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).