Description

SK Telecom (“SKT”) is the leading wireless carrier in South Korea with 18.5 million subscribers (52.0% market share). SKT is the second largest company listed on the Seoul stock exchange in terms of market capitalization. In 2003, SKT’s revenues were W9,250 B (US $ 8.21 B) and net profits were W1,942 B ($1.67 B). We expect SKT to generate levered free cash flow of W1.8 trillion (US$ 1.55 billion) in FY2004.

SKT should generate levered free cash / share of W22,336/share and EPS of W24,183 in FY 2004. SKT trades at 8.1x 2004E FCF (12.4% free cash yield) and at 7.4x 2004E EPS. SKT generated a ROE of 33% in FY2003 (return on tangible equity was 83%) and ROCE of 17% (return on tangible capital was 25%).

Investment Thesis

* Dominant wireless company, likely to remain so: SKT is superior to its competitors KT Freetel (“KTF”) and LG Telecom (“LGT”) in terms of: brand franchise, quality of network, business economics/profitability, and scale. SKT charges a premium tariff to its customers and yet has gained share from its two competitors over the past few years. In fact before the launch of MNP (mobile number portability that allowed SKT customers to port out to KTF and LGT while keeping the same number) this January, SKT’s tariffs were on average 10%+ higher than its competitors. Even now SKT’s tariffs are slightly higher than those of KTF and LGT. Brand value is surprising to us in wireless service. However, anecdotally numerous Koreans have told us that (a) SKT’s network is superior and (b) there is a “snob value” associated in being a SKT customer—particularly amongst people 40 and older. This phenomenon coupled with scale has enabled SKT to generate amongst the highest EBITDA margins in the global wireless universe. Scale has numerous advantages. SKT and KTF will spend roughly the same percent of sales in 2004 as advertising and marketing spend, however, in absolute dollars SKT will spend about twice as much. It is hard to see how SKT’s dominant position is threatened. We have met with managements of both KTF and LGT and both informed us that they would never enter a price war with SKT as they realize that doing so would be self-destructive. KTF said they will “follow the leader” in terms of pricing and LGT said that SKT is a “ferocious” competitor with whom they do not want an “all out war.” We have heard that KTF’s head of marketing is concerned that they will lose a significant portion of the customers that they have gained under asymmetric MNP from SKT (since KTF subs are only allowed to port out beginning in July) once their subs are allowed to port out to SKT. Net, net, we find it hard to believe that market shares will greatly differ in the long run.

* Superiority of Installed Network: SKT’s network is superior to its competitors’ infrastructure as well do to the coverage area offered by its frequency (800MHz). KTF uses 1600 MHz, and LGT uses 1700 MHz. With the same number of cell sites, SKT gets about twice the coverage -- or SKT can simply install fewer sites (thus lowering capex) to meet comparable quality. Another advantage enjoyed by SKT as the first mover in the market was to locate towers at military installations. These tend to be at mountain peaks and other locations of highest altitude/lowest obstruction, a trait which also reduces required density of towers. Although vandalization of towers is not a huge problem in Korea, these locations assure the safety of SKT's equipment too.

* Free cash flow should grow: We expect SKT to grow its unlevered free cash flows 6.5% annually over the next 5 years. While we expect voice revenues to remain flat, considering that Korean wireless market is quite well penetrated, we expect wireless data revenues to grow about 15% pa over this time period. Blended revnues could grow about 3% a year. Over the past three years, SKT has grown revenues 19%. So while we expect the Korean wireless market to hit a growth plateau, we think that our research into the wireless data market reveals that fairly conservative and sensible assumptions could drive wireless data revenue growth to 15% annually over the next 5 years.

