Holding Companies Right now, wrong then: ( 3) How will HMG unwind circular shareholdings? Overweight (Maintain) Ownership restructuring has been an overriding theme of 2016. We anticipate that large conglomerates, including Samsung, will continue to pursue Industry Report ownership restructuring in 2017 in an effort to secure competitiveness and solidify control over their groups. In this report, we continue examining the November 21, 2016 areas where current standards regarding ownership restructuring―which were once considered adequate―need revision, and forecast changes to come. Mirae Asset Daewoo Co., Ltd. How will HMG unwind circular shareholdings? [Holding Companies/IT Services ] Current status (1): Key circular shareholding: Mobis HMC Kia Mobis; Dae -ro Jeong Selling Kia’s Mobis stake to outsiders not an option; Buying internally also +822 -768 -4160 difficult [email protected] Hyundai Motor Group (HMG) controls Hyundai Motor Company (HMC), Kia Motors (Kia) and other affiliates through Hyundai Mobis, which is at the center Yoon -seok Seo of the group’s ownership structure. Among HMG’s four circular shareholdings, +822 -768 -4127 the key one for maintaining control over the group is bound by Kia’s stake in [email protected] Hyundai Mobis (Mobis HMC Kia Mobis). If the Monopoly Regulation and Fair Trade Act (MRFTA) is revised to require conglomerates to unwind existing circular shareholdings, Kia’s 16.9% stake in Hyundai Mobis (valued at about W4tr) will present a challenge to HMG; selling the shares to outsiders is not an option, given that they are critically tied to the controlling family’s group ownership, but it would also be difficult for group affiliates or the controlling family to buy the shares directly, given the ban on new circular investments and the sheer cost of the purchase. Current status (2): Other restructuring considerations: Shareholdings of multiple affiliates and financial affiliates’ stakes 1) Shareholdings of multiple affiliates: The key companies in HMG—Mobis, HMC, and Kia—have stakes in most HMG affiliates. If HMG establishes a holding company, one way for it to meet subsidiary shareholding requirements would be to purchase the three key group members’ stakes in affiliates. However, this would likely impose a huge financial burden on the holding company, and, moreover, the key group members would incur capital gains tax on disposal of the shares. 2) Financial affiliates’ stakes in non-financial HMG affiliates: As there are five financial companies in HMG, including Hyundai Card, HMG has to establish an intermediate financial holding company (now under consideration) in order to maintain its control over financial affiliates after holding company conversion. Forecast (1): Mobis to switch to holding company; HMC and Kia to split into investment/operating entities; Investment entities to then merge with holding company We believe HMG will opt to transition to a holding company structure to internally absorb its circular shareholdings and thus ensure managerial control and ownership transfer. This will likely be done by having Hyundai Mobis switch to a holding company, after which HMC and Kia will split themselves up into investment and operating entities, with the investment units then merging with Hyundai Mobis’s holding company. In the merger process, the existing circular shareholdings would be absorbed into the group holding company’s treasury shares. This process would allow the group holding company to meet subsidiary stake requir ements (more than 20% for listed companies; 40% for unlisted) without the need to purchase the three key group members’ stakes in affiliates. Forecast (2): Hyundai Mobis in same situation as SEC; O wnership restructuring likely to boost shareholder value HMG now owns only a 30.2% stake in Hyundai Mobis. A special resolution for spin-off and merger would need to garner a considerable number of outside votes at a special shareholders’ meeting to be approved. November 21, 2016 Holding Companies We believe converting SEC to a holding company via a spin-off would be the best way for the group to strengthen its grip on the electronics giant. In our view, SEC’s recent moves to implement a more favorable shareholder return policy can be seen as part of the company’s strategy to bring more outside shareholders on board for a future spin-off. Likewise, we think Hyundai Mobis will also adopt a more aggressive shareholder return policy, including dividend as well as share buyback and retirement, in a bid to gain more support for its ownership restructuring. The end of circular ownership Under the revision to the MRFTA enacted on July 25, 2014, large corporate groups are banned from forming new circular shareholdings or strengthening existing ones. In addition, a revision to the MRFTA was proposed in September 2016 to require conglomerates to untie existing circular shareholdings within a certain period of time (three years); the revision bill