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For those of  you who are underweight Korean value traps, let me introduce you to my friend Nong Shim Holdings (NSH).  As one would expect from a holding company writeup submitted on VIC, the holding company trades at a discount to a SOTP analysis as well as being absolutely cheap on a look through earnings basis. 

The primary asset of NSH is a 34.4% stake in publicly traded Nong Shim (NS - 004370 KS).  Nong Shim is one of Korea’s leading fast moving consumer goods companies.  NS has leading market share positions in ramen (70%+ market share), snacks (38% share in potato chips), and PET bottled water (45%).  2006 sales for the company as a whole were W1.67tr while EBIT was W0.149bn.

For those of you who are not familiar with Nongshim, the company’s ramen noodles are a Korean staple.  Koreans eat more ramen noodles than anyone else in the world, and Nongshim has 70%+ market share.  As an example of the brand’s significance, those of you who have passed through a Korean airport will likely have noticed the proliferation of various Nongshim ramen gift baskets available for purchase as a departing gift (sort of like chocolate is to the Swiss).

For a leading packaged food company with what is more or less a domestic business the margins for NS are well below what one would expect as compared to global peers.  As such you may not be surprised to here that there is a margin improvement story at NS based on sourcing cheaper broth from China, an emphasis on moving the product mix towards premium products, and lastly a price increase that was implemented in March of 2007.  As for how this all plays out, all I can say that there is a story and only time will tell if there is a happy ending.

I believe it can be argued without taking a promotional stance that NS itself is closer to being cheap than expensive on an absolute value basis.  While I leave it to others to prepare their own comp tables if interested, it can be similarly argued that NS trades at discount to its peer group and as such is relatively cheap as well.   As for the explanation, my guess is that NS receives a discount as it is viewed as a largely ex-growth cash cow, while management embodies all of the typical traits that have earned Korean companies such a warm place in the hearts of foreign investors.

To calculate the market cap of NS I use a share count of 5.782m shares outstanding, which backs out 300k treasury shares held by the company (many analyst reports and Bloomberg incorrectly include treasury shares when calculating the market cap). 

Basic s/o                      6,082,642

Treasury                       300,013

Net s/o                         5,782,629

Stock price                   250,000

Mkt cap                       W1,445 trillion

Cash & Equiv               W340 billion

EV                               W1,105

Equity investments        W61 billion

Adjusted EV                W988 billion

The company is well followed by global research houses (CSFB, UBS, Deutsche, Macquarie, Merrill Lynch, HSBC, ABN Amro, JP Morgan, CLSA, etc.) and trades around the following valuations based on 2007 estimates using my straight EV:

EV/EBITDA – 5.0x

EV/EBIT – 6.5x

Now let us turn to NSH, the actual subject of this writeup.  Holdco owns 34.4% in the aforementioned NS, as well as a 40.3% stake in publicly traded Youlchon Chemical Co (which is obviously a packaging company and not actually a chemical company).  Like NS, it could be argued that Youlchon itself is rather cheap, but this is less important given its smaller earnings contributions and proportionate market value as compared to NS.

NSH currently has an EV of approximately W475bn (5.488m shares outstanding assuming an in the money convertible bond is converted).  NSH’s stake in NS is worth about W508bn (34.4% * NS Marketcap excluding treasury shares).  Simple math obviously indicates that NSH trades a moderate discount to its stake in NS Opco.  Adding in publicly traded Youlchon, and NSH trades at ~25% discount to publicly listed stakes.

As an added bonus one also receives takes in Taekyoung (100%), Nongshim Engineering (65%), Nongshim Communications (50.0%) and Nongshim Developments (96.9%).  You can ask your friendly Korean broker for financial statements for any or all of these private companies, but to make a long story short I will tell you that as a group NSH’s stake implies proportionate shareholders equity of about W118bn and proportionate EBIT of W14bn in these unlisted companies.  As a consolidated group of companies, these various private companies if looked at in aggregate would have earned an ROE of ~10% despite the fact that are unlevered.  This would suggest to me that is probably fair to assume that proportionate equity of W118tr is a good starting point for fair market values. 

I will note that like many of its peers, in an effort to demonstrate its commitment to shareholder value NS does own the stereotypical 18 hole golf course.   Nongshim Developments (whose proportionate equity makes up W33tr of the W118tr in previously mentioned private co investments) is a golf course that management swears has a market value of W200bn.  This may be possible as the company paid W100tr (on an EV basis)  for the course at the depth of the Asian crisis when buying from a distressed seller, but I am not going to dwell on this point since the last thing I want to do on VIC is get into a pissing match as to the value of a Korean golf course (http://www.ildonglakes.co.kr/main.html).  Management has told us explicitly that they are not wed to own owning a golf course and would sell at the right price, but we will not hold our breath waiting.  Please no questions on the golf course...it is like adding salt to a wound.

