Regional Company Focus

Kakao Bloomberg: 035720 KS, Reuters: 035720.KS

Refer to important disclosures at the end of this report DBS Group Research . Equity 16 Aug 2018

BUY, KRW128,000 KOSPI: 2,282.8 Close to long-awaited turnaround (Closing price as of 10/8/18)  Revenue growth continues for Ads, high Price Target 12-mth: KRW150,000 (prev. KRW130,000) hopes for ’s new businesses Reason for Report: Rating upgrade  Kakao Page seeing higher gross merchandise value Potential catalyst: Advance towards music/video production industry and user traffic; Kakao Pay set to launch new Where we differ: We are more positive than the market on Kakao Pay’s new financial services financial services  Upgrade to BUY, TP lifted to KRW150,000 Analyst Regional Research Team [email protected] Earnings turnaround soon. We upgrade our rating from HOLD to BUY as signs of earnings turnaround should be seen for Kakao going forward. From as early as 4Q18, Kakao’s quarterly earnings Price Relative are likely to return to growth (y-o-y). Top line is expanding and 200,000 110 2H18 advertising / labour costs are expected to be similar to 1H18 100 150,000 levels, backed by efficient cost management. 90 80 Finally, new businesses to yield results. Furthermore, new 100,000 70 businesses should start to bear fruit soon, with Kakao Bank 50,000 60 projected to reach its breakeven point in 2H18. The likely shift 50 by the government towards a more relaxed separation 0 40 Aug-14 Mar-15 Oct-15 May-16 Dec-16 Jul-17 Feb-18 between banking and commerce is also a positive. Meanwhile, Stock price(LHS,KRW) Rel. to KOSPI(RHS,pts) Kakao Pay’s quarterly gross merchandise value (GMV) has hit Forecasts and Valuation KRW4tr (+37% q-o-q) in 2Q18. Based on its solid user traffic, it FY Dec (KRW bn) 2017A 2018F 2019F 2020F plans to raise its market share by expanding its merchant Revenue 1,972.3 2,369.4 2,682.7 3,079.7 network for offline QR/barcode payment and providing Alipay- EBITDA 295.2 243.4 323.0 421.2 linked services. Kakao Pay is planning to launch various new Operating profit 165.4 104.6 178.8 269.8 financial products like Alipay and Toss (P2P money transfer Pre-tax Profit 153.3 197.9 246.9 337.9 service in Korea). Net Profit 125.1 117.7 190.1 260.2 Net Pft (Pre Ex.) 125.1 117.7 190.1 260.2 Expansion into music/video production. We expect Kakao to enter Net Pft Attributable to the music/video production business after its merger with Kakao M. Controlling Interest 108.6 100.0 155.6 217.7 The merger should create synergies between Kakao’s various EPS (KRW) 1,606 1,324 2,043 2,858 intellectual properties (IPs), including Kakao Page (mobile content EPS Pre Ex. (KRW) 1,850 1,557 2,496 3,416 EPS Gth (%) 82.3 -17.6 54.3 39.9 platform)’s /webnovel IPs, as well as Kakao M’s actor/artist EPS Gth Pre Ex (%) 85.0 -15.8 60.2 36.9 and ad agencies. If the company expands into the video content Diluted EPS (KRW) 1,606 1,324 2,043 2,858 production business, content sales revenue should also grow. It is Net DPS (KRW) 0 150 150 150 also likely that Kakao will make inroads into overseas markets. BV Per Share (KRW) 59,332 68,111 70,006 72,714 PE (X) 85.3 96.7 62.7 44.8 Deserves stronger enterprise value. We lift our sum-of-the-part- PE Pre Ex. (X) 74.1 82.2 51.3 37.5 based TP to KRW150,000 given that raising our estimates for the P/Cash Flow (X) 27.7 46.4 34.0 27.3 fair value of Kakao Ads, Kakao M, Kakao Page and Kakao Pay. We EV/EBITDA (X) 28.9 32.0 23.7 17.7 Net Div Yield (%) n/a 0.1 0.1 0.1 also changed our assumption of Kakao’s stake in Kakao Bank P/Book Value (X) 2.3 1.9 1.8 1.8 slightly to 34% (30% previously), and reflected Kakao M’s net cash Net Debt/Equity (X) CASH CASH CASH CASH (minus the costs to repurchase Kakao M shares from dissenting ROE (%) 3.4 2.6 3.6 4.8 shareholders in the merger between Kakao and Kakao M) in our TP

Earnings Rev (%): 5.3 11.9 11.6 calculation. Consensus EPS (KRW): 1,324 1,972 2,343 Other Broker Recs: B : 24 S : 7 H : 5 At A Glance

Issued Capital (m shrs) 76.29 ICB Industry: Media Mkt. Cap (KRWbn/US$m) 9,765/8,645 ICB Sector: Communications Major Shareholders Principal Business: Kakao Corp. provides Internet portal services Kim Beom-soo and 31 others (%) 35.6 such as news, free e-mail, and leisure information. The Company Free Float (%) 52.78 also offers a cross-platform mobile messaging application that allows users to exchange messages. Avg. Daily Vol. (‘000) 1,270

Source of all data: Company, DBS Bank, Bloomberg Finance L.P

ed: KK / sa: LEY, CS/ CW

Company Focus Kakao

Earnings review Unit: KRW bn, % Preliminary earnings Vs. our estimates y-o-y q-o-q Vs. consensus estimates ‘18.06P ‘18.06F Diff. (%) ‘17.06A Diff. (%) ‘18.03A Diff. (%) ‘18.06F Diff. (%) Revenue 588.9 590.0 (0.2) 468.4 25.7 555.4 6.0 589.4 (0.1) OP 27.6 23.8 16.1 44.6 (38.2) 10.4 165.2 28.9 (4.5) NP 25.5 29.6 (14.0) 12.5 103.8 14.6 74.0 31.7 (19.5) Margin (%) OP margin 4.7 4.0 9.5 1.9 4.9 Net margin 4.3 5.0 2.7 2.6 5.4 Difference (ppts) OP margin 0.7 (4.8) 2.8 (0.2) Net margin (0.7) 1.7 1.7 (1.0)

