Kakao (035720 KS ) Foreign investo rs taking their cue from Facebook’s 2013-14 rally Internet Three reasons why earnings uncertainty is likely to dissipate Company Report The biggest drag on Kakao’s share price has been its earnings uncertainty. This is May 2, 2019 mainly because the company has not been generating enough revenue from new businesses (mobility, simplified payment, AI, etc.) to cover its heavy investments. However, we believe earnings momentum is beginning to materialize, as: 1) we expect new ads on KakaoTalk chat tabs to add W60bn and W150bn to mobile display ad (Maintain) Buy revenue in 2019 and 2020, respectively; 2) the company’s mobile content lineup is also expanding beyond musi c, videos, and games to webtoons/web novels in Korea, Japan, Target Price (12M, W) ▲ 170,000 and Indonesia (we estimate Japan-based webtoon service Piccoma’s revenue surged 163% YoY in 1Q19); and 3) the Korean government is planning to lower bank wiring Share Price (04/30/19, W) 120,000 fees by 90% from 2020, which should lead to W60bn in cost savings in 2020 alone. Earnings to gain momentum from 2Q19 into 2020 Expected Return 42% For 1Q19, we forecast Kakao to post revenue of W671bn (+20.9% YoY) and operating profit of W18bn (+73% YoY), with OP margin of 2.7%. The market is expecting rev enue OP (19F, Wbn) 146 of W661.8bn and operating profit of W21.3bn. Consensus OP (19F, Wbn) 146 For 2Q19, we forecast revenue of W725bn (+23.1% YoY) and operating profit of W36bn EPS Growth (19F, %) 125.0 (+29.9% YoY). We see OP margin expanding to 4.9%, driven by a sharp increase in Market EPS Growth (19F, %) -17.0 revenue from KakaoTalk ads (which have higher margins). P/E (19F, x) 87.0 Beginning in 2019, we forecast revenue to outpace spending, aided by the full-year Market P/E (19F, x) 12.0 reflection of KakaoTalk chat ad revenue, an increase in ad accounts, and improved KOSPI 2,203.59 targeting effects. Market Cap (Wbn) 10,008 Maintain Buy, and raise TP from W130,000 to W170,000 Shares Outstanding (mn) 83 Free Float (%) 62.6 We maintain our Buy call on Kakao and raise our target price from W130,000 to Foreign Ownership (%) 25.3 W170,000. Our target price is based on our 2020 revenue forecasts of each business Beta (12M) 0.78 division and the 2020F average P/S ratio of domestic and foreign peers. 52-Week Low 87,600 The stock has seen continued foreign net buying since April 10 th . We recall that in 2013- 52-Week High 128,000 14, Facebook’s P/E multiple shot up to over 1,000x after the company delivered (%) 1M 6M 12M earnings surprises driven by SNS mobile targeted ads. We believe that foreign Absolute 15.9 32.6 8.1 investors are likening KakaoTalk chat ads to Facebook’s mobile ad growth story. Relative 12.6 21.2 23.4 New business initiatives, such as Kakao Mobility’s car pool service, Kakao Pay’s acquisition of Baro Investment & Securities, and additional stake acquisitions in Kakao 120 Kakao KOSPI 110 Bank, have been progressing more slowly than expected. We believe such potential 100 sources of growth should be seen as long-term catalysts that can drive the company’s 90 enterprise value higher. 80 70 60 4.18 8.18 12.18 4.19 Mirae Asset Daewoo Co., Ltd. [ Internet ] FY (12) 12/16 12/17 12/18 12/19F 12/20F 12/21F Revenue (Wbn) 1,464 1,972 2,417 2,971 3,591 4,162 Chang -kwean Kim +822 -3774 -1614 OP (Wbn) 116 165 73 146 393 548 [email protected] OP margin (%) 7.9 8.4 3.0 4.9 10.9 13.2 NP (Wbn) 58 109 48 115 295 403 EPS (W) 874 1,602 613 1,380 3,539 4,835 ROE (%) 1.9 2.9 1.0 2.2 5.5 7.0 P/E (x) 88.1 85.5 168.0 87.0 33.9 24.8 P/B (x) 1.5 2.3 1.7 1.9 1.8 1.7 Dividend yield (%) 0.2 0.1 0.1 0.1 0.1 0.1 Note: All figures are based on consolidated K-IFRS; NP refers to net profit attributable to controlling interests Source: Company data, Mirae Asset Daewoo Research estimates May 2, 2019 Kakao I. Revenue from new sources to surge in 2019 Kakao has expanded into various business areas mainly via M&As (with Daum, Melon, etc.). MaJor revenue sources include: ads, the company’s share of customer payments for webtoons/web novel purchases (versus entire customer payments for Piccoma) and fees for commerce, mobility, and FinTech services. The company’s OP margin slid 8.4% YoY to 3% in 2018, due to higher labor costs and marketing expenses related to new business, like KakaoT and KakaoPay. Indeed, labor costs surged by over W100bn from the 2017 level. In addition to marketing expenses, fees for game and music content increased in line with revenue growth. Meanwhile, revenue growth for its traditional mainstay businesses like games and music (Melon), and ads on the Daum platform is stagnating. However, revenue from ads on the Kakao platform (KakaoTalk), other content (webtoons and web novel on KakaoPage and Piccoma), and commerce/mobility (KakaoT)/payment (KakaoPay) services is expected to expand sharply in 2019 and 2020. We proJect Kakao to maintain strong revenue growth of 22.9% in 2019 (following 22.5% in 2018) with margins also improving steeply through 2020. First, we expect KakaoTalk’s ad revenue to surge. With almost no additional costs for maintaining traffic, KakaoTalk will display ads on chat and friend list tabs. Stripping away commissions for ad agencies (about 20%), gross margin on ad revenue is estimated at 80- 85%. Accordingly, growth in ad revenue should directly boost margins. In addition, Webtoon and web novel revenue is expected to drive up top- and bottom-line growth based on strong growth in Korea (KakaoPage), Japan (Piccoma), and Indonesia (KakaoPage). The company receives higher shares of earnings for overseas distribution of domestic content. The Webtoon and web novel business is forecast to achieve economies of scale from 2019 onwards on the back of overseas success. Furthermore, the government is planning to lower bank wiring fees by 90% from 2020. The bank fees led to an operating loss of W4-50bn in 2018 alone. Table 1. Kakao’s consolidated revenue Item Service Business Portals Daum PC portal, Daum Mobile app #Tab, Plus Friend, Brand Emoticon, Talk Reward, Info-Talk, Support-Talk KakaoTalk Talk Hairshop, Talk Order, Talk Mart, Talk PC Ads SNS KakaoStory Shopping KakaoStyle Other Cash Friends(KakaoPage), Other Subsidiaries' Ad Game Mobile, PC, Other Music Melon, Kakao Music Content Web literature Kakao Page, Daum webtoon, Piccoma Emoticon Talk B2C Emoticon Commerce Talk Gift Shop, KakaoIX, KakaoMakers Mobility KakaoT (Taxi, Driver, Parking, Navigator) Other Fintech KakaoPay Other KakaoM (offline record distribution, etc.) Source: Company data, Mirae Asset Daewoo Research Mirae Asset Daewoo Research 2 May 2, 2019 Kakao Figure 1. Kakao’s major businesses and global partnership Source: Company data, Mirae Asset Daewoo Research Figure 2. Kakao’s financial subsidiaries (estimate) Kakao Common stock: 10% 60.9% Convertible preferred stock: 8% 20.0% Kakao Pay Kakao Bank Dunamu Payments, remittances, (internet bank) (financial IT services) membership program Deposits, loans, Securities data delivery, installment savings Kakao Stock operations 60% (estimate) Baro Investment & Securities Stocks, funds, real estate, other investments, financial product development Source: Company data, Mirae Asset Daewoo Research Mirae Asset Daewoo Research 3 May 2, 2019 Kakao II. Earnings to turn around in 2Q 1. To display ads on KakaoTalk chat tabs Ad revenue from the Kakao platform (KakaoTalk) is proJected to grow 51% in 2019, following a 52% increase in 2018, sharply outpacing the single-digit growth of Daum’s mobile and PC ad revenue. The Kakao platform’s contribution to the company’s total ad revenue is anticipated to rise from 36% in 2018 to 46% in 2019. In the content business, which generated 50% of total revenue in 2018, webtoon and web novel revenue from KakaoPage and Piccoma is forecast to expand 57% in 2018 and 50% in 2019, overwhelming growth in game and music revenue. Among other revenue items, commerce revenue improved 34% YoY in 2018, and revenue from KakaoT, KakaoPay, and other subsidiaries also climbed 40% YoY last year. Revenue contribution from other items is expected to rise to 24% in 2019 from 22% in 2018. Ads on KakaoTalk chat tabs, which are anticipated to become a new growth driver, are scheduled to begin in 2Q19. Revenue from the new display ad item is estimated at W60bn for 2019 and W150bn for 2020 (see Table 5 and 6). Expectations for KakaoTalk chat tab ads are premised on the facts that the revenue power of KakaoTalk ads has already been proven (the Kakao platform’s ad revenue expanded W84bn YoY in 2018 driven by KakaoTalk # tab ads) and online ads’ market penetration stood at 41% in Korea in 2018, which is over 10%p lower than those in maJor developed countries. In addition, the company is expected to attract new advertisers across a wider area, compared with Naver, which sells primitive types of targeted ads (based on gender, age, location, time, etc.) for a limited pool of products. Table 2. Quarterly and annual earnings (Wbn, % ) 1Q18 2Q18 3Q18 4Q18 1Q19F 2Q19F 3Q19F 4Q19F 2018 2019F 2020F Revenue 555 589 599 673 671 725 753 822 2,417 2,971 3,591 Ads 155 166 167 182 180 200 201 225 670 807 991 Content 286 303 307 314 321 351 376 403 1,209 1,451 1,652 Games 106 112 99 100 102 112 119 137 417 470 507 Music 126 130 136 140 142 146 150 154 533 592 620 Other 54 61 71 74 77 93 107 111 260 388 525 Other 115 120 126 177 170 174 175 194 537 713 949 Operating profit 10 28 31 4 18 36 43 50 73 146 393 OP margin 1.9 4.7 5.1 0.6 2.7 4.9 5.7 6.0 3.0 4.9 10.9 Net profit 15 25 7 -29 22 24 33 35 16 113 289 Net margin 2.6 4.3