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Value Investing Seminar — Boriz Zhilin on LG Household & Healthcare Preferred Shares

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Jul 13, 2011
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Boris Zhilin was born and grew up in the former Soviet Union. Having received a scholarship he left in 1991 to attend Syracuse University in Syracuse, NY. After graduating in 1995 with a Bachelor of Sciences degree in finance, economics and managerial statistics he spent five years at Bear Stearns & Co. Inc. as an analyst in the corporate finance department and subsequently at the Bear Stearns Merchant Banking group. In 1999, Boris joined Armor Capital, which he co-founded with his friend and former Bear Stearns colleague, Dov Plitman. Boris lives in Lausanne, Switzerland with his wife Julia and daughter Polina.

Armor is a value driven manager with a flexible global mandate, which was established in November 2008, managing about $260 million aum. We can invest wherever we want. We try to avoid financial level, both at portfolio level and company level.

We look for double digit cash flow yields.

When we were young we thought we knew a lot more, but with age we see that our conviction level diminishes.

We have no idea what our best idea or best three ideas, because we found out that they do awful. Every investment clears a high risk/reward level and that’s it.

It is tough to do 20 minute presentations, because they highlight positive and underweight the negative.

Ciccio (organizer of the event) is very charismatic so when he asked me to speak I couldn’t say no.

We think South Korean preferred stocks are very undervalued.

LG Household & Healthcare 051905 KS.

They trade at under 6x earnings.

I want to say that this presentation is an over-generalization and I am not saying all Koreans are like this, just to be clear.

We have been investing in Korea since 2004, and there is a lot not to like about it.

Koreans are very hard working, they had six hour work week and work 12-14 hour work week. The industries are extremely competitive, especially autos, consumer electronics and ship building.

The biggest problem though, is poor corporate governance. I admire Tom Russo ’s capacity to suffer, but in South Korea it is more the minority shareholders who need the capacity to suffer.

Most of the Korean companies are owned by family members, who are second generation. They do not have the entrepreneurial drive to create value. There is extreme cash accumulation, beyond what is necessary. They always say they are waiting to put that money to work but almost never do. In August 2009, which was a great time to buy, there was little activity.

Korean corporations view it as their company, and do not care about what investors think. Companies will buy real estate, or do not like dividend, they would rather keep it in the company for example.

Besides, distress situation there are no M&A transactions, so it is very hard to have outside change.

Koreans are tax conscious, and they are not interested in taking on tax liabilities.

ROC is not understood well; it has advanced, but not enough. The country has one of the lowest dividend rates and almost never buys back shares.

By nature Koreans are traders.

Koreans give traders shareholder voting rights. Therefore, traders will buy in before big decisions.

Binggae went from debt neutral, to half their market cap in cash. But they do not realize that the years of inaction makes the return on capital very low.

Rare consensus on EPS calculations from the sell side, i.e., whether to include treasury stock and preferred from shares outstanding.

Very few companies have their financials in English.

Income statements are 30-40 lines with extreme detail. Even private companies with over $7 million have to file with Korean GAAP.

English is not widely spoken, so it is hard to communicate with management.

Jinro, the leading Soju manufacturer, was prohibited by the government to raise prices for six years. The government bullies companies a lot. The government is obsessed with managing inflation; companies are scared to raise prices.

You need an investor ID to invest. The currency is quasi-convertible; it is not fully convertible.

There is a lot of investor fatigue.

A preference share gives a higher dividend rate, but does not give voting rights. However, as stated above, the ability to vote is not a big deal.

No one knows what happens to preferred shares in an M&A transaction. However, we think this risk is common in other countries like Switzerland.

Preferred shares tend to trade at 70-80% of the common share. That is usually 4x dividends and 5x FCF yields of regular stock.

Companies almost never repurchase preferred shares.

We believe that preferred shares are no different than any other country. Most investors use a dividend discount model. I think this is important but it is not that simple. If one thinks that way, Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) and Google (GOOG, Financial) would have very little value.

We think investors should assume that a few years out the dividend payout ratio will drift to 80-100%.

Long term investors can make money off the preferred shares.

Back to LG; the company makes products like soaps, detergent, toothpaste, shampoo. It has 40% of market share; Unilever (UL, Financial) does not really have a presence there.

Distribution is unique; some cosmetics are sold door-to-door, which Western companies have not been able to crack.

The market should still grow, especially with Korean women having a lot of purchasing power.

25% of their revenue comes from drinks..

We come up with 5.6x 2011PE for the preferred versus 26.7x for the common shares. Additionally, the preferreds are trading at 4.4x EBITDA, EBIT is 5.3x. The company has some debt, but we think it is understandable based on the company stability.

LG was the first company to become a holding company, to give more independence from subsidiaries. LG tends to be more forward thinking, and shareholder-friendly than other South Korean companies.

The company did their IPO in 2001, and was performing very poorly.

They brought in an outsider, Suk Cha, who worked at Proctor & Gamble (PG), both in the US and Korean branches for 13 years. He bought a lot of common shares, and has turned the company around.

He discontinued SKUs.

Repacked, changed the marketing.

He eliminated middlemen, by properly displaying products at the stores.

From 2005 around the time we began investing, the common shares have gone up 1400%, EPS grew 44% annually. The preferred shares have done very well going up 29% annually, but have underperformed the common shares.

LG H&H has ROE of 32%, and ROC of 19%

Company launched a large buy back in 2006.

They bought 90% Coca-Cola (KO, Financial) bottling in 2007, despite Lotte Chilsung being the No. 1 carbonated beverages, and Coke a far second. However, the company has had phenomenal returns.

They acquired Haitai Beverage for 2010. The outcome is still uncertain, but they bought the company for a symbolic $10, and assumed all the debt. However, we are optimistic due to scale, distribution strength, etc.

New agreement with Unicharm, a feminine hygeine product maker.

The company has used debt in these acquisitions, but it is generating a lot of FCF, so we are not worried about over-leverage.

They acquired the Face Shop in 2010.

Face Shop has a nice opportunity in China; there are already 175 stores in China.

We expect 15% growth going forward; however, even with no growth we find the preferred extremely attractive.

Disclosure: None
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