Note: Based on consolidated K-IFRS Source: DBS Bank

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Company Focus Kakao

I. Upgrade to BUY with TP raised to KRW150,000 3) Advance into music/video production business: We expect Kakao to enter the music/video production business We upgrade our rating for Kakao to BUY from HOLD. We after its merger with Kakao M. The merger should create also raise our target price by 15% to KRW150,000 from synergies between Kakao’s various intellectual properties KRW130,000 for the following reasons. (IPs), including Kakao Page’s webtoon/webnovel IPs, as well as Kakao M’s actor/artist and ad agencies. The recent 1) Earnings turnaround: We expect Kakao to see an success of ‘What's Wrong with Secretary Kim’, a drama earnings turnaround (y-o-y) from as early as 4Q18. In 2H18, series based on Kakao Page webtoon, shows great potential top-line growth should continue in divisions like advertising, synergy. commerce and music, while expenses (advertising/promotion, labour costs) should remain at 1H18 We arrive at our target price of KRW150,000 for Kakao levels. based on SOTP valuation. We have changed the valuation base year from 2018 to forward 12 months and raised fair 2) Growth in new businesses: Kakao Bank is likely to reach value estimates for Kakao Ads, Kakao M, Kakao Page and breakeven point (BEP) as early as 4Q18 and launch diverse Kakao Pay, considering: i) continued revenue growth (Kakao financial products upon an easing of separation between AD); ii) high expectation for new businesses (Kakao M); iii) banking and commerce. Kakao Pay’s GMV came in at over steady increase in GMV and users (Kakao Page); and iv) KRW4tr (+37% q-o-q) in 2Q18. While increasing GMV with expected launch of new financial services (Kakao Pay). We its money transfer service, it plans to raise its market share have also slightly raised our estimate for Kakao’s ownership by expanding its merchant network for offline QR/barcode limit in Kakao Bank from 30% to 34% and reflected net payment and providing Alipay-linked services. We expect cash of Kakao M (deducting reimbursement to dissenting the company to launch diverse financial products like Alipay shareholders) in our estimates. and Toss (P2P money transfer service in Korea).

Kakao: TP calculation 1) Operating value (KRW bn) 12MF revenue 12MF OP 12MF NP Target PE Fair value Notes Kakao Ads 259.0 51.8 39.9 23.9x 955.0 Assumed 20% OPM, applied 20% premium over Facebook's 12MF PE ads 463.7 92.7 71.4 21.5x 1,535.3 Assumed 20% OPM, applied Google's 12MF PE Kakao Game (channelling) 86.4 43.2 33.3 10.0x 332.8 Assumed 50% OPM (deducted commissions to ) Assumed 30% OPM, applied 50% discount to the 12MF PE average of Amazon, Kakao Commerce 329.6 98.9 76.1 23.3x 1,774.1 Alibaba, JD.com Assumed 17% OPM, applied 10% premium to the high in its historical PE band, Kakao M 644.9 109.6 87.0 33.0x 2,872.1 given likely expansion to music/video production business Operating value subtotal (a) 1,783.7 396.3 307.8 24.3x 7,469.3 (excl. Kakao M) 1,138.8 286.7 220.7 20.8x 4,597.2 2) Stakes in subsidiaries (KRW bn) Fair value Stake Discount Stake value Kakao Mobility 1,140.0 69.3% - 790.0 30% discount to the valuation (KRW1.6tr) at the time it attracted investments Kakao Games 1,540.0 62.4% - 960.7 2019F NP of KRW77bn, applied target PE of 20x Kakao Pay 650.0 51.0% - 331.5 30% premium to the valuation (KRW500bn) at the time it attracted investments Applied KRW1.3tr in capital, 2x P/BV, an expected stake after an easing of Kakao Bank 2,600.0 34.0% - 884.0 banking and commerce separation regulations Kakao Page 732.0 57.6% - 421.6 20% premium to the valuation (KRW610bn) at the time it attracted investments Stakes subtotal (b) 3,387.8 Added Kakao M's net cash (minus the costs to repurchase Kakao M shares of 3) Net cash (KRW bn) (c) 1,239.3 shareholders dissenting the merger of Kakao M) to parent-based net cash Total (KRW bn) (a) + (b) + (c) 12,096.5 No. of shares ('000 shares) 83,373 76.27m shares currently; 83.37m shares after the merger of Kakao M Fair price (KRW) 145,089 Target price (KRW) 150,000 Rounded off Current price (KRW) 128,000 Upside potential 17.2%

Source: DBS Bank

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Company Focus Kakao

II. 2019F revenue of KRW2.7tr and OP of KRW178.8bn However, we expect operating profits to grow y-o-y from as early as 4Q18, given: i) advertising/promotion costs We expect Kakao’s quarterly earnings to improve after declining from KRW47.9bn in 1Q18 to KRW45.3bn in 2Q18 bottoming out in 1Q18. The company saw 25% y-o-y and on effective management of expenses; and ii) revenue 2% q-o-q growth in revenue for 1Q18, despite weak growth outpacing labour cost growth (on labour force advertising seasonality. In 2Q18, ad revenue remained expansion). strong by growing 10% y-o-y and 8% q-o-q. In particular, ad revenue on the Kakao platform rose 52% y-o-y and 13% The company should show greater earnings growth from q-o-q. The company saw solid revenue growth for its game 2019 onwards. Advertising/promotion costs should remain business (on internet café service monetisation for the game at current levels until end-2018, due to aggressive ‘Battlegrounds’), paid contents from Kakao Page and marketing for Kakao Pay and Kakao Page. However, such (Japan), as well as commerce. costs should decrease from 2019 onwards, considering Kakao Pay’s quarterly GMV of over KRW4tr and a significant Meanwhile, Kakao’s operating profits have remained weak, increase in turnover for Kakao Page. Kakao already saw coming in at KRW10.4bn in 1Q18 (-77% y-o-y, -70% q-o-q) sharp growth in 2Q18 OP for its key services (advertising, and KRW27.6bn in 2Q18 (-42% y-o-y, +165% q-o-q). game, commerce, music) to KRW81.1bn (vs. KRW57.1bn in 1Q18). Earnings should increase at a rapid pace upon any decline in costs related to new services. We estimate revenue at KRW2.7tr (+13.2% y-o-y) and OP at KRW178.8bn (+70.9% y-o-y) for 2019.