* SKT should generate a lot of Free Cash: SKT should generate a lot free cash flows in the coming years. Based on our discussions with competitors, we do not foresee a price war of any sorts in Korea. MIC (the FTC equivalent in Korea) is very keen to ensure that LGT remains a viable 3rd player. This led to MIC banning the use of handset subsidies. With growth slowing down and with preservation of business economics (since competition is controlled by MIC), SKT is likely to generate significant free cash flows starting this year. SKT has not laid out plans for what it will do with all of these cash flows. The management did mention that next year they might revisit their dividend policy and recently SKT’s board approved payment of interim dividends. So we think there is a good likelihood that a significant part of this cash flow finds its way to the shareholders. There are a couple of other reasons why this might happen. First, SK Group is under a watchful eye due to recent actions of SK Corp. and its management that called into question the level of corporate governance at SK Corp. Since SK Corp owns 21.5% of SKT and dividends would be a legitimate way for them to take out cash from SKT, we feel that SKT’s dividend could be materially increased from its current level of 25% of net income (3.2% yield). Of course there is risk that the SK Group starts to use SKT as a cash cow for the group and some analysts worry that SKT free cash might be used for raising SK Group stakes in other group companies. However, as per SKT’s articles of association, any capital use above W10 billion involving an SK Group affiliate could be vetoed by the external board of directors. Presently SKT’s board of directors is equally split between internal and external board members. Amongst the external board of directors, Professor Kim is a representative of PSPD, a minority shareholder activist group. Also another PSPD nominee Professor Nam, who just retired from the board, has been retained as an advisor to the board, albeit without voting powers.

Clearly the use of free cash is going to be a critical determinant of SKT’s value in the future years. At present there is foreign ownership limit of 49% of SKT’s outstanding stock. This limit has been reached in case of SKT and hence management is restrained from buying back stock (though management is retiring 2.0% of shares that it owns in treasury). All this sets up a high possibility of dividends being raised in the near future and that could serve as a catalyst for stock’s performance.

* SKT has underperformed the KOSPI: Over the last 12 months SKT has underperformed the KOSPI by 24%. Cyclical stocks have outperformed KOSPI and non-cyclical stocks like SKT have been underperformers with wide-held expectations of a recovery in domestic Korean economy. This underperformance and sub-market multiple for the second largest stock in the KOSPI provides us downside protection in case the Korean economy’s recovery is delayed.

Korean Wireless Market
* Competition: Prior to April 1996, SKT was the only wireless telecom provider in Korea. In October 1997, three additional companies commenced providing wireless telecommunications services. As a result of consolidation since 2000, there are currently three providers of wireless telecommunications services in Korea: SKT, KTF, whose largest shareholder is KT Corporation, and LGT.

* Market Share and Penetration:
2000 2001 2002 2003 4/31/04
SKT 47.1% 52.3% 53.2% 54.5% 52.0%
KTF 35.9% 33.0% 31.9% 31.1% 32.4%
LGT 17.0% 14.7% 14.8% 14.4% 15.6%
Penetration 49.4% 61.4% 67.9% 70.1% 74.0%

* Regulation: The Korean Ministry of Information & Communications (“MIC”) has taken an active role in regulation of the sector. For example, in June of 2000, MIC banned the subsidization of handsets. In May 2002, SKT, KTF and LGT were fined an aggregate of KRW20.0 billion (KRW10.0 billion for SKT alone) by the MIC for subsidizing handsets via back channels including dealer commissions, which were used to lower handset prices. MIC also has authority to approve or deny a company from altering its tariff structure.

MIC has generally established asymmetric rules for the Korean wireless carriers. The interconnection rate received by SKT, which is recognized as a "market-dominating business entity" under the Korean Monopoly Regulation and Fair Trade Act, is about KRW39/minute when other carriers terminate calls on its network. By comparison, KTF receives KRW48/minute, LGT receives KRW53/minute, and fixed carriers (usually KT Corp.) receive KRW15/minute.

Recently, MIC mandated that customers be able to port their numbers from one carrier to another, but this mobile number portability (“MNP”) begins to affect each carrier at different stages. For SKT, January 1, 2004 was the first date on which its customers could migrate their accounts to either KTF or SKT while still maintaining their old mobile phone numbers. KTF’s customers can begin to migrate on July 1, 2004, and all Korean wireless customers will be able to keep existing numbers regardless of who they select as their carrier when LGT becomes susceptible to MNP on January 1, 2005. Migration away from SKT has lagged the estimates of analysts and the carriers, and it now appears as though MNP is going to be a net positive for SKT.

