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[Case Study] Compound Mispricings in a Korean Conglomerate

  • Nexen Corporation serves as a good example of several special-situation investments rolled into one, which leads to compound mispricings
  • Compounded discounts are multiplicative, not additive, which can lead to complex situations to assess
    • Key evaluative tool is discounted benchmarks pulled from market data or the economics of the situation, such as capitalized overhead expense for holding companies
    • Other appraisal tools include a “look through” of earnings or cash flow using normal holding and voting discounts
    • There are qualitative factors which can reduce these discounts such as better corporate governance, firm growth, increasing liquidity in shares, value enhancing events, and new management
  • Nexen Corporation is a Korean holding company with a large stake in Nexen Tire, one of Korea’s largest tire companies
    • Hold stakes in several businesses including Nexen Tire, Nexen Corp operations (tire tubes and golf balls), KNN (a TV and radio broadcaster), Nexen Technology (auto wire harnesses), real estate and other investments in several publicly traded securities
    • This structure is typical for holding companies in Korea
  • Nexen has preferred shares. Generally, preferred shares in Korea are non-voting common shares and in exchange, shares typically have higher dividend that common stock. Additionally, many firms are family controlled and thus, minority shareholders are marginalized (hence, voting rights have little value for minority shareholders)
    • These preferred shares have an interesting history because they traded at a 20% discount to the common shares pre-1998 crisis and have been sold at a larger discount (up to 70%) ever since
    • In the US, Canada, and the UK, similar securities trade at discounts of 5-10%; primary difference in the past and present-day Korea is in corporate governance because better corporate governance leads to a decrease in the discount
  • NAV of the firm is dominated by Nexen Tire (more than 85% of NAV) and its economics is the key
    • Tire business is a good business because tire companies have generated returns on invested capital in excess of 2.5%/year over their cost of capital for the past 10 years
    • Majority of the profits are made in the aftermarket and tires are resistant to obsolescence from major changes on the horizon for automobiles (in fact, electrification will increase tire demand for each mile driven)
  • Over the past 5 years, achieved above average sales growth versus competitors and has grown book-value and dividends at 17% per year
    • Driven by above-competitor cash flow margins and product-line expansions to higher-priced segments
    • In 2013, reorganized as a holding company and simplified its corporate structure – as a result, controlling family held a 50.5% stake in the holding company
  • To illustrate the power of compounded mispricings, one only has to observe “look through” EBITDA and earnings multiples of Nexen Corp and Nexen Tire
    • As of August 2017, Nexen Tire commons trade for 8.5x P/E and 5.9x EV/EBITDA which appears undervalued when compared to other tire manufacturers and even more undervalued when compared to consumer product companies
    • The compound mispricings is even better, when we look at the Nexen Tire preferred, which sells at a 52% discount to the common share – the “look through” multiples assumes a 10% non-voting discount that results in a 4.5x P/E and 4.1x EV/EBITDA
  • When looking at Nexen Corp, must consider an additional holding company discount for the “look through” analysis. One way to look at these expenses is to capitalize holding company expenses
    • If we capitalized Nexen Corp’s G&A expenses at 10%, imply a discount to NAV of 3.4%
    • If we use a 20% holding company discount, the “look through” P/E for Nexen Corp is 5.3x and EV/EBITDA is 5.3x (cheaper than Nexen Tire)
    • Here too, it’s even better because Nexen Corp has a preferred which trades at a 52% discount to the common: “look through” multiples assuming a 10% non-voting discount are 3.9x P/E and 3.2x EV/EBITDA
  • Best place to hold shares in Nexen is at the holding company, not only because it is the most undervalued place but also because the controlling family holds its shares at this level
  • This is just one example of why Korea is currently a treasure trove for special-situation investors

Bonhoeffer Capital Management 2Q17 Letter, September 1, 2017

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