Top 2 Stocks In South Korea
Summary
- Analysing the top 50 companies in South Korea, we endeavoured to identify the top few which unequivocally represented the South Korean market.
- This came in the form of Samsung Electronics and SK Hynix, which undisputedly commands South Korea, and also hold their own on the global landscape.
- In determining the prospect of buying these 2 stocks, we analysed not just these companies in depth, but also the South Korean economy and the semiconductor memory industry.
Source: Samsung, SK Hynix
Samsung Electronics (OTCPK:SSNLF) & SK Hynix (OTC:HXSCL) take the crowns as the top 2 companies in South Korea. Samsung making the top 2 is hardly a surprise, as it is also the world's 16th largest company by 2019 market cap ($278.7 bln) and the world's largest semiconductor company by 2018 total revenue ($221.5 bln). In terms of South Korea, Samsung holds the no. 1 position for total revenue, while Hynix with $36.8 bln holds the only the 10th position. However, when looking at 2018 net earnings, Hynix jumps to 2nd place with $14.1 bln in net income, behind Samsung with 39.9 bln in net income. Accordingly, this feat translates into these 2 companies accounting for 21.9% of the entire Korean Stock Exchange market capitalization. Hence, we refer to these 2 companies as the Korean Duo or K2.
The fact that K2 are extremely profitable, is no surprise as they are both semiconductor companies (which have extremely high margins). The semiconductor industry is the forefront of technology, digitalization and automation. These companies enable new technologies for emerging markets such as Artificial Intelligence, Cloud Computing, 5G, Internet of Things, Autonomous & Electric Vehicles and Augmented & Virtual Reality. What is amazing is that the combined net income of K2 ($54.0 bln) in 2018 surpasses that of the combined net income of the remaining 48 of the top 50 companies in South Korea ($43.9 bln). Finally, both companies operate under a larger group or chaebol - defined as a family-controlled industrial conglomerate of South Korea (a common occurrence in the country).
South Korean Economy
South Korea is the world's 12th largest economy, and Asia's 4th largest economy (behind China, Japan and India). According to the International Monetary Fund, South Korea is classified as an advanced economy, being just one of six Asian countries on the list (excluding the remote China states - Hong Kong, Taiwan, Macau). Its GDP has been growing at an average annual rate of 2.76% over the past 5 years. The country's interest rates averaged at 1.48% in the past 5 years but has been recently cut to a record low of 0.75% by the Bank of Korea to mitigate the negatives impacts of the pandemic in tandem with other advanced Asian economies such as Singapore, Hong Kong ('China'), and Taiwan ('China'). South Korea's interest rate is the second lowest among these advanced Asian economies, only Japan has a lower interest rate.
South Korea has an average debt-to-GDP ratio of 36% over the past 10 years but has risen to 41.4% this year and could rise further, as the government introduced several economic stimulus packages to boost the economy but the ratio still remains much lower relative to other advanced economies such at Japan at 200.6% and Singapore at 114.1% debt-to-GDP. In terms of employment, the country's unemployment rate stood at 4.15% in 2019 higher than its 10 year average of 3.59% and is expected to rise sharply this year as business sentiment is severely affected globally and widespread layoffs become inevitable.
South Korea has been a net exporter for the past 10 years, growing at an average 4% rate per year as, the semiconductor industry benefited from rising chip demand for cloud computing and telecommunication applications. Nevertheless, net exports fell by 70% in 2019 due the memory market downturn and growing threats of trade disputes between major economies. Additionally, the country's current account surplus fell by 22% to $59.97 bln in 2019 from $77.47 bln in 2018, representing a 7-year low.
The country has also witnessed a strong uptrend in foreign direct investments, increasing 26% per year on average to $23.3 bln in 2019, the trend is attributed to growing capital flows from emerging nation partners under its free trade agreements with Asian and Middle Eastern regions as well as growing number of multinational companies such as Apple, BP, Toyota establishing headquarters and investing in R&D facilities across the country.
While South Korea has become known as an electronics manufacturing hub (probably due to K2), its economy is quite diversified across the 11 sectors. The top 15 companies alone include those in Industrials [LG Chem (OTCPK:LGCLF), Hyundai Mobis, Samsung C&T], Financials [Shinhan Financial Group (SHG), KB Financial Group (KB)], Technology [Samsung Electronics, SK Hynix, Samsung SDI (OTCPK:SSDIY)], Communication [Naver (OTCPK:NHNCF), SK Telecom (SKM)], Healthcare [Celltrion], Discretionary [Hyundai Motor (OTCPK:HYMLF)], Staples [LG Household & Healthcare (OTCPK:LGHHF)], Materials [Posco (PKX)] and Utilities [Korea Electric Power (KEP)].
