Creative Consulting Group - NYU Stern School of...

of 46

Creative Consulting Group

April 9, 2003 Rating: HOLD Emerging Markets

John Genovese [email protected] Edward Mui [email protected] Ram Narayanan [email protected] Mitesh Patel [email protected] Sachin Patel [email protected] Aric Schachner [email protected]

Macroeconomic Landscape GDP Growth. As one of the Four Tigers of East Asia, South Korea has achieved an incredible record of economic growth over the past ten years. Three decades ago GDP per capita was comparable with levels in the poorer countries of Africa and Asia. Today South Korea’s GDP per capita is seven times India's, 17 times North Korea's, and comparable to the lesser economies of the European Union. Future Outlook. Analysts forecast South Korea’s real GDP to expand by 4.6% in 2003, growing to 5.3% in 2004. The foreign trade balance will make a large contribution (2.2 percentage points) to overall growth in 2003. This will largely be the result of a slowdown in import volume growth on the back of a sharp deceleration in domestic demand growth. Political Exposure In current events, President Roh Moo Hyun has assumed office as of 2003. South Korea’s new focus should be on liberalism and not populism (a political strategy based on a calculated appeal to the interests or prejudices of ordinary people). In terms of domestic politics, the outlook is faced with many unknowns. With a new president comes a new direction for the country. The GNP may oppose Roh’s promised political reforms because they view Roh as a dangerous radical. External politics are very sensitive as the situation with North Korea has increased tension. North Korea’s defiance in maintaining a nuclear development program poses great danger. President Roh promises to carry on with the “sunshine policy” by Kim Dae Jung with the US. They are facing two fronts that have isolated them from the US and North Korea, posing a great challenge for Roh to ease tensions. Telecommunications Industry The wireless market has proven to be the fastest and most profitable sector of telecommunications. Cellular penetration, a major growth driver in the past, now hovers around 65% in Korea, a level most analysts consider near saturation. This has led many telecom companies to focus growth efforts in other areas, particularly in value-added services (VAS). Wireless Internet services posts a penetration rate around 16-20%, this rate is expected to grow to at least 35-40% by 2005. Korean telecom operators are thus pushing anxiously for VAS to become the engine of future growth.


of 46

TABLE OF CONTENTS Page(s) Executive Summary………………………………………………………………………………. 3 - 4 The LG Telecom Case………………………………………………………………………….... 5

Political Conditions…………………………………………………………………………... 5 Historical Post WWII Background……………………………………………………… 5 Political Evolution………………………………………………………………………. 5-6 Political Issues of 1990’s………………………………………………………………… 6-7 Recent Political Issues……………………………………………...……………………. 7 New Regime…………………………………………………..…………………………. 8

Social Conditions…………………………………………………..………………………… 8 Background……………………………………………………………………………… 8-9 Population…………………………………………………………..…………………… 9 Education………………………………………………………………...……………… 9-10 Labor…………………………………………………………………………….………. 10 Youth………………………………………………………………………..…………… 10 Corruption & Crime…...…………………………………………………………………. 10

Macroeconomic Conditions………………………………..…………………………………. 11 Background………………………………………………………………………………. 11 Current Economic Situation…………………………………...…………………………. 11-12 Economic Outlook………………………………………………………………………. 12

Telecommunications Sector……………………………………………………..……………. 13 Mobile Phone Service Industry…………………………………………...………………. 13-14 Regulatory Environment…………………………………………………………………. 14 Tariff Cuts……………..…………………………………....……………………………. 14-15 Mobile Number Portability………………………………………………………………. 15 Handset Subsidy and Marketing…………………………………………………….……. 15-16 Technology and New Services…………………………………………………………… 16-18 3G Mobile Network……………………………………………………………………... 18-20 Telecommunications Industry…………………………………………………………… 20 Wireless Growth Drivers………………………………………………………………… 20-21

LG Telecom………………………………………………………….………………………. 21 History…………………………………………………………………...………………. 21-22 Company Description……………………………………………………………………. 22-23 Brand Names……………………………………………………………….……………. 23-24 Top Competitors………………………………………………………...……………….. 24-25

Case Solution…………………………………………………………………………….….…….. 26 Current Market Situation……………………………………………………………...………. 26-27

Stock Performance………………………………………………………………….……. 27 Historical Trading Range………………………………………………………………… 28 Network Contracts…….…………………………………………………………………. 28 De-Levering of Balance Sheet……………………………………………………………. 28

Regulatory Effects……………………………………………………………………………. 28-29 Investment Outlook………………………….………………………………………………. 29-30

Investment Positives……………………………………………..………………………. 30 Investment Risks…………………………………………………………………………. 30

Financial Analysis…………………………………………………………….………………. 31-34 Discount Rate………………………………………………………………………...………. 34-35 DCF Analysis…………………………………………………....……………………………. 35

Final Recommendations…………………………………………………………………………... 36-37 Exhibits 1 & 2 ...……………………………………………….………………………..........……. 38 Appendix (Financial Data)……………………………………………………………………….... 39-43 Works Cited………………………………………………………………………………….……. 44-46


of 46

EXECUTIVE SUMMARY

As partners of the Creative Consulting Group, we have been hired to analyze the current condition

of LG Telecom. The analysis will include a comprehensive overview of South Korea, as well as an

in-depth financial evaluation of LG Telecom. Our goal is to determine LG Telecom’s future

strategy within the wireless telecommunications industry.

LG Telecom is part of the diverse conglomerate, LG Group, which has businesses ranging from

chemical refining to mobile handsets and wireless services. LG Telecom is South Korea’s third

largest wireless services provider. However, they are faced with intense competition and strict

government regulations which are aimed to lower retail prices for wireless services through

government subsidies. These new regulations along with fierce competition may hinder LG

Telecom’s ability to survive.

Our analysis will cover the following topics:

• Political Environment

• Social Conditions within South Korea

• Macroeconomic Landscape

• Telecommunications Sector

• LG Telecom’s Business

• Current Market Situation

• Investment Outlook

• Financial Analysis

• Final Recommendation

The key elements used to evaluate LG Telecom’s position within the wireless market will focus

around statistics pertaining to the mobile phone industry. In particular we will examine the

industry’s growth drivers, such as ARPU (average revenue per user), market capitalization, and

subscriber growth. In addition, changes in regulation and the implementation of the 3G cellular

technology will be considered for our final recommendation.


of 46

Due to the uncertainty of the South Korean political environment and the ever-changing wireless

phone industry, LG Telecom is an interesting case for business students. As the first generation to

grow-up with cellular phones as a predominant means of communication, many students have made

mobile phones an integral part of their daily lives. The challenges that LG Telecom faces today are

the same challenges that cellular phone companies and service providers are facing around the

world. With the advent of 3G technology in the near future, the continuous developments in

government regulation, and the changing consumer behavior with regards to technology, the mobile

phone industry is one of the most interesting industries in the business world.

The LG Telecom case in particular is interesting for seniors to study for numerous reasons. First, as

students make the transition from school to the business world, we must be aware of international

markets and how they affect the world economy. Second, we are able to use our finance skill set to

evaluate foreign markets in regards to exchange rates, DCF computations, and sovereign risk

adjustments. Finally, many students of this class have had their first opportunity to learn more

about emerging markets and how the volatility in these markets can create and destroy an

individual’s wealth.


of 46

THE LG TELECOM CASE

POLITICAL CONDITIONS

Historical post WWII Background

The political make-up of South Korea is based on the post World War II proposal in which the

Korean Peninsula was divided at the 38th parallel. Thus, in 1948, the Republic of Korea (ROK) was

proclaimed in the southern end as opposed to the Democratic People’s Republic of Korea in the

North. There was an attempt by the North to take over the South causing the Korean War in 1950.

After the war, the peninsula was still at a stalemate and fighting stopped at the demilitarized zone

(DMZ) where the two nations are split. South Korea was then governed by a succession of

authoritarian regimes, characterizing an era of utmost corruption. A directly elected President

governs the ROK. In addition, a unicameral National Assembly is selected by both direct (90%) and

proportional (10%) elections. In 1987, President Chun Doo Hwan implemented reforms

throughout the country which shifted power to the national assembly and implemented a new

constitution. The new constitution mandated for presidential elections every five years.

Political power in South Korea rests with the president, who has enormous power over the

government and military. Cabinet ministers rarely serve more than one year in office because of

frequent reshuffles during times of crisis. While the prime minister is in charge of economic and

educational management, their position is primarily symbolic.

Political Evolution

In 1988, Roh Tae Woo took office as the elected president and attempted to improve relations with

opposition politicians as well as the situation with the North. He was able to establish diplomatic

relations with the Soviet Union in 1990 and China in 1992. However, he confirmed his party’s

financing scandals in 1995.

In 1992, Kim Young Sam of the Democratic Liberal Party (DLP, later renamed the GNP) was

elected as the new president, the first non-military civilian to hold office since the Korean War.

Tensions with his new party would arise during this time, as he was a former opposition leader who

had merged his party with Roh’s party the Democratic Justice Party (DJP). Kim launched


of 46

campaigns to eliminate corruption and administrative abuse while trying to improve relations with

the North due to economic pressures. In 1993, Kim abolished the need of government approval for

the ownership of land by foreigners. This was a big step to open up South Korea’s doors to the

international community to boost their economy. 1995 was a big year for the Korean Peninsula in

which the North began talks with the U.S. seeking economic help. The South was in an economic

danger as well and the talks were encouraged to build a unified Korea.

