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Most companies on my low price-to-book screen are U.S. sub-prime lenders, so I was interested when Korea Electric Power Company [KEPCO] (NYSE:KEP) popped up.

If you only look at the numbers, KEPCO looks pretty good: yield 2.92%, debt-to-equity 0.48, P/E 9.7. Unfortunately, a little background of the company spoils the beautiful picture.

KEPCO was once a wholly government affair, and was well run until the government pledged to the IMF during the Asian financial crisis to privatize it as a condition of a US$57 billion bailout loan. Under the resulting Basic Plan for Restructuring the Electricity Industry, approved in 1999, KEPCO’s power generation facilities were formed into six subsidiaries; five to be privatized and one, Korea Hydro & Nuclear Power Co., to be kept for security reasons. The sales, however, were halted. In 2004, a new administration suspended the basic plan, and it looks like KEPCO will remain government controlled. Under law, the government must retain a 51% share.

The government also regulates KEPCOs power rates, and national policy has traditionally forced commercial users to subsidize industrial, home and agricultural use, so the rate structure does not well reflect the company’s costs. There have been some rate increases to lift the company’s low rate of return, but more are needed and the govt. is hesitant to raise rates too fast, trying to achieve its goals by cutting costs at KEPCO instead.

On the bright side, the company’s debt, which exceeded its equity in 1998, has been reduced to 48% of equity.

As the electricity market in Korea is mature, for growth, they’ve been undertaking overseas projects, building and refurbished power plants in the Philippines; consulting on projects in Vietnam, India, Burma and Pakistan; and partnering in a Chinese coal mine. If they stuck to such projects, they might do well, but the government has saddled them with two large burdens:

1) KEDO, the consortium of countries that was to build two light-water nuclear reactors for the North in exchange for shutting down uranium enrichment activities, has backed out of the deal with the reactors 33% completed. South Korea agreed that KEPCO would assume the resultant debt, and in return keep any materials remaining in S. Korea that had been intended for the project. KEPCO estimates liquidation will cost US$150-200 mil., while the materials and equipment are worth US$830 mil. Nice on paper, but, it will be hard to actually use or recycle these materials, since the equipment is designed for different standards than those used in much of the rest of the world. Further, if there is a profit, KEPCO is expected to share it with the other contributing countries of KEDO while if there is a loss, they eat it themselves.

2) To revitalize KEPCO amid a mature electricity market, The Ministry of Commerce, Industry and Energy announced a major five-year plan to develop eight technologies, including IT-enhanced solutions for electricity distribution and transmission, and carrying broadband Internet over power lines. Some have potential, but whether there will be any actual demand for the resulting products is unknown. KEPCO will be required to purchase and promote the resulting products.

Finally, the two developments that have sent the stock price down and onto my screen:

On Feb. 8, KEPCO said its 2006 net profit fell 15.4% from a year earlier on a rise in fuel costs. Sales were up 7.4% year-on-year but operating profit declined 7.1%. Worse, KEPCO suffered a 4th quarter loss, (though less than in the previous year) after a profitable 3rd, due to high oil prices and cheap winter electricity unit prices.

KEP 1-yr chart
KEP

Disclosure: Author has no position in KEP.

Source: Korea Electric Power Company: The Not So Pretty Picture