Positive changes emerging from Korea-China FTA

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1 Sector Note July 8, 2014 Positive changes emerging from Korea-China FTA More business opportunities and tariff removal 1. Korea-China FTA negotiations underway Korea-China FTA likely within the year Thanks to Chinese General Secretary Xi Jinping s recent visit to Korea, the Korea- China Free-Trade Agreement (FTA) has a greater chance to be settled within So far, Korea-China FTA talks have seen 11 rounds of talks with the 12 th session set for July 2014 in Korea. In the 11 th round, the two parties discussed all areas including services and investment, regulations and cooperation, as well as concessions on goods. With regard to goods, both parties exchanged a second offer list that was an improvement over the first exchanged in December 2013 and a second concession request for core items in which both parties are interested. The Ministry of Trade, Industry & Energy (MoTIE) also exchanged the first concession request for services and investment areas and said much progress has been made concerning negotiations for regulations and sectors for cooperation. Korea for manufactured items vs. China agricultural/fishery products From the conventional perspective, a hot issue on the negotiation table has been determining a concession category. Korea wants early tariff elimination for manufactured goods such as petrochemicals, machinery, displays, etc., and exclude agricultural/fishery products and small companies products from the deal. What China wants is the exact opposite of Korea s wish list. Open the agricultural/fisheries, textile and apparel markets, and exclude manufacturing from the concession list: liberalizing agricultural/fisheries and textile/apparel trade while exempting manufactured products from the concession. As the negotiation is a matter of finding a path to agreement and the purpose of the FTA is to lower tariff barriers, the deal will eventually conclude in both parties favor by removing tariffs from items of the utmost priority. 2. Benefits of tariff elimination vs. benefits of deregulation in China Yeongsang Yeo yeongsang.yeo@truefriend.com Autos, auto parts and cosmetics to benefit We believe autos, auto parts and cosmetics will benefit from the tariff removal. As China s import duties on finished vehicles is much higher than Korea s (22.5% vs. 8%), the automotive sector stands to benefit. In addition, Korean automakers should gain a pricing edge over Japanese rivals in China and enjoy bigger demand for Korean cars. Auto parts makers would benefit from the tariff removal and ride the coattails of rising demand for cars made by Hyundai Motor and Kia Motors. The cosmetics sector can look forward to profit growth as well. While EPS has limited upside as the export weighting is not very heavy, the tariff removal would partly contribute to better profit. Cosmetics makers should also achieve growth on greater demand. In contrast, the tariff removal would have a marginal impact on major China-bound export items such as IT and steel products. Most steel products already trade duty-free and IT products that account for ~50% of Korea s exports to China are unlikely to benefit much from the tariff elimination. 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 AT THE END OF THIS REPORT.

2 Pay special attention to the potential expansion of Korean contents and travel agency businesses If the Korea-China FTA becomes a reality, Korean contents and tourism shares deserve more attention as their growth potential would come to the fore if China eases related regulations. The Chinese government is restricting business opportunities for overseas firms or joint ventures to protect local service industries. However, the division of labor and cooperation between the two countries has increased substantially via Korea s semi-finished goods exports to China and establishing plants there. Accordingly, expanding service industries is increasingly necessary for organic cooperation between the countries. Although details are undisclosed, the MoTIE said both parties at the 11 th round had in-depth negotiations on how to trade more freely in the services and investment areas and exchanged the concession request for the first time. We view the negotiation for concessions on goods as well as the liberalization of services and investment sectors as one of the key issues in the Korea-China FTA. In finding FTA beneficiaries in the stock market, we believe Korean contents and tourism stocks could attract more attention than manufacturing plays. Considering the current competitiveness of hallyu (Korean pop culture boom) content in China, more business stemming from deregulation is very likely to lead to robust growth. We are closely monitoring Hanatour Service (039130), Samhwa Networks (046390) and Pan Entertainment (068050), and we mark them as the de facto beneficiaries of the Korea-China FTA. 3. Impact on the major sectors 1) Semiconductor/Display/Electronics Kevin Lee kevin.lee@truefriend.com Tariff effects on electronics, panels, LEDs and mobile parts to fade If the Korea-China FTA is ratified, lowering tariffs or completely exempting Korean IT products from tariffs, we believe it will have the following effects in terms of products, production and raw material costs. First, an FTA would have no impact on semiconductors, PCs, handsets or TV BLUs as these products are already exempt from Chinese tariffs. However, home appliances (refrigerators, washing machines, 10% tariff), display panels (5%), lighting LEDs (8%) and mobile parts (4-16%) should benefit. As for production, companies have rapidly increased the weighting of local production to reduce the tax burden. But, it is positive that lower tariffs will be applied to Korean components made in China sold to finished product assembly plants in China. In terms of costs, we believe tariffs will fall for exports of intermediate parts to factories in China for finished assembly. As such, the price competitiveness of finished products should firm. Overall, we believe the Korean IT sector will benefit from the FTA. However, 1) some products are already exempt from taxes, and 2) local production weighting has already increased sharply, which should limit the positive impact. 2) Autos Sung Moon Suh sungmoon.suh@truefriend.com Autos to benefit, with Kia better off than Hyundai We believe an FTA will benefit Korean automakers, as: 1) China imposes a 22.5% tariff on automobiles, much higher than Korea s 8%, 2) the number of exports bound to China is 91,493 (up 11.3% YoY), only 3% of Korea s auto exports. However, the shipments to China are mostly mid- to large-sized vehicles, 2

