2H19 Outlook

Software Growth potential of IT services remains robust

Dae-ro Jeong +822-3774-1634 [email protected]

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 IN APPENDIX 1 AT THE END OF REPORT. Contents

[Summary] Growth potential of IT services remains robust 3

I. 2019 outlook 4

II. Investment points 5

III. Impact of related-party transaction regulations 9

IV. Top picks 11 Samsung SDS, Lotte Data Communication [Summary] Growth potential of IT services remains robust

Large players to display differentiated growth

IT investments as % of revenue; Domestic IT service firms’ affiliate Domestic economic/IT market growth and facility investments revenue contributions (%) 3.3% GDP growth 8 IT market growth 6 4 2

0 0.6% -2

-4 Domestic Global 07 08 09 10 11 12 13 14 15 16 17 18 (Wtr) Revenue (L) 200 Non-manufacturing (Wtr) (%) Affiliate revenue contribution (R) Manufacturing 10 100 150 8 80 6 60 4 40 100 2 20 0 0 50

0 07 08 09 10 11 12 13 14 15 16 17 18

Source: Statistics Korea, KRG, Mirae Asset Daewoo Research

3| 2H19 Outlook [Software] Mirae Asset Daewoo Research I. 2019 outlook

Domestic IT services • IT service firms provide customers with a wide array of solutions, including consulting, demand analysis, system market to post slower design, system component development, and system integration testing/deployment. • For 2019, KRG forecasts that the Korean IT services market will expand 3.5% YoY to US$11.8bn, and that the growth than the global global market will grow 4.8% YoY to US$1.034tr. market • The domestic IT services market has displayed relatively slow growth of 3-4% since 2015.

Domestic IT services market trend and outlook Global IT services market trend and outlook

(US$bn) (%) (US$bn) (%) 16 Market size (L) 8 1,600 Market size (L) 8 Growth rate (R) 2019-22F CAGR: Growth rate (R) 2019-22F CAGR: 4.8% 12.5% 12 6 1,200 6

8 4 800 4

4 2 400 2

0 0 0 0 15 16 17 18 19F 20F 21F 22F 15 16 17 18 19F 20F 21F 22F

Source: KRG, Mirae Asset Daewoo Research Source: KRG, Mirae Asset Daewoo Research

4| 2H19 Outlook [Software] Mirae Asset Daewoo Research II. Investment points

Growing focus on IT’s • The domestic IT services market represents a mere 1.2% of the global market. importance (in driving • Total IT spending as a percentage of revenue is very low for Korean firms (vs. global players). competitiveness) to push • Given the growing focus on IT’s importance in driving competitiveness, we look for a steady increase in IT spending going forward. up related spending • Notably, we believe that explosive growth in demand for high-tech services (e.g., IoT, cloud computing, Big Data, mobility) related to the Fourth Industrial Revolution and digitalization will also accelerate the pace of IT spending growth.

IT services market by country and % of global market Total IT spending as % of revenue: Korean vs. global companies

(US$bn) (%) 3.3% 600 Market size (L) 56.5 60 Contribution to global market (R)

500 50

400 40

300 30

200 20

0.6% 100 10 8.0 6.6 4.2 0 1.2 0 Korea China Germany Japan US Domestic Global

Source: Gartner, Mirae Asset Daewoo Research Source: KRG, Deloitte, Mirae Asset Daewoo Research

5| 2H19 Outlook [Software] Mirae Asset Daewoo Research II. Investment points

Earnings stability • The IT services industry has historically been highly sensitive to economic conditions, tracking the economic cycle supported by lower with a lag. • IT spending has traditionally been the first item to be trimmed during sluggish times and the last thing to be sensitivity to economic increased during periods of recovery. cycle • However, companies are increasingly making IT-related investments an essential part of their business plans.  The IT services industry’s sensitivity to the economic cycle has been declining. • IT service providers are expected to display steady earnings amid a reduction in earnings volatility.

