Description

Nong Shim Co. is the leading producer of instant noodles in South Korea with snack and beverage divisions as well.  Nong Shim is a household brand in Korea and its flagship products enjoy near ubiquitous recognition.  Though the stock has been fairly resilient through the Korean market's sharp downward move we believe there is still significant upside in the shares which value the company at a discount to its peer group.  Through ASP hikes and raw material price deflation, 2009 margins will be significantly stronger than 2008's and a new CEO (the first outside CEO in company history) should be able to improve productivity and pick low-hanging fruit.  We believe balance sheet strength and low valuation provide downside support, and believe there is upside of at least 70% with normalized margins.  Brief descriptions of the company's main product lines follow.

Instant Noodles/Ramen - Ramen, sold in either packaged or cup form, is an inexpensive staple found in most Korean households.  Nong Shim dominates this market, consistently commanding over 72% share.  Nong Shim produces a wide range of ramen products encompassing a variety of textures and tastes, but their flagship product is Shin Ramyun, a spicy variety launched in 1986 that alone commands 25% market share of the total instant noodle category.  Ramen sales tend to be flat to stagnant in times of economic prosperity and improve when conditions become adverse.  As a result category sales were flat from 2004-2007, as volume declines were offset by modest price increases.  However, due to the combined factors of price increases as well as volume gains due to consumers "trading down" in this slowing economic environment, category sales growth has been robust in recent quarters.

Snacks - Snacks include packaged snack goods sold to supermarkets or convenience stores.  Nong Shim's snack varieties include some of Korea's most well recognized brands including Shrimp Cracker and Honey Cracker.  Recent snack sales have suffered since an incident in March 2008 when a consumer found a mouse's head in a package of shrimp crackers.  While there was significant media coverage on the incident and strong consumer backlash, snack sales are rebounding after suffering initially with sales in 3Q down only 4% compared to 2Q when they were down 9%.

Beverages - The majority of beverage sales come from the sale of mineral water under the SamDaSoo brand, which bottles and distributes water bottled from Jeju Island, off the southern coast of Korea. 

Investment Strengths

Attractive Valuation - At \220,000/share, Nong Shim trades at 6.4x LTM EBITDA, compared to global branded food peers at 8.7x LTM EBITDA.  The discount is more pronounced given Nong Shim's depressed 2008 margins due to raw material cost pressure on both KRW weakness and abnormally high wheat and palm oil costs.  EBITDA margin on gross sales will be roughly 9% in 2008, compared to a historical average of 13%.  Raw material prices have receded from their highs and should cause margins to rebound in 2009.  We have assumed that margins get half of the way back to their average in 2009, and off those estimates Nong Shim trades at 5.1x 2009 EBITDA versus the peer group at 8.0x.  Nong Shim also trades at 0.6x sales, and 1.2x book value compared to the peer group at 1.5x sales and 3.0x book.  The new CEO is targeting margins above Nong Shim's historical average, but even if they only get back to 13% margins and are valued at 8x EBITDA, it implies a \373,000 share price, or 70% upside from current levels.

Leading Market Position and Brands - Nong Shim enjoys commanding domestic market share in all of its major products.  In 2007, Nong Shim had 72% of the instant noodle market, 37% of the snack market and 46% of the bottled water market.  Market share has stayed consistently high over the past several years.  Each of Nong Shim's major brands in noodles (Shin Ramyun), snacks (Shrimp Cracker) and water (SamDaSoo) are household names.  In a survey we performed of 50 Korean households, 100% of respondents have tried Nong Shim noodles, and 90% eat the noodles at least a few times per month.  Similarly, 100% of respondents have tried Shrimp Cracker, and 62% said they eat it at least a few times per month.  94% of respondents have tried Nong Shim's bottled water, with 48% saying they drink it at least a few times per month.

Countercyclical Products - Demand for ramen usually spikes in recessionary environments due to the low ASP on a package of roughly \700, or 48 cents.  In the last two periods of Korean economic hardship in 1998 and 2003, Nong Shim's sales rose 24% and 14%, respectively.  A similar scenario is emerging in the current difficult environment, as displayed by Nong Shim's results in the June and September quarters, with sales up 14% and 13%, respectively.

New Leadership - For the first time in Nong Shim's history, an outsider (not part of the founding family) has been named CEO in the beginning of 2008.  The new CEO, Mr. Wook Sohn, was formerly President of Samsung SDI and has had rigorous management training, a stark contrast to the legacy management team.  Mr. Sohn detailed to us a variety of processes that were flawed or inefficient upon his arrival.  Since he has been there, Mr. Sohn has begun implementation of an ERP system which was previously not in place, added incentive schemes for management, increased accountability, implemented Six Sigma, and started a formal capital allocation approval process.  His goals are to improve operating margins to 12% by 2015 (vs. 7.1% in 2007) and improve ROE to 15-20% from a current level near 10%.  We believe there is a significant amount of "low-hanging fruit" to be picked resulting from the legacy management team who ran the company inefficiently.

Cash-rich Balance Sheet - As of 9/30/08, Nong Shim had cash of \371 billion and net cash of\232 billion, or about 18% of current market cap.

Investment Concerns

Escalating Cost Pressures - Approximately 70% of Nong Shim's CoGS, or about 50% of sales, is raw material or packaging costs, which have escalated significantly in the past several quarters with soaring grain and palm oil prices.  As a result, gross margin has been squeezed considerably from 30.3% in 2007 to 25.8% in the September quarter.  Nong Shim has been raising prices to offset the cost escalation but has not been able to pass through all of the increased burden especially as the Korean government is keen on keeping food prices low for consumers.  While costs have somewhat mitigated, the weakness of the Korean Won is continuing to put pressure on Nong Shim.  We do not believe the Korean Won will stay at the 1,500+ level as it is currently, but if it does, or weakens further, margin improvement may be delayed.

Questionable Capital Management - To date, Nong Shim has not been very focused on returning cash to shareholders via dividends or share repurchases.  The annual dividend has been kept at a constant level for the past 4 years at \4,000/share, which equates to approximately a 1.8% yield.  Although the risk of a non-related business acquisition (such as a golf course) is mitigated by the fact that Nong Shim is classified as an "Operating Company" in Korea precluding it from entering business lines outside of its industry, it has broad liberty to invest within most areas in the food sector.  For example, Nong Shim has opened 2 branches of a Japanese curry restaurant called Cocoichibanya and management indicated that the restaurant business could be an area they may pursue in the future.  Additionally, management has indicated that they intend on hoarding cash generated by the business for a potential acquisition, which has no guarantee of generating an attractive return on capital invested.

Quality Control Issues - The scandal in March 2008 related to a consumer finding a head of a mouse in a bag of Nong Shim shrimp crackers underscores quality control deficiencies in Nong Shim's manufacturing in China.  To the extent these incidents occur again, brand value may be severely damaged.

Catalyst

• Margin rebound as raw material prices ease
• Increase in ramen sales due to weakening economy
• Improved profitability from new management changes