3 accounting for 3.8% of exports in terms of value. 3) We believe Japan will not sign an FTA with China, suggesting Korean automakers will benefit from more price competitiveness. Of the two major Korean automakers, Kia should benefit more than Hyundai. Hyundai has a capacity of 1.05mn units in China, versus only 0.74mn for Kia. And, Hyundai began rolling out the Santa Fe in China since December As such, Hyundai s China-bound exports fell to 17,000 units in 2013 from 37,000 in 2011 and 23,500 in In contrast, Kia s China exports jumped to 31,600 in 2012 from 29,100 in 2011, followed by a marginal decline to 30,620 in In 1H14, exports rebounded 5% YoY to 15,393 units (Sorento 10,648, Mohave 519, K7 468, Carnival 280), while Hyundai exported 6,700 units to China as of 5M14, with the Santa Fe long body model accounting for 4,700. 3) Autos parts/tire Jin Woo Kim jinwoo.kim@truefriend.com Auto parts suppliers to also benefit, but no impact on tire makers Auto parts makers should also benefit. As Korean auto parts are higher quality and have better pricing power than Chinese competition, Korean exports should increase while Chinese imports should be limited. Of note, Korea s exports are taxed 13.8%, while imports from China are taxed 5.1% (2012 weighted average basis; 2013 exports W5.57tn, imports W1.42tn). In particular, small- to mid-sized vendors that do not have factories in China should benefit most from an FTA, as these companies would be better positioned to supply to local brands and foreign joint ventures. Meanwhile, the FTA should have a relatively neutral impact on large vendors that already have factories in China. However, we still expect some positives as high value-added products could be shipped to China more cheaply than Japanese competition. Meanwhile, the three Korean tire companies should not be impacted by the FTA as all of the companies operate plants in China. And, any negative impact on the Korean market should be limited as the import weighting is only 10%, and imported tires are mainly top-tier brands. 4) Cosmetics Jung In Lee jilee@truefriend.com For Korean players structurally growing in China, tariff removal is additional good news In cosmetics trade with China, most products (both raw materials and finished goods) are exported to the country. Thus, the elimination of China s tariff (6.5-10% for cosmetics) is a plus for most Korean players operating there. Of course, Korean firms are not directly competing in terms of prices with local Chinese or global rivals. Still, tariff elimination means greater price competitiveness for Korean firms and is therefore good news. In particular, Chinese news media recently reported the possibility of a special consumption tax (30%) cut although not officially announced/confirmed by Beijing. Coupled with this likelihood, a favorable policy direction such as the Korea-China FTA spurs expectations for the long-term growth potential of Korean companies already possessing channel/brand competitiveness in China and that have entered a structural growth phase. As mentioned, tariff removal is positive for most cosmetics firms. Benefits would be greater for companies with their own brands such as AmorePacific and LG Household & Health Care rather than original design manufacturers (ODMs). Tariff removal would only have limited effects for ODMs, most of which base both production and sales in China. In contrast, companies selling domestic-made finished products in China could enjoy bigger sales on the price-cut effects or cost reduction. For AmorePacific, 4% of 2014F NP is expected to come from China, which suggests that potential tariff removal would affect EPS by 2-3%. 3