So net result is that on a SOTP based on what we view to be conservative values for both public and private investments, NSH is trading at ~40% discount (using book for the golf course and other unlisted subs and market values for public pieces).

However, our preferred route of valuing this Holdco is to use Marty Whitman style look through earnings.  The reasons are simple.  1) The Holdco is never going to be broken up.  2) Mgmnt has told us they intend to have the various subsidiaries upstream cash to Holdco, who will then distribute much of the cash as dividends.  It should be noted that upon formation of the Holdco several years ago, the founding family placed their bets with Holdco (in which they are the majority shareholders).

As an example of why it makes sense to invest alongside the family, NSH recently bought in a 48.3% stake in the Taekyung subsidiary from publicly listed Youlchon.  Holdco bought the shares at 1.1x book, EV/EBIT of 5.5x, and 7.2x FCF, which strikes me as an attractive valuation and an example of why you want to have your interests aligned with the family.

Relying on look through earnings, the EV for Holdco would look as follows.  First take NSH EV of W475tr.  1) Back out proportionate net cash at various holdings of W120bn to calculate an adjusted EV of W355tr.  2) Add up proportionate EBIT based on public company 3007 estimates and private co 2006 figures (latest available), to get a look through EBIT of W80bn.  This implies that on a look through basis NSH offers exposure to a high quality earnings stream at ~4.4x EBIT while giving no credit for the golf course and no credit for various equity investments held by NS Opco.  While we realize this is a Holdco, I would sum up my investment thesis as stating that an investment in NSH allows you to gain access to the Kellogs of Korea at ~4x EBIT (albeit a Kellogs with a slower growth profile and inferior management team).

As for management, we have met with individuals from the Youlchon, Opco and Holdco on numerous occasions.  We have been told explicitly by Opcos that they are under pressure by Holdco to upstream cash via dividends.  We have been told explicitly by Holdco that they are pressuring Opcos to upstream cash as dividends.  We can tell you explicitly that we have seen no sign of this as of yet, but are lull ourselves to sleep each night with the thought that it can only get better.

As for transparency, management is happy to chat and will share whatever information you ask for.  NS Opco and Holdco actually pride themselves on offering a tremendous amount of information to shareholders in both English and Korean.  As for capital allocation, the best we can say is that they have already bought one golf course and they don’t see any need for a second. 

Attached below is written Q&A that was originally completed in June 2005.  We subsequently have met with mgmnt in person mutilple times, and answers and general tone remains unchanged.

1. We have read that holding companies receive tax benefits provided that sakes in listed affiliates exceed 40% and stakes in unlisted affiliates exceed 80%.  Specifically with respect to Nong shim, is your intent to increase your stake to at least 40% so that dividends from NS will be excluded from taxable income? 

If we own over 40% of listed affiliates and over 80% of unlisted affiliates, 90% of the dividends from the affiliates will be excluded from taxable income. If we own 100% of any of our affiliates, dividend income from the affiliates should be free of tax.

Since Nongshim (004370) and Youl Chon Chemical (008730) are NSH’s major income source, we have intention to increase our stakes in the two companies to over 40%. However, we do not have any specific schedule to purchase those stocks in near terms.

2. Do you expect you will try and bring stakes in Taekyung, NS Engineering, NS Communications up to 80% to receive tax benefits on dividend income from these privately listed companies?

Not for NSH at the moment.

However, Youl Chon Chemical has to sell its entire stakes in Taekyung (48.33%), and NS Engineering (35%) because of cross-holdings regulation.

There could be three methods to solve the problem as follows;

1)     Selling to external investors

2)     Selling to NSH

3)     Selling to each of the companies, so Taekyung and NS Engineering buy the shares as treasury stock.

As the grace period ends March 2007, Youl Chon and NSH still have a considerable time to choose one among the above three methods.

3. Has NSH considered discussing the idea of a share buyback with NS, such that as NS repurchases shares the percentage ownership stake of NSH in NS would increase?  We ask, as this would be a cost effective manner to increase NSH’s stake in NS towards 40% without requiring additional stock purchases by NSH.

We never discussed the idea with NS. However, NS’ treasury stock purchasing cannot increase NSH’s stakes to over 40% though it could expand NSH’s voting rights, unless NS retires the treasury stock it purchases.