Domestic economic/IT market growth and facility investments

(%) 8 GDP growth IT market growth 6 4 2 0 -2 -4 07 08 09 10 11 12 13 14 15 16 17 18 (Wtr) 200 Non-manufacturing Manufacturing 150

100

50

0 07 08 09 10 11 12 13 14 15 16 17 18

Source: Statistics Korea, KRG, Mirae Asset Daewoo Research

6| 2H19 Outlook [Software] Mirae Asset Daewoo Research II. Investment points

Earnings stability based • Major domestic IT services providers are mostly subsidiaries of large conglomerates and generally focus on captive IT investment demand to drive revenue growth. on captive demand • They are better positioned (vs. external competitors) to ensure group-level security and swiftly and efficiently respond to unexpected events. • Among the top seven IT service providers affiliated with large conglomerates, revenue exposure to captive customers is as high as 77.9% (based on 2017 data). • Armed with steady revenue and profitability streams from group companies, group-affiliated IT service providers maintain leadership positions in the domestic market. Major Korean IT services players: Revenue and revenue Captive vs. non-captive market characteristics exposure to group companies (2017) (%) (Wtr) Revenue (L) Affiliate revenue contribution (R) Classification Captive market Non-captive market 10 100 1. Competition Low High

8 80 Special ties with High Low customers

6 60 Lock-in High Low

2. Threats from new 4 40 Low High entrants

Entry barriers High Low 2 20

3. Bargaining power vs. Relatively high Low 0 0 customers 4. Bargaining power vs. Relatively high Low suppliers

Conglomerate- Independent SME SI 5. Company type affiliated SI company company

Source: DART Mirae Asset Daewoo Research Source: NICE, Mirae Asset Daewoo Research

7| 2H19 Outlook [Software] Mirae Asset Daewoo Research II. Investment points

Growth oriented toward • IT service players’ earnings and market status are largely determined by the assets and investment strategies of major players their respective group affiliates. • External customers also prefer large players with proven track records. • We believe large IT service providers will display differentiated growth in line with increasing IT investment demand from both group affiliates and external customers.

Top 10 conglomerates: Total assets and revenue (2017) Top 10 IT service providers: Revenue

(Wtr) (Wtr) 500 5 Total assets Revenue 4.5

400 4

3 300 2.4

2 1.6 200 1.2 0.9 1 0.6 0.5 0.4 0.4 0.4 100 0

0

Source: DART, Mirae Asset Daewoo Research Source: NICE, Mirae Asset Daewoo Research

8| 2H19 Outlook [Software] Mirae Asset Daewoo Research III. Impact of related-party transaction regulations

Impact of related-party • Due to high dependence on orders from affiliates, domestic IT service firms belonging to large corporate groups transaction regulations are exposed to risks related to changes in related-party transaction regulations. • Under the Monopoly Regulation and Fair Trade Act (MRFTA), transactions that are essential to improving to be limited efficiency, ensuring security, and/or meeting urgent needs are exempt from the related-party transaction regulations. • Given the importance of IT security for corporate groups, most transactions involving major IT service providers and their group affiliates are unlikely to be subject to MRFTA regulations.

Major MRFTA regulations on related-party transactions

Regulation Details

No conglomerate (with total asset value of over W5tr) shall commit any act that could generate unfair profits for a specially-related person or a subsidiary/affiliate in which a specially-related person holds a stake in excess of the percentage set forth by presidential decree, via any one of the Article 23-2-1 of MRFTA following acts: (Prohibition of Unfair 1. Transactions under substantially favorable terms Trade Practices) 2. Provision of opportunities for business activities (under unfair terms) 3. Transactions of money or other financial products under considerably favorable terms and conditions 4. Transactions of a considerably large scale without reasonable consideration or comparison

Article 38-2 of Affiliates whose shares are held by a specially-related person in at least the percentage prescribed by presidential decree means an affiliate in Enforcement Decree of which said person alone or together with his/her relatives holds at least 30% (or 20% in the case of a company which is not a listed corporation) MRFTA of issued shares.