4 5) Fashion Eun Chae Na Slightly positive on apparel players, neutral on OEMs, negative on textiles We believe the effects of an FTA will differ on apparel players, apparel OEMs and textile makers. Specifically, a Korea-China FTA should be marginally positive for apparel companies, be neutral for OEMs and slightly negative for textiles. Overall, we believe the impact on the sector as a whole will be limited. Exporters, which focus on mid- to high-priced apparel and fashion accessories, should benefit most as a 10-15% duty will be exempted. However, a trade pact should have a limited impact as most apparel companies already operate plants in China and as the sales weighting from China is relatively low for exporters. However, we believe it will be a mid- to long-term positive as the number of direct apparel exporters grows moderately. In addition, waiving the import tariff on domestic fashion players that are increasingly sourcing from China should reduce costs. We expect a neutral impact on OEMs and a slightly negative effect on textile manufacturing. OEMs should not be affected given the limited production weighting in China and export-focus on developed markets. Meanwhile, textile makers looking for new growth engines have already expanded into Southeast Asia due to excessive competition in China. 6) Korean contents Heu Seok Jeong heuiseok.j@truefriend.com Chinese business to grow on content co-investments We believe domestic content, such as music, movies and TV shows, will grow in the China market backed by an FTA. Specifically, an agreement should benefit both markets, as: 1) Chinese authorities want to import Korean content to bolster the competitiveness of the local content market, and 2) Korean content companies need to expand into new markets. And, we believe Korea will enter the market via co-investments with local players rather than exporting directly as China is not likely to ease restrictions on foreign content over the near term. As FTA talks should focus on joint productions and content investments, we believe companies working closely with local partners will benefit from an FTA. 7) Tourism/Leisure Min Ha Choi minha.choi@truefriend.com To benefit from increased personnel and material exchange We believe the tourism/leisure sector will benefit from increased human and material exchanges catalyzed by an FTA and bilateral summit meetings. According to the joint statement, both countries have agreed to increase the scope of the visa waiver program incrementally. This should sustain the growth of Chinese tourists triggered by the simplified visa process and increased visa exemptions. Furthermore, we expect structural growth in the casino, travel and leisure markets as more Chinese travelers visit. Overall, the travel industry should benefit from more Chinese inbound and Korean outbound business on easier travel rules. 4

5 8) Internet/Games Jong Gil Hong Despite deregulation, direct game services in China unlikely While an FTA should ease legal restrictions, we do not expect domestic online game developers to offer online services directly in China. Currently, foreign companies are limited to 49% ownership in local subsidiaries. Furthermore, game services require government approval and an annual quota system is used for foreign games. And, it appears unlikely foreign game developers will be granted government approval without local tie-ups. Furthermore, local involvement is key to ensuring successful localization. As major Chinese players, such as Tencent and Shanda, account for most of the local market, it would be difficult for Korean game developers to attract and maintain user bases. Korean game companies face a 5% tax on total royalty revenue from China, and an FTA should bolster earnings accordingly. 5

6 Table 1. Korea-China FTA product group Normal track Sensitive track Highly sensitive track Tariff elimination in 10 years Tariff elimination in 20 years Not subject to liberalization Terms Korea s offer China s offer Petrochemicals, machineries and IT (display, computer, etc.) Machinery (bearings, tools, etc.) Electronic instruments Agricultural and fisheries Small & medium business items Source: Ministry of Trade, Industry, and Energy, Industry data, Korea Investment & Securities Agricultural and fisheries, textile fashion, nonferrous, etc. Petrochemicals, steel and machinery, etc. Petrochemicals, steel and machinery, etc. Table 2. Korea FTA list Status Country/block Negotiation start Negotiation conclusion Remarks Effective Chile Korea s first FTA, first FTA settled between trans-pacific countries Singapore EFTA Korea s first FTA with regional block, groundwork for EU FTA negotiation ASEAN India Concluded ahead of China and Japan, should benefit from early mover s advantage EU First Asian country to sign FTA with EU Peru FTA to serve as bridgehead for Latin American market US Turkey Signed Canada Initialing after settlement in March 2014 Colombia Legislative consent obtained after initialing in August 2012 Australia Signed in April 2014 In negotiation China th round in May 2014 New Zealand th round in June 2014 Vietnam th round in May 2014 Indonesia Tentatively suspended over opinion conflict on main agenda, such as item liberalization Japan Negotiating for resumption after tentative suspension in November 2004 GCC rd round in July 2009 Mexico nd round in June 2008 In preparation Russia In joint research about economic partnership agreement MERCOSUR Joint research completed, MOU signed for trade agreement in July 2009 Israel Joint research completed Note: In case of India and Indonesia, the official title is CEPA (Comprehensive Economic Partnership Agreement). Source: KITA, Industry data, Korea Investment & Securities Table 3. Korea-China FTA negotiation round Stage Round Date (YY-MM-DD) Remarks First 5 th ~28 Confirm commitment to FTA and discuss agenda content and range Summit Reach agreement on highly comprehensive FTA principles 6 th ~04 Approach agreement on modality, such as item liberalization level Agree to include conflicting fields, such as competition, transparency, electronic trading, environment and cooperation on the list of negotiations 7 th ~05 Agree on 1) items, 2) service/investment, 3) regulation, and 4) economic cooperation modality Re-confirm highly comprehensive FTA principle and set ground for the second negotiation Agree on tariff elimination level: 90% of items and 85% of value Second 8 th ~22 Start advanced discussion on draft of agreement and first offer based on modality of first stage negotiations 9 th ~10 Exchange offer and request for all items, including highly sensitive products 10 th ~21 Confirm differences in opinion about requests for item liberalization 11 th ~30 Exchange second offer and second request about items of great interest Exchange first request for services, discuss ways to liberalize service/investments Summit Reach agreement to settle FTA by this year 12 th Scheduled to be held in Korea in July Source: Ministry of Trade, Industry, and Energy, Industry data, Korea Investment & Securities 6

