Description

[Listed market cap is in US dollars, but price is in Korean Won. Current exchange rate is roughly 1,200 KRW/USD.]

My recommendation is Korea Tobacco (KT&G). KT&G is large, liquid, and cheap. Provided you can get comfortable with the risk of owning a South Korean company, which I think you can, it’s compelling at current prices.

KT&G has approx. 80% market share of the cigarette market in Korea. The company did an IPO of 28MM shares in October 1999 at 28,000 KRW. Since then, the company has become fully privatized and the stock has tricked down to the 16,000 level. KT&G's business is similar to most global tobacco companies – they sell cigarettes.

What makes KT&G interesting is its valuation. At current prices of 16,100 KRW, the stock trades at 7x 2003 P/E and 5.5x EV/EBITDA. With a 1400 KRW dividend, the yield is an eye-popping 8.7%. EPS & cash flow are growing as the company is slowly wringing costs out of the business as well as introducing premium brands.

What makes KT&G even more interesting is that the company has repurchased a good deal of its shares. The current market capitalization of 2.9 trillion won (roughly $2.5B USD) shown on most analyst reports is based on 181MM gross shares outstanding. However, the company really has only 120MM shares outstanding net of treasury stock. (The convention in Korea is not to cancel the treasury shares even though they are not outstanding).

Further repurchases are likely. The company's recent conference call featured management saying that the dividend is secure and that they plan to "return capital to shareholders" and "improve shareholder value." In some cases, these promises are hollow. Here, since the company has repurchased 1/3 of its shares since going public and has a 8.7% dividend, they seem to be real.

The capital structure includes convertible debt of 846 billion KRW. (The proceeds were used for stock repurchases.) This debt is dwarfed by the cash and investments (140B KRW), inventory (1.2 trillion KRW), investment securities (655B KRW), and loans (233B KRW) on the balance sheet. There’s not a tremendous amount of detail on the investment security portfolio, and there are no plans to sell it as of now, but it does provide another margin of safety in the investment.

Cash flow at the company is excellent. EBITDA in 2002 is expected to be 607 Bn KRW, rising to 684 in 2003 and 750-800 in 2004. Cap ex should run at 20-35 billion won in 2003-2004.

There are a few nuances to the Korean tobacco business which you must be mentioned. (For further detail, I suggest you refer to one of the many analyst reports on the company.)

1) KT&G is required to purchase tobacco leaf domestically, at a premium to global prices. They purchase 350B krw of tobacco per year. However, the cost of this is roughly 2x what it should be. Over the next 5 years, management has said they will get an additional 60-80 billion KRW from shifting purchasing to foreign leaf suppliers. This is a political situation which will take time to unwind, but I believe it provides a long-term tailwind to a cost reduction story. On the recent conference call with foreign investors, the company said that domestic leaf tobacco should decline from 72% of total leaf tobacco purchased by KT&G last year to 67% this year.

2) The litigation environment in Korea is favorable relative to the rest of the world. There are no class action lawsuits and no punitive damages permitted in Korean courts, so this company doesn’t face the litigation issues that other tobacco companies face.

3) The Korean market was recently opened to competition. While the competition is indeed a threat, it can also benefit the company. First, KT&G is coming out with premium brands to compete with premium brands like Marlboro, Dunhill, etc. In Korea, pricing of cigarettes is 1110 won per pack, with Marlboro selling for 2000 won per pack and Dunhill at 3500 won per pack. The introduction of premium brands has caused KT&G to introduce new brands at higher prices. I expect the average net sales price per pack to rise almost 15% in 2003 as a result of pricing increases. Most analyst figures project a decline of market share to the 70-75% level (on par with other privatized markets). Second, a competitor might want to acquire KT&G to gain leading share in Korea. In December, the company eliminated the cap on foreign ownership, making a takeover possible.


Also, in order to make this investment one needs to have a view regarding the situation with North Korea. Kim Jong Il of North Korea is, in my view, a desperate dictator. South Korea is more concerned about the risk of a collapse of the Kim Jong Il regime (which could cause the reunification of North & South Korea) than the nuke risk. Reunification would be a major setback to the economic growth of South Korea. I believe that the North Korean saber-rattling will ultimately pass once our diplomatic efforts take hold. (As an aside, I would venture to guess that the likelihood of a nuclear attack on South Korea by North Korea is about equal to the probability of a nuclear attack on a major US city by a terrorist…so I don’t know if the discount of 50% at KT&G is appropriate)

I believe the stock is down due to a lack of interest in Korean equities. If you look at the chart, the stock hasn’t reacted much since North Korea started making noise. This is a large, liquid company which was recently privatized, and it’s simply taking some time to sop up the liquidity.

In the next couple years, as management returns more capital to shareholders, I think this stock can trade around 10x earnings or 25,000-30,000 won per share. This value would be in line with comparable tobacco companies. Downside is protected by asset values, stock repurchases and a high dividend yield.

Catalyst

• In December, the cap on foreign ownership was eliminated, opening the possibility of a bid from BAT or MO.
• On a recent call with foreign shareholders, management reiterated that the dividend is secure and that their goal is to return capital to shareholders and improve shareholder value. The company has repurchased 1/3 of its shares since 2001, and more repurchases are likely.
• Peaceful resolution of North Korean saber-rattling might provide a lift to the whole Korean market.