June 20, 2011 Company Report Hyundai E&C (000720 KS) Construction Preparing to transform into the world’s top builder Daniel Song +822-768-2122 [email protected] Reiterate Buy call with TP of W130,000 We reiterate our Buy call on Hyundai E&C with a target price of W130,000. Currently, the company is focusing on cost control and efficient human resource management. Although Hyundai E&C is lowering its earnings and order guidance, we believe that this development is only the temporary result of the companyÊs efforts to improve its fundamentals. We believe that Hyundai E&CÊs fundamentals will improve dramatically in the long term. Transforming into a global leader The Hyundai-Kia Automotive Group (HKAG) has transferred some of its major Buy (Maintain) department heads to Hyundai E&C in order to realign the builderÊs business Target Price (12M, W) 130,000 philosophy with that of the group. Hyundai E&C needs efficient cost and Share Price (06/17/11, W) 83,100 organizational management systems to ensure steady profit margin and continued Expected Return (%) 56.4 growth. Therefore, the company is introducing efficiency measures with the aim to EPS Growth (11F, %) 10.3 become a leading builder in the global construction market. Market EPS Growth (11F, %) 23.4 P/E (11F, x) 15.8 Lately, some investors have been worrying that Hyundai E&CÊs personnel Market P/E (11F, x) 10.3 reshuffling may hurt its competitiveness, and that the companyÊs corporate value KOSPI 2,031.93 could be weakened through a potential merger with Hyundai Amco (even though Market Cap (Wbn) 9,254 Hyundai E&C has publicly stated that rumors about the M&A deal are unfounded). Shares Outstanding (mn) 111 However, we believe that the planned changes are necessary for HKAG to apply its Avg Trading Volume (60D, '000) 1,273 successful formula to Hyundai E&C. Avg Trading Value (60D, Wbn) 105 Dividend Yield (11F, %) 0.8 Higher margins to be followed by higher growth potential Free Float (%) 65.1 52-Week Low 55,600 The introduction of efficient cost and organizational management systems will 52-Week High 91,800 likely improve Hyundai E&CÊs COGS-to-sales ratio, boosting its profit margins. The Beta (12M, Daily Rate of Return) 1.1 impacts of these changes will likely be confirmed by quarterly margin trends. Price Return Volatility (12M Daily,%,SD) 2.6 Foreign Ownership (%) 19.0 Once margins improve on tighter cost controls, Hyundai E&C should turn to Major Shareholder(s): boosting its growth potential by taking more new orders. Normally, large builders Hyundai Motor et al. (34.91%) enter the growth phase by cutting costs, and then boost their growth momentum NPS (6.95%) by aggressively taking orders. As the companyÊs cost improvement strategy has not been completed, it has yet to begin aggressive order-taking. However, once the Price Performance new cost system takes root, Hyundai E&C is likely to aggressively pursue new (%) 1M 6M 12M Absolute 2.6 19.1 46.6 orders. Relative 5.9 18.8 27.6 Share price § Earnings & Valuation Metrics 180 KOSPI OP EV/ Sales OP NP EPS EBITDA FCF ROE P/E P/B 160 FY Margin EBITDA (Wbn) (Wbn) (Wbn) (W) (Wbn) (Wbn) (%) (x) (x) 140 (%) (x) 120 12/09 9,279 419 4.5 457 4,107 490 724 15.4 17.3 2.6 15.7 100 12/10 10,005 584 5.8 530 4,759 624 578 16.1 15.2 2.3 11.9 80 12/11F 11,297 631 5.6 585 5,250 646 124 14.4 15.8 2.0 13.2 60 12/12F 13,972 859 6.2 800 7,175 871 639 16.3 11.6 1.8 9.0 40 12/13F 16,042 1,058 6.6 1,000 8,976 1,068 626 17.5 9.3 1.5 6.8 6/10 10/10 2/11 6/11 Source: Company data, Daewoo Securities Research estimates Please read carefully important disclosures at the end of this report. June 20, 2011 Hyundai E&C Preparing to transform into the world’s top builder Enhancing engineering Despite Hyundai E&CÊs strong construction capabilities, the companyÊs weak engineering and human resource capabilities and inefficient human resource management have kept it from successfully management capabilities completing long-term plans. But, with the addition of major department heads from the to help the builder Hyundai-Kia Automotive Group (HKAG), these weaknesses will likely be resolved gradually. emerge as a global top Traditionally, Hyundai E&C has focused more on construction than on engineering player (designing). In fact, in domestic projects (such as housing construction and civil works), this construction-focused strategy can be effective, since buildersÊ engineering capabilities in these projects tend not to show any differentiation. However, with overseas plant projects, a construction-focused strategy can lead to faulty designs and thus can cause delays, which could result in margin fluctuations. In order to stabilize its margins and sustain growth, Hyundai E&C needs to enhance its engineering capacity, tighten cost control, and improve its human resource