Kakao: Earnings forecasts (KRW bn) 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18F 4Q18F 1Q19F 2Q19F 3Q19F 4Q19F 2017 2018F 2019F Revenue 445.6 468.4 515.4 544.7 555.4 588.9 598.2 626.9 633.0 660.8 681.7 707.1 1,974.2 2,369.4 2,682.7 Ads 133.3 151.4 151.5 159.5 154.6 166.4 167.4 181.1 182.8 191.5 194.1 199.7 595.7 669.4 768.0 Daum ads 102.7 115.0 106.1 111.7 105.1 111.5 109.7 118.5 115.8 119.7 117.0 116.7 435.4 444.7 469.2 Kakao ads 30.7 36.4 45.4 47.8 49.5 54.9 57.7 62.6 67.0 71.8 77.1 83.0 160.3 224.7 298.8 Content 223.7 235.4 262.5 265.4 285.1 302.8 306.2 311.4 317.4 323.7 330.5 337.7 987.0 1,205.4 1,309.3 Games 80.3 78.7 94.0 89.2 105.6 111.6 107.6 105.5 105.3 105.2 105.3 105.6 342.2 430.4 421.4 Music 110.3 118.1 123.0 128.6 125.7 130.5 133.1 135.7 138.4 141.2 144.0 146.9 480.0 524.9 570.6 Others 33.1 38.7 45.5 47.7 53.8 60.7 65.5 70.1 73.6 77.3 81.2 85.2 164.9 250.1 317.3 Others 86.9 81.9 102.4 119.3 115.7 119.8 124.7 134.4 132.9 145.6 157.1 169.7 390.6 494.5 605.3 Commerce 49.9 47.7 58.4 69.2 68.0 73.1 74.9 79.6 84.8 90.3 96.3 102.8 225.2 295.6 374.1 LOEN 26.6 20.2 31.8 33.4 25.8 20.4 20.8 22.8 25.1 27.6 30.4 33.5 111.9 89.8 116.6 Others 10.4 14.1 12.3 16.7 21.9 26.4 29.0 31.9 23.0 27.7 30.4 33.5 53.5 109.1 114.6 Operating expenses 405.5 423.8 468.0 509.6 545.0 561.3 567.6 590.9 604.0 616.7 630.3 652.8 1,806.9 2,264.8 2,503.9 Labour costs 98.2 101.1 98.2 116.4 125.2 123.8 124.3 130.3 140.4 134.0 133.3 138.3 413.9 503.7 546.0 Paid commissions 179.4 202.7 211.7 225.0 232.7 246.7 250.6 262.6 265.2 276.8 285.6 296.2 819.0 992.6 1,123.8 Advertising costs 25.0 21.9 33.5 36.1 47.9 45.3 46.1 48.3 47.5 49.6 51.1 53.0 116.5 187.6 201.2 Depreciation/amortisation 31.6 31.3 31.8 35.1 30.6 33.0 33.2 33.3 33.5 33.7 33.9 34.0 129.8 130.1 135.1 Content commissions 24.9 28.3 33.7 34.4 40.0 45.7 46.4 48.6 49.1 51.3 52.9 54.9 121.4 180.7 208.1 Others 46.3 38.5 59.3 62.5 68.6 66.8 67.0 67.7 68.4 71.4 73.6 76.4 206.5 270.1 289.7 Operating profit 40.2 44.6 47.4 35.0 10.4 27.6 30.6 36.0 29.0 44.1 51.4 54.3 167.2 104.6 178.8 OPM 9.0% 9.5% 9.2% 6.4% 1.9% 4.7% 5.1% 5.7% 4.6% 6.7% 7.5% 7.7% 8.5% 4.4% 6.7% Net profit 56.4 12.5 39.9 19.0 14.6 25.5 36.7 40.8 35.4 47.0 52.6 54.9 127.8 117.6 190.0 NPM 12.6% 2.7% 7.7% 3.5% 2.6% 4.3% 6.1% 6.5% 5.6% 7.1% 7.7% 7.8% 6.5% 5.0% 7.1%

Source: Kakao, DBS Bank

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Company Focus Kakao

Revision to annual earnings forecasts

(KRW bn) Previous Revised Diff. (%, ppts) 2018F 2019F 2020F 2018F 2019F 2020F 2018F 2019F 2020F Revenue 2,395.1 2,754.4 3,163.5 2,369.4 2,682.7 3,079.7 (1.1) (2.6) (2.6) Operating profit 93.5 168.5 258.7 104.6 178.8 269.8 11.9 6.1 4.3 OP margin (%) 3.9 6.1 8.2 4.4 6.7 8.8 0.5 0.5 0.6 EBITDA 232.3 313.3 411.2 243.4 323.0 421.2 4.8 3.1 2.4 EBITDA margin (%) 9.7 11.4 13.0 10.3 12.0 13.7 0.6 0.7 0.7 Net profit 111.8 169.9 233.0 117.7 190.1 260.2 5.3 11.9 11.6