Top 15 Companies in South Korea by Market Cap (2018)
Rank | Company | Market Capitalization ($US Bln) | Sales | Profits | Sector |
1 | Samsung Electronics | $278.70 bln | $197.6 bln | $18.4 bln | Technology |
2 | SK Hynix | $47 bln | $23.2 bln | $1.3 bln | Technology |
3 | LG Chem | $23.70 bln | $24.6 bln | $0.13 bln | Industrials |
4 | Naver | $23.50 bln | $5.8 bln | $0.497 bln | Communication |
5 | Celltrion | $23.10 bln | $0.97 bln | $0.26 bln | Healthcare |
6 | Hyundai Motor | $20.10 bln | $90.5 bln | $2.3 bln | Discretionary |
7 | LG Household & Health Care | $19.10 bln | $6.5 bln | $0.67 bln | Staples |
8 | Samsung SDI | $15.70 bln | $8.6 bln | $0.26 bln | Technology |
9 | Samsung C&T | $14.30 bln | $25.7 bln | $0.97 bln | Industrials |
10 | Hyundai Mobis | $13.20 bln | $31.9 bln | $1.8 bln | Industrials |
11 | SK Telecom | $12.70 bln | $15.2 bln | $0.75 bln | Communication |
12 | Korea Electric Power | $12.60 bln | $50.7 bln | $-2 bln | Utilities |
13 | Posco (PKX) | $12.10 bln | $53.2 bln | $1.3 bln | Materials |
14 | Shinhan Financial Group | $11.70 bln | $33.9 bln | $2.9 bln | Financials |
15 | KB Financial Group | $11.10 bln | $37.3 bln | $2.7 bln | Financials |
Having said this, the fact remains that K2 makes up a large portion of South Korea. In 2018, revenue from K2 represented 15.96% of the country's GDP.
South Korean Semiconductor Industry
Samsung happens to be the world's largest semiconductor company by revenue, and SK Hynix is the fourth largest semiconductor company by revenue. The South Korean semiconductor industry (which is basically just K2) has specialized into memory chip manufacturing. This gives it an edge over other Asian semiconductor companies which are mostly foundries and outsourced semiconductor assembly & test ('OSAT') providers. There are mainly 2 types of memory chips in the market; DRAM and NAND. Samsung hold the large market shares in both markets. Their closest peer competing with them in both markets is US-based Micron Technology (MU). Together with Micron, they form the global DRAM oligopoly, dubbed the 'DRAM Trio' or 'D3'.
Global Semiconductor Memory Market Share
2020 Market Share | DRAM | NAND |
Samsung | 44% | 35.5% |
SK Hynix | 29% | 9.6% |
Micron | 22% | 11.3% |
Kioxia | - | 18.7% |
WDC | - | 14.7% |
Intel | - | 9.7% |
Others | 5% | 0.6% |
Source: DRAMeXchange
Both DRAM and NAND account for nearly 30% of the global IC market. While DRAM is a volatile form of memory use, while NAND is a non-volatile form of memory, both are equally important in storage applications and has anticipated greatly in the face of rapid advances in cloud computing, 5G and AI technologies. Although market oversupply in the past few years has impacted revenue across the industry, 2020 is looking to be a year of recovery for the memory market driven by constricting supply from reduced output growth and a surge in demand for server chips as data centers scale up capacity to handle increased bandwidth from work from home and virtual learning. Due to these factors, we expect DRAM and NAND market revenues to grow at an average yearly rate of 8% and 15% respectively.
The South Korean semiconductor industry is truly the backbone of the global memory market, the country alone accounts for around 70% of DRAM and 50% of NAND output globally. To retain the status of the country as the memory manufacturing hub and fend off competition from China, Samsung and SK Hynix announced that they will invest a combined $33 bln over the next 4 years.
Now read: Micron, Samsung, And SK Hynix: The DRAM Oligopoly >>
Samsung Electronics
Most people will know Samsung Electronics for their line of consumer electronics products or the flagship Galaxy smartphones, however the group is highly diversified with business segments that encompasses mobile phones, consumer electronic devices, display panels, audio systems (Harman) and semiconductor segments. With over 200 subsidiaries involved in production, R&D and marketing, the company achieves scale unseen among its competitors, allowing the company to reach top customers including Apple (OTC:APPL), Best Buy (BBY), Deutsche Telekom (OTCQX:DTEGF), Huawei, and Verizon (VZ) which combined accounts for about 13% of revenues.
Source: Samsung
We view its semiconductor business to be most promising. Due to the extremely high margins of the industry, Samsung's semiconductor segment represents 50% of its net income despite making up only 26.17% of its revenue. The company had enjoyed an early technological lead as the first to use EUV process in mass production of memory chips which allowed the company to gain share and achieve market leadership in DRAM and NAND. With the introduction of V-NAND, the company maintains its technological leadership while extending its reach in premium memory markets in high performance computing and data centers. We expect growth to be driven by strong demand in data centers and smartphone launches with higher storage capacity in latest models.
