Korea pre-markets KT&G GDR

International offerings from Korea resume with the launch of a roughly $350 million GDR for Korea Tobacco & Ginseng (KT&G).

Under the lead management of global co-ordinators Goldman Sachs and UBS Warburg, with Dongwon and Hyundai Securities as joint-bookrunners, pre-marketing began on Monday for the final piece in the government's privatization of its tobacco monopoly KT&G. Formal roadshows are scheduled to start around July 1. Ironically this is the date when Korea lifts all price controls on the domestic production of cigarettes and international giants such as British American Tobacco (BAT) will begin to step up efforts to eat into KT&G's market share.

Pricing of an offering representing 14% of the company's issued share capital will take place on either July 11 or 12, with Deutsche Bank, ING Barings, LG and Samsung Securities acting as co-leads. The selling shareholders will be a combination of the Industrial Bank of Korea (IBK), which has a 29.34% stake, the Korea Development (KDB), which has a 6.9% stake and Export-Import Bank of Korea (Kexim), which has a 7.03% stake.

The Korean government currently owns 57.15% of KT&G and pending the successful completion of the GDR as well as a domestic offering for 19.4%, will hold a residual stake through the Resolution Finance Corp.

KT&G was last presented to international investors in October 2001 when the government sold a 20% stake via a $309 million GDR and $244.13 million convertible. The GDR was considered a great success after lead managers Credit Suisse First Boston and UBS Warburg were able to secure parity pricing to the company's Korean close by marketing the deal as a defensive buffer for accounts seeking equity protection in the aftermath of September 11.

This time round they are considered to have a more challenging job on their hands. Year-to-date, the stock has had an inverse performance to the Kospi, which closed Tuesday at 809, up 16.9% on the year. KT&G, which closed the same day at Won15,850, is down 18.3% year-to-date, having hit a high of just below Won19,000 in early April and declined steadily since then.

With a free float of 28.9%, KT&G has historically been an extremely illiquid stock. Daily trading volume averages only $2.5 million to $3 million and foreign investors are capped at 5%. However, this should begin change early next week, with the completion of a domestic sale of 7.75% through an exchangeable, 7.75% through a direct share sale and 3.9% to KT&G employees.

In turn, each remaining stage of the privatization should remove the stock overhang, which has been one of the main reasons why the price has failed to perform so far this year. Other reasons include the launch of a government anti-smoking campaign and increasing evidence that foreign brands are starting to accelerate market share gains.

Worldwide, Korea stands second to Turkey in terms of smokers per head of population, with an unhealthily large 64.1% of all adult males above the age of 15 constituting regular users in 2001 or 27.6% of the overall population. In November last year, Korea's Ministry of Health & Welfare decided to tackle the problem with the launch of a nationwide anti-smoking campaign that kicked off in February this year. In response, KT&G has stepped up its marketing drive in the run up to the World Cup producing an additional 10 million specially designed football-related packets.

The other major problem facing KT&G is the growing popularity of foreign brands. This is particularly the case with Dunhill cigarettes produced by BAT, which have become very popular with teenage smokers - the most important market segment to capture as brand loyalty becomes fixed at a young age.

At the height of the financial crisis in 1998, foreign brands had a 4.9% market share, but the figure had jumped to 14% by the first half of 2001 and 18% as of May this year. Of all KT&G's foreign competitors, BAT has the most significant market share and has also seen it double from 4.8% in early 2001 to 9% in 2002.

To counter the threat, KT&G has moved further into the production of premium brands and these now constitute 40% of overall revenues compared to 14% in 1999. Bankers further argue that since its average net selling price per packet of cigarettes is considerably lower than other comparable stocks in the region, there is plenty of room for KT&G to increase prices.

Read any analyst's report and it will always state that in comparison to virtually any other consumer sector, tobacco manufacturers find it easy to pass on price increases because their clients find it very hard to pass on the product. For example, according to research prepared Robert Campagnino, a New York-based analyst for Prudential Securities, the average number of work minutes needed to pay for a packet of cigarettes worldwide has increased by up to 30% over the last decade.

Similar to October 2001, two of the main selling points of the GDR are likely to be KT&G's huge EBITDA earnings and its equally generous dividend payout. Over the past year, analysts have applauded KT&G's cost cutting efforts and efficiency drive, which have bolstered operating margins.

For example, in terms of number of cigarettes per employee per hour, KT&G has increased the ratio from 19,000 in 1999 to 23,000 in 2001 and is aiming for 26,000 by the end of 2002. This has resulted in an increase in operating margins from 20% in 1999 to 33% in 2001 and in terms of net margins, from 17% in 1999 to 22% in 2001.

At the end of the first quarter, the company also reported that net profits were up 74% to Won112 billion ($86.2 million) with a total of 16.8 billion cigarettes sold.

For fund managers, the key buying decision will hinge on the company's ability to maintain its cash generating abilities and hence its high dividend. Currently the stock is yielding 8.75% and bankers say that KT&G paid 63% of its net income in dividends during 2001, one of the highest payout ratios in the world. The dividend is also very high relative to other Korean stocks, which average about 1.5%.

But above all else, lead managers are likely to argue that the most compelling reason to buy the stock is that it has been oversold on the back of a flurry of negative reports about encroaching foreign market share. Experts say that at Won15,000 the company is trading toward its historic lows.

In terms of EV/EBITDA ratios, it stands at four times 2002 earnings, some way below the sector's 9.5 times global average. London-listed BAT, for instance, currently has an EV/EBITDA ratio of 7.1 times and a dividend yield of 4.2%.

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