* Transactions of a considerably large scale without reasonable consideration or comparison Exemptions: Cases in which annual transaction value is less than 12% of the transacting party’s revenue and less than W20bn; cases in which the transaction is necessary for one of the following reasons: 1) Efficiency Article 38-3 of A transaction that is clearly acknowledged to reduce costs, improve quality, increase sales volume, and contribute to technological Enforcement Decree of development (vs. an arm’s-length transaction) MRFTA 2) Security A transaction that could lead to the leakage of key technologies or information, if made with a non-related party 3) Urgent need A transaction that is required to meet an urgent need, including issues related to sudden economic changes, financial crises, natural disasters, hacking, or IT system errors owing to computer viruses.

Source: Mirae Asset Daewoo Research

9| 2H19 Outlook [Software] Mirae Asset Daewoo Research III. Impact of related-party transaction regulations

Determination of related-party transactions

Source: Mirae Asset Daewoo Research

10| 2H19 Outlook [Software] Mirae Asset Daewoo Research Samsung SDS (018260 KS)

M&A-driven growth

Increased revenue contributions from strategic businesses; Additional growth via M&As (Maintain) Buy • IT services: We expect revenue of W6.2tr (+9.8% YoY) and operating profit of W928.8bn (+8.8% YoY). - The revenue contribution from strategic businesses, including smart factories, cloud computing, and AI Target Price (12M, W) 290,000 analytics, is anticipated to rise to 33% in 2019 from 30% in 2018. - Execution of Samsung Electronics’ (SEC; 005930 KS/Buy/TP: W56,000/CP: W41,200) ERP system replacement project (W700bn; through 2020) should support revenue growth. Share Price (5/7/19, W) 211,500 • Logistics BPO: Revenue and operating profit are estimated at W4.7tr (+8.0% YoY) and W47.1bn (+96.2% YoY), respectively. OP margin is anticipated to improve to the 1% level on the back of stronger operating cost Expected Return 37% efficiency and a higher mix of external orders. • We believe Samsung SDS will aggressively pursue M&A deals using its cash holdings (W3.6tr) to secure additional growth drivers. OP (19F, Wbn) 976

Consensus OP (19F, Wbn) 974 Risks EPS Growth (19F, %) 12.9 • Concerns over related-party transaction regulations due to the company’s high exposure to Samsung affiliates Market EPS Growth (19F, %) -18.2 • The logistics BPO business’s low profitability and high earnings volatility P/E (19F, x) 23.0 Market P/E (19F, x) 12.2

KOSPI 2,176.99

105 Market Cap (Wbn) 16,365 Samsung SDS FY (Dec.) 12/15 12/16 12/17 12/18 12/19F 12/20F Shares Outstanding 77 100 KOSPI Revenue (Wbn) 7,853 8,180 9,299 10,034 10,940 11,960 (mn) Free Float (%) 42.6 95 OP (Wbn) 588 627 732 877 976 1,101

Foreign Ownership (%) 14.4 90 OP margin (%) 7.5 7.7 7.9 8.7 8.9 9.2

Beta (12M) 1.22 85 NP (Wbn) 439 464 530 629 711 801 52-Week Low 181,000 80 EPS (W) 5,674 5,995 6,854 8,134 9,185 10,352

52-Week High 244,500 75 ROE (%) 10.1 9.5 9.9 10.9 11.4 11.7 70 (%) 1M 6M 12M P/E (x) 44.8 23.3 29.2 25.1 23.0 20.4 65 Absolute -9.0 12.2 -3.2 P/B (x) 4.3 2.1 2.8 2.6 2.5 2.3 60 Relative -7.7 7.1 9.418.6 18.8 18.10 18.12 19.2 19.4 Div.Yield (%) 0.2 0.5 1.0 1.0 1.3 1.3 Note: All figures are based on consolidated K-IFRS; NP refers to net profit attributable to controlling interests Source: Samsung SDS, Mirae Asset Daewoo Research estimates

11| 2H19 Outlook [Software] Mirae Asset Daewoo Research Samsung SDS (018260 KS)

