Holding Companies Right now, wrong then: (6) Brand royalties

Ownership restructuring has been an overriding theme of 2016. We anticipate that large conglomerates, including Samsung, will continue to pursue ownership restructuring in 2017 in an effort to secure competitiveness and solidify control over Overweight (Maintain) their groups. In this report, we continue examining the areas where current standards regarding ownership restructuring ―which were once considered adequate ―need revision, and forecast changes to come. Industry Report November 24, 2016 Dividends to increase, given need for legitimate way to generate cash flow In light of strengthening regulations on executive compensation disclosures and related-party transaction s, we believe one legitimate way for controlling Mirae Asset Daewoo Co., Ltd. stakeholders to generate substantial cash flow is to increase dividends on their

[Holding Companies/IT Services ] holding company shares. Once Samsung, Hyundai Motor, and Lotte groups (which still control their affiliates through circular s hareholdings) complete their Dae -ro Jeong governance overhauls and holding company transitions, we believe their holding +822 -768 -4160 companies will begin to gradually raise their dividend payouts. Holding companies [email protected] derive their income mainly from dividends, brand royalties, rental income, etc.

Yoon -seok Seo +822 -768 -4127 Brand royalties, a stable income source, to be used for dividend payments [email protected] Brand royalties have diversified the income sources of holding companies, which previously relied solely on dividends from subsidiaries. Dividend income is

contingent upon the subsidiary ’s net profit, which is affected by a number of

operating and non-operating factors outside of revenue. In contrast, royalty income is directly tied to the subsidiary ’s revenue, and thus offers a more stable source of income for holding companies. Furthermore, while raising the dividend payout of a subsidiary causes cash to flow out of the group, royalties, on the other hand, are only paid to the holding company. Thus, an increase in royalty rates would be a more effective way for holdin g companies to improve their cash flow. We believe holding companies are likely to take advantage of brand royalties and use them to increase their dividend payments.

Most domestic holding companies, including LG Corp., SK Holdings, and CJ Corp., currently receive brand royalties from their subsidiaries. Some non-holding conglomerates, including Doosan Corp., Hanwha Corp. and POSCO, also collect brand royalties. We believe such companies decided to charge brand royalties in order to avoid potentially violating the Monopoly Regulation and Fair Trade Act (MRFTA) and the Corporate Tax Act against unfair trade practices.

Samsung Group & brand royalties: Samsung C&T expected to take over brand ownership Unlike many domestic conglomerates, Samsung Group ’s trademark is co-owned by 13 of its affiliates, including Samsung Electronics (SEC) and Samsung C&T, with their stakes determined in proportion to revenue. Affiliates that are not registered as co- owners (Samsung Welstory, S1, Renault Samsung, etc.) are believed to pay a certain royalty fee. Each year, Samsung Welstory discloses inter-group transactions based on the sole sourcing contract on Samsung trademark royalties. The disclosure s reveal that royalty fees amount to 0.5% of the company’s revenue, excluding sales from transactions with group affiliates with trademark ownership.

Generally, a holding company (or the de-facto holding company of a corporate group) manages all aspects related to brands and collects royalties from affiliates. As such, we believe Samsung’s brand royalties will mostly be collected by Samsung C&T, the de-facto holding company, going forward. However, this would require rearrangement of co-ownership. Samsung C&T should be able to take over other affiliates’ rights by evaluating the brand value (intangible asset) and paying the affiliates an appropriate amount for relinquishing their rights. Alternatively, Samsung C&T could pursue spin-offs/split-offs and mergers among affiliates with brand ownership in order to take over their rights without incurring expenses.

November 24, 2016 Holding Companies

Sources of income of holding companies

Income breakdown

A typical holding company (i.e., one that does not operate its own businesses) derives income mainly from 1) dividends, 2) brand royalties, 3) property rental, and 4) other income.

1) Dividends: The MRFTA states that a holding company is a corporation that exists for the purpose of controlling another company by owning shares. Currently, dividends paid by subsidiaries account for the lion’s share of holding companies’ income.

2) Brand royalties : Holding companies receive royalties for the use of its brands to keep the brand value solid. Depending on the company, royalties are booked as trademark royalties or brand fees.

3) Rental income : Rental income comes from property owned by holding companies. By its nature, rental income includes rent from non-subsidiaries.