Although facing intense competition from Chinese manufacturers, Samsung's mobile segment retains its lead as the world's leading smartphone manufacturer with slightly below a quarter of market share while contributing 40.7% of revenues. Notwithstanding, the outlook on the mobile handset market is challenging due to market saturation and lengthening product life cycles resulting in stagnating industry sales, growth will highly dependent on 5G product launches and while the company is enjoying an early lead in terms of 5G sales in 1Q2020, we anticipate the launch of the 5G Apple iPhone to pose major competition for the company not to mention slowdown in consumer spending due to the pandemic.
Its consumer electronics segment accounts for 17.24% of revenue, this segment covers home appliances such as TVs, refrigerators, washing machines etc. The company experienced rising demand for QLED TVs and dominates the TV market with a third of market share but is expecting shipments to drop by 10% this year due to competition and the pandemic. Similarly, the Display Panel segment which accounts for 12% of sales is also expected to see overall sales decrease but may be offset to a certain extent by higher sales attributed to mobile panels in its latest mobile launches.
The audio systems segment represents the lowest segment to revenue at 3.83%. The Harman brand has a strong reputation among automotive and consumer applications but experiences stronger growth and increasing share in automotive digital cockpits enabling safer driving.
Source: NYU Stern, GuruFocus, Khaveen Investments
Based on a sum of the parts valuation, we first obtained the industry average multiples for each of Samsung's business segments. We then computed the company's equity value based on the valuation multiples to obtain an average of KRW665.44 tln, which we discounted with the company's weighted average cost of capital ('WACC') of 6.31%. We further applied a conglomerate discount of 25% due to the size of the company and derived a share price valuation of KRW68,864.58 which represents a potential 26.36% upside. We view Samsung as a fundamentally sound company with market dominance of not just South Korea, but also the global semiconductor industry. We also like its exposure to other industries which smoothens out its earnings volatility from the cyclical swings of the semiconductor industry. Hence, we maintain our Buy rating for Samsung Electronics.
SK Hynix
Compared to Samsung, SK Hynix operates as a much smaller company than the conglomerate. With over 30 years of experience in the semiconductor industry, the company has gained a solid foothold in the memory chip market with its DRAM and NAND products. In fact, along with CMOS image sensors, these products account for all its revenues with a single reporting segment, a stark contrast compared to the various segments of Samsung. The downside is that the company's revenues are highly correlated with selling prices of memory chips, which explains the decline in 2019 revenues by 33% due falling memory prices whereas Samsung's revenue decreased by a much lesser extent of 5% due to its diversity.
Source: SK Hynix
As seen, the decline in revenue also had a devastating impact on Hynix's margins. Given the high economies of scale in the semiconductor industry, a reduction in volume is sure to negatively impact the margins of the company. While revenue dropped 33%, its net earnings dropped a whopping 87%.
On a positive note, we expect the worst for the memory market to be over with rising demand coupled with tightening supply positive drivers for the company. Notwithstanding, planned supply of the chips appears to be increasing by competitors such as Samsung responding to the surge in demand which poses a risk of a future market imbalance resurfacing. To deal with this, the company is increasingly diversifying by shifting production from memory to CMOS image sensors in its Icheon facilities to compete with the likes of Sony. However, the demand of image sensors also faces uncertainty on the back of stagnating sales of smartphones as these sensors are used in mobile applications. Thus, we maintain a cautious outlook for the company.
Source: NYU Stern, GuruFocus, Khaveen Investments
Because SK Hynix is solely focused on the semiconductor industry, we based our valuation on the semiconductor industry's average multiples only. We computed the company's equity value based on each valuation multiple and derived an average equity value. We discounted that average equity value on the company's discount rate of 5.77% and derived an equity value per share of KRW89,381.88 which does not imply any upside. Given the volatility of memory prices and uncertainty in the economy, we feel Hynix would be overly susceptible to another downturn as it does not have a diversified revenue base. Hence, we do not feel the risk-return tradeoff is worth it for the near-term, and rate SK Hynix as a Hold.
Verdict
In conclusion, K2 (Samsung & SK Hynix) are undisputedly the top two companies in South Korea representing a staggering 21.9% of the entire Korean Stock Exchange market capitalization. In 2018, revenue from K2 represented 15.96% of the country's GDP. Combined, K2's net incomes are higher than the rest the top 50 largest South Korean companies combined. With the industry at the forefront of technology, K2 enables emerging technologies such as cloud computing, artificial intelligence, IoT etc. The contributions of K2 towards the South Korean economy are strongly evident with exports growing at a steady rate in the past years. Much of this growth is attributed by the semiconductor industry sector, both companies dominate the memory chip market accounting for 70% of NAND and 50% of DRAM market share combined.
Among K2, Samsung is a multinational conglomerate with a highly diversified business model. The company's products are well integrated across the various segments such as memory chips and led display panels for its mobile and consumer electronics products. On the other hand, SK Hynix is more focused on memory semiconductors which represent its only business segment. With rising demand of memory chips in servers and increasing capacity in new mobile product launches, we expect this trend to benefit both Samsung and SK Hynix, however we also note several risk such as declining smartphone sales to weigh on the chip demand. Overall we rate Samsung as a Buy and SK Hynix as a Hold.
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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SSNLF over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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