Source: Kakao, DBS Bank Note: Based on consolidated K-IFRS Revision to quarterly earnings forecasts (KRW bn) Previous Revised Diff. (%, ppts) 2018.06 2018.09 2018.12 2019.03 2018.06 2018.09 2018.12 2019.03 2018.06 2018.09 2018.12 2019.03 Revenue 590.0 607.3 642.5 651.7 588.9 598.2 626.9 633.0 (0.2) (1.5) (2.4) (2.9) Operating profit 23.8 27.0 32.3 34.6 27.6 30.6 36.0 29.0 16.1 13.3 11.4 (16.1) OP margin (%) 4.0 4.5 5.0 5.3 4.7 5.1 5.7 4.6 0.7 0.7 0.7 (0.7) EBITDA 58.3 61.9 67.5 70.2 62.1 65.5 71.2 64.5 6.6 5.8 5.4 (8.1) EBITDA margin (%) 9.9 10.2 10.5 10.8 10.5 10.9 11.4 10.2 0.7 0.8 0.8 (0.6) Net profit 29.6 31.9 35.6 37.2 25.5 36.7 40.8 35.4 (14.0) 15.0 14.7 (4.7)

Source: Kakao, DBS Bank Note: Based on consolidated K-IFRS

Kakao: Annual revenue Kakao: Annual earnings trend and outlook

(KRW bn) Revenue Growth (y-o-y) (%) (KRW bn) Revenue OP OPM (RHS) (%)

3,000 60.0 3,000 10.0 9.0 2,500 50.0 2,500 8.0 2,000 40.0 2,000 7.0 6.0 1,500 30.0 1,500 5.0 4.0 1,000 20.0 1,000 3.0 2.0 500 10.0 500 1.0 0 0.0 0 0.0 2015 2016 2017 2018E 2019E 2015 2016 2017 2018E 2019E

Source: Kakao, DBS Bank Source: Media reports, DBS Bank Kakao: Revenue from music, paid content, commerce rising Kakao: Revenue from Kakao platform ads steadily

(KRW bn) (KRW bn) Kakao ads Growth (y-o-y) (%) Music Paid content Commerce Others 400.0 70.0 70.0 60.0 60.0 300.0 50.0 50.0 40.0 40.0 200.0 30.0 30.0 20.0 20.0 100.0 10.0 10.0 0.0 0.0 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18E 4Q18E 0.0 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18E 4Q18E Source: Kakao, DBS Bank Source: Kakao, DBS Bank

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Company Focus Kakao

III. Steady growth for new businesses number of 26-week instalment savings accounts (launched at end-June) reached 330,000 in only 20 days. This is a 1) Kakao Bank: To reach BEP in 4Q18; positive on easing of remarkable achievement, considering that its total number separation between banking and commerce of instalment savings accounts was 1m before the launch of the 26-week product. Kakao Bank has shown sharp earnings growth since its launch in Jul 2017. Its operating losses narrowed Kakao Bank plans to provide new services, including loans significantly q-o-q to KRW5.4bn in 1Q18. The company linked with credit card/capital/savings banks; loans for those targeted to reach BEP in three years. However, the goal with mid credit ratings based on its own credit review should be achieved in 4Q18, backed by a rapid growth in system; as well as mobile overseas remittances. We are also loans and net interest margin (NIM) improvement. Kakao positive on the recent discussion about easing the Bank’s total assets increased to KRW7.9tr at end-1Q18. The separation between banking and commerce. Such a market widely expects that BEP will be reached with total deregulation should lead to the launch of innovative services assets at KRW8-9tr levels. based on Kakao’s existing assets. We can expect the introduction of new business models, such as financial As of end-July, Kakao Bank’s customers opening Kakao counselling and investment recommendations based on Bank accounts stood at 6.33m, with deposits amounting to Kakao Talk, financial product recommendations based on KRW8.6tr and loans KRW7tr, recording sharp growth from user location / consumption pattern data, as well as financial end-1Q18. Loans for housing rental deposits (launched on products linked to its key services 23 Jan) have exceeded KRW400bn cumulatively. The (game/commerce/mobility/music, etc.).

Kakao Bank: Quarterly financial statements Kakao Bank: Quarterly income statements

(KRW bn) 3Q17 4Q17 1Q18 (KRW bn) 3Q17 4Q17 1Q18 Cash/deposits 157.2 423.4 1,089.3 Operating income 15.8 51.6 76.3 Investment financial assets 399.9 523.6 740.4 Interest income 11.3 37.6 54.4 Loan receivables 3,315.1 4,621.7 5,860.7 Commission income 3.8 13.2 18.7 Gains on trading of financial Tangible assets 23.4 32.7 31.5 0.5 0.4 1.1 assets measured at fair value Intangible assets 74.9 77.4 74.7 Other operating income 0.2 0.3 2.1 Other assets 141.3 163.4 121.0 Operating expenses 63.9 89.0 81.7 Total assets 4,111.8 5,842.2 7,917.6 Interest cost 4.4 13.4 19.5 Deposits due to customers 3,331.2 5,048.3 7,128.6 Commission cost 21.6 33.2 31.2 Other liabilities 74.7 126.0 126.6 SG&A expenses 25.5 31.2 30.2 Total liabilities 3,405.9 5,174.3 7,255.2 Other operating expenses 3.4 1.9 2.3 Credit loss provisions for Capital 800.0 800.0 800.0 9.0 9.3 1.5 financial assets Capital adjustments -11.5 -11.5 -11.5 Operating profit -48.1 -37.4 -5.4 Other comprehensive income -0.3 -0.8 -0.5 OPM -304.4% -72.5% -7.1% Deficit -0.3 -0.8 -0.5 Pre-tax profit -48.1 -37.3 -5.4 Retained earnings -82.1 -119.8 -125.6 Corporate tax 0.0 0.3 0.1 Total capital 706.0 667.9 662.4 Net profit -48.1 -37.6 -5.5 Total liabilities and capital 4,111.8 5,842.2 7,917.6 NPM -304.4% -72.9% -7.2%