4) Other income : Holding companies also generate advisory service commissions and training service commissions from subsidiaries, as well as gains on the sale of subsidiaries. Meanwhile, operating holding companies can generate merchandise sales.

Table 1. Holding companies’ source of income Source Details Cash inflow

Equity-method income Equity-method gain/losses from subsidiaries X Dividends Dividend income from subsidiaries O Recurring Rent Income from renting out buildings O Brand royalties Income from licensing brands/logos to subsidiaries O In-house businesses Applicable to operating holding companies O Non- Service income Provision of advisory services to subsidiaries O recurring Capital gains Sale of subsidiaries’ shares, IPOs, etc. O Source: Mirae Asset Daewoo Research

Table 2. Holding company income statement example: LG (003550 KS) (Wbn) (Wbn) 2010 2011 2012 2013 2014 2015 1Q16 2Q16 3Q16 Revenue 590.7 589.5 616.6 568.0 575.7 574.1 346.5 84.7 87.1 Dividends 279.6 260.9 252.6 200.3 209.4 214.4 260.9 0.0 0.0 Brand royalties 252.8 264.9 271.1 269.1 264.9 256.8 60.3 59.2 61.6 Rental income 58.3 63.7 92.9 98.7 101.5 102.8 25.3 25.5 25.6 Operating expenses 115.9 121.3 148.3 158.6 158.7 179.3 41.8 52.1 48.0 Personnel expenses 26.0 17.6 22.3 26.2 26.1 32.1 7.7 10.5 10.0 Depreciation cost 8.8 13.2 16.2 16.3 16.3 16.6 4.3 4.3 4.5 Other operating expenses 81.0 90.5 109.7 116.0 116.3 130.7 29.8 37.3 33.5 Operating profit 474.8 468.2 468.3 409.5 417.0 394.8 304.7 32.6 39.1 Other operating profit/loss -9.8 0.7 3.1 6.3 3.3 5.7 1.2 2.0 -0.3 Financial income 6.1 9.4 3.9 7.2 6.8 7.8 1.7 2.1 1.7 Financial expenses 15.5 8.7 0.6 0.4 2.5 0.8 0.5 0.1 1.9 Other non-operating income 12.1 0.1 -0.2 1.1 0.0 0.1 0.1 0.0 0.0 Other non-operating expenses 0.0 0.0 0.0 1.7 1.0 1.4 0.1 0.0 0.1 Pretax profit 477.4 469.0 471.4 415.7 420.3 400.6 305.8 34.6 38.8 Corporate tax 56.3 73.5 63.3 59.8 59.7 54.6 22.2 8.4 9.5 Net profit 421.1 395.5 408.1 356.0 360.6 345.9 283.6 26.2 29.3 Notes: Parent basis Source: Mirae Asset Daewoo Research

Mirae Asset Daewoo Research 2 November 24, 2016 Holding Companies

Understanding brand royalties

Brand royalties, a stable income source, to be used for dividend payment

Brand royalties have diversified the income sources of holding companies, which previously relied solely on dividends from subsidiaries. Dividend income is contingent upon the subsidiary’s net profit, which is affected by a number of operating and non-operating factors outside of revenue. In contrast, royalty income is directly tied to the subsidiary’s revenue, and thus offers a more stable source of income for holding companies. Furthermore, while raising the dividend payout of a subsidiary causes cash to flow out of the group, royalties, on the other hand, are only paid to the holding company. Thus, an increase in royalty rates would be a more effective way for holding companies to improve their cash flow.

We believe holding companies are likely to take advantage of brand royalties and use them to increase their dividend payments.

Understanding brand royalties: (1) Collecting brand royalties

A brand (trademark) is defined as any name, symbol, or logo used to identify and distinguish the goods or services of a company. Brands are recognized as intangible assets and can be licensed to a third party in exchange for royalties.

Simply put, brand royalties can be seen as a form of compensation for the direct use of a brand and for the services performed to enhance its value. Generally, a holding company (or the de-facto holding company of a corporate group) manages all aspects related to brands and collects royalties, which are considered necessary to manage the brand and improve its value. Brand royalties are agreed upon in a contract between the holding company and subsidiary, or in articles of incorporation. Royalty rates vary widely by company, but they are typically charged as a percentage of revenue.

