Value Investors Club / SK Telecom (017670 KS)

Description

Introduction

SK Telecom (“SKT”) is the dominant wireless carrier in South Korea with 20.3mil subscribers and a 50.4% market share. Its scale enables it to command much higher margins than the other two players KT Freetel (32.1% market share) and LG Telecom (17.4% market share). In 2006, revenues were W10.7trillion (US$11.1B), EBITDA was W4.3trillion (US$4.5B) and net profit was W1.5trillion (US$1.5B). It is highly free-cash-flow generative, throwing out un-levered free cash flow of W1.9trillion (US$2bn) in FY2006.

We expect SKT to generate levered free-cash-flow yield of 7.7% in 2007 and 10.7% in 2008. We expect free-cash-flow in 2007 to be lower than in 2006 for two main reasons: increased marketing spend in preparation for the launch of a new network (High Speed Data Packet Access “HSDPA”) and an expected W300bn spend on funding its overseas ventures.

The stock has underperformed the KOSPI (by 16.8% YTD) and is unloved by the market because of expectations of continued high marketing expenses from irrational competitive behavior amongst the operators, and also because of the launch of its new network in 1Q2007 leading to potential increases in marketing spend. There is also considerable skepticism about how Management will deploy its FCF with expectations that Management will “waste” their cash flow on loss-making overseas acquisitions.

Our investment thesis is predicated on our belief that SKT’s long term margins will normalize to higher levels than what the market thinks (i.e. to 2005 levels, which is still lower than the historical average for the company). This pessimism provides us the opportunity to invest in a leading company with superior franchise value and strong and growing free cash flows, at attractive valuations. 2007E and 2008E margins will be depressed because of expected increase in marketing expense ratio for the launch of HSDPA. However, our forecasts have already conservatively factored in the worst case scenario in 2007 but believe that if you look at 2008 and beyond, the FCF generation significantly improves. This is due to 1) marketing expense ratio dropping back to 2006 levels by 2009; 2) lower capex/sales ratio; and 3) reduction on funding for its overseas investments.

Our DCF valuation using WACC of 9.0% and perpetuity growth rate of 1% yields a valuation per share of the core wireless business at W 338,756 per share (implying upside of 61%). Adding the value of SKT’s stake in POSCO and China Unicom to our valuation of the core business yields a valuation of W 368,871 per share (implying upside of 76%). Further potential value which has not been included in this valuation are its overseas ventures which are currently loss-making but some have shown signs of turning profitable by 2008.

Business Description and Industry Dynamics

The table in the appendix shows SKT’s leading market share against its competitors. SKT is superior to its competitors in terms of brand franchise, quality of network and scale enabling it to achieve higher profitability. Testament to SKT’s franchise value is its ability to charge higher rates and still maintain its subscriber base. For example, SKT’s market share has only dropped 4.1% (from 54.5% to current 50.4%) since introduction of MNP in 2004. Further, it still has a leading share of new subscribers (40%).

Marketing expense – Effect of Recent Industry Developments

Two recent regulatory changes resulted in significantly higher marketing spend in the year of the regulatory change. For example, the introduction of mobile number portability in 2004 brought along a significant increase in marketing expense for the whole industry. For SKT, marketing expense ratio (ads plus cellular commissions) increased from 15.4% in 2003 to 17.6% in 2004, and total commissions paid to dealers (cellular plus general commissions) increased from 22.5% to 26.6% in 2004. In March 2006, the government also implemented a new handset subsidy rule which legalized handset subsidies for specific customers who adopt the 010 MNP prefix number and who get contracts of at least 18mths. Prior to this change, handset subsidies were illegal. Therefore, in 2006, these ratios jumped further as the operators increased their subsidies to target MNP customers. Apart from these “legal” subsidies, it is widely known that despite the regulation, illegal subsidies also persist and increased in 2006. (These illegal subsidies take the form of increased upfront commissions to dealers, and the dealers themselves then pass on some of the benefits to the customers). SKT’s marketing expense ratio increased to 20.2% in 2006 from 16.3% in 2005.