Source: Kakao Bank, DBS Bank Source: Kakao Bank, DBS Bank

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Company Focus Kakao

Kakao Bank: Net interest margin rising gradually Kakao Bank: Shareholder composition

(%) Korea Post 4% Yes24 2% 2.5 SGI Guarantee Insurance 4% 2.12 Games 4% 2.0 1.83 E-Bay 4%

Ten Cent 4% 1.5 1.32 Korea Investment KB Bank 10% Holdings 50% 1.0

0.5 Kakao 18%

0.0 3Q17 4Q17 1Q18 Source: Kakao Bank, DBS Bank Source: Kakao Bank, DBS Bank

Bills on ‘easing of separation between banking and commerce’ pending at the National Assembly

Limit on industrial firms' stake (with Largest shareholders' acquisition of Bills Credit granting to largest shareholders voting rights) in banking business new shares

Bank law revision bill 50% Banned or to remain as it is To remain as it is

Act on Special Cases concerning To be banned or allowed for exceptional cases, limit To be banned or allowed for 34% or 50% Internet-only Banks such credit granting at 10% of capital exceptional cases, to remain as it is

Source: Financial Service Commission, DBS Bank Arguments for/against easing of separation between banking and commerce Proponents Opponents ·Largest shareholders' power abuse can be prevented ·Internet-only banks are also banks. If the separation is with eligibility reviews and transaction restrictions Maintaining banking-commerce exceptionally eased for internet-only banks, this will · There are not many firms that can establish internet- separation as it is result in Chaebol's ownership of banks. only banks if conglomerates are excluded as internet- ▶Examples from the US, and Korean savings banks only bank candidates

· Large ICT companies' involvement in the banking · Unlike Japan, Korean conglomerates are controlled by Easing banking-commerce industry can strengthen Korean banks' competitiveness owners or their families separation in the global markets and satisfy consumers · Political disputes may overshadow the original purpose ▶Example from Japan of establishment of internet-only banks

Source: Korea Institute of Finance, DBS Bank

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Company Focus Kakao

2) Kakao Pay: Quarterly GMV of over KRW4tr launches Seoul Pay, a zero transaction fee system for small/mid-sized merchants, it would be difficult for Kakao Kakao Pay’s GMV exceeded KRW4tr, up 37% q-o-q, in Pay to gain fees in the offline payment market. However, 2Q18. We estimate that it increased by nearly KRW1tr in the expansion of offline payments should help secure more only three months. The money transfer service accounts for payment data from users. a large share of Kakao Pay’s GMV. However, the portion of Kakao Money payment is increasing steadily on a continued We expect Kakao Pay to provide data to help launch diverse rise in Kakao Money balance (backed by it transfer service’s services, rather than generating profits from its own growing popularity). services. Kakao plans to introduce various financial products based on Kakao Pay’s GMV and payment data. Although a Kakao Pay launched the offline QR/barcode payment service detailed profit model is still unknown, we expect the launch in May. Merchants for the service expanded from 30,000 in of financial services like Alipay’s Yu'e Bao (money market 1Q18 to 110,000 in 2Q18. The partnership deal with Alipay fund or MMF service) and Viva Republica (Toss)’s credit will add Alipay’s 34,000 online/offline affiliated stores into management, loans, credit cards and stock/fund/real estate Kakao Pay’s network in 1Q19. If the Seoul government management services.

Kakao Pay: Quarterly GMV trend Kakao Pay: More diverse associated services

(KRW bn) 5,000 4,200 4,000 3,000 Transfer Split bills Utility bills Pay Card 3,000

1,800 2,000 Certify Coupons Memberships Partnership with financial firms 1,000 500 300 400

0 Make payment at offline stores 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18

Source: Kakao, DBS Bank Source: Kakao, DBS Bank Note: Based on our estimates

Ant Financial: Antpay ecosystem Toss: Easy payment app offering various financial services

Dining Services Description Welfare Games Online Financial shopping ᆞUsers can invest from KRW100,000 up to KRW10m services Micro investments in real ▶ properties Partners: P2P-based Tera Funding, Honest Fund, Together Funding Ant Financial is penetrating to a wider areas of Transport consumer culture ᆞUsers can choose between low-risk/balanced/high return Campus P2P diversified investment investments In 2015, Alibaba China's market place showed a gradual ▶Partners: P2P-based '8 Percent' decrease in its share in total product value of Ant Financial Recharge ᆞUsers can invest in funds (KRW1,000 at minimum), and phone Micro investment in funds can buy foreign companies' shares (one share at minimum) credits and overseas equities Medical ▶Partner: Shinhan Investment Credit services ᆞCredit card/loan: Display products of partnered firms and Credit Stores Money gift provide links to relevant websites One-day card/loan/insurance / transfer ᆞ house helper product recommendation Insurance: Recommend products that suit users' needs in partnerships with general agency platform 'InbyU' Source: Ant Financial, DBS Bank Source: Toss, DBS Bank

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Company Focus Kakao

3) Kakao M: Plans to establish new music/video production The new unit plans to establish a video content production unit system based on Kakao’s content IPs. We are positive on the recent success of ‘What's Wrong with Secretary Kim’, a drama series based on the Kakao Page webtoon IP. Kakao M, which will be merged into Kakao on 1 Sep, plans Although its IP-based sales should be small, the company is to spin off its music/video production and distribution expected to post more profits from direct sales after the business into a new unit. launch of its own drama/video content production business.

In Jun, Kakao M entered into a strategic investment and We also see the possibility of overseas business expansion. partnership agreement with acting agencies (BH Kakao Japan’s Piccoma has grown into the second largest Entertainment/J, WIDE-COMPANY/Management Soop) and webtoon platform in Japan, with its monthly active users model agency Ready Entertainment. It plans to advance into (MAU) reaching 3.4m in 2Q18. It launched the Piccoma TV the video production/distribution business with its network service in Jul to enter the drama/animation/film content of actors and support overseas activities of actors based on distribution market. As such, an advance into the video Ready Entertainment’s Chinese subsidiaries and global content production business based on popular overseas IPs networks. also seems likely.

