusted to compensate for any extreme currency fluctuations) is linked to the relative value of the KRW and the US dollar. This is because the fuels KEPCO uses are denominated in dollars; in addition, 36 percent of the company’s debt is denominated in foreign currencies, predominantly US dollars and Japanese yen. If the dollar increases in value against the KRW, KEPCO’s fuel costs and interest expense increase; of course, the inverse is also true. During the course of 2004, the KRW appreciated about 13 percent against the dollar.

Catalyst

1) Better investor understanding
There are at least two aspects of KEPCO’s business which are misunderstood by investors: 1) perceived regulatory uncertainty and 2) regulatory returns on capital vs. real returns on capital.

2) 2004 results
Despite rising fuel prices and slightly lower electricity tariffs, KEPCO’s earnings through 9/30/04 were up 5 percent year-on-year.

3) Falling dollar
KEPCO’s fuel costs and a large percentage of its debt are denominated in dollars. To the extent the dollar continues to depreciate vis-à-vis the Korean Won (KRW), KEPCO’s earnings will increase.

4) Deregulation
One would expect KEPCO’s existing generating assets to appreciate to their replacement value as electricity prices are deregulated. This process was started in 1999 and is moving at a slow (some would say glacial) pace.