Understanding brand royalties: (2) Holding companies’ obligation to collect royalties

Most holding companies, as brand owners, are restricted from licensing their brands to subsidiaries for free.

Under Korea’s Monopoly Regulation and Fair Trade Act, assisting an affiliated person or another company by providing a company asset without receiving compensation (or transacting under considerably favorable terms) is deemed an unfair practice (Article 23.1.7). Hence, granting a subsidiary the right to use a brand without any compensation would be considered an unfair trade practice that improperly benefits the subsidiary.

The Corporate Tax Act also designates royalty-free licensing as an unfair practice that unjustly reduces the tax burden of a corporation. A subsidiary using a brand without paying appropriate compensation can be subject to a tax penalty under Article 52 of the “Repudiation of Wrongful Calculation” provision. For example, in 2010, Kumho Petrochemical was hit with a W8bn tax fine by the National Tax Service after failing to charge group affiliates for using its trademark, Kumho, of which the company is a co-owner.

Table 3. Licensing of corporate brands to subsidiaries for free is legally restricted Article Details

Assisting a person with a special interest or other companies by providing advanced payment, loans, Fair Trade Article 23.1.7 manpower, immovable assets, securities, goods, services, rights to intangible properties, etc. thereto, or Act (Prohibition of Unfair Trade Practices) by transacting under substantially favorable terms

Where the head of the tax office having jurisdiction over the place of tax payment or the commissioner of the competent regional tax office deems that the tax burden of a domestic corporation has been Corporate Article 52 unjustly reduced through the wrongful calculation of the amount of income of the domestic corporation Tax Act (Repudiation of Wrongful Calculation) in transactions with a related party prescribed by presidential decree, he/she may calculate the amount of income of the domestic corporation for each business year regardless of the wrongful calculation of the amount of income of such domestic corporation Source: Mirae Asset Daewoo Research

Mirae Asset Daewoo Research 3 November 24, 2016 Holding Companies

Current status

1) Holding companies

Most domestic holding companies, including LG Corp., SK Holdings, and CJ Corp., currently receive brand royalties from their subsidiaries, typically as a fixed percentage of revenue after advertising and promotional expenses. Meanwhile, the Fair Trade Commission (FTC) has said that the dividends or brand royalties holding companies receive from their subsidiaries will not be subject to the government’s regulations on related-party transactions. Thus, we believe holding companies’ brand royalties will steadily increase in line with the revenue of subsidiaries.

Table 4. Brand royalty overviews for major holding companies Holding company Brand royalty calculation Term LG Corp Subsidiary’s revenue x 20bps One year SK Holdings (Subsidiary’s revenue minus advertising and promotional expenses) x 20bps Three years CJ Corp (Subsidiary’s revenue minus advertising and promotional expenses) x 40bps One year Source: Dart, Mirae Asset Daewoo Research

Table 5. LG Corp.’s cash flow (Wbn) 2010 2011 2012 2013 2014 2015

Ordinary net cash flow (1) - (2) 170.0 155.4 240.5 169.0 199.3 181.5 Ordinary cash inflow (1) 590.7 589.5 616.6 568.0 575.7 574.1 Dividends 279.6 260.9 252.6 200.3 209.4 214.4 Brand royalties 252.8 264.9 271.1 269.1 264.9 256.8 Rental income 58.3 63.7 92.9 98.7 101.5 102.8 Ordinary cash outflow (2) 420.7 434.1 376.1 399.1 376.5 392.6 Administrative expenses (excl. depreciation) 106.2 107.5 131.3 141.3 141.5 161.5 Taxes 48.7 64.2 68.8 67.7 60.6 57.3 Dividend payment 175.5 175.9 175.9 175.9 175.9 175.9 Tangible/intangible asset investments 80.4 88.0 3.1 20.6 5.6 3.2 Net interest expenses 9.9 -1.5 -3.1 -6.5 -7.2 -5.4 Source: Mirae Asset Daewoo Research

