Description
OVERVIEW
On this day before Christmas my true love said to me: “Go buy shares of KEP”.
Korea Electric (KEP) is a South Korean government controlled, integrated electric company which possesses an effective monopoly over transmission and distribution and a near monopoly in power generation.
Trading at $10.44 as ADR’s on the NYSE (each ADR represents ½ a share of KEP), there are 1.28 billion ADR’s (640,100,876 issued and outstanding shares) for an equity market capitalization of $13.4 billion. At 9/30 funded debt and lease liabilities amounted to $11.7 billion and cash and short term financial instruments $ 747 million. Enterprise value at current share prices totals $24.4 billion.
What initially attracted me to KEP was its discount to Korean GAAP book value against a backdrop of regulated rates of return, and its dividend yield of about 3.2%.. Korean GAAP book amounted to $32.6 billion at 9/30/03; shares trade at a lowly 41% of book. There are certainly adjustments to be made between Korean GAAP and US GAAP. As outlined in the 20-F, US GAAP book value amounted to $23,005 million (approximately $17.97 per ADR) at 12/31/02...the discount is still large. For those sharp pencil types, I’d appreciate a US GAAP number for the most recent period, but I don’t have the talent or energy. I’m just encouraged by the discount and the knowledge (as described below) that the fair rates of return are calculated on “inflated” Korean GAAP.
My twelve (plus one) reasons for buying and recommending the shares are as follows:
1) Trades at a meaningful discount to book
2) KEP is central to South Korea’s effort to attract equity dollars to help in resolving a private sector debt problem and working out/restructuring the cheabols
3) A series of divestitures are expected in the coming years as part and parcel of the restructuring of the electricity industry
4) Regulated returns on capital are reasonable
5) Pays a well covered dividend
6) Plans to grow generating capacity, particularly in nuclear
7) Will trade at some multiple of book in the future considering its reasonable returns on capital and growth
8) Company is efficient and well managed
9) Transparency in financial reporting is improving country-wide
10) South Korean economic growth is accelerating
11) Recent successful debt restructuring, facilitating the separation of generating assets
12) Owns 4 affiliates which are likely to come on the block in the future, and
13) North Korea is a possible power market in the longer term.
DEREGULATION
Pursuant to a government plan to deregulate the industry, KEP will retain its monopoly position in transmission and distribution and will retain its nuclear and hydroelectric assets, but the other generation assets will be sold to the public. It should be noted that the nuclear and hydro are relatively cheap sources of energy and that Korea imports goodly amounts of its fuels (uranium, oil, coal, LNG). under contracts in currencies other than the Won.
The Government’s objectives in its restructuring of the industry is principally to: 1) introduce competition and thereby increase efficiency in the electricity generation industry in Korea; and 2) ensure the stable supply of electricity in Korea. Subsequent to the eventual divestiture of the generation subsidiaries, KEP will purchase power from the deregulated power generation industry.
The deregulation will take place in Phases and I suggest that those interested review the 2002 20-F for details. Suffice it to say, the objectives of this entire process do not explicitly include reducing prices to consumers, but rather to improve efficiency in production and ensure availability.
RATES
With regard to rates, consider the following:
“As contemplated by the Rate Laws, electricity rates are established at levels intended to permit us to recover our operating costs attributable to our basic electricity generation, transmission and distribution operations and to provide a fair investment return on capital employed in those operations. For the purposes of rate approval, operating costs are the sum of:: 1) operating expenses, plus 2) adjusted income taxes.
Fair investment return is equal to the rate base times a fair rate of return. The rate base is equal to the sum of: 1) net utility plant in service (equal to utility plant minus accumulated depreciation minus revaluation reserve) plus 2) working capital for two months (equal to 2/12 of operating expenses other than depreciation expenses and any other non-cash expenses) plus 3) construction in progress using equity fund.” KEP 20-F p 37-38
As of year end 2002, the fair rate of return on debt component of the company’s capitalization was 5.8% and on equity 9.15%.
EQUITY RETURNS
On account of my simple mindedness, I’ve devised a very simplistic model with which to calculate prospective returns on an investment in KEP from current priced...one which assumes an average return on invested capital derived from the regulated rates.
Book Increase in
Year Value ROIC Earnings Dividend Book Value
0 18.00 8.25% 1.49 0.33 1.16
1 19.16 8.25% 1.58 0.33 1.25
2 20.41 8.25% 1.68 0.33 1.35
3 21.76 8.25% 1.80 0.33 1.47
4 23.22 8.25% 1.92 0.33 1.59
5 24.81 8.25% 2.05 0.33 1.72
Total 1.98
Total Total x Purchase Ann Total
P/B Book Y5 Dividends Return Price Return
1.00 24.81 1.98 26.79 2.57 21%
1.25 31.01 1.98 32.99 3.16 26%
1.50 37.21 1.98 39.19 3.75 30%
1.75 43.42 1.98 45.40 4.35 34%
2.00 49.62 1.98 51.60 4.94 38%
On top of this, one is likely to receive securities in numerous generation companies that might trade in the market at premiums to the share of book value lopped off of KEP. And remember, there are assets that are likely to be sold in non-power related businesses that should generate cash and gains.
It should also be mentioned that there are aggressive plans to build plants over the next few years. These new facilities might require additional debt but should draw regulated returns akin to what is described above.
Finally, no provision is made above for any possible increase in the dividend.
RISKS/ISSUES
1) Korean economy falls out of bed
2) Deregulation plans go awry impacting negatively the rates of return available on generation, transmission and distribution assets (though a halt to the program is not necessarily a negative)
3) Geopolitical risk
4) Currency risks
Catalyst
1) Further clarity with regard to the timing of asset divestitures.
2) Continued depreciation of the dollar and growth throughout Asia leads to a diversion of capital to that part of the world and appreciation in financial assets there.