Description

Summary:

            Fitch Ratings’ 74% Korean-listed subsidiary, Korea Ratings (034950 KS), might be the world’s cheapest publicly listed credit ratings agency in terms of historical dividend yield (4.1%) or EV/ consolidated FCF (8x).  Excluding parent level cash (worth 22% of market cap), a controlling 65% stake in publicly listed e-Credible (worth 48% of market cap), and a passive 11% stake in unlisted Korea Credit Bureau (worth 4% of market cap), Korea Ratings’ EV/parent FCF multiple falls to just 5x.  

We feel this is too cheap considering 1) the Korean credit ratings industry is still developing from a low base, and 2) the fact that the Korean central bank cut policy interest rates four times since August 2014 to an all-time low of 1.5%, a significant incentive for companies to issue more debt (see below).

http://www.koreaobserver.com/corporate-debt-sales-soar-amid-low-rates-31167/

Corporate debt sales soar amid low rates

SEOUL, June 16 (Yonhap) — Bond sales by South Korean companies have surged this year as the companies are increasingly opting to float debt instead of borrowing from banks amid a low interest rate trend that has lowered issuance costs, data showed Tuesday.

Companies’ net issuance reached 1.9 trillion won (US$1.7 billion) in May, more than doubling from 700 billion won in the previous month, according to the Bank of Korea (BOK).

Cumulative net issuance totaled 2.1 trillion in the first five months of the year, also breaking the 1.8 trillion won posted in the same period last year.

When including corporate stock issuances, companies were tallied to have raised 7.1 trillion won through direct financing in the January-May period, bigger than the 6.4 trillion won logged in the entire January-December period last year.

The trend comes as bond issuance costs have fallen sharply compared with bank interest rates, following a series of rate cuts by the central bank, with the latest move earlier this month sending the key rate to a new low of 1.5 percent.

While corporate bond and CP rates have fallen to the 2 percent level, bank interest rates are still hovering at the 3 percent range.

(Note: for English financials, click here and type in 034950 for the stock code http://englishdart.fss.or.kr/dsbd002/main.do)

The first reason to buy Korea Ratings: it owns a collection of growing monopolies

The collection of businesses Korea Ratings owns – a 100%-owned credit ratings agency (#1 market share), a 65%-owned corporate information platform (#1 market share), and an 11%-owned consumer credit bureau (#2 market share) – all have significant competitive advantages with runways for growth.

·        Credit ratings: this business accounts for 2/3 of consolidated profit.  Only four companies including Korea Ratings are licensed to provide credit rating evaluations in Korea.  Of these four, only three have major reputations and market share: Korea Ratings (40% share, Fitch-controlled), Korea Investors Service (30% share, Moody’s-controlled), and Nice Investors Service (30% share, locally controlled).  As a rule, all corporate bond issuers must obtain ratings from at least two agencies.  The Big Three are a toll gate on the country’s bond market, and in some cases even foreign direct investment.  A close friend had some recent experience with this – his firm, which is developing property in Korea, was required by the government to obtain ratings from two of the Big Three even though they weren’t issuing any debt in Korea!

While the Korean ratings industry is already consolidated, it remains very small (i.e. industry revenues are less than USD 90 million) and appears to have a long runway for growth.  For example, the market for high-yield bonds in Korea is almost nonexistent.[1]  Small/medium sized enterprises account for just 1% of total issuance, and LBO/M&A bonds are rare.  Even if we don’t believe that Korea’s bond market will develop exactly the way the United States bond market has, at the very least there should inevitably be a larger universe of issuers for ratings agencies to serve beyond just the top-rated large companies.  For industry background in Korea, see page 31 of this report https://www.dropbox.com/s/9ucqj2xnshtsol5/201409%20nice%20holdings%20initiate.pdf?dl=0.