Table 6. SK Holdings’ cash flow (Wbn) 2010 2011 2012 2013 2014 2015

Ordinary net cash flow (1) - (2) 235.6 354.4 283.6 686.5 596.2 -427.2 Ordinary cash inflow (1) 543.8 752.7 733.2 1,062.6 991.7 428.3 EBITDA - - - - - 304.8 Dividends 379.1 577.8 491.0 797.9 723.1 0.8 Brand royalties 132.8 143.0 210.6 229.7 233.2 98.9 Rental income 31.9 31.9 31.6 35.0 35.4 23.8 Ordinary cash outflow (2) 308.2 398.3 449.6 376.1 395.5 855.6 Administrative expenses (excl. depreciation) 188.2 172.6 182.2 139.3 128.4 472.0 Taxes 2.5 4.0 12.4 2.9 23.1 104.6 Dividend payment 80.0 80.0 102.5 102.5 102.5 88.0 Tangible/intangible asset investments 26.9 7.6 3.5 8.2 16.0 79.3 Net interest expenses 10.7 134.1 148.9 123.4 125.6 111.7 Notes: SK Holdings merged with SK C&C in Aug. 2015. Source: Mirae Asset Daewoo Research

Table 7. CJ Corp.’s cash flow (Wbn) 2010 2011 2012 2013 2014 2015

Ordinary net cash flow (1) - (2) -18.3 -22.2 -94.9 -12.4 20.5 17.5 Ordinary cash inflow (1) 67.7 90.3 108.0 90.4 98.5 103.6 Dividends 26.0 38.0 48.3 17.9 16.6 19.9 Brand royalties 33.2 44.8 52.0 64.8 73.4 75.7 Rental income 8.5 7.5 7.7 7.7 8.6 8.0 Ordinary cash outflow (2) 86.0 112.5 202.9 102.8 78.0 86.1 Administrative expenses (excl. depreciation) 47.0 50.0 41.4 36.9 42.4 50.8 Tax 2.9 32.3 132.7 36.4 -6.2 -0.3 Dividend payment 22.4 22.5 18.5 18.5 27.0 27.1 Tangible/intangible asset investments 0.7 0.9 1.1 3.3 10.3 3.0 Net interest expenses 13.0 6.9 9.2 7.6 4.5 5.6 Source: Mirae Asset Daewoo Research

Mirae Asset Daewoo Research 4 November 24, 2016 Holding Companies

2) Corporate groups without a holding company structure

We believe the majority of non-holding corporate groups do not collect any brand royalties. However, a few groups without a holding company structure, namely Doosan, Hanwha, and POSCO, receive brand royalties in order to avoid potentially violating the MRFTA and Corporate Tax Act.

Doosan Corp. has collected brand royalties since converting to a holding company in 2009. In April 2015, the Doosan Group was excluded from the list of corporate groups with a holding company structure, as asset growth at the operating unit had resulted in the total value of the holding company’s subsidiary shares falling below 50% of total parent-basis assets. However, Doosan Corp. has continued receiving brand royalties as a trademark rights holder.

Hanwha Corp. holds trademark rights as the de-facto holding company of the Hanwha Group. The company works to improve brand value via advertising and public relations activities, and manages brand-related affairs, including applications, registration, and maintenance. In July 2015, the company reached brand licensing agreements with affiliates using the Hanwha brand and has received brand royalties based on annual revenue.

POSCO, meanwhile, has collected royalties from affiliates using the POSCO brand since 2012. The company recognized royalties of W8.5bn in 2012 and W8.7bn in 2013. According to media reports, POSCO charges royalties as the lower of either: 1) [the affiliate ’s revenue in the previous year] x [royalty rate] x [an adjustment factor reflecting group affiliate revenue], or 2) [the affiliate ’s EBITDA in the previous year] x 1%. The royalty rate varies by affiliate, ranging between 0.01% and 0.3%, and royalties are collected on a quarterly basis.

Table 8. Doosan Corp.’s cash flow (Wbn) 2010 2011 2012 2013 2014 2015

Ordinary net cash flow (1) - (2) -220.8 -128.1 -177.4 -35.8 69.5 -49.0 Ordinary cash inflow (1) 228.5 334.5 282.3 400.9 532.0 428.8 EBITDA 174.4 231.7 191.8 247.4 312.4 270.5 Dividends 24.5 69.8 47.7 102.2 170.2 114.3 Brand royalties 29.6 32.9 42.8 51.3 49.3 44.0 Rental income 0.0 0.0 0.0 0.0 0.0 0.0 Ordinary cash outflow (2) 449.3 462.6 459.7 436.7 462.5 477.9 Administrative expenses (excl. depreciation) 183.0 254.8 268.6 269.3 304.0 283.1 Taxes 128.2 9.3 29.7 13.4 14.9 33.3 Dividend payment 58.3 57.9 65.3 74.3 73.5 72.3 Tangible/intangible asset investments 63.5 114.1 65.1 46.7 32.9 55.4 Net interest expenses 16.3 26.5 31.0 33.0 37.2 33.8 Notes: Brand royalties are estimates Source: Mirae Asset Daewoo Research