is currently pending in the National Assembly, and we believe there is a chance it will pass ahead of the presidential election in late 2017 if the political parties reach an agreement that existing circular shareholdings should also be directly regulated. These developments spell the end of circular ownership as a means for large Korean conglomerates to maintain managerial rights and expand control over their groups. Most of them have already begun undertaking serious efforts to unwind their existing circular shareholdings to avoid potential policy risks. Most will continue to unwind existing circular shareholdings, while also improving ownership structure and making the transition to a holding company structure. Mirae Asset Daewoo Research 2 November 21, 2016 Holding Companies How will HMG unwind circular shareholdings? ▶▶▶ Key circular shareholding is Mobis →→→ HMC →→→Kia →→→ Mobis; Selling Kia’s Mobis stake to outsiders not an option; Buying internally also difficult HMG has four circular shareholdings, with Hyundai Mobis at the top of the ownership structure controlling HMC, Kia, and other affiliates <Table 1>. Of the four, the key one for maintaining control over the group is bound by Kia’s stake in Hyundai Mobis (Mobis HMC Kia Mobis). If a pending revision to the MRFTA ends up passing, requiring HMG to unwind its circular shareholdings, the simplest way to do so would seem to be disposing of Hyundai Mobis stakes owned by Kia (16.9%), Hyundai Glovis (0.7%) and Hyundai Steel (5.7%). However, HMG can ill afford to sell Kia’s 16.9% stake in Hyundai Mobis. For one, the stake is key in maintaining control over group affiliates, and so selling it to outsiders is not an option. Secondly, the ban on new circular investments and the sheer size of the stake (valued at about W4tr) mean that buying the shares internally is also unfeasible. 1) Sell-off to third-party buyers not an option: HMG owns 30.2% of Hyundai Mobis shares. With President Chung Mong-koo holding just a 7.0% stake, selling Kia’s 16.9% stake to third- party buyers would lower the group’s stake to 13.3%, causing HMG to lose control of the group. 2) Sell-off to affiliates unlikely: Hyundai Mobis cannot buy back its shares from Kia due to legal restrictions (Article 341 of the Commercial Act). HMC must dispose of Mobis shares it purchases within six months of the acquisition due to the cross investment ban. Financial constraints or regulatory bans also prevent other affiliates from buying Kia’s 16.9% stake. The controlling family cannot afford to buy the stake in its entirety, given the huge financial commitment. A stock swap between the controlling family and Kia shareholders does not seem feasible, either, due to taxation issues involving large shareholders, and potential changes in stake values following the exchange. Table 1. Current circular shareholdings of HMG (%) Affiliate 1 Affiliate 2 Affiliate 3 Affiliate 4 Affiliate 5 Hyundai Hyundai Hyundai 1 → → Kia Motors → Mobis Motor Mobis 20.80% 33.90% 16.90% (W6.0tr) (W5.0tr) (W4.0tr) Hyundai Hyundai Hyundai 2 → → Hyundai Glovis → Mobis Motor Mobis 20.80% 4.90% 0.70% (W6.0tr) (W0.3tr) (W0.2tr) Hyundai Hyundai Hyundai 3 → → Hyundai Steel → Mobis Motor Mobis 20.80% 11.20% 5.70% (W6.0tr) (W0.7tr) (W1.3tr) Hyundai Hyundai Hyundai Hyundai 4 → → Kia Motors → → Mobis Motor Steel Mobis 20.80% 33.90% 19.60% 5.70% (W6.0tr) (W5.0tr) (W1.3tr) (W1.3tr) Notes: Numbers in parentheses indicate stake value; Based on Nov. 18 closing prices Source: Fair trade Commission, Mirae Asset Daewoo Research Mirae Asset Daewoo Research 3 November 21, 2016 Holding Companies Figure 1. Corporate governance of HMG Source: Mirae Asset Daewoo Research Mirae Asset Daewoo Research 4 November 21, 2016 Holding Companies ▶ Other restructuring considerations: Shareholdings of multiple affiliates and financial affiliates’ stakes If HMG conducts governance restructuring to unwind circular shareholding and strengthen its control over the business group, it is likely to consider converting to a holding structure. In this process, the group will likely have to address the following issues. 1) Stakes in affiliates held by Hyundai Mobis, HMC, and Kia: The key companies in HMG—Mobis, HMC, and Kia—have stakes in most HMG affiliates. If HMG were to follow in the footsteps of most Korean holding companies, an HMG affiliate would be split into a holding company and an operating entity, with the former then purchasing the three key group members’ stakes in affiliates to meet subsidiary shareholding requirements. However, this would likely impose a huge financial burden on the holding company, and, moreover, the key group members would incur capital gains tax on disposal of the shares. 2) Financial affiliates’ stakes in non-financial HMG affiliates: HMG currently has five financial affiliates, including Hyundai Card and Hyundai Capital. Under the current law, a non-financial holding company is not allowed to have a financial subsidiary.