Privileged and Confidential March 24, 2020 Coway: Uncertainty priced in, a rare entry point to a high-quality company Executive Summary Coway is the leading water- and air purifier rental company in South Korea and traditionally a low-beta dividend yield play in an Emerging Market with strong macro fundamentals and a relatively stable currency. Coway is a high-quality company having delivered 5yr average ROIC of 17.9% and a 6.6% 5yr average Free Cash Flow margin (to end 2018). This is mostly thanks to its “Cody” distribution force of >13,000 people – more than 3x larger than its closest competitor (sustainable competitive advantage or moat). The bulk of Coway’s revenue is generated through 5yr+ rental agreements, with low churn, which generates stable revenue growth, profitability and cash flows. Apart from the uncertainty around Covid-19, and the impact this is having on Global Financial markets, the key controversy driving the Coway share price is what impact the recent inclusion of Netmarble (251270 KR) as a key, 25% shareholder will have on, not only its future dividend policy but also profitability. Although we might get some clues as to how this plays out following next week Monday's (30 March 2020) AGM, it could still be months before clarity returns and the share price is once again efficiently priced by the market. In this note, I try to offer insight, stress-testing and analysis on whether this is a rare entry point to a high-quality company or the beginning of a protracted downgrade cycle. Based on my analysis it seems that these risks are already more than priced in following Coway’s 47% share price correction since the release of their 4Q2019 results on 14 February 2020, which ushered in a cut in dividend and lack of 2020F guidance. Coway currently trades on an 8.2x NTM PE, which is about half its 5yr historical average and a 5.0% 2020F dividend yield, on very conservative dividend pay-out assumptions, a significant discount to its 5yr historical average dividend yield of 3.9%. I estimate fair value at KRW80,000/share (66% upside). Detail Company description Coway is the leading healthcare-related consumer electronics products company, with a leading market share in Water purifier, Air purifier and Bidets, in South Korea. These are mostly rented out on 5yr contracts, including maintenance services, through their best-in-market door-to-door sales force. They also have similar subsidiary operations in Malaysia, Thailand and the USA, providing significant growth off a very low base. Coway also offers ODM manufacturing services in its South Korean and Chinese manufacturing plants – although these do not contribute materially to profits. Founded in 1989 as part of the Woongjin Group, Coway’s ownership structure has seen it transition to Private Equity controlled and back to its Woongjin roots, until this 25% stake was sold to Netmarble (251270 KR) during December 2019. Coway is however widely owned with a 58.6% free float alongside large stakes by GIC (8.2%) and the National Pension Service of Korea (8.2%). Roughly 57.6% of shares are held by foreign investors. Shareholder Holding % Netmarble 25.1% GIC (Singapore) 8.2% National Pension Service of Korea 8.2% Free float 58.6% Source: Company data, FactSet financial data and analytics 1 | Page Privileged and Confidential March 24, 2020 Source: Company reports Industry overview Coway is the premium brand in the space with ARPU’s c.20-30% higher than lower-end-focussed local competitors Cuckoo and SK Magic (pricing premium will be less compared to higher-end-player, Chungho), depending on the product. Coway has been steadily losing market share since at least 2006 given their unrelenting focus on the high-end. Although overall market penetration is still lower than the likes of Japan, I sense that it in metros and the high-end penetration is comparable, with incremental volume growth being driven by rural and lower-end markets, where the likes of Cuckoo and SK Magic continue to grab volume share. Coway maintains its focus on Value- and Profit share (where they estimate significantly higher share than the volume market share numbers in the table below), choosing to stick to the high-end products, driving ARPU growth through new product developments which carry higher pricing points – like the clothes care systems launched in 2018. Coway estimate volume share for Water purifiers at 37% (stable), Air purifiers at 20% including lump-sum sales or 28-30% for purely the rental market (growing) and Bidets at 30% (stable). COWAY market share trend 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Water purifer 58% 56% 57% 52% 56% 55% 50% 45% 43% 41% 39% 37% 37% 37% Air purifer 52% 52% 41% 50% 45% 44% 41% 38% 34% 36% 32% 24% 27% 29% Bidet 49% 48% 48% 48% 47% 47% 43% 38% 29% 25% 28% 28% 29% 30% Source: Coway (based on the internal survey