Table 9. Hanwha Corp.’s cash flow (Wbn) 2010 2011 2012 2013 2014 2015

Ordinary net cash flow (1) - (2) -226.3 -327.4 -272.6 -306.7 -247.8 -336.4 Ordinary cash inflow (1) 294.4 233.7 239.8 227.5 256.9 330.5 EBITDA 289.4 160 161.5 159.4 214.3 235.6 Dividends 5 73.7 78.3 68.1 42.6 62.4 Brand royalties - - - - - 32.6 Ordinary cash outflow (2) 520.7 561.1 512.4 534.2 504.7 666.9 Administrative expenses (excl. depreciation) 230 251.5 281.6 320.8 269.0 325.6 Tax 52.8 38.2 15.6 -0.1 9.9 54.6 Dividend payment 41.8 41.8 31.3 31.3 27.8 34.8 Tangible/intangible asset investments 85.9 128.7 97.2 107.8 124.7 169.9 Net interest expenses 110.2 101 86.6 74.4 73.2 81.9 Notes: Brand royalties collected from Jul. 2015; Brand royalties in 2015 is estimates Source: Mirae Asset Daewoo Research

Mirae Asset Daewoo Research 5 November 24, 2016 Holding Companies

Samsung Group & brand royalties Unlike many domestic conglomerates, Samsung Group ’s trademark is co-owned by 13 of its affiliates, including SEC and Samsung C&T, with their stakes determined in proportion to revenue. Affiliates that are not registered as co-owners (Samsung Welstory, S1, Renault Samsung, etc.) are believed to pay a certain royalty fee. Each year, Samsung Welstory discloses inter-group transactions based on the sole sourcing contract on Samsung trademark royalties. The disclosures reveal that royalty fees amount to 0.5% of the company’s revenue, excluding sales from transactions with group affiliates with trademark ownership.

Generally, a holding company (or the de-facto holding company of a corporate group) manages all aspects related to brands and collects royalties from affiliates. As such, we believe Samsung’s brand royalties will mostly be collected by Samsung C&T, the de-facto holding company, going forward. However, this would require the group to rearrange its co-ownership system. Samsung C&T should be able to take over other affiliates’ rights by evaluating the brand value (intangible asset) and paying the affiliates an appropriate amount for relinquishing their rights. Alternatively, Samsung C&T could pursue spin- offs/split-offs and mergers among affiliates with brand ownership in order to take over their rights without incurring expenses.

Table 10. Samsung Group’s revenue (Wbn) Major listed subsidiaries 2012 2013 2014 2015 1H16 SEC 141,206 158,372 137,826 135,205 66,052 Samsung Heavy Industries 14,424 14,706 12,584 9,333 4,975 Samsung C&T (舊Cheil Industries) 2,700 3,018 3,313 8,885 9,590 Previous Samsung C&T 17,241 18,845 19,150 - - Samsung SDI 4,908 2,919 4,720 6,680 2,223 SEMCO 5,469 6,119 4,784 5,297 2,491 Samsung Engineering 9,285 8,235 7,472 4,923 2,709 Samsung SDS 4,424 4,633 4,575 4,353 1,949 Hotel Shilla 2,190 2,275 2,795 2,782 1,573 S1 1,007 1,160 1,620 1,789 882 Cheil Worldwide 854 927 882 820 486 Multicampus 80 103 122 126 83 Samsung Life 30,383 19,209 26,886 27,014 13,064 Samsung F&M 19,258 15,205 20,675 21,386 10,533 Samsung Securities 2,545 2,087 3,042 3,880 2,460 Samsung Card 3,699 2,811 3,432 3,212 1,659 Total (1) 259,671 260,623 253,879 235,685 120,728