·        Corporate information: this business accounts for 1/3 of consolidated profit.  This is represented by Korea Ratings’ 65% stake in e-Credible (034950 KS), a publicly listed company focused on enabling hundreds of large Korean manufacturers to know more about the thousands of smaller companies that supply to them.  E-Credible’s profit center is the DNA or digital network authentication system, which charges an annual fee worth a few hundred USD to tens of thousands of small companies (potential suppliers) for the right to upload their financial profiles into a database that over hundreds of large companies (potential customers) can access for free.    E-credible estimates DNA’s market share in this corporate information niche to be 65-70%.  Usage of the DNA system has been so widespread in Korea that small companies now use it to authenticate the creditworthiness of even smaller companies that supply to them.  This is a sticky business: if smaller companies don’t authenticate their information via e-Credible’s DNA system, they lose access to hundreds of large potential customers.  Unlike the ratings agencies in Korea, the DNA business is unregulated and unprotected.  Despite this, the presence of newer competitors like Dun & Bradstreet Korea have not prevented e-Credible from growing.  For more background, see https://www.dropbox.com/s/612nyjcluvtevn0/2009%20initiation.pdf?dl=0.   

·        Consumer credit bureau: Korea Ratings is the largest shareholder (11% stake) in Korea Credit Bureau or KCB, the largest consumer-only credit bureau in Korea and second largest credit bureau overall.  KCB’s business model is to collect credit repayment information on millions of Korean consumers and re-sell that data to businesses that need it for risk management purposes.  KCB is highly profitable, but its revenues and profits are not reflected in Korea Ratings’ financial statements due to IFRS accounting.  Instead, Korea Ratings conservatively values its 11% stake in KCB at KRW 6.6 billion, or 9x 2013 operating profit, a discount to the 15-20x multiples that publicly listed Korean, Australian, and American credit bureaus trade at today.   

The importance of consumer credit bureaus to a financial system was not something that we fully appreciated until recently.  After speaking to a major shareholder of another Asian consumer credit bureau this year, we finally realized how much of a competitive “moat” these businesses have over future new entrants. 

To begin with, credit bureaus require scale to succeed.  Governments that encourage the formation of credit bureaus care more about risk management than competition.  What matters most is that the financial system has access to high quality consumer credit data so that lenders can make sound credit decisions that lead to healthy profits and continued economic growth.  High quality data can only be guaranteed if credit bureaus are large enough to be commercially successful, and commercial success can only be guaranteed by limiting competition.  Not surprisingly, only a handful of consumer credit bureaus exist in most countries.[2] 

Next, coordination among lenders is critical to the success of a new credit bureau.  The founding shareholders of a credit bureau are typically companies that already generate lots of consumer repayment data (i.e. banks).  Because these founding shareholders are incentivized to make their own credit bureau startup a commercial success, they won’t be rushing to provide their credit data to competing credit bureaus.  In other words, new credit bureau entrants should find it difficult to convince banks to provide data.

Lastly, the credit bureaus with the longest history tend to have the most robust data and become the most commercially successful.  Not surprisingly, the biggest credit bureaus in developed countries like the United States, the United Kingdom, and Australia are the same handful of companies – Equifax, Experian, Transunion, and Veda – that have dominated those markets for decades.  For industry background in Korea see https://www.dropbox.com/s/bazfwxh6eefdd72/GMS_030190%40KS_032215_11242.pdf?dl=0.

The second reason to buy Korea Ratings: it benefits from recent government policies

Some recent government policies could be extremely favorable to Korea Ratings.  For example, on 10 June 2015, the Korean central bank lowered its key policy interest rate to an all-time low of 1.5%.  This is the central bank’s fourth rate cut since August 2014, and it seems to be spurring companies to issue more debt securities.  According to the Financial Supervisory Service, total corporate debt issuance for Jan-Mar 2015 and Jan-May 2015 increased 8% and 5%, respectively.[3]  Similarly, commercial paper and asset backed securities issuance Jan-May 2015 increased 82%.[4]  Not surprisingly, Korea Ratings reported consolidated revenue and pre-tax profit growth of 8% and 20%, respectively, in the quarter ending March 2015.  In that same quarter, Korea Ratings’ parent-only (i.e. ratings agency only) revenue and profit growth increased 5% and 6%, respectively.

