Description

At current prices, Shinsegae E&C (“E&C”) is a stable to growing 19% FCF yield with predominantly contractual cash flow for the next several years.  As the company transitions away from its primary revenue source of building supermarket/department stores for the largest Korean retailer, its other revenue sources (commercial and civil construction and operating owned golf courses) are growing rapidly. 

 

This is a US$160mm market cap company that only trades US$75,000/day on average, so this idea is clearly not for those with a strong need for daily liquidity (we took our position primarily via block trades).  That said, the nature of this investment (huge margin of safety, contractual c/f with no capex risk, etc) gives me plenty of comfort in owning this.

 

Key Valuation Metrics (valuation is discussed more fully below)

FD Sh/out	4.0
Price	37,000
Mkt Cap			148
Est. cash at 3/31/07			48	(cash at 12/31/06 was 38bn)
Securities			9
EV			91

19% 2007 FCF yield to equity (NI plus depreciation less capex)

2.4x 2006 EBIT, 2.6x 2007F EBIT

5.8x 2006 earnings, 5.7x 2007 earnings

3.5% dividend yield (using expected 2007 dividend; 2.7% using trailing)

 

Investors should get the company’s January 11, 2007 investor presentation from the company’s website at www.shinsegae-con.co.kr/ir/IRNews.asp (original English page/link is being restored and presentation is being updated, but this gets you to the latest English presentation) which lays out projections and a lot of other data.

 

Business

Like many publicly-listed construction companies in Korea, E&C is really a contractor and architectural/engineering services firm.  Its construction contracts typically have pass-through or cost-plus provisions for increases in labor and raw materials during the project, labor is typically subcontracted out, and equipment is leased.  As a result, like most of its peers, E&C’s depreciation and capex are less than 1.0% of revenue (i.e., de minimis), margins are generally stable (i.e., no cost overrun issues), and with a 27.5% tax rate, FCF is typically very robust.

 

There is plenty of sell-side research on the overall Korean construction market (for each segment) by local and international firms (CLSA, Macquarie, Morgan Stanley, etc), although the industry environment isn’t really core to the thesis for E&C.  Its worth noting that generally non-residential construction in Korea is somewhat counter-cyclical (federal government uses it to pump prime the economy), the ’07 outlook/government budget is pretty good after a so-so 2006 year for new orders, and the EBIT/EBITDA multiples for all the well-covered construction companies are over twice those assumed in the analysis below.

 

E&C has three primary sources of revenue, each fairly straightforward.

 

Construction work for Shinsegae

Shinsegae (ticker: 035510; US$13bn mkt cap) is the largest department store and supermarket retailer in Korea.  Trading at a deserved premium to the market multiple, Shinsegae is widely-regarded as an excellent operator with strong growth prospects and highly-respected management.  In early 2006, Wal-Mart exited Korea due to inability to compete successfully against Shinsegae and Carrefour, and sold its 16 stores to Shinsegae.  Shinsegae owns 35% of E&C and actively influences E&C’s dividend policy, etc.

 

E&C has a contract to build all of Shinsegae’s E-marts (mid-size grocery stores/supermarkets) and department stores in Korea.  As laid out in E&C’s investor presentation, there are still approximately 47 E-marts and 3 large department stores to be built in the next 4 years.  For E&C, the average revenue it will receive for the E-marts is 25-30bn Won (E-marts range from 25-35bn depending on size and location) and for department stores it is 200bn.  This is in-line with the prices received by Shinsegae in the last few years.  E&C earns a 5% operating income margin on its Shinsegae business and has the ability to pass-through most cost increases.

 

With respect to the 47 E-marts and 3 department stores to be built, I would note that not only has Shinsegae taken a conservative approach and bumped up its footprint estimates a few times in the past two years, but it has already purchased the land for the substantial majority of the E-marts to be built i.e., it is fully committed, and is incentivized to build out its footprint quickly.  By 2010, Shinsegae will have over 150 E-marts and 20 department stores and may focus more on overseas opportunities.

 

Assuming only 25bn/Emart and 200bn/department store, the present value (at 12% discount rate) of the after-tax EBIT from the E-marts and department stores to be built is 52bn. 

 

In addition, E&C handles all the re-modeling work for Shinsegae.  Every few years, E-marts and department stores require re-modeling/maintenance, and on average, it works out to be about 0.4bn/store per year for the E-marts and 5bn/department store per year.  With ~150 E-marts (includes 16 Wal-mart stores recently acquired by Shinsegae) and 9 department stores at maturity, plus some other Shinsegae projects (outlet stores, etc), and assuming a 5% EBIT margin, I believe this component is worth 35bn Won (6x EBIT or 9x earnings).

 

In addition, there are 3 new projects that Shinsegae has contracted E&C to work on (Chelsea outlet stores, a major shopping mall complex in Pusan and the reconfiguration of the Wal-marts it bought).  Details on these are below (and also in the investor presentation).

 

Construction work for third parties

E&C is focused on rapidly growing this business (for commercial, civil and residential construction) given that its business with Shinsegae will wind down after 2010.  E&C’s third party business typically runs at 6-7% EBIT margins (a little lower than industry averages for commercial and other construction) and  has grown incredibly fast as it begins to focus on non-Shinsegae projects, with third party orders in ’07 expected to be 500bn versus 245bn.  The company’s 2008 projection is for over 600bn of third party orders and continued growth in 2009 and 2010.  

 

Civil engineering projects often require a basic amount of “pre-qualification” or PQ points to participate in the bid, and E&C has been accumulating these by taking a small role in big construction projects led by an established player.  In addition, E&C now has the balance sheet to participate in SOC projects (under which the government guarantees a return on equity investment).

