Description

I like KT&G (033780 KS) as a long. They are a Korean consumer company deriving most of their revenues (~68%) and operating income (86%) from tobacco, with the other meaningful operation being ginseng (20% of sales, 10% of operating income). They also have a small real estate operation, and also have stakes in a couple of businesses doing cosmetics and pharmaceuticals. The real estate business is profitable, the other two had been loss making but are about breakeven now - the purpose of having them is part of a longer-term attempt to diversify away from tobacco. The tobacco business can be further split into the domestic business and the international business - domestic is about 3x the size of international. 

The investment case is fairly simple - I just think that the business will be a steady compounder over time, the dividend yield should be supportive and the people are probably a bit too worried around the short-term earnings impact from tax hikes on tobacco in Korea that are in the process of being digested by the consumer at the moment. You also have some support from the balance sheet, as the company has a net cash position of just under 10% of the current capitalisation. That helps the case a bit in terms of peer group relative value - it trades at only a small discount to international peers on P/E (around 3%-5%), but adjusting for the net cash position it is ~15%.

Unfortuantely I didn't get the chance to write up the case before the recent interims, when some of the dynamic around overblown concerns on the near-term earnings played out, but that can still be supportive to the case. 

The business in numbers is roughly as follows:

                           Sales(KRWbn)                 EBIT(KRWbn)

Tobacco               2,812.4                           1,002.8

Ginseng               820.8                              117.7

Real Estate           154.2                              38.7

Others                 325.7                               19.8

Elimination                                                  -7.1

Group                  4113.0                           1,171.8

I will focus on the tobacco business, mainly the domestic as that is the most important thing for the case. They are the market leader with just under 60% market share - consolidated maket with three competitors including BATS, Japan tobacco. Market share has oscillated between 55% and 64% over time, depending upon the competitive environment, currently at 57% as competition has been a bit more aggressive on price (one of the bear points at the moment). The market is mature and not growing (certainly in volume terms) - volume declines (excluding strange impacts from changes in the industrywide inventory levels around tax hikes) I would put at -1% to -2% per annum. They have been able to take about 1.5% of pricing. I actually don't mind this dynamic where you are taking away volume and replacing most but not all of it with price due to the better incremental margin on the units of price - you should see margin improvement over time obviously and the absolute level of profitability should be quite robust. 

The last year has been quite a volatile one. A few quarters back the govermnent announced a sizeable tax hike, effectively doubling the retail price in an attempt to discourage smokers. The leg down that the stock took last year was on the back of that as people feared volumes would fall off a cliff. Volumes were indeed down strongly in January, when we saw ~40% declines, however by the end of March that had in fact moderated to 17% declines. Worth noting that KT&G took 13% pricing in Q1 overall per the recent conference call, so the margin offset from the pricing should indeed be a tailwind. The point about volume declines getting markedly less severe over the course of the quarter I think is pretty important and speaks to the price inelasticity of demand. 

The way I see the domestic tobacco part playing out is that at the industry level, the YoY declines in volume exit 2015 down mid to high teens, and from there on out the old dynamic of small volume declines resumes. The market had been concerned specifically on KT&G as they lost some market share in Q1 on the back of competitors not hiking prices as much as them in an effort to try to take some share. Management gave some commentary on that issue on the most recent conference call, stating that this impact had moderated and that in recent weeks the share trend had improved, so we have that to look forward to in the numbers over the course of the year.

The international business is fairly widely spread out - of the total sales in 2014, the Middle Eastern market took up 41 percent; China-Southeast Asia 28 percent; Central Asia-Russia 17 percent; the U.S. 7 percent; and Europe-Africa 7 percent. They wanted to pursue international sales to try to diversify a bit away from the domestic market which is competitive and slow growing - sales have not really grown over the last 3-4 years, but there have been a number of issues to contend with there, namely exposure to Russia a couple of years back (and now) and the KRW recently strengthening a bit. The trend has improved in recent quarters and in Q115 we saw ~1.5% growth in spite of a currency headwind.

In terms of commentary on recent developments on the tobacco business. as stated above, there had been concerns that top line and profitability would be crushed on the tax hikes. In fact what happened was that the volume declines were not quite as severe as people had feared and the pricing was pretty good. There was also a one-time benefit in Q115 from inventory produced before the tax hike being revalued at the new price level and sold at a profit - consensus had not properly modelled this impact, which drove the big move a couple of weeks ago on a headline EPS beat. I don't have that much to say on this beyond thinking that it highlights how this part of the business is not that well appreciated by analysts/investors - fundamental drivers not properly understood (excessive focus on short-term EPS) and then a huge move up on an exceptional EPS beat which quickly reversed.

For the overall tobacco business. I see 2015 as being a difficult year due to the strange impacts from the tax hikes, but longer-term I expect flat to small positive volume growth with any growth coming from the international business, with low single digit pricing growth and margin progression.

The ginseng business I have less to say on - it is a bit like the domestic tobacco business in that there is limited growth but they have a strong market position, it is profitable (though less than half as profitable as the tobacco business) and cash generative.

I think that the tobacco and ginseng businesses together can generate >500bn KRW of normalised FCF and growing, which is more than enough to finance the dividend, which costs ~400bn and any capex requirements.

The other businesses are stakes in a cosmetics company called Somang which does not register meaningful profits currently, and a Pharma company Yungjin, which is modestly profitable (~6bn KRW) currently but is still really in the development phase - pipeline details are here: http://eng.yungjin.co.kr/rnd/rndfields.asp. I don't think they need to come out with anything successful for the investment to work here - I see the tobacco and ginseng businesses as more than justifying the valuation. 

For 2015, I see the tobacco and ginseng businesses generating ~1,050bn KRW of operating income. A peer EV/EBIT multiple of 13.5x gets me to 14.2trn KRW of value, plus net cash = 15.2trn = ~20% upside, not accounting for the real estate business generating ~40bn KRW of operating income annually and the pharma/cosmetics businesses which are modestly profitable to about breakeven but have growth prospects. Think the downside is capped by the >3% dividend yield which is easily covered by the cash generation from the cash cow businesses, together with the strong balance sheet.

Catalyst

*Volume trends start to stabilise in tobacco

*Market share continues to recover

*Dare I say valuation