The key question now is whether the HSDPA launch in 2007 will lead to even higher marketing spend and this is where most discrepancy exist in analyst expectations. During its 1Q07 earnings call, SKT stated that it will abstain from aggressive marketing for HSDPA and will not be a leader in the marketing war. At the same time, it stated its intentions of keeping a 50.5% market share and mentioned that its size gives it significant advantages in marketing. We view this as a signal to KT Freetel to abstain from engaging in an irrational marketing war and view this as a positive stance. However, to be conservative, we have also calculated the incremental expense associated with the HSDPA launch assuming SKT pays the maximum allowable handset subsidy to all its new HSDPA subs (even though the Company guided it will use a tiering system).

Capex

SKT spends an average of W1.6 trillion on capex every year. 2006 capex spend was W1.5trillion and 2007E company guidance is also W1.5 trillion. This translates to 14.3% of sales which is still a high capex/sales ratio for a market as developed as Korea, and with no impending groundbreaking new technology standard coming up. For comparison purposes, the average capex/sales ratio for developed European wireless operators is 11.4% and for developed Asian wireless operators outside Korea, the ratio is 10.6%. We believe that SKT can continue to spend the same absolute capex amount but as a percentage of sales, this will come down to 13.3% of sales in the terminal year.

Key Financials and Assumptions

(Note: Worst case scenario for marketing expense has been factored into years 2007 and 2008)

My Assumptions

2005 2006 2007E 2008E 2009E 2010E Terminal Year

Revenue 10,161,129 10,650,952 10,863,971 11,081,251 11,302,876 11,528,933 11,644,223

Growth 4.8% 2.0% 2.0% 2.0% 2.0% 1.0%

Advertising expenses      260,699      300,829      304,191      310,275      293,875      288,223      279,461

% of sales 2.6% 2.8% 2.8% 2.8% 2.6% 2.5% 2.4%

Cellular Commissions 1,490,000 1,851,891 2,324,331 2,346,059 2,036,653 1,729,340 1,746,633

% of sales 14.7% 17.4% 21.4% 21.2% 18.0% 15.0% 15.0%

Total Marketing expenses 1,750,699 2,152,720 2,628,522 2,656,334 2,330,528 2,017,563 2,026,095

% of sales 17.2% 20.2% 24.2% 24.0% 20.6% 17.5% 17.4%

General Commissions 1,405,214 1,464,660 1,499,228 1,529,213 1,559,797 1,590,993 1,606,903

% of sales 13.8% 13.8% 13.8% 13.8% 13.8% 13.8% 13.8%

Total Commissions 2,895,214 3,316,551 3,823,559 3,875,271 3,596,450 3,320,333 3,353,536

% of sales 28.5% 31.1% 35.2% 35.0% 31.8% 28.8% 28.8%

EBIT 2,671,066 2,622,291 2,049,625 2,181,760 2,633,026 3,052,800 3,119,009

% of sales 26.3% 24.6% 18.9% 19.7% 23.3% 26.5% 26.8%

EBITDA 4,217,351 4,269,845 3,725,494 3,827,800 4,286,326 4,734,665 4,793,644

% of sales 41.5% 40.1% 34.3% 34.5% 37.9% 41.1% 41.2%

Capex (1,416,622) (1,520,000) (1,850,000) (1,518,131) (1,525,888) (1,556,406) (1,548,682)

% of sales -13.9% -14.3% -17.0% -13.7% -13.5% -13.5% -13.3%

EBITDA - Capex 2,800,729 2,749,845 1,875,494 2,309,669 2,760,438 3,178,259 3,244,963

% of sales 27.6% 25.8% 17.3% 20.8% 24.4% 27.6% 27.9%

WC change     (205,024)               -         (22,084)       (25,348)       (72,681)       (41,050)         (4,934)

% of sales -2.0% 0.0% -0.2% -0.2% -0.6% -0.4% 0.0%

FCF to firm 1,928,664 1,279,516 1,673,428 1,950,510 2,282,425 2,366,706

FCF yield to Firm 11.1% 7.7% 10.7% 13.6% 18.2% 22.4%

FCF to equity holders 1,810,226 1,184,454 1,623,360 1,966,051 2,383,383 2,569,270

