Description

People & Telecommunication (KS 054340)

We recommend a long position in People & Telecommunication Inc. (hereinfter "PNT"). PNT is an Asia-based, Korea-listed cell phone case manufacturer.

The investment itself poses as a net-net idea, downside protected with abundant cash and assets. PNT currently suffers from negative market sentiment caused by temporary operational distress.  We anticipate an upside of at least 150%~250% from the current price level without a turnaround, while anticipating a 300%~400% profit in the case of operational turnaround (free call option).

<Background Summary>

- Founded in 1977 and has been one of the top two cell phone case vendors for Samsung Electronics (side note: Samsung is now the #1 seller of smartphones worldwide, surpassing Apple)

- Supplies 100% of its production to Samsung

- Together with Intops, another leading Samsung case vendor, have commanded 60% of all Samsung phones

- Due to an unfortunate incident in 2010.1Q (explained further below), the Company's business and stock price plummeted 

1. Valuation Summary (denominated in local currency, Korean Won)

 To simply put in USD terms (assuming 1 USD=1,100 Won):

Stock Price: $2.44

Market Cap: $40 million

Net Debt: ($102 million)

TEV: ($62 million)

A.  Asset-based Valuation – In the case of NO turnaround

B.  Normalized Earnings Valuation – In case of turnaround (Unit: KRW billion)

<Net Realizable Value, i.e. Proxy for liquidation value>

(Units: KRW billions) (Note for round-off error)

Footnotes:

(1): ST and LT bank checking and saving account

(2): We have written all accounts other Account Receivables down to 0.  As for Account Receivables, the Company’s only client is Samsung Electronics, and we consider their outstanding receivables to be fully payable.

(3): Due to recent operational shrinkage, PNT has slowly drawn down inventory levels only to those absolutely needed.  In favor of conservatism, we have written down 50% of the book value.

(4): ST and LT bank checking and saving account

(5): Korean government treasuries plus 50% of equity stake in Samsung Venture Investment Inc. (SVI), a private company fully invested and managed by Samsung Group.  SVI has very little debt and is fully operational company.

(6): Subordinated bonds of KB Bank and Woori Bank ofKorea.  Expected to be paid in full

(7): Lease deposit. Expected to be paid in full

(8): PNT’s equity stake in various subsidiaries.  We have written most of the companies to 0 except for PNT Tianjin.  That company is flourishing as a Chinese manufacturing arm of the Company, directly supplying to Samsung Tianjin for globally exporting phones.  In favor of conservatism, we only acknowledged the BV of KRW 35 billion, instead of the NAV of KRW 50 billion.

(9): Only accounted for the fair market value of land and 50% of the building.  Fully wrote off any values from machinery and equipment in favor of conservatism.

<Reasons to buy>

1. The stock is too cheap, both on a liquidation and a normalized basis.

             - See above valuation section. 

2. Why is it cheap?

<Background>

PNT was founded in 1977 making plastic goods and during the 2000s had established itself as one of the top two cell phone case manufacturers for Samsung Electronics.

By the late 2009~early 2010, outside subcontractor firms that buy and dispose of PNT’s defects and scraps (hereinafter “scrap disposers”) got caught smuggling the scraps to Chinese knock-off manufacturers.  As a result, Samsung punished some of its case suppliers – whose scraps were being managed by these scrap disposers – by cutting the case suppliers off from new orders under the pretext that it was the suppliers’ (i.e. PNT and others) responsibilities to manage their own subcontractors well.  Consequently, PNT’s sales, earnings, and thus market value drastically dropped. 

Unlike suppliers of other cell phone parts such as antenna modules or camera modules for instance, cell phone case makers suffer from the risk of having to restrict itself to serving only one buyer (i.e. cell phone maker) at a time.  For example, if you are an LG supplier, you only serve LG; if you are a Sony supplier, you only serve Sony.  Likewise, PNT has been restricted to only supplying for Samsung.  The reason is that, unlike internal cell phone module parts, the designs of external parts such as cell phone cases ultimately end up being one of the most, if not the single most, significant factor in consumer behavior.  Cell phone companies develop their new designs spending lots of money and in great secrecy for many months.  Once set on a new design, they develop the batch version with their pre-fixed group of suppliers to check for defects and feasibility.  Throughout the entire process, the vendors must uphold the highest level of confidentiality.  The leak in design may potentially jeopardize any impact the phone makers intended to bring to the market.  As such, case vendors cannot simultaneously supply to competing cell phone makers.

Given the nature of this risk, these case vendors are well taken of care of by their respective phone makers, as the financial failure of the vendors may also put a lot of stress on the phone makers’ ability to source quality phones in time.  This symbiotic relationship leads the phone makers to give a solid quota of orders to a fixed group of case vendors once the vendors have established themselves as reliable (meaning, minimal defects and timely order fulfillment) suppliers.