Major unlisted subsidiaries 2012 2013 2014 2015 1H16 Samsung Display 22,305 29,387 24,981 26,397 11,421 Samsung Welstory - 120 1,584 1,662 844 Samsung Medicine 277 269 285 268 119 Samsung Economic Research Institute 154 166 172 166 - Samsung BioLogics - 0 29 91 136 SECUi 94 104 94 86 35 Samsung Lions 53 43 51 58 31 Samsung Venture Investment 26 24 23 37 - Samsung Bioepis - 44 76 24 - Samsung Asset Management 137 106 138 164 90 Samsung Futures 74 47 53 58 22 Total (2) 23,120 30,310 27,485 29,013 12,698 Other affiliates (3) 20,149 42,959 21,533 7,182 - Total revenue (1)+(2)+(3) 302,940 333,892 302,897 271,880 133,426 Notes: Parent basis; Total revenue is based on Fair Trade Commission announcement; Some unlisted subsidiaries have not announced 1H16 earnings Source: Mirae Asset Daewoo Research

Mirae Asset Daewoo Research 6 November 24, 2016 Holding Companies

APPENDIX 1

Important Disclosures & Disclaimers

Analyst Certification The research analysts who prepared this report (the “Analysts”) are registered with the Korea Financial Investment Association and are subject to Korean securities regulations. They are neither registered as research analysts in any other jurisdiction nor subject to the laws and regulations thereof. Opinions expressed in this publication about the subject securities and companies accurately reflect the personal views of the Analysts primarily responsible for this report. Mirae Asset Daewoo Co., Ltd. (“Mirae Asset Daewoo”) policy prohibits its Analysts and members of their households from owning securities of any company in the Analyst’s area of coverage, and the Analysts do not serve as an officer, director or advisory board member of the subject companies. Except as otherwise specified herein, the Analysts have not received any compensation or any other benefits from the subject companies in the past 12 months and have not been promised the same in connection with this report. No part of the compensation of the Analysts was, is, or will be directly or indirectly related to the specific recommendations or views contained in this report but, like all employees of Mirae Asset Daewoo, the Analysts receive compensation that is impacted by overall firm profitability, which includes revenues from, among other business units, the institutional equities, investment banking, proprietary trading and private client division. At the time of publication of this report, the Analysts do not know or have reason to know of any actual, material conflict of interest of the Analyst or Mirae Asset Daewoo except as otherwise stated herein.

Disclaimers This report is published by Mirae Asset Daewoo, a broker-dealer registered in the Republic of Korea and a member of the Korea Exchange. Information and opinions contained herein have been compiled from sources believed to be reliable and in good faith, but such information has not been independently verified and Mirae Asset Daewoo makes no guarantee, representation or warranty, express or implied, as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein or of any translation into English from the Korean language. If this report is an English translation of a report prepared in the Korean language, the original Korean language report may have been made available to investors in advance of this report. Mirae Asset Daewoo, its affiliates and their directors, officers, employees and agents do not accept any liability for any loss arising from the use hereof. This report is for general information purposes only and it is not and should not be construed as an offer or a solicitation of an offer to effect transactions in any securities or other financial instruments. The intended recipients of this report are sophisticated institutional investors who have substantial knowledge of the local business environment, its common practices, laws and accounting principles and no person whose receipt or use of this report would violate any laws and regulations or subject Mirae Asset Daewoo and its affiliates to registration or licensing requirements in any jurisdiction should receive or make any use hereof. Information and opinions contained herein are subject to change without notice and no part of this document may be copied or reproduced in any manner or form or redistributed or published, in whole or in part, without the prior written consent of Mirae Asset Daewoo. Mirae Asset Daewoo, its affiliates and their directors, officers, employees and agents may have long or short positions in any of the subject securities at any time and may make a purchase or sale, or offer to make a purchase or sale, of any such securities or other financial instruments from time to time in the open market or otherwise, in each case either as principals or agents. Mirae Asset Daewoo and its affiliates may have had, or may be expecting to enter into, business relationships with the subject companies to provide investment banking, market-making or other financial services as are permitted under applicable laws and regulations. The price and value of the investments referred to in this report and the income from them may go down as well as up, and investors may realize losses on any investments. Past performance is not a guide to future performance. Future returns are not guaranteed, and a loss of original capital may occur.

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Mirae Asset Daewoo Research 7 November 24, 2016 Holding Companies

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