In 1996, South Korea joined the OECD. Later that year, 5000 students protesting for reunification

with the North were arrested by the Army. President Kim Young-Sam announced that he would

take leaders to court under the anti-communist national security law to prevent treason and

corruption. He also implemented a new policy of “real names” reform where bank accounts must

be held using real names instead of assumed names to prevent graft.

Political Issues of 1990’s

During the nineties, South Korea had developed a strong bilateral relationship with the U.S. They

became partners and allies sharing common democratic values and practices to advance

democratization and human rights. The U.S. provided a strong security force for South Korea with

the 1954 U.S.-Korea Mutual Defense Treaty to help defend them from external aggression. The

U.S. has about 37,000 troops in the country. 1997 was another major point in South Korea’s history

as a new president was elected and the nation as well as other Asian countries was faced with the

Financial Crisis. Kim Dae-Jung’s election was the first time that power was transferred to an

opposition party since the country’s independence. Their chief opposition was the Grand National

Party (GNP). His presidency representing the left-leaning National Congress for New Politics

(NCNP) was one filled with reform on the economy largely based on the support of the labor and

National Assembly. The labor movement supported his views with labor unions willing to

cooperate with his government. Kim had struggles with controlling the National Assembly because

of the resilience of the opposition party GNP. He attempted to split the GNP but failed to do so

and instead, had to form coalitions with the United Liberal Democrats (ULD) and the Democratic

People’s Party (DDP). Eventually his party gained substantial power in the June 4 local elections.

His recovery efforts from the 1997-1998 financial crises were crucial in bringing the Korean

economy up. From 1998 to 2000, the coalition with the ULD fell apart twice due to differences

between the ULD leader Prime Minister Kim Jong Pil and Kim Dae Jung. Kim Jong Pil formed the


of 46

feared Korean Central Intelligence Agency, which attempted to assassinate President Kim Dae

Jung. With this coalition problem, they also faced pressure from the largest party in Korea, the

GNP. Policy implementation was difficult at this time with the pressures and bitterness coming

from the GNP and ULD. In 2000, Prime Minister Kim Jong Pil resigned as prime minister and was

succeeded by Park Tae Joon of the ULD. However, he too resigned after a scandal and ULD leader

Lee Han Dong became the prime minister.

When Kim had taken office in 1998, he announced his “sunshine policy” of positive engagement

towards the North. In 1998 they found a North Korean submarine in their territory inside fishing

nets. Later that year, the ROK sunk a North Korean semi-submersible. Their navies would clash

again in July 1999 in disputed waters. Things seemed to turn around in 2000 when the first ever

inter-Korean summit is held in North Korea’s capital, Pyongyang. In 2001, the Millennium

Democratic Party (MDP) reactivated their coalition with the DPP and ULD who later leaves the

coalition. In 2002, Roh Moo-hyun of the MDP and Lee Hoi-chang of the GNP

faced off in the presidential election. Roh Moo-hyun narrowly prevailed. Again, the

parliament was dominated by the opposition GNP. Currently, they are attempting

to block his choice of prime minister.

Recent Political Issues

South Korea’s major political issue is the military threat coming from North Korea. North Korea’s

aggression towards the South is strong and a major threat because of their stockpile of chemical

weapons (one of the world’s largest), and they’re nearly one million strong army. Terrorism coming

from the North has been ever present such as the assassination of four members of South Korea’s

cabinet in Burma, bombings of Korean Airlines plane, and the violations of South Korean territory

by naval vessels. US troops now remain in South Korea near the DMZ to prevent tensions from

arising. Things do not seem to look brighter as the Bush administration labels North Korea as part

of the “axis of evil.” Tensions are more likely to rise than fall in the years ahead. With the North

refusing to disclose nuclear information and their possession of weapons of mass destruction in the

aftermath of 9/11, a crisis is looming over their reactivation of a nuclear generator. The US has

linked ties between North Korea and Osama Bin Laden and their continued harboring of Japanese

Red Army hijackers since 1970 with the selling of weapons to terrorist groups in the Philippines.


of 46

A New Regime

In current events, Roh Moo Hyun is to assume office on February 25th. He has formed a transition

team to gain formal status and plans for the parliament. The team is made up of mostly professors,

rather than politicians or bureaucrats. Their focus should be on liberalism and not populism. A

Kim Dae Jung loyalist, Moon Hee Sang of the MDP was appointed as the chief of staff and has

stated his opposition to changes in the MDP structure. In terms of domestic politics, the outlook is

faced with many unknowns. With a new president comes a new direction for the country. They

face obstacles from the opposition GNP who controls the parliament and will likely encounter

legislative programs being obstructed. Roh has promised political reform, but GNP may oppose

because of their view on Roh as a dangerous radical. External politics are very sensitive as the

situation with North Korea is increasing tension. North Korea’s defiance in maintaining a nuclear

development program poses great danger. This will also makes things worse for their alliance with

the US. Roh promises to carry on with the “sunshine policy” by Kim Dae Jung with the US. There

have been recent protests centered on the acquittal by court martial of the drivers of a US military

vehicle that killed two teenage girls. They are facing two fronts that have isolated them from the US

and North Korea, posing a great challenge for Roh to ease tensions. Roh wanted US forces out of

Korea and has planned for military forces to take place in the event the US pulls out their troops.

Like the US, China and Russia oppose pressing the North’s leader Kim Jong Il too hard and seek a

diplomatic solution. But if the US topples over Saddam Hussein in Iraq, North Korea will likely be

the next military target. Roh is unknown in Tokyo as much as in Washington and there are fears of

him being too much of a nationalist. His stand on foreign investments is not clear, but is dependent

on the growing nuclear crisis in the North.

SOCIAL CONDITIONS

Background

South Korea is one of the most ethnically homogeneous countries in the world, resulting in mostly

an indigenous Korean populace. Korea was first populated by a “Tungusic branch of the Ural-Altaic

family”, which migrated to the Korea peninsula from the northwestern regions of Asia, as early as

5000B.C. Some also settled parts of northeast China (Manchuria); Koreans and Manchurians still

show physical similarities-in height, for example. People of Chinese descent make up the country’s

largest minority group. Interestingly enough South Korea enjoys religious diversity of multiple

denominations including: Christianity, Buddhism, Shamanism, Confucianism, and Chondogyo.


of 46

Population

The population of South Korea is 48,324,000. The country’s population density of 487 persons per

sq km is one of the highest in the world. The majority of the population lives in the southern and

western coastal areas. The annual rate of increase has dropped steadily from more than 3 percent in

the late 1950s to 0.85 percent in 2002. Urbanization of the country has proceeded rapidly since the

1960s, with substantial rural to urban migration; 82 percent of the population is now classified as

urban.

In addition, the average life expectancy is increasing at a high rate to a predicted average of 75.6

years of age as opposed to the current life expectancy of 57 years. Industrialization has lead to

improvements in Korea’s water supply, sanitation, housing, diet, and medical services.

The same language and culture is promoted through out the

country, with little differences across regions and cities. Society is

very urban, where more than half the population resides in big

cities. One quarter of the population is located in Seoul, while the

government continues to promote regional urban centers to

encourage further urban growth.

Education

Primary education is free and compulsory for all children between the ages of 6 and 15. Secondary

education consists of three years of middle school and three years of high school. Private schools

play an important role, especially above the primary level. The country has 297 institutions of higher

education, with a total annual enrollment of 2.5 million students. The principal universities are

Korea University, Seoul National University, Ewha Women’s University, and Yonsei University. An

estimated 100 percent of the adult population of South Korea is literate.

Education in South Korea takes an important role in the government’s budget. As a result, 16.4%

of South Korea’s government spending was reserved for education. This level surpasses the United

States. The Korean government is trying to educate not only urban areas, but also rural areas to

create an equally educated population.


of 46

Labor

In 2000 the total labor force was 24 million. Of this figure, some 11 percent were

engaged in agriculture, forestry, and fishing; 28 percent in industry; and 61

percent in services. W omen make up 41 percent of the labor force. The

principal labor organization is the Federation of Korean Trade Unions, with a

membership of more than 1.8 million.

Youth

South Korea’s opinionated study body is well educated and therefore has strong views on social,

political and economic issues. Protests against the rise of capitalism are frequent due to their

socialist ideals even though they claim to support the benefits of capitalism. Nationalism is still

prominent and is a major sentiment among Korea’s youth.

Corruption and Crime

South Korea maintains a relatively low level of crime. They are one of the world’s safest countries.

Organized crime and corruption has been much reduced. In past cases, Korean firms were subject

to slush funds and fraud. For example Daewoo, the second largest group, was found to have

committed frauds. Their executives were found participating in organized crime that revolved

around the firm. Civil unrest in South Korea has been calmer now than in the past. Known for

mass demonstrations and militant trade unionism, moralistic civic groups have emerged. Theses

demonstrations focus on the social democratic and anti-trust nature, not anti-capitalist. With a anti-

communistic mentality, South Korea has opened up their doors to foreign business. They are a

member of the WTO and the OECD. Violent crime in general is very limited in South Korea,

although white collar crimes such as extortion and bribery are commonplace. The country is known

as one of the safest in the world. Terrorism is no longer such a fervent threat as it used to be in the

past; however, the United States does claim that North Korea has contacts with Al Qaeda’s terrorist

network.


of 46

MACROECONOMIC CONDITIONS

Background

South Korea has achieved an incredible record of economic growth over the past ten years. Three

decades ago GDP per capita was comparable with levels in the poorer countries of Africa and Asia.

