14 December 2010 Produced by: RBS Asia Limited (Seoul) Branch Kumho Petrochemical Initiation of coverage Buy Reborn as a core chemical player Target price Kumho Petrochem is one of the least covered chemical stocks in Korea. W119000 However, with apparently diminishing risk related to the Kumho Asiana group, we Price W79300 believe it's time to focus on Kumho Petrochem's strong fundamentals and Short term (0-60 days) attractive valuation. Buy. n/a Market view Key forecasts Underweight FY08A FY09A FY10F FY11F FY12F Revenue (Wb) 3,182 2,802 3,853 4,470 4,821 Price performance EBITDA (Wb) 353.5 218.0 458.1 564.1 626.4 Reported net profit (Wb) -19.7 -614 317.7 418.5 488.7 (1M) (3M) (12M) Normalised net profit (Wb)¹ -19.7 -614 317.7 418.5 488.7 Price (W) 79400 66800 23950 Equity | Korea | Materials Equity | Korea Normalised EPS (W) -777 -24,183 12,497 14,537 16,041 Absolute (%) -0.1 18.7 231.1 Rel market (%) -4.3 8.1 174.8 Dividend per share (W) 750.0 0.00 750.0 1,000 1,000 Rel sector (%) -1.3 6.0 173.3 Dividend yield (%) 0.95 0.00 0.95 1.26 1.26 Normalised PE (x) n/m n/m 6.35 5.46 4.94 Dec 07 Dec 08 Dec 09 100000 EV/EBITDA (x) 11.20 19.10 8.79 6.00 5.03 Price/book value (x) 1.73 3.77 2.41 1.69 1.28 ROIC (%) 8.78 2.70 10.30 12.60 14.50 1. Post-goodwill amortisation and pre-exceptional items year to Dec, fully diluted Accounting standard: Local GAAP Source: Company data, RBS forecasts A leading synthetic rubber manufacturer globally 0 011780.KS Korea Composite We expect Kumho Petrochem to benefit from strong tyre demand given its leading position in synthetic rubbers (57% of total sales annually). Kumho’s market shares in butadiene rubber Market capitalisation (BR) and styrene butadiene rubber (SBR) are around 10% and 9%, respectively. Potential W2.02t (US$1.76bn) growth in replacement tyre demand in China, combined with limited capacity additions for BR Average (12M) daily turnover W10503.23m (US$9.00m) and SBR in 2011 and 2012, should push up the synthetic rubber price, helped by strong natural rubber prices. Sector: BBG AP Chemicals RIC: 011780.KS, 011780 KS Priced W79300 at close 13 Dec 2010. 56.4% CAGR 2010-13F in equity method gains from subsidiaries Source: Bloomberg Another positive development by Kumho is the rapidly growing equity method gains it receives from its chemical-related subsidiaries after spinning off from the Kumho Asiana group in early 2010. We expect equity method gains to see a 56.4% CAGR over 2010-13 due to significant operational improvements at Kumho P&B, which produces phenol, bisphenol- A (BPA) and epoxy resin, due mainly to strong polycarbonate demand related to smartphones. Analysts Angela Choi Fast deleveraging and improving corporate governance South Korea We expect Kumho Petrochem to deleverage quickly given its EBITDA of W500bn pa and +82 2 2131 6459 [email protected] possible sale of assets related to the Kumho Asiana group (W545bn book value as of 3Q10). We expect its ratio of net debt to equity to decline from 402% in 2009 to around 60% in 2012. Avin Sony Thailand Kumho Petrochem’s spin-off from Kumho Asiana group reduces corporate governance +66 2 680 1264 uncertainties; hence we focus on the company’s strong fundamentals. [email protected] David Johnson Initiating coverage with a Buy Hong Kong We value Kumho Petrochem on sum of the parts, based on 2011F EV/EBITDA multiples for +852 3988 7185 [email protected] the core operation and other chemical subsidiaries, and calculate a target price of W119,000 (equivalent to 8.2x 2011F PE and 2.4x 2011F P/B, with 36.9% 2011F ROE). Currently, 6/F, Seoul Finance Center, 84, Taepyeogno 1-ga, Jung-gu, Seoul 100- Kumho trades at 5.5x 2011F PE, a 59% discount to the petrochemical sector average in Asia 768, South Korea for companies under our coverage. http://research.rbsm.com Important disclosures can be found in the Disclosures Appendix. The basics Versus consensus Catalysts for share price performance We believe strong price spreads in synthetic rubbers will be the key catalyst for the share price. EPS Ours Cons % diff This may come with a natural rubber price increase, or tyre price hikes by tyre makers. Growing 2010F 12,497 11,549 8.2% replacement