Since NSH or NS needs huge amounts of fund to raise NSH’s stake in NS to 40%, it will take time for us to decide what to do regarding the issue.

4. Once the company has increased its stakes in its affiliates (assuming that is the intent), will the priority be on debt reduction? 

If we have lots of debt, of course we will focus on debt reduction. However, we don’t have much of debt now. We had about W14bn of interest bearing debt earlier this year, but redeemed most of the debt with the fund we raised from CB issuing.

So, we can safely say that the only debt we have now is the CB.

5. Does NSH wish to have any debt longer term, or would management rather pay off all of the debt once it has the cashflow to do so?  If so, how many years does management expect it to take to pay off all debt.

Sure, if we have debt, our management would try to pay off all of the debt. Nongshim and Lotte’s managements have been famous for being free from debt.

6. Assuming the convertible bond is redeemable, does management intend to redeem the bond prior to maturity assuming it has the cash flow to do so?  Alternatively, prior to maturity would management consider taking out a regular term loan and use the proceeds to redeem the convertible bond, thereby eliminating the potential dilution that would be caused by the convert?

They are redeemable, but managements do not intend to redeem the bond.

We want the CB to be converted into stock, because we feel we don’t need to redeem the CB. Many investors complain about lack of liquidity of NSH stock, and since the coupon rate of the CB is merely 1%, it is quite cheap for us to keep the CB.

We view all the CB owners would exercise their conversion rights because NSH share is much undervalued.

If we must redeem the CB on maturity, then we would have to pay about 4.5% of interests in total (1% of coupon rate + 1.5% per annum).

(author’s note – as noted previously this CB is out of the money and has been treated as debt when calculating the EV of NSH)

7. If the company required cash to increase NSH stakes in affiliates or reduce debt, would the company ever consider divesting NS Development (golf course), given that it could be viewed as an asset that is less integrated in the operations of NS.

Currently, we don’t have any plan to sell NS Development and we do not think we will need to sell it in the near future.

NS Development has generated stable net profits of about W2bn per annum and it has been used for many golf tournaments Nongshim group has held. Besides, the golf course’s price rose by 2~3 times compared to the price when we had purchased.

We invested only W20bn in acquiring NS Development, and redeemed all the financial debts with revenues from golf membership sale. NS Development is ranked within top 5 among domestic golf courses.

Therefore, we believe our investment in NS Development has been a success.

8. Are there any plans to make capital infusions into any of the existing affiliates in the next few years to fund expansion plans?  If so, which affiliates are likely to receive capital contributions to fund expansions?

No. All of our affiliates keep healthy financial status and steady profitability. They do not plan to expand their existing businesses aggressively, nor enter into new business.

If Nongshim group wants to commence a new business, NSH will be in charge of doing the new business.

So, NSH is the one which needs fund infusion from the affiliates, if it is the case.

9. What is the company’s dividend strategy?  E.g. Is there a fixed payout ratio the company is working towards?

We never gave fixed dividend ratio or fixed payout ratio to the investors, because we might not be able to pay the dividend we suggested if we do not make enough profits.

However, we have continuously increased our dividend payments in line with our profit increase and are trying to keep the trend in the future.

10. In an effort to pay down debt at a quicker pace, would the company consider reducing or eliminating the dividend for a period of time?

We might. But, we never thought of the possibility because we never needed to.

As for CB, we believe it would be converted by 100%. Even if share price falls during the conversion period, we think the owners should convert them into stock because even the current stock price is undervalued.

11. Does IR have any sense as to whether the Shin family has a preference for higher dividends, or is the family indifferent given that they are already very wealthy and do not need the cash?

They are rich, but they always want to get more dividends than the previous years’ as long as the company’s profit increases.

12. We have noticed that the discount on NSH is higher than that of other Korean holding companies.  1) Does the Shin family care that the discount is so wide, or are they indifferent.  2) Does the IR team have any idea as to why the discount is so large, and does IR have any plans as to how the company can try and narrow the holding company discount over time?

1) Shin family believes the share price would rise naturally in line with the improvements in the company’s earnings. So, they do not think of taking some specific measures to solve the discounts.

2) IR team thinks the main reason for NSH’s discounts is market’s lack of knowledge about holding company, resulted from short history of holding company system in Korea. Not so many analysts are covering holding companies. But time will solve the problem somewhat, we think. Another reason is that most of the holding companies have low profitability and not very sound financial status. As NSH boasts healthy financial status compared to the other holding companies and has many profitable affiliates, we think NSH’s discounts should be removed in the long run. We think NSH’s market cap has to be at least over 1/3 of Nongshim market cap because NSH holds 34% of Nongshim.

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