Today its GDP per capita is seven times

India's, 17 times North Korea's, and

comparable to the lesser economies of t

he European Union. This success

through the late 1980s was achieved by

a system of close government/business

ties, including directed credit, import

restrictions, sponsorship of specific

industries, and a strong labor effort. The

government promoted the import of raw materials and technology at the expense of consumer

goods and encouraged savings and investment over consumption. However the stream of good

luck for South Korea ran out.

The Asian financial crisis of 1997-99 exposed certain longstanding weaknesses in South Korea's

development model, including high debt/equity ratios, massive foreign borrowing, and an

undisciplined financial sector. Growth plunged by 6.6% in 1998, and then strongly rebounded to

positive 10% in 1999 and 9% in 2000. This surge in growth did not last long; growth fell back to

3.3% in 2001 because of the slowing global economy, falling exports, and the perception that much-

needed corporate and financial reforms had become stagnant.

Current Economic Situation

South Korea’s economy showed great resilience in 2001 despite the turmoil in the U.S. and Japan,

with continued strong GDP growth. Real GDP was in the black by 3.0%, a sign that sector-related

weakness and global IT slowdown were not enough to bring the nation into recession. According to

the Ministry of Finance and Economics (MOFE), Asia’s fourth largest economy is projecting

growth of 6.3% for 2002, staying on track with earlier estimates. The Bank of Korea and external

analyst reports reiterate this prediction. Long-term, South Korea’s expansion is expected to continue

with GDP growth projected around 6% in 2003.


of 46

The economy has slowly recovered since mid-1998 following the Asian Financial Crisis, and the

Bank of Korea (BOK) has maintained a low interest rate policy aimed to stabilize slightly over 5%.

As part of the IMF bailout plan in the late 1990’s, BOK implemented high interest rates to ensure

foreign currency liquidity and stabilize the exchange rate. However, these high interest rates caused

the real economy to contract and pushed many firms towards bankruptcy. In 1998, the government

pursued lower interest rates to rescue the economy from a recession. As a result, the inter bank call

market rate decreased to 6% in 1998 from its peak of 20% in late 1997, then falling again to 4% in

1999. The stable inflation forecast of 2002-2004 is due to further deregulation of closed areas of the

economy, particularly the services sector, and the Won’s continued appreciation against the US

Dollar. Consumer price inflation in the first nine months of 2002 averaged 2.6% year on year;

broadly in line with expectations of an average increase of 2.8% for the year. Forecasted inflation

rates are shown above. The forecasted appreciation of the Won against the US Dollar in future

years will be supported by a continued favorable trade position and net capital inflows. Stability of

the currency has mainly been the result of the steady rise in foreign-exchange reserves, increased

foreign direct and portfolio investment, and a decline in foreign borrowing. In addition, the

government no longer intervenes directly in foreign-exchange markets to maintain a target for the

exchange rate.

Economic Outlook

Analysts forecast South Korea’s real GDP to expand by 4.6% in 2003, growing to 5.3% in 2004.

The foreign trade balance will make a large contribution (2.2 percentage points) to overall growth in

2003. This will largely be the result of a slowdown in import volume growth on the back of a sharp

deceleration in domestic demand growth. Export volume growth will slow in 2004, to 9.5%, partly

reflecting a decline in competitiveness as a result of the continued appreciation of the won. This

slowdown will serve to reduce the contribution of the foreign trade balance to overall growth to just

1.2 percentage points.


of 46

TELECOMMUNICATIONS SECTOR

Mobile Phone Service Industry

In 2001, South Korea became the leader in providing CMDA 2000 services in

the world telecom industry. In October of 2000, Korea's top mobile carrier, SK

Telecom became the world's first operator to launch a commercial mobile

service using CDMA 2000 technology, which was first developed by U.S. firm

Qualcomm Inc. CDMA 2000 technology at that point in time was the

dominant wireless technology in the United States and South Korea. CDMA,

or Code Division Multiple Access, is a cellular technology which can deliver

multimedia applications such as games, video on demand, video messages and

high-speed Internet access. It competed against the GSM 2.5G networks found

in Europe. These technologies were precursors to the full third-generation

(3G) services that are available today.

In 2002 the Korean mobile sector ended with 32.34 million subscribers, this is up 11.4% from the

2001 figures. The mobile sector’s performance is based on Average Revenue per User (ARPU) and

Minutes of Use (MOU).

In addition, penetration of users is used to determine what percentage of the country has access to

mobile phones. In 2002, they reached a penetration rate of 67.7%. The Gross additions less

deactivations gives us their net new subscribers which ended at 0.33 million new subscribers at the

end of year 2002. LG gained 0.05 million net subscribers, in 2002. With LG standing in third place

as the wireless providers, they maintain a 14.8% market share compared to SKT’s 53.2% and KTF’s

31.9%.

Market Share 2001 Market Share 2002


of 46

Since commercial services began in June 2001, 2.5G and CDMA have increased at a very high rate.

Based on the number of deployed handsets at the end of 2002, South Korea is believed to have 28.2

million or 55.2% of total subscribers carrying the new handsets. With the introduction of the new

3G technology, the telecom sector should have a greater outlook with the new technology.

Regulatory Environment

The Ministry of Communication (MIC) governs the communications industry within South Korea.

Their main goals are to accelerate information, promote the IT industry, and facilitate market

deregulation and liberalization. Their focus is to ensure fair competition and to promote transparent

corporate governance. In addition, they promote venture capital along with R&D within the

communications sector. Their efforts have been instrumental in closing the digital divide within

Korean society and to establish an innovative and world renowned communications sector for

South Korean.

Regulation by the Ministry of Information and Communication (MIC) will continue to weigh on the

performance of Korean telecom companies for the foreseeable future. Although most of the bad

news appears to be out already, there is always the lingering uncertainty as to the next regulatory

issue – as seen in the sudden capital expenditures increase induced by MIC at the end of 2002.

Nonetheless, LG Telecom appears to have been able to grow and attain profitability to a degree

throughout difficult regulatory situations in the past several years, including market share restrictions

in 2001 and several tariff cuts.

Tariff Cuts

Tariff cuts have been the most high-profile regulation concerning wireless telecom companies in

Korea. Although MIC only regulates tariff rates for LG’s competitor SKT, this has a ripple effect as

LG and other telecom companies have to lower rates at the same time to stay price-competitive.

MIC cut SKT’s rate by 8.3% in January 2002 and again by 7.3% in effective January 2003 vs

consumer groups’ demand of a 20-30% slash. Deep tariff cuts run the risk of a less competitive

environment in the wireless sector since companies are unlikely to be able to turn profitable at low

tariff levels.


of 46

Tariff cut history (Standard plans)

Mobile Number Portability

Mobile number portability (MNP) may become the next big regulatory risk in January 2004 for

wireless operators because of the potential increase in marketing costs and higher churn rates for

operators. With MNP, wireless subscribers can switch operators without having to change their

mobile phone numbers. LGT subscribers will be granted MNP in January 2005. MNP is being

phased in because a MIC-commissioned study indicated that LG’s competitor, SKT’s market share

will swell by up to five percentage points if MNP is implemented at the same time.

In addition, the single dialing prefix system (010) to be implemented beginning 2004 and the rollout

of W-CDMA 3G around end-2003 may shift subscribers’ focus from tariff rates to the quality of

operators and specific features. Most subscribers are accustomed to their current operators’ services

and fee schemes, and that the majority of wireless subscribers would not switch operators unless

there were a compelling reason – such as a significant tariff gap. Switching operators involves the

hassle and cost of buying new handsets and learning about different services and fee schemes.

Handset Subsidy and Marketing

The allowance of certain handset subsidies and some marketing activities, such as membership or

royalty programs, may well help clarify marketing costs for wireless operators. It appears that the

MIC is likely to be stricter in enforcing its policy on handset subsidies. The MIC has announced

plans to allow limited subsidies, 10-20% of retail handset price, for certain handsets from March

such as 3G, PDA and handsets that have been sitting in inventory for over 12 months. The ‘indirect

handset subsidy’ has been one of the biggest cost items for wireless operators since the ban in June


of 46

2000, and the limited handset subsidy should help reduce marketing costs. MIC has also imposed

restrictions on marketing activities via membership or royalty programs starting January this year,

which should also help reduce marketing costs for the wireless operators. Instead of providing

almost unlimited benefits such as significant discounts at ski resorts, theme parks, and restaurants,

operators are now required to sum up and restrict the total discounts and benefits per member,

while charging annual membership fees to reduce discrimination against non-members.

Technology and New Services

As the subscriber market nears saturation, telecom companies in Korea will continue to introduce

new services using better technology to increase ARPU or market share. Wireless operators, except

LG Telecom have started to offer CDMA 1x EVDO (evolution data only) services since mid-2002,

which provides 2.4Mbps of transmission speed vs. the regular CDMA 1x speed at 144Kbps. EVDO

enables downloads of bandwidth-intensive and more sophisticated wireless data content. An

example would be streaming video, which increases the profile of wireless data and opens up new

business opportunities such as wireless commerce and finance.

