20161212-三星证券-Priced-in_concerns_allow_chance_to_bottom_fish_13页_527kb

Sector Update Summary: Korean Defense Stocks in 2016

Core Content

This report provides an analysis of the Korean defense sector in December 2016, focusing on the performance of major defense firms such as Korea Aerospace Industries (KAI), LIG Nex1, and Hanwha Techwin. It highlights the reasons behind the sector's decline in 2016, evaluates the current valuation, and offers a recommendation on investment opportunities.

Main Factors Behind the Sector's Weakness

• Decline in Earnings and Performance: Korean defense stocks had surged in 2015 but experienced sharp corrections in 2016, particularly in the second half. This was attributed to:
  • Poor 3Q results, which raised concerns about a potential long-term earnings decline.
  • Reduced defense spending forecasts by the Ministry of National Defense, driven by fiscal deficits.
  • A shift in investor sentiment towards traditional industrials due to improved macroeconomic conditions and commodity prices.
• Loss of Premium: Defense stocks were no longer viewed as a premium over traditional industrials due to:
  • Rebounding oil prices and easing macroeconomic uncertainties.
  • Increased domestic policy uncertainties, including potential defense budget cuts.
  • A lack of momentum in the near term, as large projects faced delays.

Key Concerns and Analysis

• Profitability Cycles: The report argues that the profitability decline is a natural cycle rather than a long-term structural issue. Defense firms' high-margin mass production phases are unsustainable, and profitability should rebound as projects progress.
• Impact of Budget Cuts: While budget cuts may affect balance sheets, they are unlikely to result in project cancellations. Delays in payments may increase accounts receivable, but risks are minimal due to government as the primary client.
• Export Trends: The export environment has remained stable, with global military spending increasing slightly in 2015. Korean firms benefit from rising domestic defense spending and increased demand from Middle Eastern countries due to improved oil prices.

Valuation Check

• Target Prices and Upside Potential:
  • KAI: Target price of KRW86,000, offering 31.3% upside.
  • LIG Nex1: Target price of KRW90,000, offering 20% upside.
• P/E Ratios:
  • KAI: 17.8x 2017 P/E, a 34% discount to its post-IPO average of 25x.
  • LIG Nex1: 17.8x 2017 P/E, a 33% discount to its post-IPO average of 29.4x.
• Discount to Overseas Peers:
  • KAI and LIG Nex1 are trading at 6% and 11% discounts to Lockheed Martin and Raytheon, respectively, despite their growth potential.

Investment Recommendation

• The report suggests that defense stocks are currently undervalued and presents a buy recommendation on weakness, especially after the release of 4Q earnings.
• Uncertainties should peak before earnings releases, making this a strategic time to consider investment.
• The government is expected to unveil its medium-term defense plans around the time of earnings reports, which may normalize performance expectations.

Summary of Key Metrics

Conclusion

Despite recent concerns and a decline in share prices, the report believes that Korean defense stocks are undervalued and that the current corrections have priced in most of the risks. It recommends buying on weakness, particularly after the release of 4Q earnings, as the sector is expected to continue benefiting from domestic defense spending growth and geopolitical factors.