Kakao M: Key subsidiaries and companies it invested in Music production subsidiaries Artists FAVE Entertainment (80%) IU, Zia Creker Entertainment (80%) , The Boyz Plan A Entertainment (70%) , (76.4%) K.Will, , Cosmic Girls, , Yoo Yeon-seok Munhwain (67.5%) Lena , Seenroot Video production subsidiaries Description Krispy Studio (100%) Mobile video content producer (67.2%) Drama series producer mTech Crew (100%) Software developer Invested subsidiaries Actresses/actors BH Entertainment Lee Byung-hun, Go Soo, Yoo Ji-tae, Han Hyo-joo, Han Ga-in J,Wide-Company Lee Sang-yoon, Kim Tae-ri, Baek jin-hee, Uhm Ji-won, Bae Jong-ok Soop Entertainment Gong Yoo, Kim Jae-wook, Gong Hyo-jin, Jung Yu-mi, Seo Hyun-jin, Jeon Do-yeon

Source: Kakao M, DBS Bank

Series based on Kakao Page’s web cartoon Kakao Page: Quarterly GMV showing solid growth ‘What’s Wrong with Secretary Kim’

(KRW bn) 60.0

48 50.0 42 39 40.0 35 31 30.0 26

20.0

10.0

0.0 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18

Source: tvN, DBS Bank Source: Kakao, DBS Bank

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Company Focus Kakao

IV. Two risk factors 2) Fiercer competition ahead from new internet-only banks

1) Delayed IPO of Kakao Games, but likely within 2018 Amid recent signs of an easing of the banking-commerce separation, many expect the establishment of new internet- The Initial Public Offering (IPO) of Kakao Games, which was only banks by players such as , , SK Telecom, previously scheduled for Aug, has been postponed, due to and Kyobo Life. Kakao Bank currently dominates Korea’s the delayed review by the Financial Supervisory Service (FSS). internet-only banking market, but competition in this market The company received a fast-track designation and obtained is likely to intensify with the likely emergence of new preliminary approval for its planned IPO on 21 Jun. However, players. the IPO has become uncertain owing to a more prolonged audit by the FSS. At its 2Q18 earnings conference call, the However, the risks from intensifying competition should be management said that the IPO could possibly happen by limited at the moment. Kakao Bank has seen a sharp growth end-2018. Still, uncertainties remain considering that an FSS in the number of customers as shown by its accounts audit could take anywhere from a month to a year. (6.33m), deposits (KRW8.6tr), and loans (KRW7tr). This was achieved only one year after its launch. Furthermore, it Nonetheless, we have already reflected Kakao Games’ fair would take a long time for a competing new bank to obtain value at KRW1.5tr in our SOTP valuation. We see limited approval, start business, and expand its deposits and loans. downside risk to its fair value even in case of a delay in the IPO, considering its strong new game line-up.

Kakao Games: Game line-ups Category Name Launch schedule Genre Developer PC online game Black Desert Dec 2014 in Korea, Mar 2016 in North America/Europe MMORPG Battle Ground Service at Internet cafés launched in Nov 2017, paid service started in Apr 2018 Battle royale PUBG A:IR 1st CBT for North America/Europe in 3Q18 MMORPG Bluehole Mobile game Ensemble Stars Launched on 31 Jan Simulation Happy Elements (Publishing) Bang Dream! Girls Band Party! Launched on 6 Feb Rhythm Craft Egg Eight Kingdoms Launched on 14 Mar Tactical simulation Supernova 11 Dragon Nest M Launched on 28 Mar MMORPG Eyedentity Games Blade 2 Launched on 28 Jun Action RPG Action Square New Born Launched on 4 Jul Survival adventure Saltlab Friends Gem Launched on 17 Jul Puzzle Lunosoft

The War of Genesis: Battle of Antaria 2H18 (soft launched in Canada, Australia in May) Tactical MMORPG Joy City

Priston Tale 2H18 (Chinese CBT took place on 19-26 Jun) MMORPG Funcell123 Ping Pong King Mickey 2H18 Sports - Lookism 2H18 Action RPG YD Online Project Snake 2H18 Adventure RPG Kong Studios Tera Mobile 2H18 MMORPG Lantu Games Eternal Rhapsody 2H18 Tactical MMORPG Action Square Gigantic X 2H18 SF shooting action Action Square Capcom Super League 2H18 Tactical RPG Capcom Princess Connect Re:Dive 2H18 RPG Cygames Mobile game Friends Racing 2H18 Racing Friends Games (in-house) Friends Golf 4Q18 Sports Friends Games Friends Town 4Q18 SNG Friends Games