of sample population), my estimates Sustainable Competitive Advantage (moat) 90% of rental sales are done door-to-door by Coway’s 13,000+ Cody (“Coway + Lady”) sales force, alongside 1,000+ home-care professionals and some 3,000+ direct sales agents. This is around 3x larger than their closest 2 | Page Privileged and Confidential March 24, 2020 competitor, Chungho, and far ahead of lower-end players, like SK Magic and Cuckoo. Each Cody services around 420 accounts and can be highly efficient as they need to cover less than 1km2 each. These are not formally tied employees of Coway, and rather act as independent business owners, but are exclusive to Coway. Given that most of their commission is earned on after-sales service, the Cody would naturally want to work for the company with the biggest volumes. SK Magic and Cuckoo offers higher sales commissions, but since total volumes are lower their representatives tend to earn less from service commission. This has resulted in a very strong network effect and provides a natural barrier to entry for the likes of Amway and lower-priced Chinese brands. This network also improves customer relationships, increases the cross-selling ability and has helped maintain churn at very low levels. Source: Company reports Strategy and Ownership changes The strategy has pivoted over the past decade as we have seen changes in key shareholders. After MBK Partners (private equity) acquired Woongjin’s 31.5% stake in 2013, the company was heavily focussed on managing costs. This was done very successfully as we saw Operating Margins expand from 11.3% to 18.8% between 2012 and 2017. This was however done at the expense of market share and top-line growth. In early 2018 the focus shifted towards driving revenue growth through launching new products (Examples: Tankless water purification system, Clothes care system) and further international growth (with Malaysia being the most notable contributor). MBK Partners exited their investment by selling their stake back to Woongjin last year, which didn’t result in any meaningful change in strategy. In February this year, however, Woongjing finalised the sale of their 25% stake to South Korean online game developer and publisher, Netmarble (251270 KR) which has raised significant questions over future strategy. Management & Board The completion of the Netmarble minority stake acquisition also triggered the appointment of a whole new Board of Directors – except for Hae Sun Lee, who remains the CEO, which should provide at least some consistency in culture and strategy. As part of their minority stake, Netmarble was also awarded 2 seats on the Board, including appointing the Chairman (Jun Hyuk Bang, Netmarble founder) and a new CFO (Jang Won Seo, who ran the deal from Netmarble’s side). Coway, however, maintained 4 Independent Directors – although they are new to the Board – which means that Netmarble will need the approval of the 4 Independent Directors to push through a significant dividend cut. The audit committee remains fully independent. 3 | Page Privileged and Confidential March 24, 2020 Hae Sun Lee, the company CEO, is generally perceived as being very impressive. He has a marketing background coming from CJ O Shopping. The general feeling is that he is very much a products-focussed manager who doesn't talk much about the numbers but knows every small detail of the products they sell. There is limited disclosure over exact remuneration policies, but the CEO has stock options vesting over multiple years. Board of Directors Name Position Age Appointed Background and Professional Experience Jun Hyuk Bang Chairman 52 2020 Founder and Chairman of Netmarble. Executive advisor, Game Business Division CJ E&M. (Netmarble rep.) Hae Sun Lee CEO 64 2016 Current CEO of Coway, Former President of CJ CheilJedang, Previous CMO of Amorepacific, Previous CEO of CJ O Shopping. Harvard Business School General Management Program, Doctor's degree in Business Administration SungKyunkwan University, M.A. in International Marketing National Chengchi University, M.A. in International Business SungKyunkwan University, B.A. in Economics Chung-Ang University. Jang Won Seo Executive 49 2020 Head of Corporate Management Division at Coway, Officer in Investment Strategy and (Netmarble rep.) Communication for Netmarble, Previous Senior US Attorney for Sejong Law Firm. CFO (appointed Feb-20) Jin Bae Kim Non-executive / 58 2020 Professor at Korea University and also on the Board of GS Engineering & Construction. Received an Independent undergraduate degree from Seoul National University, a doctorate from Carnegie Mellon (Audit comm.) University and an MBA from The University of Chicago. Previously an Assistant Professor at Boston University. Kyu Ho Kim Non-executive / 58 2020 Professor at Sogang University, focused on academic-industrial cooperation.