Description

Lotte Confectionary is the leading candy/chocolate manufacturer in Korea as well as the owner of stakes in a number of companies including the leading soda pop company in Korea and one of the largest shopping center companies in Korea. Lotte Confectionary is trading at 65% of a conservatively estimated net asset value. This is not a short-term trade, but there is a 2006 catalyst with the probable listing of Lotte Shopping which comprises 25% of Lotte Confectionary’s NAV. The listing of Lotte Shopping will result in more attention paid to Lotte Confectionary and may serve to close the gap between price and fair value.

History
Lotte Confectionary is the leader in the Korean confectionary market with total revenue of 1.1 trillion won and over 5,400 employees. Sales mix is 17% gum, 18% biscuits, 13% chocolate, 7% candy, 6% snacks, 5% pies, 33% ice cream. Market shares in gum is 70%, chocolate - 57% market share, and each of candy, biscuits and ice cream at about 38% market share. The company distributes its products through route sales, wholesalers and major retailers.

Supermarkets account for about 50% of total sales, chain stores are about 30%, and kiosks, small stores, etc. accounting for the remaining 20% of sales. The company has great products, mind-share, and long-standing distribution. As a result, it towers over Wrigleys, Hersheys, Mars in the South Korean market.

The company has a few overseas outposts, including: Lotte China – 40% stake, founded in 1994, gums & pies; Lotte India – 80% stake, founded in 2004, candy & gum; Lotte Vietnam – 10% share, 1996, gum; Lotte Philippines – 10% share, 1995, gum.

Financials
Lotte Confectionary has 1.421 million shares trading at 1,170,000 won per share. I estimate normalized EBITDA for the core business at about 150 billion won per year, with capex about 45 billion won per year Gross margins have been around 38-40%, and operating margins are generally in the 9-11% range. EBITDA was near 200 billion KRW in 2002-2003 but fell off to 140 billion in 2004 due to increased competition against the Xylitol chewing gum franchise. EBIT/EBITDA in 1H 2005 was 61bn/88bn KRW vs 62bn/88bn KRW in 1H 2004. I value the business at 8x EBITDA.

Investment assets
The company owns 12.4% of Lotte Shopping which is expected to come public next year with a 5-6 trillion won market cap and about 700 billion won for Lotte Confectionary’s stake. Lotte Shopping is expanding and is raising capital for growth efforts. In 2004, Lotte Shopping did 850 billion of EBITDA on sales of 8.3 trillion KRW. The leading competitor Shinsegae trades at 12x EBITDA and does 750 bn KRW in EBITDA. The press has reported that Lotte engaged Daewoo for the IPO in Seoul and Goldman & Nomura for IPO in London. Lotte Shopping needs money for the opening of Lotte stores in China, a Lotte department store/hotel/theme park in Moscow, and possibly M&A of a large discount store in Korea to compete with Shinsegae’s Emart.

The company has stakes in affiliated listed companies worth 181 billion krw at market as of 6/30/05 and 107 billion krw of unlisted investment assets at book value. The listed assets are 9.9% of Lotte Chilsung (public soda co) and 9.8% of Lotte Samkang (ice cream) shares. Significant unlisted assets (aside from shopping) include stakes in Lotte India and Lotte China where they’re trying to export their success in Korean confections. Lotte China is carried at 13 billion won and Lotte India is carried on the books at 9 billion won. Lotte China is doing about 50 billion won in sales, and Wrigleys is the company’s biggest competitor.

Lotte Confectionary also has real estate assets which analysts estimate to be worth well over 300 trillion won. Book value of the land is 211 billion won, most of which was acquired a very long time ago. The company’s real estate is located in the heart of many major cities in South Korea. Management is well aware of the fact that the highest & best use of their sites is not manufacturing confectionary products but rather residential and/or retail. I think it’s a matter of time before factories are relocated and sites are redeveloped, but I don’t expect this to happen anytime soon.

The sum of the parts (in billion KRW except share count and NAV/share):

Confectionary business 1,200 (8x EBITDA)
Listed companies 181
Unlisted companies 107
Lotte Shopping 700 (same multiple as Shinsegae)
Net cash 260
Realty 300
Sum of the parts 2765

Shares 1.421 million
NAV/share 1,934,000 krw

Current price/share 1,179,000 krw
Discount to NAV ~ 40%

This is like buying the Wrigleys/Hersheys of Korea, and getting stakes in Saks/Coca Cola and some great real estate assets…for 60% of NAV. US investors are unable to read Korean press releases and we are too far removed from Korean newsflow to have our finger on the pulse of the market. However, the valuation is too cheap to ignore for a patient value investor.

Catalyst

This is not a short-term trade, but there is a 2006 catalyst with the probable listing of Lotte Shopping which comprises 25% of Lotte Confectionary’s NAV. The listing of Lotte Shopping will result in more attention paid to Lotte Confectionary and may serve to close the gap between price and fair value.