20151210-三星证券-Defense__A_safe_haven_from_macro_uncertainties_34页_1mb

Sector Update Summary

Core Content

This document provides an analysis of the Korean defense industry and its performance in 2015, highlighting the reasons for the strong stock performance of major defense firms and offering an investment strategy for 2016.

Main Points

• Defense as a Safe Haven: In 2015, Korean defense stocks outperformed the Kospi index. They traded at an average of 18x 2016 P/E, a 51% premium over the Kospi's 12x. This is attributed to macroeconomic uncertainties affecting other industrials, while defense firms remain relatively stable.
• Stable Profitability: Defense firms benefit from high entry barriers, steady military expenditure growth, and government policies aimed at strengthening the industry. Their profitability is backed by guaranteed returns on challenging projects.
• Mass Production Boosting Earnings: Projects initiated in the mid-2000s are entering mass production, which increases utilization and leads to economies of scale. This phase typically yields higher profitability compared to the R&D stage.
• Export Growth Enhancing Earnings: Korean defense firms are improving their export capabilities, which helps sustain profitability and maintain high utilization rates. The government's support and the development of indigenous weapons have enhanced export potential.
• Government Influence: The Korean government is the largest customer of the defense industry, and its policies significantly shape the market. While defense firms depend on domestic demand, they have strong bargaining power due to the government's commitment to their development.

Key Information

• Korea Aerospace Industries (KAI): Target price is KRW105,000, representing a 25.1% premium. It has a strong R&D presence and is entering mass production for key projects.
• LIG Nex1: Target price is KRW132,000, a 22.2% premium. The firm has a high exposure to defense operations and is benefitting from mass production and export opportunities.
• Global Defense Trends: The global defense industry is dominated by a few major players, with the US and Russia accounting for 36% and 21% of 2014 arms exports, respectively. Korea is ranked ninth in the world for defense technology, suggesting it is on par with developed nations.
• Korea's Defense Spending: Military expenditure in Korea has been steadily increasing, and procurement spending is expected to grow faster than total military spending due to the shift towards quality over quantity and demographic changes.
• Contract Types: Korea's defense procurement contracts include both fixed-price and cost-reimbursement types. Cost-reimbursement contracts, which account for 67.3% of total value, protect firms from cost overruns.

Investment Strategy

• Focus on Stability: Defense stocks are seen as a safe haven in the machinery sector due to their stable profitability and reduced exposure to macroeconomic volatility.
• Target Firms: The most promising defense firms are those that:
  1. Enjoy solid profitability through mass production.
  2. Have strong exporting capabilities.
  3. Can carry out government-led weapon development projects.
• Buy Opportunities: The report advises investors to take advantage of any share-price weakness in early 2016 to accumulate shares, especially in LIG Nex1 and KAI, which have high exposure to defense operations and justify their valuation premiums.

Conclusion

The Korean defense industry is well-positioned for continued growth due to increasing military spending, government support, and the transition of R&D projects into mass production. As a result, defense stocks are likely to remain attractive to investors seeking stability in a volatile market.