Evolution of Wireless Telephone Industry

These new services can generate commission revenue for wireless operators, for providing the

network, along with traffic fees, helping to reinforce growth and expand margins. The improvement

in wireless data platforms, such as virtual machines (VM), is also enabling faster operation of data

such as games on wireless handsets. Meanwhile, improved wireless security features such as W-PKI

(wireless public key infrastructure) and encryption technology should provide a safer environment


of 46

for wireless finance and commerce to take place While voice capacity is ample for all wireless

operators (only requiring 9.6Kbps per subscriber), exponential growth in data demand is causing

certain quality issues.

Surging non-SMS data sales in South Korea

Wireless data is also requiring increasing bandwidth (average downloading speed currently at 20-

30Kbps) as content is becoming more sophisticated – with correspondingly larger file sizes – and as

more subscribers are downloading bandwidth-intensive content such as games and video clips. The

problem is that a base station can handle only so much voice and data bandwidth requirements

concurrently. For example, a CDMA 1x base station can concurrently handle approximately

900Kbps per channel or sector (1 FA) while base stations normally have three sectors (countryside

base stations may have one or two sector systems). This means that the maximum voice calls a

normal base station can handle would be 282 calls (94 voice calls per sector x three sectors).


of 46

3rd Generation Wireless Technology Capabilities

3G Mobile Network

1X EV-DO (EV-DV)

Current 2G networks are based on the asynchronous method, which was led by Europe, and the

synchronous method, led by the U.S. Accordingly, 3G networks will be set up based on two

methods asynchronous W- CDMA and synchronous cdma2000.

As most global mobile carriers adopt W-CDMA, it is becoming main stream in the global telecom

industry. In Korea, SKT and KTF will provide 3G services based on W-CDMA, while LGT will

base its 3G services on cdma2000. The standards for 3G cdma2000 are 1X EV-DO, and 1X EV-

DV.

In Korea, 1X EV-DO has been commercialized in frequency bands between 800Mhz and 1800Mhz

(3G services operate under 2GHz frequency). Synchronous 1X EV-DO is compatible with existing

networks (IS-95A/B, cdma2001X), and can offer multimedia services (including MMS, VOD,

mobile broadcasting, etc.) at a maximum speed of 2.4Mbps.


of 46

1X EV-DV technology is an upgrade of EV-DO. EV-DO, dedicated to data services, cannot offer

voice services. On the other hand, EV-DV can provide both voice and data services, improving

network efficiency. Despite this, 1X EV-DV has still not been commercialized. Going forward,

LGT plans to base its 3G network on 1X EV-DV technology.

W-CDMA

W-CDMA has the following features has three main features. First, in terms of data transmission

speed, W-CDMA does not differ much from EV-DO. Accordingly, WCDMA is not significantly

distinguished from other technologies (if excluding visual telephone services provided by W-

CDMA).

However, W-CDMA guarantees stability with its transmission speed of 384Kbps. Additionally, 1X

EV-DO cannot guarantee quality of data communications, as capacity is concentrated on certain

users in the case of using high-capacity data services.

Third, massive CAPEX is required for W-CDMA due to incompatibility with existing synchronous

networks. Furthermore, W-CDMA does not support handoff between 2G and 3G networks. In

light of technological development, W-CDMA has greater growth potential relative to cdma2000.


of 46

Telecommunications Industry

Valuations of Korean telecommunications companies have been hit hard by concerns over

regulatory issues such as tariff reductions and government capital expenditure requirements.

However, because this news is already priced in and the heavy sell-off seems overdone, Korean

telecom companies are quite cheap when compared to their global peers. Until very recently, profit

growth for Korean telecom companies has been rather stagnant. The wireless market has proven to

be the fastest and most profitable sector of telecommunications. Cellular penetration, a major

growth driver in the past, now hovers around 67.7% in Korea, a level most analysts consider near

saturation. This has led many telecom companies to focus growth efforts in other areas, in value-

added services (VAS). The total market size of wireless Internet services in South Korea is estimated

at W1.25tn for 2002, which is 9.5% of industry revenues. Wireless Internet services posts a

penetration rate around 16-20%, leaving room for tremendous growth in this sector. In fact, this

rate is expected to grow to at least 35-40% by 2005. Korean telecom operators are thus pushing

anxiously for VAS to become the engine of future growth.

Wireless Growth Drivers

There are a few critical catalysts that will drive the growth of the wireless Internet in Korea. First, at

present, the majority of the users of wireless Internet in South Korea are teenagers. In order to


of 46

widen the user base beyond young adolescents, useful new applications are being developed in

mobile commerce that allow the user to place financial transactions, view video, and perform a

wider array of functions. Second, standardized hardware platforms are being created so that content

providers need not develop software for different mobile handsets. This increases download

capability, enhances security, facilitates the introduction of new multimedia content, and above all,

stimulates customer interest. Finally, the development and implementation of the 1X EV-DO

wireless infrastructures to replace traditional CDMA networks will greatly enhance the speed of data

transfer. It is also important to note that Korean customers are generally Internet savvy, as rising

figures for Internet usage frequency reveal. In addition, the Korean government is actively engaged

in the promotion of wireless Internet through plans such as the Public Mobile Services Decree that

would allow the public to access government services through a mobile website. This along with the

perpetual demand for Internet access further lends itself to sustainable growth in this emerging

industry.

LG TELECOM

History

LG Telecom was established in July 1996, with the opening of its Main Switching Center in Seoul,

and in January 1997 the Korean government authorized the company’s R&D Center as a national

center for industrial research. In June 1997, the company’s Network Management Center (NMC)

was established, and the Customer Services Center was opened in July 1997. In October 1998, the

company launched its commercial PCS service in Korea. In January 1998, the company introduced

its CDMA Optical Transmission Antenna (L’COTA), and in March 1998, the company established a

partnership with the Venezuelan PCS Consortium, for the perfection CDMA PCS network

architecture, in order to bring master technical and operational know-how to the company. In

October 1998, the company and BT formed a strategic partnership. BT bought an approximate 23%

stake in the company. In 1999, the company’s wireless Internet commercialization and ez-channel

launched, the world’s first broadcasting service provided by a mobile phone. In 2000, the company

launched a number of new services, including btob, Korea’s first mobile telecommunications brand

designed exclusively for business, and ez-java, a PCS eMoney service. In 2001, the company spun

off its Customer Service Division. LG’s parent company announced in September 2002 that it plans

to invest KRW1.8 trillion in R&D in this division, over the coming year.


of 46

The company is headquartered in Seoul, South Korea and has 1207 employees. LG Telecom

commenced PCS services in October 1997 and is Korea’s smallest wireless communications service

provider. As of December 2002, LGT had approximately 4,790,000 subscribers, or a market share of

14.8%. LGT comes under the aegis of the LG Group, a diverse conglomerate with strong domestic

electronics and refinery businesses. The LG Group’s telecommunications-related holdings include

Dacom Corporation, primarily a DLD and ILD service provider, and Hanaro Telecom, a broadband

and licensed local voice provider. Fiber-optic backbone provider Powercomm is slated to enter the

LG fold shortly.

LG Subscriber Breakdown 2002

Company Description

LG Telecom is a provider of a wide range of

PCS services (Personal Communications

Services, which use CDMA technology. A PCS

allows the user to make and receive local and

overseas. The company has approximately 4

million subscribers. In 1996, the company

succeeded in commercializing CDMA technology through cellular services for the first time in the

world and provides a nationwide PCS service in Korea. The company offers integrated wire and

wireless Internet services which can be accessed by a mobile phone, the first of its kind in Korea,

and offers WAP Internet services.

The company concentrates on establishing networks through network design, base station

construction and advanced system operation while accelerating extension of coverage areas as well

as the development of calling quality through L’COTA, repeaters, and L’Pico according to the

specific geographical conditions of each region of Korea.

LG Telecom (LGT) was one of the biggest turnaround stories in Korea during 2001. LGT posted a

sharp turnaround in 2001, recording net income of W154bn, up from a net loss of W442bn in 2000.

The turnaround was due mainly to the ban on handset subsidies and steady ARPU and subscriber

growth. The success of LGT attests to the benign competitive environment for cellular operators in

Korea. Korean mobile operators boast some of the highest profitability margins globally, yet as seen


of 46

in LGT’s stock they continue to trade at significant below their value. At the end of the last year,

LGT was also able to raise W343.6bn in equity financing, shoring up its balance sheet considerably.

Subsequently, its debt to equity ratio dropped from an alarming 695% in 2000 to a respectable 128%

in 2001.

LG Telecom Brands

• Ez-i: LG TeleCom has been providing the first Korean wireless Internet service since May

1999. Through its over 8,000 options, customers are able to experience the diverse wireless

Internet services offered by LG TeleCom, which are useful in everyday life. Also, LG

TeleCom commercialized the world’s first Java Station; using an alliance with BT Genie, LG

are leading the world wireless Internet market on the basis of the accumulated ez-i

technology and know-how.