FCF yield to equity holders 11.9% 7.8% 10.6% 12.9% 15.6% 16.8%

Net debt (cash) 2,080,852 1,457,287      411,410     (957,810) (2,725,682) (4,677,697)

Enterprise Value 17,340,292 16,716,727 15,670,850 14,301,630 12,533,758 10,581,743

Other key info

Handset subsidies (captured within Cellular commissions)      542,000      787,933 1,237,933 1,237,933 1,042,000      807,025      815,096

% of sales 5.3% 7.4% 11.4% 11.2% 9.2% 7.0% 7.0%

ARPU (KRW)        44,202        44,601        44,601        44,601        44,601        44,601        44,163

Growth % 0.902% 0.0% 0.0% 0.0% 0.0% -1.0%

Valuation

My DCF valuation with the above assumptions and using WACC of 9.0% and perpetuity growth rate of 1% yields a NPV of Won 26,663 billion. Subtracting net debt of Won 2,048 billion gives equity value of Won 24,615 billion. Dividing by 72.6 million shares (not the 81million on Bloomberg since Bloomberg includes the treasury shares which has been bought back) yields a DCF value per share of the core business of KRW 338,756 per share (representing 61% upside to current price). However, if you add SK Telecom's non-core assets as well (worth KRW 30,115 per share), you get to a fair value per share of KRW368,871 per share representing 76% upside.

Trading Multiples - Very compelling on every measure

Trading Multiples	2006	2007	2008	2009

EV/EBITDA	4.1x	4.5x	4.1x	3.3x
EV/EBIT	6.6x	8.2x	7.2x	5.4x
EV/(EBITDA - Capex)	6.3x	8.9x	6.8x	5.2x
EV/FCF	9.0x	13.1x	9.4x	7.3x
P/E	10.5x	12.3x	10.7x	8.1x
EV/Sub (US$)	$908	$858	$788	$705

Why now?

We believe SK Telecom is close to an inflexion point with much of the negative news already priced in and with the following potential catalysts on the horizon:

· Realization that HSDPA isn’t a big deal and not as many subscribers are switching to HSDPA ?less HSDPA marketing expense

· Some research analysts starting to turn bullish on the stock and might lead to further upgrades (e.g. CSLA recently upgraded the stock)

· Increase in dividend payout ratio

Risks

1) Another round of irrational marketing war leading to increased marketing expense ratio. However, we do not think this will happen from SKT's recent stance on marketing. Further, our estimates have already factored in a worst case scenario for marketing expense increase.

2) Government cutting tariff. This is a risk that can happen and is difficult to predict. We can only keep monitoring.

Appendix/Additional Info

SKT has a number of overseas investments and non core aassets. They are:

· Helio, a U.S. MVNO that is a 50:50 JV with Earthlink (ELNK US). Currently loss making and not expected to be profitable until 2009. Might require total additional funding of US$100-200mil pro-rata between SKT and ELNK. We have factored the total US$75mil contribution to come from SKT.

· Vietnam (73% stake in SLD Telecom, a CDMA wireless JV). Currently loss making but gaining market share rapidly and expected to turn around in 2008. Forecasting additional W180mil funding to increase SKT’s stake.

· China Unicom. US$1bn convertible bond into 899.745 mil shares of China Unicom from July 2007 onwards. This option is already in the money.

· POSCO. SKT owns 2.48 million shares of POSCO currently worth W976B

· Melon. The itunes of Korea. This is the leading music download site

· Cyworld. The “Myspace” of Korea.

Note that both Melon and Cyworld have not been factored in our valuation.

Market share data

Market share	2001	2002	2003	2004	2005	2006
SKT	52.3%	53.2%	54.5%	51.3%	50.9%	50.4%
KTF	33.0%	31.9%	31.1%	32.1%	32.1%	32.1%
LGT	14.7%	14.8%	14.4%	16.6%	17.0%	17.4%

Net add market share

SKT 32.6% 61.9% 87.5% 15.7% 42.5% 40.0%

KTF 52.7% 22.5% 8.7% 43.0% 32.6% 33.0%

LGT 14.7% 15.6% 3.7% 41.3% 24.8% 27.1%

Catalyst

Lower marketing expenses than expected by the market for HSDPA. Further upgrades by research analysts and Increase in dividend payout ratio

show sort by

			2007	2008
Price:	210,000.00	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	15,894	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT

