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Morningstar | Korean Mobile Price Cuts Hurt KT’s 2018 Result; We Lowered FVE to $17 but It Remains a Good Value. See Updated Analyst Note from 12 Feb 2019

KT’s 2018 result was worse than expected with both revenue and operating profit trends being negatively impacted by the mobile price cuts and competition in the fixed-line business. Reported service revenue was flat for the year but down 0.6% in the fourth quarter with operating income down 11% for the full year and 36% for the quarter. Early resolution of a labor collective bargaining agreement in the second quarter 2018 which caused a one-off spike in labor costs in both the second and third quarters of this year also didn’t help. Excluding this we estimate that operating profit would have been down around 4% for the year. We reduce our forecasts in response to the weaker fourth quarter and our fair value estimate falls to $17 from $8 per ADR. Our forecasts incorporate operating earnings declining by around 3% per year over the next five years which we think is conservative but despite this the stock trades at a price to fair value of under 0.8 times and we think it’s slightly undervalued. At our fair value, KT would trade on a price/earnings ratio of 11.9 times and a dividend yield of 2.9%. Note, management increased the dividend 10% to KRW 1,100 and guided to 2019 revenue of KRW 24 billion. Unusually, no capital expenditure guidance was provided given the uncertain forecast spend on 5G which will be commercialized in March this year. We also retain our narrow moat rating based on efficient scale with the incumbent mobile operators having many advantages over any credible potential new entrants considering joining the market.

Mobile services revenue declined by 2.3%, for the full year, not helped by the government mandated discount for customers not taking a handset subsidy. Trends were worse in the fourth quarter with wireless service revenue down 6.2%. While revenue declines are not ideal, KT performed better than larger rival, SK Telecom, which reported 9.0% mobile service revenue decline in this quarter and 7.1% decline for the full year.

The relative outperformance is largely due to KT continued addition of customers with KT adding 1.1 million mobile customers in 2018 and 200,000 in the fourth quarter compared with SKT’s 689,000 for the year and 112,000 in the fourth quarter. In September 2017, the Korean Ministry of Science and ICT increased the discount rate provided to customers not taking a handset and associated handset subsidy from 20% to 25%. This has been applied to re-contracting or new customers since Sept. 15, 2017. Existing subscribers that opted for the 20% rate discount plan are also allowed to apply for a 25% discount if there is less than six months remaining on their contract. After KT outperformed key rival SKT in the mobile market over 2015 and 2016, we saw SKT get a bit more aggressive in 2017 but KT seems to have gained ground again in 2018, albeit in a falling market. We believe the underlying traditional customer base is likely to be broadly flat for both operators with much of the growth coming from second device, Internet of Things and business-to-business users. KT management expects growth to return to the wireless services market in the second half of 2019.

KT’s full-year wireline revenue declined 2.1% year-on-year, with fourth quarter down 1%. Telephony revenue decline of 6.7% for the full year was partially offset by broadband revenue growth of 1.9% with the company adding 956,000 fiber-to-the-home services called “GIGA,” representing 56% of its broadband subscriber base, despite the overall broadband customer base declining over the year. Total broadband customers actually declined by 59,000 in February and 69,000 in March. However, the company returned to a decent growth rate in the second half, adding 37,000 customers this quarter. The company also added a further 76,000 IPTV customers this quarter bringing its total to 7.9 million customers and driving 12.5% growth in media/content revenue for the quarter and 9.4% for the full year. Although it does not formally provide margin breakdowns, management indicated the IPTV business reached break-even in 2017 on a full year basis and profitability improvement continues. It has previously stated that it expects the business to generate margins in line with its telecom business in two to three years. By our estimates, this would add around KRW 150 billion to KRW 200 billion of operating profit over this period or 10% to 14% on top of the current overall operating profit.

We are aware that any continued declines in wireline revenue and profit may eat into some of this growth, but if the IPTV profitability does improve as planned this would likely provide some upside to our company forecasts, which have around 3% per year decline in operating income over the next five years. Full-year real estate revenue increased 1% to KRW 451 billion. Management is targeting real estate revenue of KRW 700 billion by 2020, and has previously estimated that the company’s real estate assets have a market value of KRW 8.8 trillion, which is nearly 80% of its current enterprise value. We doubt if investors put anywhere near this value on these real estate assets.