Source: Kakao Games, DBS Bank

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Company Focus Kakao

BALANCE SHEET INCOME STATEMENT

(Unit:KRWbn) 2016 2017 2018F 2019F 2020F (Unit:KRWbn) 2016 2017 2018F 2019F 2020F Current Assets 1,217.0 1,993.1 3,185.8 3,364.3 3,612.6 Revenue 1,464.2 1,972.3 2,369.4 2,682.7 3,079.7 Cash & Short-term 886.6 1,567.9 2,783.4 2,921.9 3,114.6 Growth (%) 57.1 34.7 20.1 13.2 14.8 investment Accounts Receivable 251.0 307.2 283.8 320.1 371.0 Operating Profit 116.1 165.4 104.6 178.8 269.8 Inventories 12.6 21.6 21.1 23.8 27.6 Growth (%) 31.1 42.4 (36.7) 70.9 50.9 Fixed assets 4,267.2 4,356.3 4,368.6 4,388.0 4,416.0 EBITDA 229.9 295.2 243.4 323.0 421.2 Non-operating Investment Assets 280.1 395.7 411.8 428.5 445.9 (15.8) (12.1) 93.3 68.1 68.1 Gains/Losses Tangible Assets 253.9 271.0 291.8 318.4 352.5 Net Interest Income (4.2) 5.8 59.9 51.4 51.4 Intangible Assets 3,733.2 3,689.6 3,665.1 3,641.1 3,617.5 Foreign Currency Gains 7.8 (13.4) 0.0 0.0 0.0 Total Assets 5,484.1 6,349.4 7,554.4 7,752.3 8,028.6 Equity Method Gains (0.5) 13.4 37.4 20.3 20.3 Current Liabilities 806.0 1,040.9 1,079.7 1,125.7 1,187.9 Pre-tax Profit 100.3 153.3 197.9 246.9 337.9 Accounts Payable 263.1 280.4 313.4 353.5 409.7 Net Profit 65.5 125.1 117.7 190.1 260.2 Net profit attributable to Short-term Debts 211.3 176.6 176.6 176.6 176.6 57.7 108.6 100.0 155.6 217.7 controlling interest Non-current Liabilities 975.2 800.7 808.0 815.5 823.4 Growth (%) (16.9) 91.1 (5.9) 61.6 36.9 Long-term Debts 795.9 620.8 620.8 620.8 620.8 NOPLAT 75.8 135.0 62.2 137.6 207.7 Total Liabilities 1,781.2 1,841.6 1,887.7 1,941.3 2,011.3 (+) Dep 113.8 129.8 138.7 144.3 151.4 Capital Stock 33.9 34.0 38.1 38.1 38.1 (-) Wc (171.9) (174.6) (61.7) (6.0) (6.5) Capital Surplus 3,105.0 3,603.6 4,668.4 4,668.4 4,668.4 (-) Capex 81.0 75.2 90.3 102.2 117.4 Earned Surplus 304.0 402.5 492.5 636.9 843.1 OpFCF 280.5 364.2 172.4 185.7 248.3 Capital Adjustment (10.3) (11.0) (11.0) (11.0) (11.0) 3 Yr CAGR & Margins Treasury Stock (0.8) (0.8) (0.8) (0.8) (0.8) Revenue growth(3Yr) 90.8 58.1 36.5 22.4 16.0 Total Equity 3,702.9 4,507.8 5,666.7 5,811.0 6,017.3 OP growth(3Yr) 20.8 (2.1) 5.7 15.5 17.7 Invested capital 3,613.3 3,415.4 3,345.7 3,337.9 3,337.3 EBITDA growth(3Yr) 46.9 14.0 14.1 12.0 12.6 Net debt / (cash) 120.6 (770.4) (1,986.0) (2,124.5) (2,317.2) NP growth(3Yr) 2.2 (5.8) 14.3 42.7 27.6 ROA 1.5 2.1 1.7 2.5 3.3 OP margin (%) 7.9 8.4 4.4 6.7 8.8 ROE 2.2 3.4 2.6 3.6 4.8 EBITDA margin (%) 15.7 15.0 10.3 12.0 13.7 ROIC 2.7 3.8 1.8 4.1 6.2 NP margin (%) 4.5 6.3 5.0 7.1 8.4

CASH FLOW KEY INDICATOR

(Unit:KRWbn) 2016 2017 2018F 2019F 2020F (Unit:KRW,x,%) 2016 2017 2018F 2019F 2020F Operating cash flow 332.8 403.7 270.3 293.1 363.2 Per share Data (w) Net Profit 100.3 153.3 117.7 190.1 260.2 EPS 881 1,606 1,324 2,043 2,858 Depr. & Amort. 113.8 129.8 138.7 144.3 151.4 BPS 50,965 59,332 68,111 70,006 72,714 Chg in Working Capital 131.0 59.8 61.7 6.0 6.5 DPS 148 0 150 150 150 Chg in Accounts (28.4) (2.0) 23.4 (36.3) (50.9) Valuation (x,%) Receivable Chg in inventories (7.8) 0.5 0.4 (2.7) (3.8) PER 87.8 85.3 96.7 62.7 44.8 Chg in Accounts Payable 105.2 3.4 33.0 40.1 56.2 PBR 1.5 2.3 1.9 1.8 1.8 Investing cash flow (1,019.2) (400.4) (131.9) (162.3) (178.9) EV/EBITDA 23.2 28.9 32.0 23.7 17.7 Chg in Short-term 234.9 (201.1) (18.3) (19.1) (19.8) Dividend yield 0.2 0.0 0.1 0.1 0.1 Investments Chg in Long-term (45.6) (62.6) 24.3 6.7 6.2 PCR 19.8 27.7 46.4 34.0 27.3 Investment Securities Capex (81.0) (75.2) (90.3) (102.2) (117.4) PSR 3.5 4.7 4.1 3.6 3.2 Disposal of Tangible & (23.4) (24.9) (44.7) (44.7) (44.7) Stabilities (%) Intangible Assets Financing cash flow 927.3 481.6 1,058.8 (11.3) (11.4) Liabilities Ratio 48.1 40.9 33.3 33.4 33.4 Chg in debt 795.7 (188.1) 0.0 0.0 0.0 Net debt/Equity 3.3 CASH CASH CASH CASH Chg in Equity (11.3) (19.7) 1,058.8 (11.3) (11.4) Net debt/EBITDA 52.5 CASH CASH CASH CASH Dividend Payout 11.3 16.0 10.0 11.3 11.4 Current ratio 151.0 191.5 295.1 298.9 304.1 Chg in Cash 244.5 475.1 1,197.2 119.5 172.8 Interest coverage ratio 27.9 n/a n/a n/a n/a Gross cash flow 255.3 334.3 208.6 287.1 356.7 Interest/revenue 1.0 0.6 1.3 1.1 0.9 (-) Chg in WC (171.9) (174.6) (61.7) (6.0) (6.5) Asset Structure (-) Capex 81.0 75.2 90.3 102.2 117.4 IC 75.6 63.5 51.2 49.9 48.4 (+) Disposal of Assets (23.4) (24.9) (44.7) (44.7) (44.7) Cash + IC(%) 24.4 36.5 48.8 50.1 51.6 Free Cash Flow 322.9 408.9 135.4 146.2 201.1 Capital Structure (-) Other Investments 45.6 62.6 (24.3) (6.7) (6.2) Debt/Asset 21.4 15.0 12.3 12.1 11.7 Free Cash 277.3 346.3 159.7 152.9 207.3 Equity/Asset 78.6 85.0 87.7 87.9 88.3 Source:Source: KTB DBS Investment Bank & Securities *Asset = Equity + Debt, P/E is derived by using diluted EPS. Note:Note: Results Results are are consolidated consolidated This report has been prepared for informational purposes only, and does not constitute an offer or solicitation of a contract for trading. Opinions in this report reflect professional judgment at this date based on information and data obtained from sources we consider reliable. However, KTB Investment & Securities does not warrant or guarantee the accuracy or completeness of this document and has no liability for its content. *AssetThe investment = Equity should be+ madeDebt, based P/E on iseach derived client's own by judgment, using dilutedand we expressly EPS. disclaim all liability for any investment decisions and any results thereof. This report is a copyrighted material of KTB Investment & Securities Co. and thus, it may not be reproduced, distributed or modified without the prior consent of KTB Investment & Securities Co. This report has been prepared for informational purposes only, and does not constitute an offer or solicitation of a contract for trading. Opinions in this report reflect professional judgment at this date based on information and data obtained from sources we consider reliable. However, DBS Bank does not warrant or guarantee the accuracy or completeness of this document and has no liability for its content. The investment should be made based on each client's own judgment, and we expressly disclaim all liability for any investment decisions and any results thereof. This report is a copyrighted material of DBS Bank and thus, it may not be reproduced, distributed or modified without the prior consent of DBS Bank.

