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 Kakao Ads, high Price Target 12-mth: KRW150,000 (prev. KRW130,000) hopes for Kakao M’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 webtoon/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 Page 2 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 Daum 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 Kakao Games) 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.