Sector Note April 28, 2017

Food & Beverage and to also Overweight benefit from holding company conversion

Company Rating TP (KRW)

Lotte Confectionery BUY 250,000 Lotte holding company to also benefit three food companies Lotte Chilsung Lotte group announced plans to adopt a holding company structure. And, this BUY 2,250,000 Beverage should lift the value of Lotte Confectionary, Lotte Chilsung, Lotte Food and Lotte Lotte Food Hold - Shopping, which will be involved in the process of establishing (tentative name). As the Lotte group has the most complicated governance structure, including circular investments, improvements to managerial/governance transparency, managerial efficiency and the overall restructuring effects should outpace previous holding company conversions. Furthermore, equity value should improve as unlisted subsidiaries, including Korea Seven, and Lotte Information & Communication, are expected to list. Furthermore, there are incentives for the three food players to increase synergies with Japanese affiliates, expand overseas operations and develop the value of property holdings.

No reason for poor Lotte Confectionary share performance; Rakhat to return to operating company eventually After yesterday’s holding company announcement, shares of shares of Lotte Confectionary – which will be formed after merging the four investment companies (Lotte Confectionary Investment to merge with the other three investment companies after the spinoffs) – slipped 0.47%. First, there were concerns that the merger ratios of the investment companies is unfavorable as Lotte Shopping will have a larger stake in the holding company than Lotte Confectionary and as a re- rating occurred on the investment company news. While these subsidiaries are valued under a more aggressive DCF method, stakes do not appear overvalued as the total shareholder value of Korea Seven alone is estimated at W637bn.

Second, the bigger concern is that Rakhat, a confectionary company in , and other wholly-owned subsidiaries are being allocated to the investment company rather than the operating company. Typically, operating companies are valued higher than investment companies, and worries are mounting that synergies will be reduced as confectionary companies are separated. But, we believe stakes in these overseas confectionaries will be eventually transferred to the operating companies. The recently acquired overseas subsidiaries will be allocated to the investment companies as sales and stakes will be less than 30% that of the operating companies, so it is more favorable in terms of tax liabilities for the investment companies to hold these stakes. Furthermore, sales and stake ratios can change going forward. To establish a link between Lotte Holdings and the Lotte Confectionary operating company, the operating companies will have to hold stakes in the overseas subsidiaries after the spinoffs. As such, managerial efficiency improvements, a key value of the conversion, should not be eroded. Kyoung Ju Lee 822-3276-6269 [email protected]

Youjin Jung 822-3276-6228

youjinjung @truefriend.com Analysts who prepared this report are registered as research analysts in Korea but not in any other jurisdiction, including the U.S. PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES & DISCLAIMERS AT THE END OF THIS REPORT. Food & Beverage

Lotte Confectionary stakes to be revalued, synergies to grow with Lotte Japan Overall, Lotte Confectionary should benefit more from the holding company conversion. The value of equity stakes should grow backed by the listing of Korea Seven, Lotteria and other subsidiaries. If Lotte Shopping’s value grows after the spinoff, this would also bolster equity value. If the group’s plans proceed as expected, Shin Dong-Bin’s dominance over the group should be reinforced, and this will likely enhance synergies with Lotte Confectionary Japan. Over 70% of the Lotte group’s sales in Japan are generated from the food business, which is similar to that of Lotte Confectionary’s. If Lotte Confectionary Korea and Japan are combined, this would be the second-largest player in Asia. Given the potential synergies with Lotte Japan (Table 3), Lotte Confectionary shares should rise 26.9% compared to yesterday’s closing price, applying peer valuations.

Lotte Chilsung investment stakes to be revalued, land value to grow Lotte Chilsung has more upside than Lotte Confectionary based on current share prices. Sales, OP and shareholders’ equity at the two companies are similar, but the market cap gap is almost 30%. As for Lotte Chilsung, the IPO of Lotte Information & Communications, Lotteria and other subsidiaries should bolster enterprise value. And, the value of the Seocho site may re-rate. , which garnered substantial political pressure, has been completed, while efforts have been underway for several years to develop key property holdings in Seocho. If the Seocho property, which is allocated to the operating company, is valued at W1.5tn and affiliate stakes are valued at similar levels as peers, upside would reach 47.8% from the current share price. Meanwhile, the outlook for the beer division is robust, while the owner family may swap its stake in the operating company for a larger stake in the investment company.

