EUR 850.00 For Business Accounts Only

Morningstar | Solid 2Q Result for KT After One-Offs; Accounting Changes Muddy the Waters but KT Remains Good Value. See Updated Analyst Note from 03 Aug 2018

KT’s second-quarter result was broadly in line with our forecasts on an underlying basis despite the large reported operating profit decline. Services revenue was down 0.4% and operating income down 15.7% on a reported basis using the old accounting standard. Early resolution of a labor collective bargaining agreement caused a one-off spike in labor costs, which was the main driver of the operating profit decline. Excluding this, we estimate that operating profit would have been flattish or even grown slightly. However, the disparity between accounting standards was again highlighted, with the new accounting standard (K-IFRS 115) producing an operating income figure for this quarter that was 6% above the figure using the old standard (IFRS 1018), after the first quarter’s figure was 9% below. We decrease our fair value estimate to USD 18.00 from USD 18.30 per ADR on a weaker Korean won, and we still base our earnings forecasts on the old accounting standard. Our forecasts incorporate operating earnings declining by around 5% per year over the next five years, which we think is conservative, but despite this, the stock trades at a price/fair value of under 0.8 times, and we believe it’s undervalued.

Net debt/EBITDA has decreased from a peak of over 4.5 times at the end of 2014 to a more manageable 1 times now due to the sale of noncore assets and improved profitability over the past three years. Net debt/EBITDA is well below a previously mentioned target of 1.5 times, so we anticipate a strong lift in shareholder returns. We expect dividends to increase to KRW 1,300 in 2018 and stay at that level during our forecast period, implying an approximately 40% payout ratio. At our fair value, KT would trade on a price/earnings ratio of 12.1 times and a dividend yield of 3.2%. 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 0.7%, which was not helped by the government-mandated discount for customers not taking a handset subsidy. 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 recontracting 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 was less than six months remaining on their contract. At the full-year 2017 result in February, management indicated that around 59% of new and upgrading customers are opting for a selective tariff discount plan, and the cumulative rate was around 32%. After KT outperformed key rival SKT in the mobile market over 2015 and 2016, we saw SKT become slightly more aggressive in 2017. 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’s wireline revenue declined 2.4% year on year in the first quarter, also broadly in line with the full-year 2017 decline. Telephony revenue decline of 6.1% was partially offset by broadband revenue growth of 1.6%, with the company adding 263,000 fibre-to-the-home services, known as Giga, representing 51.9% of its broadband subscriber base, despite the overall broadband customer base declining. After averaging net adds of 21,000 per month over the 12 months to January 2018, total broadband customers actually declined by 59,000 in February and 69,000 in March. The company returned to growth this quarter, adding 6,000 customers. The company also added a further 99,000 Internet protocol television, or IPTV, customers this quarter, bringing its total to 7.7 million customers and driving 7.4% growth in media/content revenue for the quarter. 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-KRW 200 billion of operating profit over this period, or 10%-14% on top of the current overall operating profit. We are cognizant 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 include an approximate 5% decline in operating income over the next five years. Real estate revenue also declined by 15%, with the company expecting real estate to generate at least KRW 700 billion by 2020, up from KRW 430 billion in 2017. Management estimates that the company’s real estate assets have a current market value of KRW 8.8 trillion, which represents 115% of its current market capitalization and 70% of its current enterprise value.