Korea's economy will likely grow 3% this year, while Japan is expected to grow by about 1.5%, the U.S. by 2%, and the four largest economies in the European Union (Germany, France, Italy, and Spain) are expected to decline a combined 0.3% in 2013, according to the IMF. Among the developed countries, Korea offers some of the best opportunities for economic growth. Three Korean companies that will benefit from this continued economic strength and whose shares are traded on a U.S. exchange are the steel giant POSCO (PKX), KB Financial Group (KB), and Korea Electric Power Corp (KEP). These three companies are leaders in their areas and their shares seem undervalued compared with other global companies in their industries. Importantly, these companies will likely deliver even stronger results if relations between Korea and North Korea improve.
Benefits of developing business relations with the North
North and South Korea share the same culture, language, and history. However, following World War II, the country was artificially divided in two along the 38th parallel. More than 60 years later, the North has a population of 24.5 million, a land mass of 46,528 square miles (size of Pennsylvania), and a 2011 nominal GDP per person of $506. At the same time the South's population is around 50 million living on 38,691 square miles (slightly larger than Indiana) with a 2012 nominal GDP per person of $23,100.
POSCO, KB and Korea Electric Power will benefit almost overnight in the case of stronger ties between the two countries due to the following major reasons:
Sharing the same culture, ethnicity, language, and history, and
Lack of competition in the North in the areas of steel production, financial services and electricity generation and distribution.
In addition, there are company specific benefits for each company. For POSCO the benefit is two sided. In terms of raw materials, the North can provide coal and iron ore as it has major reserves of iron ore and coal as well as other minerals used in the production of steel. POSCO usually imports coal and iron ore from around the world and as far as Quebec, Canada, as seen in POSCO's recent investment in an iron ore mine there. And on the demand side, North Korea will need to upgrade its infrastructure (roads, railways, airports and buildings) and its citizens will likely want to buy modern appliances and cars. Steel is a major material used in all these products.
The only bank in North Korea with an estimated 220 branches is the Central bank. It was created in 1946 and, following the merger between the Central and Farmer's bank in 1959, it remains the single financial institution in North Korea. KB Financial is likely to benefit from having access to 25 million new consumers who have lacked access to modern financial services including loans, credit cards, mortgages, and investment and retirement services. Another advantage is that KB Financial is the largest bank in South Korea and also has experience in emerging markets including China, India, Vietnam, Cambodia and Kazakhstan. All this, together with the more general advantages that all Korean companies share in entering their Northern neighbor's market, should contribute for a significant revenue and profit boost for this leading Korean bank.
Finally, similar to POSCO, Korea Electric Power should benefit from access to new customers as well as sources of energy. Despite having access to coal and hydro-power sources of energy, North Korea is significantly behind in electricity consumption. The country's electricity situation is described in this recent article from the The Atlantic Cities as being in an energy bankruptcy. And according to the International Energy Agency, energy use in South Korea in 2010 was 2,908 Terawatt hours (Twh) of which 2,571 Twh was imported. North Korea produced 236 Twh of energy of which it used 224 Twh and exported 12 Twh.
Korea Electric Power is virtually the only company generating and supplying energy in South Korea. It is a vertically integrated company with its six regional power generating subsidiaries as well as segments that engage in the design, building and maintenance of electricity generation plants and transmission infrastructure. Also, Korea Electric Power has recently expanded in other developing markets in Asia and Africa and it should be able to establish itself in the neighboring North Korean market.
Business condition and valuation
Even without better relations between the two countries materializing in the near future, POSCO, KB Financial and Korea Electric Power common stocks offer good investment opportunities. POSCO should be able to benefit from demand in South Korea as it controls 42% of the Korean steel market. In addition, any decrease in the price of iron ore and/or coal will benefit the company's bottom line. A declining South Korean won, or KRW, will make its input costs higher but end products more competitive. On the other hand a strong KRW against other currencies will make input costs lower, which is more beneficial for POSCO as it is already a low-cost producer of steel. The KWR has declined against the U.S. dollar by about 4% so far this year and a reversal is expected. In addition, declining commodity prices are currently benefiting POSCO.
KB Financial is a conservative bank by European and U.S. standards. This is due mainly to the Asian financial crisis that the region experienced earlier than the U.S. and European financial crisis of 2008. In addition, banks in Korea play a much larger economic role due to limited sources of alternative financing (private equity and hedge funds) and an economy that is focused on capital intensive industries (machinery, autos, appliances and electronics). In terms of assets, KB Financial is the largest bank holding company with about 13.7% of all assets held by local lenders followed by Woori Bank (WF) with 13% and Shinhan Bank (SHG) with 12.5%.
Similar to POSCO, Korea Electric Power is well positioned to benefit from an increase in electricity demand in South Korea. In addition, even though the company is the only major power generating (over 80% market share) and distributing (over 90% market share) company in South Korea, it spends a significant amount in research and development making it a highly competitive monopolist. Also, it is developing new power plants and modernizing existing ones in a number of countries (including Indonesia, India, Senegal and Jordan) as well as coal (Indonesia and Australia) and uranium (Canada and Niger) developments.
Korean Electric Power is managed conservatively and the company is expected to generate its first profit since 2007 in 2013. Due to these recent losses and recent power shortage issues in South Korea, the company expects to successfully negotiate with the government for higher rates. The company is the fourth-largest electricity generator in Asia and is well positioned to benefit from increasing demand for electricity in Korea, which is expected to outpace the increase in GDP for the foreseeable future. Below is a table of major valuation and fundamental metrics for Korea Electric Power, KB Financial, POSCO and the S&P 500.
Enterprise value [EV]
One year total return*
Source: Capital IQ and Thomson Reuters. EBITDA - earnings before interest, tax, depreciation and amortization.
* As of April 19, 2013
POSCO, KB Financial and Korea Electric Power are the leaders in their business areas in South Korea and also have significant international exposure. Their shares are inexpensive based on a number of measures even though they operate primarily in an economic environment that is healthier than those in Europe and even the U.S. There are risks due to economic uncertainties and high household debt in South Korea. However, there is significant margin of safety with their shares. In addition, investors in these companies are holding an option whose value will be realized if South and North Korea improve economic ties. These three companies are well positioned to benefit by providing all the necessary steel, financing and electricity (and also taking advantage of the natural resources in the North) to their northern sibling if it decides to take the path of a free economy.