				My Assumptions
		2005	2006	2007E	2008E	2009E	2010E	Terminal Year
Revenue		10,161,129	10,650,952	10,863,971	11,081,251	11,302,876	11,528,933	11,644,223
	Growth		4.8%	2.0%	2.0%	2.0%	2.0%	1.0%

Advertising expenses		260,699	300,829	304,191	310,275	293,875	288,223	279,461
	% of sales	2.6%	2.8%	2.8%	2.8%	2.6%	2.5%	2.4%

Cellular Commissions		1,490,000	1,851,891	2,324,331	2,346,059	2,036,653	1,729,340	1,746,633
	% of sales	14.7%	17.4%	21.4%	21.2%	18.0%	15.0%	15.0%

Total Marketing expenses		1,750,699	2,152,720	2,628,522	2,656,334	2,330,528	2,017,563	2,026,095
	% of sales	17.2%	20.2%	24.2%	24.0%	20.6%	17.5%	17.4%

General Commissions		1,405,214	1,464,660	1,499,228	1,529,213	1,559,797	1,590,993	1,606,903
	% of sales	13.8%	13.8%	13.8%	13.8%	13.8%	13.8%	13.8%

Total Commissions		2,895,214	3,316,551	3,823,559	3,875,271	3,596,450	3,320,333	3,353,536
	% of sales	28.5%	31.1%	35.2%	35.0%	31.8%	28.8%	28.8%

EBIT		2,671,066	2,622,291	2,049,625	2,181,760	2,633,026	3,052,800	3,119,009
	% of sales	26.3%	24.6%	18.9%	19.7%	23.3%	26.5%	26.8%

EBITDA		4,217,351	4,269,845	3,725,494	3,827,800	4,286,326	4,734,665	4,793,644
	% of sales	41.5%	40.1%	34.3%	34.5%	37.9%	41.1%	41.2%

Capex		(1,416,622)	(1,520,000)	(1,850,000)	(1,518,131)	(1,525,888)	(1,556,406)	(1,548,682)
	% of sales	-13.9%	-14.3%	-17.0%	-13.7%	-13.5%	-13.5%	-13.3%

EBITDA - Capex		2,800,729	2,749,845	1,875,494	2,309,669	2,760,438	3,178,259	3,244,963
	% of sales	27.6%	25.8%	17.3%	20.8%	24.4%	27.6%	27.9%

WC change		(205,024)	-	(22,084)	(25,348)	(72,681)	(41,050)	(4,934)
	% of sales	-2.0%	0.0%	-0.2%	-0.2%	-0.6%	-0.4%	0.0%

FCF to firm			1,928,664	1,279,516	1,673,428	1,950,510	2,282,425	2,366,706
	FCF yield to Firm		11.1%	7.7%	10.7%	13.6%	18.2%	22.4%
FCF to equity holders			1,810,226	1,184,454	1,623,360	1,966,051	2,383,383	2,569,270
	FCF yield to equity holders		11.9%	7.8%	10.6%	12.9%	15.6%	16.8%

	Net debt (cash)		2,080,852	1,457,287	411,410	(957,810)	(2,725,682)	(4,677,697)
Enterprise Value			17,340,292	16,716,727	15,670,850	14,301,630	12,533,758	10,581,743

Other key info
Handset subsidies (captured within Cellular commissions)		542,000	787,933	1,237,933	1,237,933	1,042,000	807,025	815,096
	% of sales	5.3%	7.4%	11.4%	11.2%	9.2%	7.0%	7.0%
ARPU (KRW)		44,202	44,601	44,601	44,601	44,601	44,601	44,163
	Growth %		0.902%	0.0%	0.0%	0.0%	0.0%	-1.0%

Net add market share
SKT	32.6%	61.9%	87.5%	15.7%	42.5%	40.0%
KTF	52.7%	22.5%	8.7%	43.0%	32.6%	33.0%
LGT	14.7%	15.6%	3.7%	41.3%	24.8%	27.1%