Description

Background

KT&G (033780 KS), formerly Korea Tobacco & Ginseng, is the dominant cigarette manufacturer in South Korea. KT&G was a government-owned cigarette monopoly that was privatized through an IPO in 2001. South Korea opened the tobacco market to competition in 1988. Despite 16 years of competition, primarily from BAT and Philip Morris, KT&G has been able to retain an astounding 77% market share of the South Korean cigarette market through aggressive management of its 30+ brands, a strong distribution network, and innovative product development.

In December 2004, the government imposed a 500won/pack tax (approximately 45 cents). In anticipation of this tax hike, substantial stockpiling occurred in the second half of 2004, which artificially inflated 2004 sales – and will have an opposite effect in 2005. Thus, for purposes of analyzing/valuing the company, it is probably best to use a “normalized” 2006, which should smooth out the effects of the tax hike.

Valuation

From a valuation perspective, KT&G is cheap. Although the current price is 39,800 won per share, the company has net cash of approximately 5,000 won per share – creating it at 35,000 won. On 2006 EPS, the company should make earn approximately 4,200 won per share, creating it at 8.3 x earnings. On an EV/EBITDA basis, it is valued at approximately 5.6x 2006. Assuming an 1,800won/share 2005 dividend, the stock has an estimated dividend yield of 4.5%. The Company paid a dividend of 1,400/sh in 2002, 1,600/sh in 2003 and 2004.

By comparison, the U.S. Companies (e.g., RJR, Altria) trade at approximately 11x 2006 earnings, while Japan Tobacco is valued at approximately 15x 2006 earnings. Moreover, in March, Philip Morris announced an agreement to purchase HM Sampoerna, Indonesia’s third largest tobacco company, at a bid price of approximately 16x 2006 earnings and 12x 2006 EBITDA.

Quality of Business

As mentioned earlier, KT&G is the dominant cigarette manufacturer in South Korea, with a market share of approximately 77%, and sales exceeding KRW2,000bn per year. Although smoking is expected to decline in Korea, the Company continues to maintain/grow the top-line – in large part by increasing the net average selling price (ironically capitalizing on the trend towards non-smoking / ”well-being” by selling higher priced low-tar cigarettes, which now comprises 35% of domestic sales) – from 426 won in Q1 2002 to 573 in the Q4 2004. While Q1 sales/earnings were well below Q1 2004 due to the stockpiling that occurred at the end of 2004, recent indications are that industry tobacco sales volume and KT&G’s market share have come close to fully recovering in Q2. Also, additional upside going forward includes growth of branded ginseng products, continued penetration of foreign markets, and the monetization of KT&G’s excess real estate holdings.

There has been talk about a second tax hike, but the Ministry of Finance strongly opposes such a hike due to inflationary pressures. While such a hike could still occur in the foreseeable future, it is difficult to estimate with certainty the timing of such a hike.

Finally, and perhaps most importantly, our Korean counsel has indicated that KT&G has substantially limited product liability exposure. Specifically, Korean law does not provide for punitive damages or class action lawsuits. There is also no jury system in Korea – thereby limiting the “lottery”-style jury awards that have become commonplace in the United States. Also, where there are no directly applicable Korean case precedents (as is the case in tobacco litigation), Korean courts rely upon Japanese case law, which has been consistently favorable to tobacco company defendants.

Management

KT&G is considered a model of corporate governance in South Korea, and has won awards attesting to such. Management is shareholder-oriented, committing to repurchase 20% of the company’s stock outstanding within the next three years – in addition to the 10% that has already been repurchased. 75% of the Board is filled by outside directors. Although management has spoken in the past about other business lines and diversification, the Company seems focused on maintaining their market share in South Korea, growing ASP, and eventually turning their export business into a profit center.

Catalyst

Spike in 2006 sales

Continued monetization/accretion from strong balance sheet

Migration towards higher ASP-priced products

Traction in export business