SK Telecom: Market Leader On Sale

SK Telecom (SKM) is the leading wireless telecom operator in South Korea, providing 3G voice and data services along with "convergence" services such as portals, mobile entertainment, satellite GPS, etc. They also have operations in Vietnam, the U.S and Mongolia as well as a significant stake in China Unicom (CHU).

Valuation

• Intrinsic Value: at least $40.
• Accumulation Range: $25 or better

SK Telecom generates significant free cash flow and on this basis, the company looks very cheap. Based on a 5-year average FCF of 1.5T (trillion) KRW, SKM trades at around 12x FCF. For the 9 months ending 09/30/2007, FCF was 1.45T KRW so that 5 year average looks solid or even understated.

Running a crude DCF analysis, assuming 3% growth on 1.5T KRW FCF, gives a rough valuation of $36 per ADR. 1.7T KRW FCF puts intrinsic value around $41.50 per ADR. At 2T KRW, which the company has generated in the past and could very well hit in 2007 once Q4 results are announced, we get a value of $50 per ADR. Tightening the range, I'm comfortable using an intrinsic value of at least $40 per share.

Examining the company's efficiency, SK Telecom seems a solid company. ROIC (as measured by Greenblatt's pre-tax returns on operating capital) has slipped from 37% a year ago to slightly under 30% this year. I've added 15% of depreciation back in as CapEx:Deprec&Amort has averaged around 85% over the last few years. That ratio may be a little fuzzy due to the difficulty in isolating solely operating revenues but I'm confident within 5-7%. The declining trend is worrisome but explainable due to the current price wars in the handset market and associated subsidies. If the incoming President lowers mobile tariffs as promised, returns and margins will slip further but so far, indications are these tariffs will be moderate and voluntary.

Finally, the company's balance sheet is attractive. Debt levels are very low at around 30% of equity and some analysts consider the company underleveraged. They have over 500B KRW in cash as well as sizable stakes in China Unicom and Posco shares which are not reflected in the cash flow analysis due to non-cash appreciation.

The Skinny

In keeping with our theme to diversify away from the U.S dollar, SK Telecom is an attractive opportunity. While I am hesitant to describe the company's wireless operations as having a moat, SK Telecom has proven its ability to maintain its position in the midst of a fierce price war over the last year or so. In fact, they've managed to add market share in that time period.

So why would an entrenched market-leading company be available at such attractive levels? I would put forth that it is a combination of factors: 1) the threat of further regulated price cuts; 2) general anxiety of a U.S-led slowdown affecting the world economy; 3) historic market discount of the S. Korean stock market.

Investors are also probably turned off by SK's lack of strong growth prospects. However, I have never been as focused (obsessed) as analysts on this aspect; after all, it's possible to generate growth that destroys shareholder value. As it is, SK Telecom may be the example that proves the point as I would consider the Helio venture to be a poor opportunity.

The S-Fone venture looks much better, with SK seemingly increasing their share of new adds above their proportion relative to the market (20.6% of new adds vs. 9% market share). Vietnam has a huge under-served population and it is encouraging that the government there has allowed SK to own a 73% stake in the company. Management has made no mention of any interference or blockage by the Vietnamese government, which is encouraging.

The company also has a sizable investment in China Unicom, ostensibly to build a relationship to take advantage of the Chinese market. However, other than the paper gains, little tangible gain has come out of this supposed strategic investment. As rumors have swirled for some time of a break-up of China Unicom, it is unclear what SK Telecom's strategy will be toward entering the Chinese market.

SK Telecom is also coming into the tail end of their domestic capex cycle. They've expanded theWDCMA network with HSDPA capability, allowing for faster downloads and are working on HSDUA and WiPro buildouts (for faster uploading and wireless broadband, respectively). This should be beneficially reflected in two ways: 1) higher ARPU and margins as customers upgrade up the technology value chain; 2) increased cash flow as capex comes down.

In the end, discounting any foreign market growth (Vietnam, U.S, China, Mongolia, possible North Korean reconciliation) adding anything to the top or bottom lines, SK Telecom is still the market leader in the one of the world's most advanced wireless societies. My expectations for their non-domestic businesses and their convergence strategy are very low and I am not basing the investment thesis on this.

Basically it is a question of valuation. Their cash flow, operating results and dividends should be stable going forward and the stock is priced such that it's a fairly low-risk proposition.

Performance Measurements

• 2008 FCF ~1.7T - 2.0T KRW
• Marketing expenses (commissions paid + advertising as shown on income statement)
• Keep market share stable or slightly increasing.
• See Vietnam S-Fone venture become "successful" (i.e. generate FCF).
• Maintain or increase dividend payout.
• Integrate Hanarotelecom and recognize synergies via bundled offerings.

This is an excerpt edited specifically for Seeking Alpha. You can find a more thorough detail of risks, upside, probabilities and management here.

Disclosure: Author has a long position in SKM