EUR 850.00 For Business Accounts Only

Morningstar | SKM Updated Star Rating from 27 Jul 2018

Operating profit in SKT’s core telecom business for second-quarter 2018 was down 20%, with government-mandated tariff cuts introduced on Sept. 15, 2017, continuing to negatively affect mobile, partially offset by growth in IPTV and Internet of Things, or IOT, revenue. We continue to model and assess the business on the historical accounting standard, given that the company is yet to provide 2017 accounts with the new IFRS 15 accounting standard. The noncore business (excluding SK Hynix) reported an operating loss of KRW 14.7 billion, which is slightly higher than the corresponding period in 2017 and first-quarter 2018. Given the very strong memory semiconductor market, SKT’s 20.6% stake in SK Hynix at the current share price represents 53% of SKT’s enterprise value. An investment in SKT is almost equally an investment in a memory semiconductor business and a traditional telecommunications business. We reduce our fair value estimate to USD 26 per ADR from USD 29, with a downgrade of our core business forecasts and a slight weakening of the Korean won partially offset by the increase in market value of the SK Hynix stake. Our fair value estimate implies a forward price/earnings ratio of 5.5 times with a dividend yield of 3.8%. We retain our narrow moat rating based on the core telecom business. At current prices, we see the shares as slightly undervalued. SK Telecom’s unwillingness to return free cash flow to shareholders is a large factor in our Poor stewardship rating on the company, as the firm continues to pour investment into its noncore businesses, which we largely view as no-moat. Management indicated that it expects a flat dividend in 2018.

SK Telecom’s second-quarter core telecom revenue decreased by 5.5%, with mobile services revenue declining by 7.4% as a result of government-driven tariff reductions. This is an acceleration on the 3.1% and 3.5% respective declines reported in the first quarter. In September 2017, the Korean Ministry of Science and ICT increased the discount rate provided to customers not taking a handset and the 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 is less than six months remaining on their contract. We see this change as a negative for each of the Korean operators, including SKT. Service revenue has decreased, and though this is partially offset by reduced handset subsidy costs, we believe it is still a net negative.

Investors should note the continued very strong performance of SK Hynix, the semiconductor memory company in which SK Telecom owns a 21% stake. In the second quarter, the business grew revenue 55% year over year and 19% sequentially, with operating profit up 83% year over year and 28% sequentially. The memory market is seeing very strong demand, and with only three main DRAM and five main NAND suppliers, supply is well controlled. However, as we’ve seen over the past two years, the industry is very cyclical. SK Hynix’s operating profit margin troughed at 11% in the second quarter of 2016 and rose to 54% in the second quarter of 2018. The other key suppliers, Micron and Samsung Electronics, are also reporting record margins from their memory divisions. It’s always difficult to forecast the peaks and troughs, but the current margins would suggest we are near the peak. However, with increasing demands for memory from mobile phones and data centres with the advent of Big Data and future demand expected from such applications as automated driving and virtual reality, the industry still looks attractive. The increased capital expenditure and know-how required to produce top shelf memory should insulate the current players from potential future competition from the Chinese for at least another five years, in our opinion.

In June, SKT purchased 5G spectrum rights consisting of 100 MHz of spectrum in the 3.5 GHz band and 800 MHz of spectrum in the 28 GHz band for KRW 1,425.8 billion. The spectrum will become usable starting in December 2018 for 10 years for the 3.5 GHZ spectrum and five years for the 28 GHz spectrum. SKT also invested KRW 702 billion to buy a 55% stake and management rights in domestic security systems company ADT Caps. The investment was made in partnership with Macquarie. ADT Caps is a former unit of Tyco International, offering central monitoring, access control, video surveillance control, and other integrated security services. It has an enterprise value of KRW 2.97 trillion and an enterprise value/EBITDA multiple of 11 times, according to SKT, which implies EBITDA of around KRW 270 billion. SKT indicated that ADT Caps had an annual revenue growth of 4.1% and operating margin of nearly 20% for the past three years, and that it planned to add new computing and telecom capabilities to the business to provide advanced security solutions.

SKT was also successful in attracting investment of KRW 500 billion in its 11st e-commerce business from H&Q Korea in June, which would value the business at KRW 2.75 trillion and therefore SKT’s stake at around KRW 2.25 trillion, or around 10% of SKT’s enterprise value. We doubt that public equity investors would value it this highly, given it has reported operating losses totaling KRW 83.1 billion over the past five quarters. There may be some light at the end of the tunnel, however, given that its operating loss is reduced to KRW 3.9 billion in the second quarter after KRW 6.9 billion in the first quarter, so it is nearing break-even. However, revenue for 11st declined by 2.2%, which may point toward the cost reductions in the business affecting revenue.