Figure 1. Lotte Holdings structure post divestiture

Lotte Holdings

Foreign Shopping Korea Seven Chilsung Lotte Members subsidiaries

Daehong Lotte Lotte HImart By the way Communications Development Asahi Lotte Global FRL Korea Lotte Logistics Lotte Insurance Lotte E&C Logistics Confectionery Woori Lotte Station Canon Korea Lotte.com Lotte Fujifilm Home shopping Building Food Lotte Gimhae Lotte JTB Lotte International Development CH Beverage MJA Wine Suwon station Lotte Data Shopping town Communication Chungbuk Soju Songdo Hyundai info. Shopping town Baekhak Technology Beverage Korea STL Nestle Korea CS Distribution Lotteria

Source: Lotte Group, Korea Investment & Securities

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Table 1. Split merger ratio Chilsung investment Confectionery Shopping Food investment investment (acquired) investment (merged) (acquired) Common Preferred (merged) A. Intrinsic value (W bn) 1,952.7 2,911.9 806.6 35.0 185.7 - Portion of intrinsic value 33.2% 49.4% 13.7% 0.6% 3.1% B. Shares outstanding 35,535,000 31,490,892 1,237,203 120,000 1,369,436 pre-divestiture (shares) C. Divestiture ratio per 70.4% 10.7% 35.4% 35.4% 17.4% share D. Shares outstanding post-divestiture (BxC, 25,012,241 3,368,845 437,857 42,469 237,566 shares) E. Intrinsic value (A/D) 78,070 864,374 1,842,221 823,202 781,717 F. Stock merger ratio (Acquired value per share 1.00 11.07 23.60 23.60 10.01 /Merged value per share) G. Divestiture/merger 1.00 1.18 8.35 8.35 1.74 ratio(CxF) H. Shares 25,012,241 37,299,024 10,332,128 1,002,143 2,378,750 outstanding(BxG, shares) Source: Lotte Group, Korea Investment & Securities

Table 2. Ownership status of investment and operating companies

Lotte Confectionery Lotte Chilsung Lotte Food Investment company Operating company Investment company Operating company Investment company Operating company Available for sale Available for sale Available for sale Lotte Qingdao Foods PT. LOTTE RND Center PT. LOTTE RND Center financial asset financial asset financial asset Lotte Confectionary Daehong Lotte Chilsung Beverage Lotte Shopping Lotte Global Logistics (S.E.A) Pte Communication Lotte Food Lotte Taiwan Lotte E&C Lotte Asahi Lotte Logistics Igis I Corporation Lotte Shopping Lotte Food Igis I Corporation Lotte Station Building Lotte Station Building Lotteria Lotteria Korea Seven Investment in affiliated Investment in affiliated companies companies Lotte Europe Holdings Philippines,Inc. B.V. Lotte Lotte Investment in Investment in Lotte Food(Seperate) Confectionery(Seperate) Chilsung(Seperate) subsidiaries subsidiaries Lotte Confectionery Chungbuk Soju Holdings B.V. Rakhat JSC Baekhak Beverage Lotte Aodeli Beverage Joint venture

investment stock Lotte Nestle Korea

Source: Lotte Group, Korea Investment & Securities

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Table 3 . Lotte Confectionery change in value post -divestiture (W bn, X ) Comment Elimination of subsidiaries net income Scenario 1 Operating company NP 62.3 from investment company (Worst) Global peers PE 20.4 PE applied to operating co 20.4 Total 1,271.3 Investment Net asset 1,843.0 company PB applied to investment co 0.7 Industry average Total 1,290.1 Operating company NP 2,561.4 Global peers PE -15.6%