Key investment variables

IT services revenue from SEC New businesses as % of IT services revenue (Wtr) (Wtr) (Wtr) (%) 300 SEC revenue (L) 3.0 8 IT services revenue (L) 80 New business revenue (L) IT services revenue from SEC (R) 250 2.5 New business revenue contribution (R) 6 60 200 2.0

150 1.5 4 40

100 1.0 2 20 50 0.5

0 0.0 0 0 09 10 11 12 13 14 15 16 17 18 19F 16 17 18 19 20F Source: DART, Mirae Asset Daewoo Research Source: DART, Mirae Asset Daewoo Research

IT services revenue and OP margin Cash and equivalents (Wtr) (%) (Wtr) 8 16 5 Consulting/SI (L) 4.3 Outsourcing (L) 14 4 3.7 6 2.9 12 3 2.5 4 2.0 10 2 1.7 1.1 2 0.8 8 1

0 6 0 16 17 18 19F 20F 12 13 14 15 16 17 18 19F

Source: Company data, Mirae Asset Daewoo Research Source: DART, Mirae Asset Daewoo Research

12| 2H19 Outlook [Software] Mirae Asset Daewoo Research Lotte Data Communication (286940 KS)

HIT merger to create additional business opportunities

Data-based businesses to gather momentum; Biggest beneficiary of Lotte Group’s IT spending (Maintain) Buy • Lotte Data Communication recently decided to absorb Hyundai Information Technology (HIT; 59.7% stake). The merger aims to: 1) increase cost competitiveness; 2) internalize HIT’s competitive edge in SOC projects; Target Price (12M, W) 63,000 and 3) increase momentum for data-based businesses. • Currently, a fourth data center dedicated to cloud (5,000m2, W49.5bn invested) is being built in Yongin, Gyeonggi. We expect the company to expand its cloud business via partnerships with global players. Share Price (5/9/19, W) 48,350 • The company should deliver steady revenue growth of more than 10% annually through 2025. • Lotte Group is pursuing digital transformation, with plans to invest W50tr in its domestic and overseas Expected Return 30% businesses over the next five years. Risks OP (19F, Wbn) 45 • Concerns over related-party transaction regulations arising from the company’s high exposure to Lotte Consensus OP (19F, Wbn) 45 affiliates.

EPS Growth (19F, %) 10.6 • Potential delay to Lotte Group’s investment plans

Market EPS Growth (19F, %) -18.2 P/E (19F, x) 19.8

Market P/E (19F, x) 11.7 KOSPI 2,102.01

Market Cap (Wbn) 691 190 Lotte Data FY (Dec.) 12/15 12/16 12/17 12/18 12/19F 12/20F Shares Outstanding Communication 14 KOSPI Revenue (Wbn) - - 149 812 910 1,016 (mn) 170 Free Float (%) 24.0 OP (Wbn) - - 5 39 45 54 Foreign Ownership (%) 1.8 150 OP margin (%) - - 3.4 4.8 4.9 5.3

Beta (12M) 0.05 NP (Wbn) - - 2 26 35 39 130 52-Week Low 25,850 EPS (W) - - 1,139 2,205 2,439 2,702

52-Week High 51,300 110 ROE (%) - - 1.0 9.6 9.6 9.9 (%) 1M 6M 12M P/E (x) - - - 16.1 19.8 17.9 90 Absolute -1.0 40.3 0.0 P/B (x) - - - 1.4 1.8 1.7 70 Relative 4.2 39.3 0.018.7 18.9 18.11 19.1 19.3 Div.Yield (%) - - - 1.8 1.3 1.3 Note: All figures are based on consolidated K-IFRS; NP refers to net profit attributable to controlling interests Source: Lotte Data Communication, Mirae Asset Daewoo Research estimates

13| 2H19 Outlook [Software] Mirae Asset Daewoo Research Lotte Data Communication (286940 KS)

