Tuesday, October 2, 2007

Samsung the Elephant

Samsung dominates life in its home country like no other company in the world. But the slogan "what is good for Samsung is good for South Korea" is open for debate.

The South Korean economy is a paradox. It has become the third largest economy in Asia after Japan and China. Its 48 million citizens have in one generation enjoyed a sizable jump in their standard of living and no country has benefited more than South Korea from the rise of China which has become a vital export market. Its sovereign credit rating was recently upgraded due to reduced tensions with North Korea and it enjoys foreign exchange reserves of over $200 billion. The Korean people should be full of satisfaction for a job well done but instead are rather a discontented lot.

Its per capita income is about one third that of the OECD average. Economic growth is expected in the 3-4% range closer to a mature economy than an Asian tiger. Unemployment is becoming an issue and a stronger currency and relatively high wage levels are crimping exports which account for 40% of its economy. Exports are up only 7% this year after a 31% jump last year. After a credit card binge, average net consumer borrowing is equal to 100% of disposable income and the bank of Korea recently bumped up its benchmark rate for the first time in three years.

What is going on here? Somewhat surprisingly, South Korea is experiencing many of the same outsourcing issues that Americans complain about. It was the largest investor in China last year with over $6 billion in fixed investments. Its largest steel maker POSCO announced its intention to invest $12 billion in a steel plant in India where it already runs 24 steel companies. Hyundai manufactures 600,000 autos in China and its affiliate Kia makes 150,000 more.

Meanwhile Samsung Electronics has become Asias largest technology company by market cap (larger than Sony), and its largest maker of memory chips and flat panel screens and mobile phones. Samsung enjoys a credit rating higher than South Koreas sovereign rating. With 62 affiliates, the Samsung group dominates life in Korea like no other company in history. It represents 15% of the nations total economic activity, 25% of the capitalization of the KOSPI stock market and the taxes it pays represent almost 10% of total government income!

Samsung, up 25% so far this year, is still attractive at about 11 times consensus 2006 earnings estimates and its operating profit was up 29% in the third quarter. Despite third quarter net income declining 30%, a strong fourth quarter is expected. There is a shortage of LCD television panels and its flash memory chip global market share exceeds 60%. As prices have come down flash chip sales have gone up 40%.

But the company is not a terrific play on the South Korean economy. Rather it is a global play on its three key markets and the expected payoff from its extraordinary commitment to R&D. The South Koreans are discontented because the five largest companies are growing outside the country more than in it and at a stage of development where it should be more competitive manufacturing onshore. The challenge is the low cost manufacturing platform with huge economies of scale just next door the issue is China. Samsung already has already has 29 plants and 50,000 workers in China.

Since China is already starting to manufacture stuff like machine tools that the South Koreans were busily exporting in 2003 and 2004, South Korean planners believe it must quickly transform itself into a finance, communications and transportation hub akin to the role of Singapore or Switzerland. The question then becomes do they have the right companies, the right skills and what is its competitive advantage?

Together, Samsung, POSCO, KEPCO (Korea Electric Power) and SK Telecom account for almost 50% of South Korean stock markets market capitalization. To use a basketball analogy, the South Korean starting five are strong but its bench is a bit thin and its team has lost the home court advantage. The problem is not Samsung but rather that they need about ten more Samsungs.

The top four companies also make up 40% of the South Korea iShare (EWY) ETF which is up 29% so far this year. Samsung alone accounts for 23% of this ETF and buying the iShare gives you more exposure to the top ten South Korean companies. I am trimming our position in the South Korea iShare to take some profits off the table and with the expectation that the stronger won and higher interest rates will lead to a slowdown in exports. Together with the likely re-emergence of the North Korean problem, this may very well undermine investor confidence.

Bottom line: buy Samsung based on valuation and top notch global reach and R&D but expect tougher going for the South Korean economy as China turns from robust export market to direct competitor.

or more information go to http://www.chartwellasia.com or call 877-221-1496

Carl Delfeld is head of the global advisory firm Chartwell Partners and editor of the the "Asia-Pacific Growth" newsletter. He served on the executive board of the Asian Development Bank and is the author of "The New Global Investor." For more information go to http://www.chartwellasia.com or call 877-221-1496.