Elimination of subsidiaries net income Scenario 2 Operating company NP 62.3 from investment company (Moderate 1) Global peers PE 20.4 PE applied to operating co 20.4 Total 1,271.3 Investment Net asset 1,843.0 2016 company Premium compared to industry PB applied to investment co 1.0 average Total 1,843.0 Total 3,114.3 upside 2.6% Elimination of subsidiaries net income Scenario 3 Operating company NP 62.3 from investment company (Moderate 2) Global peers PE 20.4 PE applied to operating co 20.4 Total 1,271.3 Investment Net asset 1,843.0 company Core Subsidiaries Stake Book value Target value Diff. Lotte Shopping 8.7% 548.1 838.7 290.6 Lotte Chilsung 19.3% 355.6 544.2 188.6 Korea Seven 16.5% 104.1 105.1 1.0 Korea Data Communication 6.1% 39.6 43.1 3.5 Lotteria 13.6% 78.7 76.0 (2.7) Subtotal 480.9 Total 2,323.9 PB applied to investment co 0.7 Industry average Subtotal 1,626.7 Total 2,898.1 upside -4.5% Elimination of subsidiaries net income Scenario 4 Operating company NP 62.3 from investment company (Best) Global peers PER 20.4 Premium rate 20% Considering synergy with Lotte Japan PE applied to operating co 24.5 Total 1,525.6 Investment Core Subsidiaries 1,843.0 company Lotte Shopping Stake Book value Fair value Diff. Lotte Chilsung 8.7% 548.1 838.7 290.6 Korea Seven 19.3% 355.6 544.2 188.6 Korea Data Communication 16.5% 104.1 105.1 1.0 Lotteria 6.1% 39.6 43.1 3.5 Subtotal 13.6% 78.7 76.0 (2.7) Core Subsidiaries 480.9 Lotte Shopping 2,323.9 PB applied to investment co 1.0 Industry average Total 2,323.9 Total 3,849.5 upside 26.9% Note: 1. Excluded dividend earnings from business company’s 2017F NP after equity spinoff, NP is controlling-int. NP 2. Net asset value of the investment company applied spin off plan announced on April 26 3. Scenario 3 and 4 used DCF valuation for core subsidiaries of investment companies described in divestiture plan 4. Shareholder value for Korea Seven is W637bn, Lotte Data Communication W704bn, Lotteria W559bnm Lotte E&C W1.8 수 5. Lotte Shopping and Lotte Chilsung used KIS’s TP W340,000 and W2,250,000 Source: Korea Investment & Securities

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Table 4 . Lotte Chilsung change in value post -divestiture (W bn, X) Comment Operating Elimination of subsidiaries net income Scenario 1 NP 94.2 company from investment company (Worst) Global peers PE 20.9 PE applied to operating company 20.9 Total 1,968.8 Investment 2016 Net asset 818.7 company PB applied to investment company 0.7 Industry average Total 573.1 Total 2,541.9 upside 8.7% Operating Elimination of subsidiaries net income Scenario 2 NP 94.2 company from investment company (Best) Global peers PE 20.9 PE applied to operating company 20.9 Total 1,968.8 Seocho-dong real Seocho-dong-Debt 537.0 estate worth W1.5tn Total 2,505.8 Investment Net asset 818.7 company Book Core subsidiaries Stake Fair value Diff. value Lotte Shopping 3.9% 274.1 419.3 145.3 Lotte E&C 3.2% 74.6 58.2 (16.4) Lotte Data communication 1.5% 10.0 10.8 0.9 Lotteria 2.2% 12.1 12.1 0.1 Subtotal 129.8 Total 948.5 PB applied to investment company 1.0 Total 948.5 Total 3,454.3 upside 47.8%

Note: 1. Excluded dividend earnings from business company’s 2017F NP after equity spinoff, NP is controlling-int. NP 2. Net asset value of the investment company applied spin off plan announced on April 26 3. The value of the major subsidiaries of the investment company in Scenario 2 is applied to the external valuation value using the DCF reported in the split plan 4. Lotte Information & communication’s total shareholder value is W704.2bn, Lotteria W559.3bn, and Lotte E & C W1.841tn. 5. Applied house TP 340,000 on Lotte Shopping Source: Bloomberg, Korea Investment & Securities

