June 24, 2011 Company Report SM Entertainment (041510 KQ) Entertainment An irresistible Buy! Chang-kwean Kim +822-768-4321 [email protected] Global expansion efforts beginning to bear fruit Jee-hyun Moon SM Entertainment (SM) is growing as a global player in the music industry, tapping +822-768-3615 into the European, North American, and South American markets (on top of the [email protected] Asian market). Indeed, songs, music videos, and concert footage featuring SM artists are spreading around the world through social media websites such as YouTube and Facebook. The global music market should offer numerous new opportunities to SM, especially considering the companyÊs content development capability has proven to be superior to that of its domestic rivals. Maintain Buy rating with TP of W30,000 Buy (Maintain) SMÊs shares have remained stagnant since early this year, due to: ① low earnings Target Price (12M, W) 30,000 predictability (earnings are dependant on the success/failure of songs); ② Share Price (06/23/11, W) 18,900 uncontrollable risks inherent to the industry (scandals, etc.); ③ sell-offs by large Expected Return (%) 58.7 shareholders; and ④ deterioration of quarterly earnings. However, we expect the EPS Growth (11F, %) -32.9 stock to break out of its current trading range, given the companyÊs Japanese Market EPS Growth (11F, %) 23.4 earnings momentum. P/E (11F, x) 21.0 Market P/E (11F, x) 10.4 The surprising success of SMÊs artists in Japan should translate into full-swing KOSDAQ 464.62 earnings growth in 2012. The companyÊs P/E (based on a 2012F EPS) is 7.2x, Market Cap (Wbn) 313 which seems extremely undervalued compared to the domestic peer groupÊs Shares Outstanding (mn) 17 average P/E of 15.4x. Thus, we maintain our Buy rating on SM with a target price of Avg Trading Volume (60D, '000) 597 Avg Trading Value (60D, Wbn) 11 W30,000. Dividend Yield (11F, %) - Free Float (%) 75.6 52-Week Low 11,400 52-Week High 22,500 Beta (12M, Daily Rate of Return) 0.7 Price Return Volatility (12M Daily,%,SD) 3.8 Foreign Ownership (%) 6.6 Major Shareholder(s): SM Lee (24.43%) KB Asset Mgmt. (11.24%) Partners Venture Capital and et. al (7.25%) Price Performance (%) 1M 6M 12M Absolute 10.5 24.8 38.5 Relative 12.3 32.3 44.6 Share price § Earnings & Valuation Metrics 180 KOSDAQ OP EV/ Sales OP NP EPS EBITDA FCF ROE P/E P/B 160 FY Margin EBITDA (Wbn) (Wbn) (Wbn) (W) (Wbn) (Wbn) (%) (x) (x) 140 (%) (x) 120 12/09 62 9 15.0 4 278 12 11 7.3 16.2 1.2 3.7 100 12/10 86 25 29.5 22 1,342 28 23 29.1 12.6 3.3 8.2 80 12/11F 90 17 19.2 15 901 20 21 16.0 21.0 3.2 11.6 60 12/12F 145 52 35.9 44 2,637 54 43 36.0 7.2 2.2 3.3 40 12/13F 159 59 37.0 50 3,029 60 51 29.8 6.2 1.6 2.2 6/10 10/10 2/11 6/11 Note: Parent basis under K-GAAP, Source: Company data, Daewoo Securities Research estimates Please read carefully important disclosures at the end of this report. I. Investment summary ...................................................................................................................3 II. Valuation ......................................................................................................................................4 1. Difficult to analyze entertainment companies ...........................................................................4 2. Valuation premium anticipated..................................................................................................5 III. Success in Japan .......................................................................................................................8 IV. Earnings outlook......................................................................................................................16 2 June 24, 2011 SM Entertainment I. Investment summary Strong R&D and marketing capabilities Internal training, content SM has proven its superior ability to find and nurture successful performing artists from development and which globally-competitive contents can be created and sold. Such a strong (so-called) R&D copyrights capability (finding, training and nurturing successful artists) helps the company significantly lessen the shock of failed albums or artists. SM owns the copyrights to all its content. As platforms and networks increasingly diversify (smartphones, smart TVs, etc.), customer contact points are broadening. Moreover, the one source, multi-use environment (same content for different platforms) is spreading across the globe. This indicates that the companyÊs copyrighted contents are increasing in value. Global marketing The success of SM Town concerts in Paris (June 2011) proved that K-pop is hugely popular through social media in Europe. Indeed, songs, music videos, and concert footage featuring SM artists are websites spreading around the world through social media websites such as YouTube, Facebook and Twitter. The global music market should offer numerous new opportunities to SM, especially considering the companyÊs content development