tyre demand in China following strong original equipment tyre demand in the past 2011F 14,537 12,305 18.1% 2012F 16,041 13,032 23.1% three to four years, and fast deleveraging and possible sale of idling assets (eg Asiana, Kumho Industrials) are other potential catalysts. Source: Reuters, RBS forecasts Earnings momentum Despite a maintenance shutdown in the synthetic rubber division in October 2010, we expect 4Q10 results to show 358.4% yoy growth in operating profit, led by strong prices in synthetic rubbers and synthetic resins. This trend should continue, and we expect 16.3% and 10.3% EPS growth yoy in 2011 and 2012, respectively, given a capacity addition in high-butadiene rubber (HBR) of 120,000 tonnes on top of the current 167,000 tonnes and strong tyre demand globally. Valuation and target price We derive our W119,000 target price from our sum-of-the-parts valuation, which we believe Forced ranking* properly reflects the value of hidden assets (eg the three petrochem subsidiaries, treasury assets, etc). Company Rec Upside/ downside How we differ from consensus Kumho Buy 50% Besides our bullish assumptions for earnings (18% and 23% higher than consensus in 2011 and PTT Chem Buy 28% LG Chem Buy 24% 2012, respectively), we are the first foreign broker covering Kumho Petrochemical. It has in the Honam Buy 24% past been an under-covered stock due to risks related to Kumho Asiana Group. After almost completed spinning off from the group, Kumho Petrochemicals’ balance sheet is clean and *by difference to target price as at time of publication. Recommendations may lie corporate governance has improved. We focus on the company’s strong fundamentals and outside the structure outlined in the disclosure page. attractive valuation. Source: RBS forecasts Risks to central scenario The major downside risk we see is the company’s self-sufficiency in BR (one of the key raw materials in synthetic rubbers) falling from the current 40% to 20% in 2011 as Kumho renewed its contract with Honam Petrochemical (011170 KS). According to our regional analyst Sony Avin, large capacity additions in butadiene are due to come online from 2011; therefore, we don’t worry about the supply of butadiene. However, without efficient control over the butadiene supply because so much has to be bought in, Kumho’s earnings could be hurt to some degree. Key events Upside risk stems from an abrupt surge in tyre replacement demand in China, which we don’t reflect in our models even though we comment on it in the text of this report. Date Event End of Jan 4Q10 result Source: Company Kumho Petrochemical | The Basics | 14 December 2010 2 Key assumptions and sensitivities Kumho Petrochemical’s major products are styrene butadiene rubber (SBR), butadiene rubber (BR), polystyrene (PS) and acrylonitrille butadiene styrene (ABS). Table 1 : Basic assumptions on major petrochemical products (US$/tonne) 2005 2006 2007 2008 2009 2010F 2011F 2012F 2013F SBR 1,600 1,500 1,600 2,360 1,440 2,220 2,553 2,834 2,692 BR 1,820 1,745 1,760 2,960 1,590 2,900 3,248 3,573 3,573 PS 1,170 1,248 1,435 1,413 1,055 1,341 1,400 1,550 1,550 ABS 1,408 1,528 1,701 1,848 1,358 1,900 2,000 2,020 2,020 BD 929 1,055 1,205 1,753 894 1,800 1,700 1,700 1,500 Source: Company data, RBS forecasts Table 2 : Revenue and operating profit breakdown (Wbn) 2006 2007 2008 2009 2010F 2011F 2012F 2013F CAGR Sales 1,753.0 2,124.5 3,182.5 2,801.7 3,853.3 4,470.4 4,821.0 4,777.1 15.4% Synthetic rubber 892.1 1,095.7 1,886.0 1,478.7 2,222.2 2,679.9 2,901.8 2,766.9 Synthetic resin 720.5 877.8 1,027.7 1,010.2 1,185.3 1,233.4 1,250.7 1,207.9 Others 140.4 151.0 268.8 312.8 445.7 557.1 668.5 802.3 Operating profit 86.9 160.8 281.3 116.2 356.2 464.0 525.6 459.5 26.9% Synthetic rubber 46.4 120.0 241.6 54.3 207.2 278.9 312.1 235.0 Synthetic resin (8.6) (5.1) (27.6) 37.3 67.9 76.5 83.8 66.4 Others 49.1 45.9 67.3 24.6 81.1 108.6 129.7 158.0 OPM (%) Synthetic rubber 5.2% 11.0% 12.8% 3.7% 9.3% 10.4% 10.8% 8.5% Synthetic resin -1.2% -0.6% -2.7% 3.7% 5.7% 6.2% 6.7% 5.5% Others 35.0% 30.4% 25.0% 7.9% 18.2% 19.5% 19.4% 19.7% Source: Company data, RBS forecasts Kumho’s earnings are highly dependent upon the prices of SBR, BR and BR.