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Table 5. Coverage valuation

Recommendation & TP Earnings & Valuation Company Sales OP NP EPS BPS PE PB ROE EV/EBITDA DY (W bn) (W bn) (W bn) (KRW) (KRW) (X) (X) (%) (X) (%) Lotte Recommendation BUY 2015A 2,258 144 75 5,345 182,020 42.2 1.3 3.0 15.4 0.5 Confectionery (004990) TP (KRW) 250,000 2016A 2,248 128 70 4,911 171,840 36.4 1.0 2.8 13.7 0.6 Price (Apr 27, KRW) 213,500 2017F 2,355 155 86 6,055 164,768 35.3 1.3 3.6 14.4 0.7 Market cap. (W bn) 3,034 2018F 2,457 174 98 6,900 159,201 30.9 1.3 4.3 13.2 0.9 2019F 2,562 191 110 7,765 154,545 27.5 1.4 5.0 12.4 1.4 Lotte Chilsung Recommendation BUY 2015A 2,299 143 100 73,389 1,721,282 30.2 1.3 4.3 13.2 0.4 Beverage 2,250,0 (005300) TP (KRW) 2016A 2,369 149 69 51,073 1,729,103 28.6 0.8 3.0 10.1 0.7 00 1,815,0 Price (Apr 27, KRW) 2017F 2,521 150 87 64,166 1,753,897 28.3 1.0 3.7 10.9 0.6 00 Market cap. (W bn) 2,245 2018F 2,718 174 106 77,972 1,796,578 23.3 1.0 4.4 9.9 0.6 2019F 2,893 208 132 97,384 1,864,519 18.6 1.0 5.3 9.0 0.7 Lotte Food Recommendation Hold 2015A 1,706 69 50 36,713 651,806 25.8 1.5 5.8 11.3 0.5 (002270) TP (KRW) - 2016F 1,762 80 58 42,481 688,336 15.4 0.9 6.3 7.2 0.7 Price (Apr 27, KRW) 653,000 2017F 1,823 92 66 48,262 730,646 13.5 0.9 6.8 5.7 0.7 Market cap. (W bn) 894 2018F 1,886 96 72 52,586 777,280 12.4 0.8 7.0 5.3 0.7 2019F 1,941 103 78 56,954 828,281 11.5 0.8 7.1 5.4 0.7

Source: Korea Investment & Securities

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Changes to recommendation and price target

Company (Code) Date Recommendation Price target Company (Code) Date Recommendation Price target Lotte Chilsung Lotte Food (002270) 12-02-15 Hold - 05-03-15 BUY W2,800,000 Beverage (005300) Lotte Confectionery 05-14-15 BUY W250,000 07-24-15 BUY W3,100,000 (004990) 03-08-16 BUY W290,000 11-04-16 BUY W2,500,000 10-24-16 BUY W250,000 01-16-17 BUY W2,250,000

Lotte Food(002270) Lotte Confectionery(004990)

1,400,000 350,000

1,200,000 300,000

1,000,000 250,000

800,000 200,000

600,000 150,000

400,000 100,000

200,000 50,000

0 0 Apr-15 Aug-15 Dec-15 Apr-16 Aug-16 Dec-16 Apr-17 Apr-15 Aug-15 Dec-15 Apr-16 Aug-16 Dec-16 Apr-17

Lotte Chilsung Beverage(005300)

3,500,000

3,000,000

2,500,000

2,000,000

1,500,000

1,000,000

500,000

0 Apr-15 Aug-15 Dec-15 Apr-16 Aug-16 Dec-16

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■ Guide to Korea Investment & Securities Co., Ltd. stock rating allocation (as of Mar 31, 2017)

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Korea Investment & Securities Co., Ltd., or its affiliates was not making a market in securities of the companies mentioned in this report at the time that the research report was published.

Korea Investment & Securities Co., Ltd. does not own over 1% of shares of the companies mentioned in this report as of April 28, 2017. Korea Investment & Securities Co., Ltd. has not provided this report to various third parties. Neither the analyst/analysts who prepared this report nor their associates own any shares of the company/companies mentioned in this report as of April 28, 2017. Korea Investment & Securities Co., Ltd.,or its affiliates has special interests in Lotte Chilsung Beverage as of April 28, 2017.

Prepared by: Kyoung Ju Lee

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