* Prefixes: Each Korean wireless carrier has traditionally had its own exchange of numbers with prefixes as follow, but recently, an indistinguishable 010 prefix has been adopted for non-porting new customers of all carriers.
• SKT: 011, 017
• KTF: 016, 018
• LGT: 019
• All carriers (as of January 1, 2004): 010

SKT, the original wireless carrier in Korea, had as customers the first adopters of wireless technology in the market. As in most wireless markets around the world, the original customers were typically wealthy, and possessing a cell phone carried a certain social status. In Korea, these consumers were all SKT customers with a 011 prefix. Hence, the Korean market has ascribed a certain distinction to 011 numbers, making those SKT customers less likely to discontinue their service. Similarly, having a number that began with one of the other carriers’ prefixes (especially LGT’s 019) was viewed as a cheap alternative by brand-conscious Korean consumers. The addition of 010 numbers on January 1, 2004 changed this landscape. SKT, recognizing its branding abilities, began announcing before completing a call that the party being called on a new SKT 010 number was an SKT customer, but MIC quickly banned this practice.

Notably, many (1.97 million) new subscribers have been added in the first four months of 2004, and penetration has increased from 70.1% to 74.0%. This dramatic and unsustainable growth in the mature Korean market is attributable to several factors. 1) Price discounting and heavy advertising related to MNP have drawn new customers into the market, especially younger customers according to KTF management. 2) New customers have been drawn into the market by the 010 prefix and the opportunity to choose their number within the new 010 exchange. A double-count has arisen with this phenomenon, as many customers with an older prefix that generally is not desirable enough to port (016, 019, etc.) are keeping old accounts active for a short while to overlap with a new 010 account so as to be able to inform callers that their numbers have changed. 3) Dealers have reported “inventory subscribers,” phantom subscriptions that earn no revenue and that dealers activate to receive the sign-up commissions, which are higher during promotional periods. To be able to report these inventory subscribers, dealers pay the sign-up fees of approximately KRW48,000 per subscriber and sometimes buy handsets as well. Their goal is to fill these open subscriptions with actual subscribers at a later date when sign-up commissions have decreased to normal levels of KRW65,000-70,000 per new subscriber. Hence the new subscriber numbers in the first couple of months may have been inflated. Estimates of the level of exaggeration from SKT and KTF range from 10%-20% of new 010 subscribers.

* Capital Expenditures: SKT management will be able to manage its capital spending level to KRW1.7 trillion, roughly equal to last year’s level. Excluding certain one-time, non-network-related expenses in 2003 (such as KRW 150 billion for a new building), 2004E cap ex will actually be a greater percentage of sales (16.7% vs. 16.2%). With most of the landline backbone that SKT was building being completed last year, this 2004 guidance seems even more realistic. 2005 capital spending should be very similar to the 2004 level, as management has indicated its goal to once again spend KRW1.7 trillion. With a robust backbone completed, we estimate that future capital expenditures will approximate 16% of sales.

* Growth: With market penetration at 74.0% and with 77.1% of the Korean population being between the ages of 15 and 74, there may not appear to be much growth potential in the Korean wireless market. We discuss below the prospects for voice and data markets.

Wireless voice MOU’s penetration is high. In Korea, the proliferation of wireless telephony is cannibalizing wireline usage. Although the rate of this substitution is decreasing, wireless minutes of use are still increasing. Wireless outgoing minutes constituted only 21.5% of total outgoing minutes in Korea in 2000, but this share nearly doubled to 39.2% by the end of 2003. We expect the trend to continue with wireless minutes reaching approximately 48% share by 2007, although it does not appear that wireline will lose its market lead. While these trends continue at a slower pace, wireless MOUs will also benefit from future substitution as wireless tariffs fall more rapidly than wireline ones in a market marked by price elasticity. Programs such as KTF’s “One-Phone” convergence plan (by which customers have a single phone number from which they make wireline calls within a 50-meter “home zone” and wireless calls beyond that territory) will contribute to the slowing pace of substitution though.

Wireless data’s full market potential has not yet been realized. Wireless data is becoming an increasingly large portion of the Korean wireless market, and ARPUs are increasing (13.9% pa from 2003 through 2008E for SKT). The multiple segments of the wireless data market that will lead growth include short messaging, m-commerce applications, digital media broadcasting (TV to the handset) and downloads of ringtones, backgrounds, adult content and other content provided by third parties.