• Khai: Launched on February 2000 aiming at the new generation in the 19-24 age group, is a

cultural trend combining mobile communication and cultural facets. Mobile communication

has now evolved past simple voice calls to a device that satisfies the diverse cultural needs of

the new generation. With Khai, customers are able to experience diverse cultural aspects

including fashion, sports, music, performances, and dancing with discount benefits added.

• Khai Holeman: Conceived to suit the patterns of mobile telephone use among teenagers,

has evolved past being merely a rate system to a device that satisfies the diverse needs sought

after by teenagers. Khai Holeman includes not only a teen-only rate system, but also

incorporates teenage interests in such things as invitations to various events and discounts.

In particular, taking into consideration that animated chara cters are mostly in demand by

teenagers, the unique character of Holeman was created. Diverse marketing techniques were

implemented under this brand, meeting with an enthusiastic response from not only teens

but also from adults.

• Btob: Originated for more effective communication, more efficient work, and more

optimum resource management, is the first Korean mobile communication service

exclusively for business. LG TeleCom has the largest market share in the mobile office

market; the mobile office is an essential infrastructure to an enterprise. Btob is a tool to

bring innovations in work from the perspective of business process redesigning; LG


of 46

• TeleCom is already providing corporate sales service which is at the level of mobile

consulting on the basis of numerous past successes. LG TeleCom aims to open a new age in

the corporate mobile communication market through providing enterprises with the highest

level of competitiveness by creating not only the mobile office but also specialized data

solutions tailored to your needs.

• IMT (International Mobile Telecommunication) 2000: A worldwide next generation

mobile communication that allows access from one IMT-2000 handset unit (handheld

computer + phone) to wire/wireless and satellite network integrated global roaming service

(using the same number overseas) as well as real time multimedia service. It includes

Internet, data, fax, video, video communication/conference, TV viewing, and motion

picture. The service is accessible anytime, anywhere, and with anyone.

Top Competitors

LGT is trading at a discount to its Korean peers, but the question to be asked is whether it is a good

buy. When comparing the discount applied between first and second tier operators within

respective markets, LGT appears to be trading in line with its peers as seen in exhibit 1. However,

Hong Kong and Taiwan’s wireless sectors are fragmented with Hong Kong having six and Taiwan

having five telecom companies. As was true with Korea around 1999, such fragmentation creates

the potential for dramatic shifts in market dominance through mergers and failures of competitors.

However, the dynamics in Korea are now quite different as consolidation has already occurred. The

only change that may have a dramatic impact on the Korean market would be the demise or

acquisition of LGT.

• Korea Telecom Freetel: Established in January 1997, and successfully launched

commercial service in October 1997. KT Freetel signed more than one million subscribers

within their first six months of operations. After 18 months of service, the company has

more than 3 million subscribers. As of April 2000, KT Freetel has over 4.7 million

subscribers. For the fiscal year 2001, revenues totaled $4.3 billion. In September 1999, KT

Freetel became the first cellular operator to launch IS-95B wireless Internet service. This

service expanded nationwide in February 2000. KTF, concluded the merger contract with

KTICOM in 2002 and was KTF ranked No.1 in mobile Service on the Business weeks's IT

100 in the world. It is headquartered in Seoul, South Korea.


of 46

• SK Telecom: South Korea’s number one wireless telecommunication services provider.

For the fiscal year 2001, revenues totaled $6.37 billion. The company has interests in a

variety of fields covering energy production and distribution, films, fibers, petrochemicals,

telecommunications, engineering, international trade and finance. The company is part of the

SK Group which is made up of 60 member companies, including around seven that are

listed on the Korean Stock Exchange. SK Telecom has a presence on six continents. The

company is headquartered in Seoul, South Korea.


of 46

CASE SOLUTION

The case solution is comprised of the following steps:

• Current Market Situation

• Regulatory Effects

• Investment Outlook

• Financial Analysis

• Ratio Analysis

• Discount Rate / DCF Analysis

• Conclusion and Suggestions

CURRENT MARKET SITUATION

Despite the recent economic recovery in Korea, LGT's top-line growth has been declining. Even

though LGT is third in market share, they maintain high EBITDA margins (39% estimated in 2003),

an accomplishment that is difficult to find in other countries. In 2001, the Korea mobile sector

ended with 29.05 million subscribers, which were up 8.3% from 2000. The mobile sector’s

performance is based on Average Revenue per User (ARPU) and Minutes of Use (MOU). In

addition, penetration of users is used to determine what percentage of the country has access to

mobile phones. In 2001, they reached a penetration rate of 61.2%. The Gross additions less

deactivations gives us their net new subscribers which ended at 0.19 million new subscribers at the

end of year 2001. Though LG lost 0.06 million net subscribers, they gained 4.28 million in the

month of December alone. With LG standing in third place as the wireless providers, they maintain

a 14.7% market share compared to SKT’s 52.3% and KTF’s 33.0%.

Management is targeting 5.3m subscribers (+11% YoY) by the end of 2003 (with a market share of

16%), and has earmarked a Won400bn marketing budget (almost similar to the Won418bn in 2000).

The company’s rationale behind the aggressive expansion and marketing plan is to strengthen its

weak competitive position and brand image in order to benefit when the MNP is introduced in

2004.


of 46

In 2002, LGT experienced an 11% subscriber base growth, but at the same time, its ARPU fell 9.5%

YoY and net profit fell 53% YoY. While the "Mini" low-end tariff plan helped subscriber growth, it

diluted overall MOU and ARPU levels. Mini currently accounts for 14% of LGT’s total subscriber

base Its expansion plan resulted in an increase in marketing expenses as well as other costs such as

rental and maintenance costs which was due to an increase in the number of retail shops.

LG Subscriber Trend for

New Tariff Schemes

Stock Performance of LG Telecom

LG Telecom is listed on the KOSDAQ in South Korea. Its ticker symbol is 32640.KQ. It currently

trades at W4,140.00. Its 52 week high was W5,050 and the 52 week low was W3,370 Its current

market capitalization is about W1.3 million. It provides no dividends and the EPS for 2002 was

W739m.


of 46

Historical Trading Range

Despite its solid operations, LGT has traditionally traded at a significant discount to other mobile

operators. LGT is currently trading at a forward EV/EBITDA base of 3.0x to its competitors SKT

and KFT’s 6.8x and 7.3x. Due to this discounted trading factor, and in-turn weaker competitive

position, LGT is to trade at a discount to other leading mobile operators.

Network Contract

LG Telecom’s 5-year exclusive contract with Korea Digital Satellite Broadcasting to provide wireless

network service will enhance revenue streams. KDSB will be responsible for downloading contents

to subscribers, while LGT will handle the uploading of interactive data through its wireless network.

LGT anticipates receiving 30-60% of the monthly subscription fee, which the company estimates at

W11,000-21,000. LGT also gets 100% of phone usage revenue. LGT expects some of the content

providers to shoulder some of the burden. However, KDSB will be competing with both cable TV

and PC broadband services.

De-levering of Balance Sheet

With revenue and EBITDA growth slowing, de-levering of the balance sheet has continued to drive

earnings for LGT. In addition, the improving financial health of the company should facilitate

reductions in cost of debt, further aiding earnings growth. This will also reduce the company’s cost

of capital, having positive implications for share price performance.

LGT’s earnings multiples are more compelling than SKT’s, but not by a significant amount. LGT’s

forecasts and, therefore, earnings based multiples fail to take into account potentially favorable

regulatory and de-levering changes. Also, short-term multiples fail to take into account longer term

improvements in LGT’s fundamentals and differing costs of capital.

REGULATORY EFFECTS

Last year Korea’s regulator, the Ministry of information and Communication (MIC), approved the

merger of SKT and Shinsegi Telecom (STI), without imposing additional conditions upon SKT, or

other regulations that would favor competitors. LGT and KTF claim they are disadvantaged

following the merger and argue that some form of asymmetrical regulation needs to be introduced


of 46

to curb SKT’s dominance. LGT should achieve operational efficiencies when some form of

regulation such as the proposed ban on handset subsidies. With this new regulation subscriber

growth, APRU gains and margin expansion are possible.

The MIC is currently studying the mobile-to-mobile interconnection rate structure, with the

intention to rebalance the tariffs in favor of smaller operators, particularly LGT. However, the

government’s argument is that SKT has been in operations for 17 years versus four years for PCS

operators (LGT and KTF), and therefore, SKT’s imputed interconnection cost is lower than that of

the PCS operators.

INVESTMENT OUTLOOK

The investment outlook for LGT relies not only on financial valuation techniques, but qualitative

benchmarks and signals/warnings for potential expansion or the antithesis, consolidation of

acquisition of LGT. LGT’s performance will remain vulnerable to such external factors:

1. LG Group Strategy: Several recent developments demonstrate that the LG Group’s

focus on wireless services many be diminishing. This raises the possibility that LGT will be

“marginalized or used as political currency to further the LG Group’s other strategic

thrusts”, such as power generation.

2. MIC philosophy: In the past, the Korean regulatory agencies have felt three big players

must be in position to ensure adequate levels of competition in the wireless markets. The

most important of these agencies being the Ministry of Information and Communication

(MIC), in the past had a steadfast opinion on this issue. However, recently this dictum has

been rethought, and a new plan of having a single large competitor to compete against SKT

in the new liberalized market environment, seems to be the most viable course of action

hindsight of the negative experience of the past three years. According to this, consolidation

of LGT by KTF is the logical way to achieve this goal.