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Company Focus Kakao

Stock Ratings

The stock investment opinion below is based on the expected return of the recommended stock over the next 12 months relative to the closing price of the day it is recommended.

STRONG BUY: Expected to produce a return of at least 50% from the closing price of the day the stock is recommended BUY: Expected to produce a return between 15% and 50% from the closing price of the day the stock is recommended HOLD: Expected to produce a return between -5% and 15% from the closing price of the day the stock is recommended REDUCE: Expected to produce a return of less than -5% from the closing price of the day the stock is recommended RATING UNDER REVIEW: Temporary suspension of recommendation when there is material uncertainty in corporate value. TP is not provided.

The investment opinion presented in this report is based on the industry’s outperformance relative to the market, and may differ from that of an individual stock. Overweight: The industry’s return is expected to outperform the average total return of the KOSPI over the next 12 months. Neutral: The industry’s return is expected to be in line with the average total return of KOSPI, over the next 12 months. Underweight: The industry’s return is expected to underperform the average total return of KOSPI, over the next 12 months.

Notes) The industry’s return is on a risk-adjusted basis

Recent 2yr. Rating and TP Change

Kakao (035720 KS) Date 2016.8.12 2016.9.7 2017.2.10 2017.5.12 2017.8.11 2017.10.30 Rating HOLD HOLD HOLD HOLD HOLD HOLD TP 100,000 85,000 90,000 100,000 110,000 150,000 Date 2018.2.9 2018.5.10 2018.8.10 Rating HOLD HOLD BUY TP 140,000 130,000 150,000 Source: DBS Bank Analyst Name: Regional Research Team

Recent 2yr. TP Change Kakao (035720 KS) (KRW) Stock price Target price 200,000 160,000 120,000 80,000 40,000 0 Aug-16 Dec-16 Apr-17 Aug-17 Dec-17 Apr-18 Aug-18 Source: DBS Bank Analyst Name: Regional Research Team

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Company Focus Kakao

Completed Date: 16 Aug 2018 11:42:30 (HKT) Dissemination Date: 16 Aug 2018 14:30:16 (HKT)

Sources for all charts and tables are DBS Bank unless otherwise specified

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Company Focus Kakao

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Company Focus Kakao

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Company Focus Kakao

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Company Focus Kakao

DBS Regional Research Offices

HONG KONG MALAYSIA SINGAPORE DBS Bank (Hong Kong) Ltd AllianceDBS Research Sdn Bhd DBS Bank Ltd Contact: Carol Wu Contact: Wong Ming Tek (128540 U) Contact: Janice Chua 18th Floor Man Yee Building 19th Floor, Menara Multi-Purpose, 12 Marina Boulevard, 68 Des Voeux Road Central Capital Square, Marina Bay Financial Centre Tower 3 Central, Hong Kong 8 Jalan Munshi Abdullah 50100 Singapore 018982 Tel: 852 2820 4888 Kuala Lumpur, Malaysia. Tel: 65 6878 8888 Fax: 852 2521 1812 Tel.: 603 2604 3333 Fax: 65 65353 418 e-mail: [email protected] Fax: 603 2604 3921 e-mail: [email protected] e-mail: [email protected] Company Regn. No. 196800306E

INDONESIA THAILAND PT DBS Vickers Sekuritas (Indonesia) DBS Vickers Securities (Thailand) Co Ltd Contact: Maynard Priajaya Arif Contact: Chanpen Sirithanarattanakul DBS Bank Tower 989 Siam Piwat Tower Building, Ciputra World 1, 32/F 9th, 14th-15th Floor Jl. Prof. Dr. Satrio Kav. 3-5 Rama 1 Road, Pathumwan, Jakarta 12940, Indonesia Bangkok Thailand 10330 Tel: 62 21 3003 4900 Tel. 66 2 857 7831 Fax: 6221 3003 4943 Fax: 66 2 658 1269 e-mail: [email protected] e-mail: [email protected] Company Regn. No 0105539127012 Securities and Exchange Commission, Thailand

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