management. This is why the company is currently working to implement efficient systems. Lately, some investors have been worrying that Hyundai E&CÊs personnel reshuffling may hurt its competitiveness, and that the companyÊs corporate value could be weakened through a potential merger with Hyundai Amco (even though Hyundai E&C has publicly stated that rumors about the M&A deal are unfounded). However, we believe that the planned changes are necessary for HKAG to apply its successful formula to Hyundai E&C. Figure 1. Hyundai E&C Âs SWOT analysis Strength Weakness • Various construction experiences • Weak engineering capabilities (power, gas, infrastructure, plants) • Inefficient human resource management • Strong project capabilities • Significant fluctuations of quarterly margins • Excellent human capital • Lack of experience for building refining and petrochemical plants SWOT Opportunity Threat • Favorable investment cycle for energy sector over the next decade • Oil prices falling below US$70/bbl • Abundant oil money in Middle East • Falling oil income in the Middle East • Massive investments in infrastructure and plants • Margin erosion from competition • Indian/Middle Eastern rivals with price • Growing South American and South East Asian economies competitiveness • Strengthening competitiveness (higher global MS) Source: Daewoo Securities Research Daewoo Securities Research 2 June 20, 2011 Hyundai E&C First step: Improving margins through tighter cost control The largest weakness of Hyundai E&C is the significant and unpredictable fluctuations of quarterly margins. This problem exists because some of the companyÊs projects have posted losses during their completion phases due to a lack of checks-and-balances systems enabling communication between construction sites and the head office. Indeed, given that most of the companyÊs managers (including heads of construction sites and the heads of major departments) have traditionally been engineers (who share a certain camaraderie), reports about construction projectsÊ potential losses are not always given immediately to the head office. For example, even if the margin of a construction project is forecast to fall shy of the companyÊs estimate of 10% and reach only 8%, the head office sometimes isnÊt notified until the completion phase. As these practices have been repeated, quarterly margins have fluctuated considerably and been unpredictable. In particular, the margins of overseas construction projects have been more volatile than those of domestic projects. Going forward, We expect that, going forward, Hyundai E&C will be able to improve its margins, as: 1) Hyundai E&C will be Hyundai E&CÊs head office plans to procure construction materials for all projects, and 2) the able to improve its companyÊs purchasing power is likely to increase under the management of HKAG, and 3) margins efficient communication should enable site managers and the head office to keep each other in check. The impacts of these changes will likely be confirmed by quarterly margin trends. Given that construction projects take three to four years, improved cost management systems will be applied to projects that are already underway. We believe that growing concerns about Hyundai E&C should ease with quarterly COGS-to-sales ratio reductions. Figure 2. Hyundai E&CÊs quarterly gross and overseas profit margin outlooks (%) Gross profit margin 20 Overseas profit margin 15 10 5 0 -5 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12 Source: Company data, Daewoo Securities Research estimates Daewoo Securities Research 3 June 20, 2011 Hyundai E&C Second step: Securing growth potential through new orders Hyundai E&C should Once margins improve on tighter cost controls, Hyundai E&C should turn to boosting its turn to boosting its growth potential by taking more new orders. Normally, large builders enter the growth phase growth potential by by cutting costs, and then boost their growth momentum by aggressively taking orders. As taking more new orders the companyÊs cost improvement strategy has not been completed, it has yet to begin aggressive order-taking. However, once the new cost system takes root, Hyundai E&C is likely to aggressively pursue new orders. Considering that global energy-related investments are expected to stay robust over the next decade, the company has enough time to improve its internal processes (cost and human resource management) before turning to order-taking. Hyundai E&CÊs new orders are forecast to fall below expectations until end-2Q. However, given that the companyÊs 2011 quarterly orders are forecast to be concentrated in 2H (20.1% in 1Q; 8.2% in 2Q; 26.2% in 3Q; and 45.5% in 4Q), Hyundai E&C is likely to generate overseas momentum in 2H (when new systems are forecast to take root).