Both of these issues could have dramatic consequences for LGT’s valuation in the medium term,

and both lead to the same conclusion: “LGT is not economically viable in a liberalized market


of 46

environment and should be merged with KTF, to the advantage of both operators.” This

conclusion has important implications for our valuation of LGT, as it introduces political factors to

the valuation process. Within this realm of political factors, a government-led merger of LGT and

KFT, it is likely that the government would heavily influence LGT’s valuation.

Investment Positives

1. High Beta: Historically, short-term trading momentum can drive LGT’s share price to

outperform its peers.

2. MIC: The three-operator sector policy enhances LGT’s returns primarily through

asymmetric interconnection rates. We estimate that LGT’s net interconnect revenue will

constitute 36% of it gross interconnection revenue in 2002E, a ratio that may improve to

45% in 2005.

3. Marketing Expertise: The LG Group has redefined “consumer-level” branding and

marketing efforts to an art form over the past40 years. LGT’s efforts at market segmentation

and brand-building are innovative.

Investment Risks

1. Heavily Dependent on Regulation: LGT’s long-term viability is dependent on the

continuation of the MIC’s current philosophy toward the wireless sector.

2. Lack of Parent Support: LG Group support for LGT appears weaker than for its other

business areas. LG Group emphasis appears to be in the areas of consumer electronic and,

in the future, power generations.

3. Dividend Policy: While none of the wireless players currently pays out a significant

proportion of net income in dividends, we believe that market maturity and falling capital

expenditures may see an increased emphasis on dividend policy. We believe that LGT’s

chaebol affiliation and precarious market positioning will prevent the company from paying

out a significant proportion of its free cash flow in the future.


of 46

FINANCIAL ANALYSIS

LG Telecom reported a gross profit of W425,920 million, for the first time in its history in fiscal

year 2001. For 2002, the profit was W177,606 million, a decrease of 58% from the previous year.

Since its inception in 1996 it has been competing for market share with the other telecoms and is

still behind its competitors Korea Freetel and SK Telecom. It has been able to keep up with these

two competitors mostly due to financial backing by the LG Group. The EBITDA margin was 35%

for 2001, but only 8% in 2002. The profitability for 2001 can be attributed to its steadily increasing

subscriber base with 4.3 million subscribers at the end of 2002 in its grasp and its ability to cut

COGS by lowering depreciation, marketing, & R&D costs. However, in 2002, the dramatic decrease

was due to the new 3G technology that their competitors have started to introduce, lowering of

customer tariffs, and increases mainly due to higher marketing, wages, and other costs, such as

repair/maintenance and transportation. The increase in subscriber base has had a positive impact

on sales with revenues increasing by 28.66% in 2001 and increasing since 1998 at an average rate of

20.5%. However this number has been increasing at a decreasing rate. LG has been able to cuts

COGS, by lowering R&D costs by 86%, Depreciation expenses by 85%, and marketing expenses by

94% from 2000. But 2002 proved that lower expenditures on 2.5G infrastructure may have created

quality of service issues that weakened their brand image. To compensate the reduction of capital

expenditures on 2.5G they had to increase their SG&A expenses in 2002. The end result is a

decrease in market share leading to smaller profitability growth.

LG Telecom’s main revenue stream comes from their

PCS Voice sales. A breakdown of the revenues shows

that PCS Voice made up 65.8% of their revenues in 2002.

There has been only moderate growth in the PCS service

due to the tariff rate cuts and lower interconnection rate

adjustments made in 2002. PCS service revenues

declined by 3% from 2001. In addition, high marketing,

customer acquisition costs, and market saturation is the

catalyst for slower growth. Even though their market

share has increased slightly, the market has seemed to

reach saturation.


of 46

Although it was able to cut costs LG had declining voice ARPU and MOU in 2002. Average

revenue per user declined 9.5% and was W33.25million in 2002. Minutes of use (MOU) was at 121

minutes for outbound traffic while inbound traffic was 107 minutes, overall it increased by 2.7%

over 4Q01 . The main reason for the flat ARPU seems to be the slower growth in its wireless

Internet revenues and decline in call volumes. The slower data revenue growth may be a function of

a much slower subscriber migration to CDMA2000 1x services with only 213,000 vs. KT Freetel’s

700,000 and SK Telecom’s 2.68 million subscribers.

Monthly ARPU by Carrier 2002

Monthly MOU by Carrier 2002


of 46

One thing that stands out when looking at LG Telecom’s balance sheet is that LG increased their

long term borrowings by 150% from 2001. The total debt load taken on by LG Telecom increased

by 15% from 2001. D/E increased to 188.72 compared to 169.63 in 2002. This is a big change

from the decreased D/E of 735.85 in 2000 to 169.63 in 2001. This is largely due to the increase in

capital expenditures spending in 2002. The company spent W358 billion on the network expansion

for the 2G services. This represented 72% of the total capital expenditures in 2002. The remaining

capital expenditures is made up of the 2.5G upgrades and other IT related equipment. This is a

complete reversal from 2001 when they were able to generate rights offering of W320 billion and

debt repayments of more than W200 billion.

Another key when looking at LG Telecom are their activity ratios. The activity ratios give the

liquidity of specific assets and the efficiency of managing these assets, the short term ratio viewed

here were the inventory turnover and receivables turnover. LG’s inventory turnover went from

26.34 in 2001 to 21.96 days in 2002. This means that demand for its handsets are growing and they

are staying less in their warehouses. The popularity of the new color screen handsets increased

demand therefore generating a better inventory turnover ratio. Its receivables turnover has reduced

from 8.24 to 7.86 from 2001. The long term ratio that is important is the fixed asset ratio. Its gross

fixed asset ratio has gone up from 1.22 to 1.39 from 2001. This increase is due to the increase in

LG’s asset base from new capital expenditures.

Also important is the Liquidity of LG. Liquidity ratios give a firms ability to meet cash needs as they

arise. Their current ratio has decreased slightly from 0.50 to 0.46 in 2002. The cash ratio decreased

from 0.21 to 0.01 in 2002. This is not a good sign as LG’s cash resources are decreasing. Current

assets and cash flow from operations are of concern because of their decrease in profitability and

increase in debt.

Overall since attaining profitability for the first time in the companies’ existence in 2001, they were

able to maintain profitability in 2002. Return on Assets, Return on Equity, and Return on Capital

decreased in 2002 from 2001. ROA was 2.47%, ROE 8.59%, and Return on Capital was 6.13% in

2002. These figures for 2001 were 6.14%, 30.42%, and 13.76% respectively. These decreases were

due to the changes in capital structure in the changing telecommunications industry. They were


of 46

forced to invest in new technologies in order to maintain their market share while battling market

saturation at the same time.

From this analysis, there are some major concerns about its financial condition. Their decision to

cut costs in 2001 reflects the increase in SG&A expenses in 2002 because of the poorer quality in

their service and products. Typically, wireless operators that invest less on networks suffer from

weaker brand power as a result of lower service quality or limited ability to offer services based on

the newest technology. LG will focus mainly on raising market share in 2003 by spending to

upgrade call quality and to increase their profitability. This means if the ban on subsidies is relaxed

or eliminated in 2003 the risk to LG’s profitability growth becomes significant.

DISCOUNT RATE

To find the calculation for the “Return on Equity” we must first decide the parameter of which we

will use. In this case, we decided to use the Goldman Model to adjust for sovereign risk instead of

just using the Capital Asset Pricing Model. We estimated this figure taking into account the risk-free

rate for South Korea, which is 4.75%. Additionally, we used a company Beta of 1.5, and a market

return rate according to the MCII index. In addition to this analysis using the MCII Market Return

rate, a similar analysis will be made using the South Korean Market Return Rate. We also used a

sovereign yield spread of 5% which was calculated by subtracting the 10- year US bond yield of

3.875 from a similar 10-year South Korean bond yield of 8.875. After these numbers have been

compiled we used the Goldman Model formula RE = Rf + SYS + B(Rm-Rf) to find a return on equity

for LGT of 19.13%

To find the “Return on Debt” we looked at LGT’s non-current liabilities section concerning long

term debt. Taking into account the different maturities and yields we found a weighted average cost

of debt of 10.5%. Using the return on debt of 10.5% and a return on equity of 19.13%, we can

apply both of these rates to find the weighted average cost of capital (WACC) for LGT.

In the calculation for the “Weighted Average Cost of Capital” we must first compute the debt to

equity ratio for LGT. We figured debt to be 1,181,582m and equity to be 876,009m, which means

that the value of the entire company is 2,057,591m. The next step will be to apply these numbers to

the WACC formula which is WACC = E/V*RE + D/V*RD*(1-TC) where D is debt, E is equity, V is


of 46

the entire value of the company (D+E), and TC is the tax rate applied to LGT. Our calculations

found the weighted average cost of capital to be approximately 12%, which will be used in our DCF

valuation calculation.