 

To be conservative, we have valued this business at 5x EBIT (7x earnings at 27.5% tax rate) and assumed revenue of 400bn Won and EBIT margins of 6.5% (i.e., well below ’07 expectations, let alone ’08).  That gets you 130bn of value.

 

Given that the company has built up an impressive track record of projects, and is able to leverage the Shinsegae name/brand (namebrand/reputation is an important element in the construction industry in Korea as any developer will attest to), 7x earnings seems low.  As one can see from reviewing E&C’s recent projects in its investor presentation and talking to the company, and given its build-up of PQ points, E&C is poised to continue winning larger and larger projects.

 

Golf course

E&C is also a golf course operator.  It generated 20bn of revenue and 2.8bn of EBIT in 2006 from leasing golf carts, equipment, etc. at a high-end course that it owns, and EBIT should continue to increase steadily by 10+% in ’07 and ’08.  Golf is a national obsession in Korea, and the limited amount of land has caused green fees to rise steadily in the past several years.  By using a 6.5x EBIT (9x earnings) multiple on 3.2bn of ’07 EBIT, we get to a value of 21bn.

 

The company recently acquired land adjacent to the existing golf course for an attractive price (the owner was undergoing a major restructuring) which it will develop into another golf course with expected additional EBIT of 3.5bn.  Pre-sold memberships of 120+bn (the assumptions on this are conservative) should be received in the next 18 months and will finance the construction of the golf course and an IRR of 20+% is expected from this project.  While we can debate over what this course is worth, we are simply using a value of 6.5x EBIT or 23bn for the second golf course rather than the higher book or liquidation value.  Although this EBIT won’t start coming in until 2009, we are not factoring in the excess cash flow from the membership sales over and above construction cost.

 

Valuation

This is what I think E&C is worth:

 

			Value	Assumptions
Cash and securities			57
E-mart, dept store c/f at 12% disc. rate			52	25bn/E-mart; 5% EBIT margin
Re-modeling business			33	6.0x EBIT valuation
Wal-Mart conversion business			3	90bn of revenue; 5% EBIT margin
Chelsea stores at 12% disc. rate			3	100bn of revenue; 5% EBIT
Pusan project at 400bn revenue			11	5% EBIT margin; 25% discount
Existing golf course			21	6.5x EBIT
New golf course			23	6.5x EBIT
Core Business			130	400bn of revenue; 5.0x EBIT
Value			333
		per share	83,231

 

E&C is in a relatively dull business and one can sleep decently knowing that both the cash steadily generated from E&C’s contracted business and the revenue growth at E&C should slowly force up the share price by making a very cheap/asset-rich company even cheaper every quarter. 

 

Within a year from now, if the share price is unchanged, E&C will be trading at under 2x EBIT.  Meanwhile, there is upside to my EBIT expectations considering that Shinsegae may announce more retail and other projects as it keeps doing. Note that the above assumes the Pusan shopping mall project (aka Centum complex) is 400bn of revenue to E&C but this is under 50% of the expected revenue E&C is budgeting in the company’s investor presentation (I am being obscenely conservative and factoring in any timing issues).

 

Investor Transparency

In addition to the investor presentation and detailed financials available from KISline, E&C has nice audited annuals and semi-annuals in English (prepared by Deloitte & Touche) that the company will send out upon request.  I met with management in Seoul in January for the second time and have found the CFO and IR/Treasury guy to be very friendly and accessible by phone and email.

 

ABN Amro produced some OK reports in English on the stock for a short period in 2006 but the analyst has since left ABN.

 

Risks

Given that the rock solid balance sheet provides a huge margin of safety, and one is effectively creating a going concern construction business for almost nothing and getting other stable cash flow assets too, I believe the biggest risks are simply capital allocation. 

 

E&C is returning around 30% of net income to investors and management reiterated to me in person that investors should fully expect to see the annual dividend continue to go up materially, as it has done every year since 1999.  As mentioned above, its 35% owner, Shinsegae, is an economic and shareholder-friendly company that is unlikely to create ill will and screw other shareholders by pushing E&C to do something that isn’t arms-length or reasonable.

 

Its likely that E&C will continue to invest cash flow into projects such as the golf course, although its track record and the fact that such projects are far more likely to possess a better return than idle cash give me comfort that these are an economic reinvestment of cash flow.

 

Conclusion

Go ahead and put a sum-of-the-parts or liquidity discount.  However, I don’t think one can hair-cut the above assumptions or use lower multiples without being downright unreasonable, and I still come up with 330+bn of NAV on a 148bn market cap company with solid corporate governance and good transparency.  I can easily argue that the company’s construction business is worth 50% more than assumed in this writeup, and still be in low earnings multiple territory.  Either way, it seems likely that the market should start to properly value this business as it becomes a greater part of the EBIT and this is not labeled as just a Shinsegae story.

 

Moreover, with a 19% (contractual) FCF yield to equity, a ~3.0% minimum dividend yield and at 2.6x EBIT, its hard to see how one cannot consider this an attractive risk-reward.  Its possible mgmt will truly find religion and buyback stock, or sell-side coverage will resume, but whether these events occur or not, shareholders should be able to invest in this cash flow machine with a de minimis chance of permanent capital impairment and plenty of upside over a 12-18 month period.

Catalyst

Recognition of the company's non-Shinsegae business as this becomes over 50% of revenue and EBIT in '07, and continues to grow
Resumption of sell-side coverage
Screening cheaply i.e., will be under 2x EBIT if stock is unchanged for 12 months