EUR 850.00 For Business Accounts Only

Morningstar | Tariff Cuts Continue to Hit SK Telecom’s Earnings; FVE Reduced to $25. See Updated Analyst Note from 30 Oct 2018

Operating profit in SKT’s core telecom business for the third-quarter 2018 was down 13% with government-mandated tariff cuts introduced on Sept. 15, 2017 continuing to have a negative impact on mobile, which growth in IPTV and "Internet of Things" revenue partially offset. We continue to model and assess the business on the historical accounting standard given the company has yet to provide 2017 accounts with the new IFRS 15 accounting standard. The noncore business (excluding SK Hynix) reported an operating loss of KRW 21.7 billion, broadly in line with recent quarters. Given the very strong memory semiconductor market we note that SKT’s 20.6% stake in SK Hynix at current share price represents 43% of SKT’s enterprise value, excluding the potential capital gains tax payable should it sell the business. 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 $25 per ADR from $26, with a slight downgrade of our core business forecasts and weakening of the KRW. Our fair value estimate implies a forward enterprise value/EBITDA ratio of 5.2 times with a dividend yield of 3.9%. 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 with the firm continuing to pour investment into its noncore businesses, which are largely no-moat, in our opinion.

SKT management indicated that it expected a flat dividend in 2018 but there was some chance of increased SKT dividends based on SK Hynix paying out increased dividends.

SK Hynix lifted its 2017 dividend by 66% to KRW 1,000 per share and consensus forecasts this to rise to around KRW 1,500 in 2018, which would mean SKT would receive KRW 219 trillion in SK Hynix dividends in 2019. This would equate to around KRW 3,080 per SKT shareholder or around $0.30 per ADR holder. We have kept our dividend forecasts flat at KRW 10,000 or $0.97 per ADR, but note that the risk is to the upside.

SK Telecom’s second quarter core telecom revenue decreased by 5.3%, with mobile services revenue declining by 6.5% as a result of government-driven tariff reductions. 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 who 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 reduced which has been partially offset by reduced handset subsidy costs but we believe it is still a net negative. SKT indicated that although 5G related investment has begun this year, total capital expenditure guidance of KRW 2.1 trillion is unchanged, achieved through efficient investment in existing networks. 5G vendor selection finished in September this year and SKT plans to begin the network rollout process in the fourth quarter.

Investors should note that SK Hynix, the semiconductor memory company in which SK Telecom owns a 21% stake, continues to perform very well. In the third quarter, the business increased revenue 41% year over year and 10% sequentially, with operating profit up 73% year over year and 16% 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 has risen to 57% in the third 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. DRAM Exchange expects DRAM prices to fall 5% or more in the fourth quarter and 15%-20% in 2019, after having experienced nine consecutive quarters of sequential price growth. NAND flash pricing has already turned, down around 10% in the third quarter and expected to be down 10%-15% in the fourth quarter and a further 25-30% in 2019. However, with increasing demands for memory from mobile phones and data centers with the advent of Big Data and future demand expected from such applications as automated driving and virtual reality, the long-term outlook for 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.

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 if public equity investors would value it this highly given it has reported operating losses totaling KRW 211.4 billion over the past seven quarters. After the business was spun out, revenue declined by 11% in the third quarter but the operating loss narrowed to KRW 22.1 billion from KRW 29.8 billion in the same period in 2017. The sale process likely had a negative impact on business performance, in our view, but we will be looking for a turnaround to justify the valuation implied in this transaction.