DCF ANALYSIS

Our cash flows in exhibit 2 are based on a five-year DCF analysis. We arrived at a 12-month target

price of KRW 5,000. In our analysis we assumed a WACC of 12%, a perpetual growth rate of 4%

and a terminal EBITDA multiple of 4x to reflect LGT’s weak and possibly deteriorating market

position as well as the stable ARPU as well as stabilizing marketing costs and declining interest

expense. 72% of the DCF value resides in the terminal value. Our DCF valuation implies an

estimated 2003 EV/EBITDA multiple of 4.4x.

In comparing LGT versus domestic companies in other sectors, LGT is trading at a slight premium

basis. For instance, the leading 24 companies in Korea have 2003 P/E of 6.8x, which is nearly 18%

discount to LGT's P/E. LGT EPS growth rate from 2002 to 2003 is expected to be 6% versus the

leading 24 companies EPS growth rate of 15%. Hence, LGT may be most exposed to a downside

risk relative to the other domestic telecoms given LGT's lower ROIC, earnings growth rate, and a

premium P/E multiple relative to our index.


of 46

FINAL RECOMMENDATIONS

After considering the market environment, political landscape, risk factors, financial information and

valuation analysis, there are a number of paths one could make for the future of LG Telecom. Based

on our findings we conclude that LG should divest LG Telecom based on the computed financial

and valuation analysis. This information suggests that the handheld service market is not as

profitable as the as compared to the handheld component market of LG Electronics. From the

income statement we can divulge the fact that profits are greater than that of the manufacturing

sector because of the large fixed costs with is associated with upgrading and implementing wireless

technology. Another important factor is the subsidized costs of handheld electronics, tariff rate

competition and the strength of competitors in the wireless telecommunications industry.

Currently, LG Telecom uses only 4FA CDMA technology (of a total 7FA) and thus, has no

frequency shortage problems. But we view that the company will try to gradually construct a

cdma2000-based 3G (EV-DV) network, to cope with intensifying competition in the wireless

Internet services market. We estimate that it will take about W0.8tn and 3-5 years for LG Telecom

to build a EV-DV network in Korea’s six largest cities. Nevertheless, it is still unclear if LG

Telecom, a CDMA2000-mode operator, will see its profitability improve given that it is difficult for

the company to reach economies of scale due to its inferior customer base. Furthermore, this fact

will be highlighted during the network evolution stage, when mobile telecoms will have to make new

investments. One point that must be noted is that when analyzing the profitability of LG Telecom’s

3G services we assumed that the company’s CAPEX and market expense would be significantly

lower than those of SKT and KFT.

Since the technology is expensive and requires a significant capital expenditure, LG will find it hard

to compete with the much larger and more capital intensive SKT and KFT. With this in mind, we

believe that LG may follow one of four possible strategies. In reflection of the diverse financial

restructuring decisions that can be made, Creative Consulting Group recommends the merger

solution mentioned below.


of 46

1. We recommend that LG Group divest their Telecom subsidiary because of its low

subscriber and APRU rates. Considering the company as a whole, LG can benefit from the

money generated from its sale to use towards more profitable NPV projects.

2. LG may implement the 3G technology themselves, but we feel this may be too costly due to

declining profits and a need for LG to cut costs.

3. LG Telecom may also decide to keep the status quo and implement the 3G technology after

seeing how it has affected the other firms. LG Telecom will not have first mover advantages

because of high implementation costs and uncertain future profits from the new technology.

4. LG Telecom may merge or create a strategic alliance with SKT or KTF so that the

risk and expenses of implementing the 3G technology can be split between the two

firms. We feel that this may be the most probable solution, however the problem

with this proposition is that government regulation may prohibit the merger due to

monopoly or competition regulations. This is the solution that Creative Consulting

Group feels that LG Telecom should implement.


of 46

EXHIBIT 1 - Competitor Analysis of First and Second-Tier

Operators (2002)

EXHIBIT 2 - LG Telecom Discounted Cash Flow Analysis ( KRW

Billions)

2002 2003E 2004E 2005E 2006E 2007E EBIT 230 276 368 412 444 472 Net Income 161 194 258 289 312 332 + Depreciation & Amortization 314 322 324 332 332 314 + (Inc) / Dec in net working capital (99) (16) (26) (9) (11) (13) - Capex 359 321 391 350 359 347 Free Cash Flow 17 178 165 262 264 286

Terminal EBITDA Multiple

Discount Rate 2 3 4 5 6 7 8 8% 2826 4834 6842 8850 10857 12865 14873 9% 2553 4471 6388 8305 10223 12140 14057 10% 2294 4126 5957 7789 9621 11453 13284 11% 2047 3798 5549 7299 9050 10801 12552 12% 1812 3486 5160 6834 8508 10182 11856 13% 1589 3190 4792 6393 7994 9595 11196 14% 1377 2909 4441 5973 7505 9038 10570 15% 1174 2641 4108 5574 7041 8508 9974 16% 981 2386 3790 5195 6599 8004 9409

Korea Taiwan Hong Kong First Second First Second First Second

KTF LGT Taiwan Cellular

Far EasTone SmarTone Sunday

EV/EBITDA 5.3x 5.1x 6.5x 4.8x 3.2x 4.4x EV/OpFCF 14.8x 16.0x 36.5x NM 6.0x NM EV/Revenue 1.7x 1.2x 2.8x 2.0x 0.1x 0.7x P/E 4.3x 12.5x 2.2x 5.0x 9.9x 3.0x


of 46

APPENDIX – Financial Information Price Ratio Analysis 2002 2001 2000 P/E 15.80 5.89 11.15 P/Book 1.31 1.48 2.81 P/Sales 0.38 0.43 0.81 P/CF 2.49 2.12 4.05 P/EBITDA 1.76 1.45 2.74

Activity Ratios/Growth Potential 2002 2001 2000 Inventory Turnover 21.96 26.34 48.71 T12 Inv Turn-Day 16.62 13.85 7.51 A/R Turnover 7.86 8.24 8.83 T12 A/R Turn-Day 46.45 44.30 41.45 Gross Fixed Asset Turnover 1.39 1.22 1.05 Net Fixed Asset Turnover 1.39 1.40 1.32 EPS Year Change -64.55 NA -94.14 BVPS Year Change 7.59 178.90 -72.75 Asset Year Change 12.49 22.41 3.52 Working Capital 22.84 17.76 -117.13 Total Cap Exp Growth 4.26 -18.17 7.52 Depreciation Change 21.52 -30.00 113.83 Cash flow/share growth -19.04 243.41 NA FCF/share growth NA NA 61.64

Profitability #'s in % 2002 2001 2000 Gross Margin 10.34 20.07 -11.80 Sales Yearly Change 6.82 14.65 28.66 Net income growth -52.98 NA -173.64 Operating margin 7.84 17.43 -14.53 Pretax margin 4.56 10.51 -20.34 Effective Tax Rate 29.70 30.80 -17.53 Profit margin 3.20 7.28 -23.90 Return on assets 2.47 6.14 -19.91 Return on equity 8.59 30.42 -94.40 Return on cap. 6.13 13.76 -13.83


of 46

ROE Decomposition #'s in % 2002 2001 2000 Return on equity 8.59 30.42 -94.40 Tax burden 70.30 69.20 117.53 Interest burden 58.14 60.32 139.97 EBIT margin 7.84 17.43 -14.53 Asset turnover 0.77 0.84 0.83 Financial leverage 3.48 4.95 4.74

Debt Factors #'s in % 2002 2001 2000 Debt to assets 53.13 49.93 65.38 T debt/Com equity 188.72 169.63 735.85 LT debt/Com equity 131.76 56.66 350.85 Total Debt/EBITDA 3.37 2.20 15.03 Com equity/assets 28.15 29.43 8.88 Com equity/Total Cap 34.64 37.09 11.96 Total debt/Total Cap 65.36 62.91 88.04 LT debt/Total Cap 45.64 21.01 41.98 CFO/Debt 0.21 0.31 0.08 Net debt 1,643.37 1,075.79 1,416.47 Net Debt/Share Equity 187.30 132.13 705.49

Per Share Data 2002 2001 2000 Cash Flow/Basic share 1,659.61 2,049.99 596.95

FCF/share -33.84 425.79 -

1,577.62 Sales/share 10,849.15 10,156.43 9,705.02

Op income per share 850.16 1,770.43 -

1,410.22

Pretax Income per share 494.25 1,067.84 -

1,973.88

Cont income per share 347.46 738.94 -

2,319.81 Book value/share 3,159.32 2,936.39 1,052.86

EPS before XO items 262.00 739.00 -

2,320.00

EPS after XO items 262.00 739.00 -

2,320.00 Average # shares for EP 0.21 0.21 0.19 EPS Year change -64.55 NA -94.14 Cash/Share 35.42 1,101.24 319.68 Dividends/share 0.00 0.00 0.00


of 46

Employee Data Thousands: (Year Only) 2002 2001 2000 # of Employees NA 1,207.00 1,253.00 Employee Yearly Change NA -3.67 20.25 Net Income/Employee NA 127.90 -353.04 Sales/Employee NA 1,757.89 1,476.97 Assets/Employees NA 2,291.77 1,803.54 Personnel expenses 69.78 62.49 NA

Liquidity Analysis 2002 2001 2000 Cash ratio 0.01 0.21 0.05 Current ratio 0.46 0.50 0.33 Total Debt/Total Cap ratio 65.36 62.91 88.04 Cash & equiv/Current Assets 2.02 41.58 13.73