Another policy in favor of Korea Ratings has to do with the recent changes in the tax code designed to discourage corporate cash hoarding and encourage more shareholder dividends.[5]  Though Korea Ratings has long been among the highest dividend payers in Korea (typically 2/3 of profit), management once complained to us they have not been able to pay as much as they wanted to thanks to constant scrutiny of foreign-owned financial services companies.[6]  If the government’s latest reforms allow Korea Ratings to pay more dividends, then the company’s current 4.1% dividend yield could reach 6% even without dipping into its consolidated cash pile worth 32% of its market cap.

The third reason to buy Korea Ratings: it’s rare to be able to buy this collection of businesses this cheap

In our opinion, it is rare to be able to buy this collection of businesses – a #1 ratings agency, #1 corporate information platform, and #2 credit bureau – at a price that values the core ratings agency for as little as 5x free cash flow.  As far as we know, the last time a similar collection of businesses was available in one package at a price that nearly gave away the ratings agency for free was in 1999 when Dun & Bradstreet was in the process of spinning-off its 100% stake in Moody’s.  Investors, including Berkshire Hathaway, who intended to keep their Moody’s spin-off shares and sell their leftover Dun & Bradstreet parent shares were able to acquire Moody’s at a 70% discount.[7]  With hindsight, shareholders would have done well keeping stakes in both companies.  According to Bloomberg, Moody’s and Dun & Bradstreet’s total returns to shareholders since they began trading as separate companies in September 2000 through May 2015 has been 852% and 765%, respectively, versus 95% for the S&P 500.

So at least one example in history shows that that buying a #1 ratings agency at a 70% discount is a good idea.  That’s the same opportunity that Korea Ratings presents today.  At a share price of KRW 41,150 per share, Korea Ratings has a market cap of KRW 187 billion, which reduces to just KRW 48 billion after subtracting the market value of the stake in e-Credible (KRW 90 billion), parent-level net cash (KRW 42 billion), and the stake in Korea Credit Bureau (KRW 7 billion).  This KRW 48 billion net price tag for the ratings business is just 5x the KRW 9 billion of parent free cash flow it generated in 2014.  Even if we don’t give any credit to the stock market value of e-Credible, Korea Ratings’ EV / consolidated free cash flow multiple is still under 8x.

Key risk: regulatory

Korea Ratings is possibly the world’s cheapest publicly listed ratings agency.  This probably has something to do with the fact that the company is listed in Korea, where many investors (including us) have had bad experiences.  Yet the main risk facing Korea Ratings – regulatory backlash – is no different from what ratings agencies face all over the world.  Korea Ratings’ President Mr. Yoon In-Sub warned us about regulatory risk when we last spoke in 2012.  As it turned out, he was right to be concerned – too right.  The Korean government recently asked him to resign, along with his counterparts at Korea Investors Service and Nice Investors Service, over alleged “illegal sales” tactics.[8]  This is alarming news on the surface, but our contacts suggest everyday business at Korea Ratings has not been disrupted.[9]  We don’t have a crystal ball, but we don’t think the bond market’s reliance on credit ratings will change any time soon just because some executives were asked to resign.  More importantly, at 5x parent-only free cash flow – with 74% of our acquisition cost covered by cash and shares in businesses that have nothing to do with credit ratings – we’re being paid very well to assume some regulatory risk, especially given the industry’s long-term growth potential. 

Catalyst

Privatization by Fitch/Hearst:

In December 2014, Hearst raised its stake in Fitch Ratings to 80%, up from 50% previously.  Since Korea Ratings accounts for most of Fitch's revenues in Asia, it would not surprise us if a privatization bid by the group’s new majority-owner were to materialize at some point.  How likely or remote are the chances?  We don't know -- management has said there is no business reason for them to remain listed (and in fact, they don't take IR meetings anymore), but there are definitely pros to being perceived as a "Korean" listed company in Korea. 

Might Fitch/Hearst try to squeeze out minority shareholders in Korea Ratings?  Maybe, but Korea Ratings' track record of dividends has given us comfort that the ultimate owners respect the right of minority shareholders to earn a return, too.