Until the above unfortunately incident, PNT had established itself as the #1 or #2 case vendor to Samsung, only to alternate rankings with Intops, another cell phone case vendor.  Once cut off from Samsung, however, their sales did not merely slide but plummeted from its #1 market share position.  A company that once had operating income of around KRW 34 billion (US $31 million) at the 2005 peak and had operating income of KRW 24 billion (US $22 million) until FY2009, PNT incurred in 2011.1Q a TOTAL REVENUE of KRW 18 billion (US $16 million).  Even this revenue was mostly from backlogs of Samsung low-end phones, none of the new “Galaxy S” series smartphones.  Needless to say, operating income turned into losses.

Several other chain of events ensued, leading the market value to sharply decline.  The market had originally anticipated the PNT to return as a Samsung vendor by April 2011, the one-year-anniversary point for PNT being kicked out from the Samsung vendor group.  However, this did not happen.  As such, a slight upward creeping of the stock price by the beginning of this year fell sharply, as hopeful investors were disappointed by the false catalyst.  Operational distress continued into 2011.3Q.  On top of the distressed operations, the low liquidity of the stock and the subsequent global market downturn throughout the latter half of this year allowed for a sharper downturn in the market value.

3. The market value is priced in for failure

As shown in the above valuation, the current market value of the Company is priced for the failure.  Any expectation for the Company’s turnaround, not to mention the mere sustenance, is extremely low.  The current market value is lower or equal to that during the financial debacle panic selling period of October 2008.

In the every great investment opportunity inherently exists great uncertainty about the future.  The current global macro economy is sensitive to any latest news about sovereign debt, which may negatively impact the consumer products like smartphones, and PNT’s protracted dry spell seems endless from the present vantage point.  As a result, unsophisticated or short-term traders systematically sell the stock, creating a downward vicious cycle in the stock price.  Overshooting ensues and the stock price arrives at a highly irrational place.  Spineless investors will allow the market value to dictate their views about the Company’s true worth and profess that the stock price will never recover from the current state.  As such, value investing is easier said than done.

Our job, as investors, is not too prophesize (or “project”) any exact outcome of PNT’s fate.  Neither is it our jobs to vindicate (through our purchase of stocks) a “great” company.  We are mere scavengers of asymmetrical bets that have been created by market folly.  In the case of PNT, of course there always exists a possibility that the company will never supply to another cell phone maker again (whether Samsung or not) and slowly bleed to its eventual demise.  But the important thing is that the market value has already reflected that possibility as a sure outcome.  Thus, anything better than this worst case outcome will positively move the stock price.

4. In the case of no operational turnaround, it is still too cheap

**A CASE FOR AN OPERATIONAL TURNAROUND**

1. Management Incentive

-          PNT’s insider ownership is strong is very strong.  Kim Chul, the former CEO (until last year), his wife, current CEO (Cho Hyun Ho), and newly hired Executive VP (Kim Jong Dae) owns a combined 47.99% of the Company. 

-          Management has been consistently returning capital to investors.  Before the operational downturn, management had been paying an annual dividend between KRW 150~440 per share since 2002, amounting to 5.6~16.4% dividend yield.  In the loss year of 2010, the Company paid KRW 60 per share, a 2.2% yield from the current stock price.

-          Newly recruited Executive VP (Kim Jong Dae) elected to be paid in Company’s common stock at current price level.

-          Unofficial sources confirm that most of the net worth of Kim Chul (former CEO and 40% owner) is his PNT stock holdings.  Thus, his personal fate is most closely tide with the fate of PNT.

2. Quality Supplier

-          Until the recent incident that arbitrarily penalized the Company, PNT had proved itself to be the #1 provider of Samsung cell phone cases both in quality and capacity.

-          As the Company’s manufacturing competitiveness remains intact, it can either return as a Samsung vendor or transform itself as a supplier for Samsung’s competitors.

3. Company’s capability of flexible headcount reduction

-          As soon as the Company’s production hit a wall in early 2010, the Company was able to swiftly lay off 50% of its employees within a year (2010.2Q: 1,038 employees à 2011.2Q: 515 employees).

-          Ability to restructure largest cost structure (salaries) with great agility and little resistance

4. After endless employee layoffs, PNT started rehiring production staff and reported higher plant utilization rate

-          According to the 2011.3Q 8K released 3 days ago, the Company increased its staff by 16% after its lowest headcount level of 515 in 2011.2Q.

5. Killing PNT will only lower Samsung’s bargaining power against remaining case vendors, which will put a strain on production costs and delivery

Catalyst

1. No known catalyst
2. Buying during the Company’s most fearful time makes sense (both on a external macro and company-specific micro level)
3. Company’s increase in production staff and plant utilization rate after a heavy restructuring
4. Company’s imminent turnaround and abundant cash and assets as staying power
5. Eventual normalization of macro and micro environments