Leverage Analysis 2002 2001 2000 Assets/Equity 3.55 3.40 11.26 LT debt/Total cap 45.64 21.01 41.98 Total debt/Equity Market value 1.37 0.60 2.22 Total debt/Total cap 65.36 62.91 88.04 Debt to assets 53.13 49.93 65.38 Total debt 1,653.20 1,381.14 1,477.43 Shares outstanding 0.28 0.28 0.19

Income Statement: Common Size % of Total Revenue 2002 2001 2000 Net sales 100.00 100.00 100.00 Cost of Goods Sold 89.66 79.93 111.80 Sell, Gen & Adm. Expense 2.50 2.64 2.73 Operating Income (loss) 7.84 17.43 -14.53 Interest expense 4.53 7.64 9.16 Net non-op L (G) -0.72 -0.72 -3.35 Income tax expense 1.35 3.24 3.56 Income before XO item 3.20 7.28 -23.90 XO L (G) pretax 0.00 0.00 0.00 Minority Interest 0.00 0.00 0.00 Net Income (loss) 3.20 7.28 -23.90 EBIT 7.84 17.43 -14.53 Pretax income 4.56 10.51 -20.34 Total Cash pref. Dividend 0.00 0.00 0.00 Total Cash comm. Dividend 0.00 0.00 0.00 Reinvested earnings 3.20 7.28 -23.90 Depreciation expense 13.74 12.08 19.78 R&D expenditures 0.62 1.01 2.18


of 46

Income Statement: Trend Analysis % Change 2002 2001 2000 Net sales 6.82 14.65 28.66 Cost of Goods Sold 19.84 -18.04 36.87 Sell, Gen & Adm. Expense 1.06 11.05 49.37 Operating Income (loss) -51.98 NM -151.01 Interest expense -36.68 -4.33 0.29 Net non-op L (G) -6.91 75.23 -37.55 Income tax expense -55.37 4.16 NM Income before XO item -52.98 NM -173.64 XO L (G) pretax 0.00 0.00 0.00 Minority Interest 0.00 0.00 0.00 Net Income (loss) -52.98 NM -173.64 EBIT -51.98 NM -151.01 Pretax income -53.72 NM -61.07 Total Cash pref. Dividend 0.00 0.00 0.00 Total Cash comm. Dividend 0.00 0.00 0.00 Reinvested earnings -52.98 NM -173.64 Depreciation expense 21.52 -30.00 113.83 R&D expenditures -34.30 -47.10 40.33

Assets: Common Size % of Total 2002 2001 2000 Cash & near cash 0.24 9.27 2.70 Marketable securities 0.07 1.77 0.00 Acct & notes Receivables 9.54 10.12 10.40 Inventories 3.30 2.98 2.05 Other current assets 2.48 2.41 4.50 Current Assets 15.64 26.55 19.65 Gross fixed assets 52.95 58.08 83.26 Accumulated depreciation 0.00 0.00 20.15 Net fixed assets 52.95 58.08 63.12 LT Inventory & LT Receivables 6.33 7.38 4.14 Other assets 25.09 7.99 13.10 Total assets 100.00 100.00 100.00


of 46

Liabilities: Common Size % of Total 2002 2001 2000 Accounts payable 7.50 4.12 8.27 ST borrowings 16.04 33.25 34.21 Other ST liabilities 10.34 15.77 16.75 Current Liabilities 33.87 53.14 59.22 LT borrowings 37.09 16.68 31.17 Other LT borrowings 0.88 0.75 0.72 Total liabilities 71.85 70.57 91.12 Offered equity 0.00 0.00 0.00 Minority interest 0.00 0.00 0.00 Total common equity 28.15 29.43 8.88 Shareholder equity 28.15 29.43 8.88 Total Liability & Equity 100.00 100.00 100.00


of 46

WORKS CITED Frank, Rudiger. “South Korea Index,” http://oefre.unibe.ch/law/icl/ks_indx.html. Jan 17, 2003. Ghosh, Partha. “LG merges telecom unit,” Business Standard. March 27, 2003. Lei, Tao Ai. “War jitters hit Asian IT exports,” Asia computer Weekly. Apr 07, 2003. Sung-jin, Yang. “Korea leads internet usage rate in East Asia,” The Korea Herald. Apr 4, 2003 Sung-jin, Yang. “Domestic mobile carriers to offer diverse discount packages to year,” http://www.mic.go.kr/eng. Dec 30,2002. Sung-jin, Yang. “Mobile phone numbers portable in 2004,” http://www.mic.go.kr/eng. Dec 23,2002. Sung-jin, Yang. “KT, KTF set to merge landline, Internet services,” The Korea Herald. Feb 12, 2003. Thomas, Andrea. “South Korea wireless operations March subscribers up on month,” http://sg.biz.yahoo.com. Apr 3, 2003. Walsh, Bryan. “The cost of sunshine,” http://www.time.com. Feb 3, 2003. Ward, Andrew. “LG shows the way with chaebol reform model,” FT.com/business/Asia-Pacific. Apr 7, 2003. “Volatile markets push Asia down,” http://edition.cnn.com/2003business. Apr 8,2003. “KTF suggests W-CDMA partnership with SK Telecom,” RCR Wireless news. Apr 4, 2003. “Wellink and Wi-Lan collaborate on development of broadband mobile wireless international transportation systems products,” http://www.stockhouse.ca/news. Apr 1,2003. “Wireless in South Korea,” http://www.emarketer.com/news. Apr 7,2003. “Foreign Investment in South Korea Falls,” http://news.yahoo.com/news. Apr 4, 2003. “LGT urges MIC to ease handset subsidy ban,” The Korea Herald. Apr 4, 2003. “Telcos Profit Estimates Boosted,” KoreaNet News. Apr 3, 2003. “Korea: LG Telecom adds net 56,380 subscribers for cellular services in March,” Afx Asia Newswire. Apr 3, 2003. “LG to expand presence in market through Hanaro,” The Korea Herald. Apr 1, 2003. “KTF takes limelight in 3G roll-out,” The Korea Times. March 25, 2003.


of 46

“SKT seals mobile internet deal with China Unicom,” The Korea Herald. March 21, 2003. “Single mobile internet platform plan at risk,” The Korea Herald. March 10, 2003. “Handset subsidy to be allowed from April,” The Korea Herald. March 10, 2003. “Korea to allocate 3G access code,” The Korea Herald. March 5, 2003. “Mobile service sector remains flat in February,” The Korea Herald. March 4, 2003. “Korean KTF telecom to use new code in preparation for 3G service.” Asia Pulse. March 3, 2003. “Korea: LG to launch LG Corp as groupwide holding co on March 1,” AfxAsia Newswire. Feb 28,2003. “Ministry set to kickstart m-government project,” The Korea Herald. Feb 24, 2003. “South Korea: Political Environment,” http://www.tradeport.org/ts/countries/shora/political/html. 1995 “LG Telecom to exceed FY 370 bln won marketing budget after high Q3,” AfxAsia Newswire. Nov 9, 2002. “LG Telecom Hemorrhages From Soaring Marketing Cost,” The Korea Herald. Nov 11, 2002. “LG Telecom to decide on tariff cut mid-Dec, concerned over earnings impact,” AfxAsia Newswire. Nov 19, 2002. “KTF, LGT expected to follow SK in Mobile phone rates cut,” Aisa Pulse. Nov 18, 2002. “LG Telecom outclasses KTF in mobile phone competition,” The Korea Herald. Dec 5, 2002. “LG electronics promoting mobile phones among young, tech-savvy.” The Korea Herald. Nov 25, 2002. “LG Group to invest its way to top in communications field,” The Korea Herald. Dec 11, 2002. “Korea streamlines mobile access code,” The Korea Herald. Jan 20, 2003. “Ministry to keep pushing flat rate for telecom services,” The Korea Herald. Dec 23, 2002. “Korea: LG Telecom sets 2003 capex at 410 bln vs 358 bln in 2002,” AfxAsia Newswire. Feb 6, 2003. “LG Telecom Sees Drop in Profits,” The Korea Times. Feb 6, 2003. “LG Telecom fined W640 mil for illegal sales of mobile phones,” The Korea Times. Jan 20, 2003.


of 46

“Minister denies favoring KTF over SK Telecom,” The Korea Herald. Jan 20, 2003. “Korea pursuing global leadership in info-tech industry,” The Korea Herald. Jan 20, 2003. “Mobile phone numbers portable in 2004,” The Korea Herald. Dec 23, 2002. The Economist Intelligence Unit. “Country Report: South Korea.” Feb 2003. RESEARCH REPORTS Kim, Shawn. “Korea Handset Components.” Morgan Stanley Equity Research, March 2003 Scott, Alistair. “TV on Call.” Merrill Lynch Media-Telecom Equity Research, February 2003 Won, Kyunghee. “LG Electronics” HSBC Company Report, May 2002 WEBSITES http://www.lgtel.co.kr http://www.bloomberg.com http://www.finance.yahoo.com http://www.djinteractive.com http://www.investext.com http://www.onesource.com http://www.images.google.com http://www.countrywatch.com http://www.standardandpoors.com

Creative Consulting Group - NYU Stern School of...

Documents

Transcript of Creative Consulting Group - NYU Stern School of...