capability has proven to be superior to that of its domestic rivals. Korean music industryÊs PWC, a market research firm, forecasts the global share of the Korean music industry at only global market is forecast 1.6% in 2011, which means there is huge growth potential for Korean music firms. In at 1.6% in 2011 particular, Japan should provide a great opportunity to Korean music companies, as the countryÊs offline music market is 66 times larger that that of Korea (15 times larger in terms of total music market size). SM is gaining market In 2010, SM delivered an earnings surprise thanks to strong 2009 sales in Japan (TVXQ sold share in Japan, the 942,000 CDs and 374,000 concert tickets). In 1H11, TVXQ sold 284,000 CDs, GirlÊs worldÊs third largest Generation sold 370,000 CDs (pre-order of 600,000 CDs), and pre-orders for SHINeeÊs June music market single reached 120,000 copies. SM should sell at least 432,000 tickets for its SM Town concerts in Japan in 1H11, and SHINee plans to hold concerts in five Japanese cities beginning in July. We forecast SMÊs CD sales in Japan to reach 2.02mn copies (to be reflected in 2012 earnings), more than twice the figure in 2009. Figure 1. Quarterly operating profit forecast and share price trend (Wbn) Operating profit (L) Earnings to grow thanks to (W) 18 Share price (R) Japan business 24,000 (TVXQ, Girls' Generation, SHINee and Super Junior) in 2011~2012 12 TVXQ's success in Japan in 2009: 18,000 - Concerts: 374,126 tickets sold Earnings gap to - Singles: 624,913 CDs sold widen due to - Albums: 317,314 CDs sold 6 earthquake in Japan 12,000 0 6,000 -6 0 1Q08 1Q09 1Q10 1Q11 1Q12F Source: Daewoo Securities Research Daewoo Securities Research 3 June 24, 2011 SM Entertainment II. Valuation 1. Difficult to analyze entertainment companies Difficult to estimate It is more difficult to analyze entertainment companies and estimate their earnings than earnings; Large other companies. In Korea, entertainment companies are reluctant to announce precise shareholders and sales-related data due to the nature of the entertainment industry, which is sensitive to executives have sold rumors. As for SM, the percentage of overseas sales (including Japan) out of its total sales some of their stakes; rose to 42.4% in 2010, making it even more difficult to estimate earnings. The company Share price has been accounts for overseas sales two quarters after sales are generated (sales of CDs in Japan in range-bound 1Q will be recognized as overseas sales in 3Q). SMÊs stock has risen on higher overseas royalty income and domestic digital music sales since 2009, while the companyÊs large shareholders and executives have sold some of their stakes. Since the remaining stock options that are exercisable from March 2012 are equivalent to only 294,000mn shares (out of the total of 526,000mn shares), overhang is unlikely to occur for the time being. The companyÊs stock has been range-bound around W20,000 since early this year, due to ① weaker quarterly earnings and ② the recent earthquake in Japan. We expect the stock to break thorough this range, as earnings should improve on the success of the companyÊs performers in Japan. Figure 2. Quarterly overseas sales and operating profit trend and forecast (Wbn) Overseas sales 18 Operating profit TVXQ's 2009 success in Japan - Domestic: Offline/digital music sales, management sales 12 - Overseas: Offline/digital music sales, management sales (Recognized as royalty income two quarters after they are generated) 6 0 -6 1Q08 3Q08 1Q09 3Q09 1Q10 3Q10 1Q11 Source: Daewoo Securities Research Figure 3. Share price performance and sales by major shareholders Figure 4. Domestic institution's cumulative net buying (W) Major shareholder Soo-man Lee ('000 shares) Domestic institutions' cumulative net buying (L) (W) 25,000 Share price sold 500k shares 4,000 Share price (R) 25,000 during extended tranding hours 20,000 Four executives sold 90,000 shares 3,000 20,000 during extended trading hours 15,000 2,000 15,000 Neowiz Internet (Bugs Music) Neowiz bought 2,479,203 shares Internet over the counter sold 10,000 1,000 10,000 Neowiz 430k shares Internet sold 5,000 799,203 Four executives 0 5,000 shares sold 60k shares 0 -1,000 0 1/09 7/09 1/10 7/10 1/11 1/10 4/10 7/10 10/10 1/11 4/11 Source: Daewoo Securities Research Source: Daewoo Securities Research Daewoo Securities Research 4 June 24, 2011 SM Entertainment 2. Valuation premium anticipated SM just entered a new It is difficult to derive fair valuation multiples for entertainment companies as their valuations phase of growth depend on the success of performers as well as the emergence of new media devices and distribution channels. In valuing SM, we noted that the global entertainment giant, Disney, traded at two to three times the market average P/E during its growth phases – between 1986 and 1998 – thanks to 1) blockbuster films, such as The Lion King and Toy Story and 2) the popularity of its music, movies, and dramas in the U.S.