Key investment variables

Lotte Group’s assets and revenue; Lotte Data Communication’s Lotte Group’s five-year investment plan (2019-23) revenue Value (Wtr) (Wbn) Details Proportion 140 Lotte Group total assets (L) 700 (Wtr) ㆍOnline business expansion 120 600 Retail - Digital transformation (AI, Big Data, etc.) 25% 12.5 ㆍ 100 500 Development of an integrated online shopping mall ㆍNew product development 80 400 F&B (AI utilization to increase) 10% 5.0 ㆍExpansion of production facilities 60 300 ㆍCapacity expansion at home and abroad Chemicals/ ㆍStrengthening of cost competitiveness via 40 200 40% 20.0 construction feedstock diversification 20 100 ㆍExpansion of value-added products Tourism/ ㆍSteady domestic and overseas expansion 25% 12.5 0 0 services 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 Total 100% 50.0

Source: DART, Mirae Asset Daewoo Research Source: Lotte Group, Mirae Asset Daewoo Research

Affiliate revenue and contribution Cash and equivalents

(Wbn)Affiliate revenue (L) (%) (Wbn) 800 100 200 Cash and equivalents Non-affiliate affiliate (L) 90 600 150 80 400 100 189.8 70 163.2 200 50 60 76.1

0 50 0 17 18 1Q19 14 15 16 17 18

Source: Company data, Mirae Asset Daewoo Research Source: DART, Mirae Asset Daewoo Research

14| 2H19 Outlook [Software] Mirae Asset Daewoo Research Coverage overview

Target price Current price Company Ticker Rating (12M, W) (5/9/19, W)

S1 012750 KS Buy W120,000 W93,000

Samsung SDS 018260 KS Buy W290,000 W201,500

Lotte Data Communication 286940 KS Buy W63,000 W48,350

Source: Mirae Asset Daewoo Research

15| 2H19 Outlook [Software] Mirae Asset Daewoo Research APPENDIX 1

Important Disclosures & Disclaimers 2-Year Rating and Target Price History

Company (Code) Date Rating Target Price Company (Code) Date Rating Target Price Samsung SDS(018260) Lotte Data Communication(286940) 07/29/2018 Buy 290,000 04/09/2019 Buy 63,000 02/04/2018 Trading Buy 280,000 07/19/2017 Buy 240,000 01/24/2017 Buy 200,000

(W) Samsung SDS (W) Lotte Data Communication

400,000 80,000

300,000 60,000

200,000 40,000

100,000 20,000

0 0 May 17 May 18May May 17 19 May 18 May 19

Stock Ratings Industry Ratings Buy : Relative performance of 20% or greater Overweight : Fundamentals are favorable or improving Trading Buy : Relative performance of 10% or greater, but with volatility Neutral : Fundamentals are steady without any material changes Hold : Relative performance of -10% and 10% Underweight : Fundamentals are unfavorable or worsening Sell : Relative performance of -10%

Ratings and Target Price History (Share price (─), Target price (▬), Not covered (■), Buy (▲), Trading Buy (■), Hold (●), Sell (◆)) * Our investment rating is a guide to the relative return of the stock versus the market over the next 12 months. * Although it is not part of the official ratings at Mirae Asset Daewoo Co., Ltd., we may call a trading opportunity in case there is a technical or short-term material development. * The target price was determined by the research analyst through valuation methods discussed in this report, in part based on the analyst’s estimate of future earnings. * The achievement of the target price may be impeded by risks related to the subject securities and companies, as well as general market and economic conditions.

Equity Ratings Distribution & Investment Banking Services Buy Trading Buy Hold Sell Equity Ratings Distribution 83.52% 8.24% 8.24% 0.00% Investment Banking Services 82.61% 4.35% 13.04% 0.00% * Based on recommendations in the last 12-months (as of March 31, 2019)

16| 2H19 Outlook [Software] Mirae Asset Daewoo Research APPENDIX 1

Disclosures As of the publication date, Mirae Asset Daewoo Co., Ltd. has acted as a liquidity provider for equity-linked warrants backed by shares of Samsung SDS as an underlying asset; other than this, Mirae Asset Daewoo has no other special interests in the covered companies. We managed the IPO of Lotte Data Communication within the past one year.

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17| 2H19 Outlook [Software] Mirae Asset Daewoo Research APPENDIX 1

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19| 2H19 Outlook [Software] Mirae Asset Daewoo Research