Emerging markets value: A case study

In previous posts I have discussed my conviction that US markets are far too expensive to justify a large chunk of my capital currently. Instead, I have been focusing a large amount of my time in foreign markets, particularly the Emerging Markets, which display unusually cheap valuations today (https://superfluousvalueblog.wordpress.com/2020/04/23/fertile-hunting-grounds/).

Continuing along this vein, I am going to outline my thesis for what I consider to be one of the most attractive investments on the planet- KT Corp (KT:NYSE). I added the stock in November at $11.09 a share and I continue to hold a 5% exposure. I would like to add in the future, but KT didn’t fall as far as many others during March Madness and I am sitting tight for now.

KT Corp is Korea’s second largest telecom and one of its largest chaebols (conglomerates). The company started life as a public utility (Korea Telecom) before being privatised in 2002.

KT is a modern telecom “quad play” (combining broadband, entertainment, telephone and wireless services), but is perceived as a stodgy, declining dinosaur. This is were I see the huge mis-pricing in the business. While KT provides modern services and has grown modestly over the last five years, it is still being priced like a melting ice cube/value trap.

The company’s legacy is actually a strong plus, as it allows delivery of its current bundles through access to its dominant infrastructure network. This is an enormous advantage in a sector where a moat is generally hard to come by. In fact, KT’s infrastructure will see it earn substantial fees from its competitors SK Telecom and LG Uplus as 5G is rolled out.

KT was lead by Chang-Gyu Hwang from 2014 and has just announced his successor Ku Hyeon-mo, who is a KT insider and I hope will be a steady pair of hands to continue the progress enacted over the last several years.

Under Hwang, the business grew revenue from 22 trillion Korean Won (tKW) in 2015 to 24tKW today. These are not barnstorming numbers, but they are far from a company in terminal decline. Additionally, the company gained 800 000 subscribers in wireless last year and 180 000 in broadband. Another bright spot was media revenue increasing 13% on continued uptake of KT’s entertainment and music platforms. In the negative, Telephone revenues declined 7.6% and will continue to be a shrinking part of the business.

Korea is classified as an Emerging Market and trades like one at a CAPE (Cyclically Adjusted PE Ratio) of 10x. In spite of this, I view it as having much more in common with its developed-world neighbour Japan than many of its Asian emerging peers, with strong and improving corporate governance, an accountable rule of law, low levels of corruption and high standards of living. GDP growth has also been relatively stable between 2-4% over the last 8 years.

The huge South Korean tail risk is obviously the barbaric political regime to the north. While this issue isn’t likely going away anytime soon, an investor is paid to bear risk sensibly and is currently being well compensated for the KJU factor in South Korean share prices.

A China slowdown would also hit Korea hard. Although it is far from the only country that would suffer, with a huge amount of global growth coming from China over the last decade.

Foreign investors in South Korea have the benefit of a cheap currency adding a future tailwind to their investments. The Won is currently close to 5 year lows against the USD. I have no ability to predict currencies, but I prefer a lower starting point than a higher one.

The impact of Covid-19 on KT, as on many companies, is still unclear. I am confident, however, that broadband and telecom companies will fare better than most. Clearly, fast reliable internet is a necessity for work and passing time under lockdown. Either way, KT has ample liquidity to make it through this period, with 2.3tKW in cash and EBIT of over 4x interest payment for 2019.

The current dividend yield is 4.2%, although I would be very happy for KT to withdraw this and husband cash until we are through this crisis (as I am for any company I own and I think most should).

So where do we stand on valuation?

To describe its current stock price as cheap is a monumental understatement. KT has market strength, predictable revenue and trades for extraordinarily cheap multiples of EV/EBITDA and P/FCF. The fact KT is available at these prices is a testament to the way EM stocks and traditional value sectors have been left for dead of late.

The company has an EV (enterprise value) of 11tKW (6tKW market capitalisation + net debt of 5tKW) and produced 4.7tKW in EBITDA last year. You read that right an- EV/EBITDA of 2.34x. EBITDA has been a stable denominator over recent history, rising slightly from 4.6tKW in 2015.

It is inconceivable to me that KT could remain at such a ridiculously low valuation when you consider its global comps. For example- its Korean stablemate SK at 4.8x, Nippon Telegraph at 3.8x (much more legacy than KT), the long suffering Telecom Italia at 4.8x, Telefonica Brasil at 5.5x, Liberty Global at 6.7x and AT&T at 6.7x. Many of these names are considered cheap themselves and currently have value activists pushing for change, so KT is truly the cheapest of the cheap. It is also much more advanced in its journey to full quad play status than many of these peers.

It is quite plausible that one day KT will trade at an enterprise multiple of 6x. This seems a far cry from today, but I it may prove conservative once the companies legacy phone business shrinks further and the cash generation and new reality of its 5G driven quad play bundles becomes more apparent. On current debt levels, that would see a four-bagger for the equity ($36 per ADR share).

I never use an EV multiple without a cash flow multiple for context, otherwise you will continuously find yourself tied up with companies drowning in maintenance and capex expenses and their operating profits will never reach you. KT is luckily a strong free cash flow generator.

For 2019 KT produced free cash flow of 500 billion KW (3.7tKW net operating cash flow – 3.2tKW capex), for a P/FCF of 8%. However, 2019’s capex was a huge year of build out preparing for 5G and I expect it to return towards its five year average of 2.5tkW annually, which would give a 20% yield to equity holders going forward. This number also assumes no growth in the business, which I consider unlikely, but builds a margin of safety into the price.

Extra value can be found in KT’s investment property portfolio, which has a carrying value of 1.4 tKW (25% of the current market cap) on the balance sheet. These are not used in telecom operations and carried separately to KT’s operational PP&E. They could be sold to access liquidity with only a minor impact on net profit (the rental income). Note 12 to the financial statements explains that the company considers fair value of these properties to be 2.3tKW (40% of the current market cap) by NPVing the expected rental flows.

So in summing up, KT Corp is the sort of deep value situation I love to own. It is a stable business, with strong cash flows selling for very low multiples and in my opinion, doesn’t require a spreadsheet to value. My intrinsic value is $36 based on an achievable future enterprise multiple of 6x. I have assumed that the company won’t see any growth in revenues or EBITDA and am ignoring property investments for the sake of conservatism.

I expect to see these returns through a mixture of dividends (current yield of 4.9%) and multiple expansion over a 5-7 year time frame. I will need to drastically revisit my thesis if revenues, EBITDA or operating profits fall permanently, capex remains sustained at high levels or new management behaves in a value destroying manner.

Guy

PS. I have never publicly written about stocks before and wanted to say- please be aware I am not an investment professional. I’m just an extremely passionate retail investor, who is very happy discussing what I do- warts and all. Make sure you do your own research with any stock you buy and seek financial advice if you’re not confident and competent. Happy investing!