SMS ARPU should increase as additional components are added to short messaging abilities. Included in this group are not only short text messages but also multimedia messages, which should grow in the near term. Multimedia messaging services (“MMS”) include the ability to send brief voice or video messages over the data network just as a consumer might send a text message. The charge for downloading a ring tone or display background (but not the packet usage or data “air time” associated with those downloads) are also included here. We do not expect growth from this component of the SMS revenue line.

Analysts’ estimates and carriers’ growth estimates of the nascent m-commerce market vary widely. This segment includes m-banking transactions (balance checks, account transfers, etc.), debit card transactions, credit card transactions, ATM transactions, transportation card activity such as paying subway fares and other e-wallet transactions.

There are three components of the telematics market for vehicle-based services: navigation, entertainment and tracking. Navigation systems are GPS systems like On-Star that give diving directions. Groups such as the Telematics Research Group and others expect installation of telematics systems in Korean cars to grow in excess of 75% pa for the next few years. Entertainment services pertain to search features that can recommend a nearby restaurant or other destination. Tracking revenue is that used to locate vehicles that may be involved with shipping and delivery services or that may be in need of an emergency response. We assume that only a fraction of a percent of SKT customers will use this service each year, and it does not materially affect results.

* New applications and technologies are being adopted in Korea. Korea and Japan have traditionally been at the forefront of wireless innovation and technology adoption by consumers. Such opportunities to increase the size of the wireless telecommunications pie in Korea include DMB and mobile commerce. M-commerce is already starting to grow, with each carrier offering some form of mobile banking application linked to a cell phone. E-wallet (debit card), subway fare and credit card applications have been available for over a year. The economics of these card-related transactions include any standard fees from the data usage plus a small fraction (~0.3%) of the transaction size. The most recent additions to the Korean wireless carriers’ m-commerce offerings are mobile banking (account inquiries, deposit confirmations, money transfers, etc.) and ATM withdrawals. For their m-banking services, SKT and KTF charge KRW800/month or KRW6.5 per 512 bytes of data. This pricing excludes any traditional banking fees associated with transactions. According to a recent industry survey, 48% of subscribers are expected to gradually embrace these m-commerce services as banks and large retailers begin to push them.

Digital multimedia broadcasting (“DMB,” also known as “satellite multimedia broadcasting,” or “SMB”) is expected to be rolled out by TU Media (30% owned by SKT, 5% owned by KTF) in Q3 2004. DMB cannot carry voice or two-way data transmission, just a broadcast; MIC regulations prevent such a broadcast from being transmitted to viewers in a home watching a television set. Although SKT through its ownership of TU Media will likely allow other carriers to offer DMB services to their customers so as not to attract attention from MIC, SKT should have a 6- to 12-month head start on the competition in offering handsets for this driver of data ARPU growth. Initial pricing plans are expected to be about W13,000/month.





Catalysts
* A key concern for SKT is future growth, considering that penetration levels are high. Our work on data revenue forecasts suggests that our forecast of 15% pa growth in data revenues is appropriate. We think that robust data revenue growth will provide a catalyst for SKT’s revaluation.

* There is considerable amount of skepticism about SKT’s ability to deliver to its targeted profit levels for 2004. We believe that SKT will report higher revenues, EBITDA, and net profits for 2004 than many sell-side analysts expect. SKT should close the year with higher profits than its Q1 results imply as marketing expenditure should come down in the second half of the year.

* There is a distinct possibility that SKT could meaningfully increase its dividend. Either SKT will grow faster than the market expects, or it will generate a tremendous amount of cash. With the MIC-imposed limitation of 49% foreign ownership (which has been reached), SKT likely will not be able to buy its own shares. Given the scrutiny of SKT and all other SK Group affiliates as of late, management seemingly will not be able to misappropriate the cash it generates. Hence, we feel the most probable use of this cash is an increase in the dividend, which could serve as a nice catalyst for SKT’s stock. If management cannot buy back 2% of its shares at the end of 2004, it will instead issue a special dividend (in addition to the ordinary dividend equal to 25% of net income) in this amount. Total yield of the ordinary and special dividend would be approximately 5.2%.

Catalyst