7 Table 4. Korea-China tariff comparison by industry (USD mn, %) Korean tariffs on Chinese imports Imports Weighted Industry Tariff WTO Actual tariff from China average Chinese tariffs on Korean imports MFN tariff Imports from Korea Actual tariff Weighted average (%) (%) (USD mn) (%) (%) (%) (USD mn) (%) (%) Digital appliances , , Semiconductor/display , , Non-metallic mineral , Nonferrous , , Household items , , Petrochemicals , , Textiles , , Medical device Pharmaceutical Machinery , , Automobile , , Electronics , , Fine chemical , , Shipbuilding , , Heavy electric machine , , Steel , , Communication device , , Aviation Others , , Other manufacturing , , Total , , Note: Based on2012 tariff Source: KIET, Korea Customs Service, China Customs Service, Korea Investment & Securities Table imports from China & exports to China (USD mn, %) Export Import Items Value (USD mn) Weighting (%) Value (USD mn) Weighting (%) Agricultural & Fishery 1, Mineral products 8, , Chemicals 28, , Plastic, rubber / leather 3, , Textile 2, , Daily necessities Steel 7, , Machinery 22, , Electronics 70, , Sundries Total 145, , Source: KITA, Korea Investment & Securities 7

8 Figure exports to China by item Figure imports from China by item Agricultural & forest & marine products (%) Agricultural & forest & marine products 0.3 (%) Mineral product 6.0 Mineral product Chemical industry manufactures Chemical industry manufactures Articles of plastic rubber or leather 19.3 Articles of plastic rubber or leather Textile & apparel Textile & apparel 40.9 Livingware 48.2 Livingware Articale of iron or steel & metals 2.4 Articale of iron or steel & metals 7.6 Machinery Machinery Electrical articles & electronic articles 5.2 Electrical articles & electronic articles Miscellaneous articles / sundries 1.9 Miscellaneous articles / sundries Source: KITA, Korea Investment & Securities Source: KITA, Korea Investment & Securities Table 6. China-bound content export trends (USD 000, %) Industry (USD 000) (USD 000) (USD 000) Weighting(%) CAGR ( 10-12, %) Publication 23,790 33,693 37, Cartoon Music 3,627 6,836 8, Game 595, ,296 1,018, Movie 966 1,628 2, Animation 1,577 1,659 1, Broadcast 20,955 21,269 13, (20.7) Character 49,368 89,257 86, Knowledge/information 33,621 36,287 39, Contents solution 17,331 20,322 20, Total 747,667 1,118,909 1,229, China-bounded weighting (%) Note: Advertisement excluded Source: Ministry of Culture, Sports, and Tourism, KOCCA, Korea Investment & Securities Table 7. China content market size (USD mn, %) Industry (USD mn) (USD mn) (USD mn) (USD mn) Weighting (%) CAGR ( 10-13, %) Publication 23,698 26,189 27,167 28, Cartoon Music Game 6,014 6,900 7,804 8, Movie 2, ,264 3, Animation Broadcast 13,183 15,273 17,354 19, Advertisement 21,903 27,549 31,081 35, Character/license 3,452 4,616 5,036 5, Knowledge/information 30,366 37,055 45,313 53, Total 87, , , , Note: Cartoon-publication, animation-movie/broadcast, and advertisement-movie/broadcast/game/publication/knowledge market share some sales Source: Ministry of Culture, Sports, and Tourism, KOCCA, Korea Investment & Securities 8

9 Table 8. Korea content market size (W bn, %) Industry (W bn) (W bn) (W bn) Weighting (%) CAGR ( 10-12, %) Publication 21,244 21,245 21, (0.3) Cartoon Music 2,959 3,817 3, Game 7,431 8,805 9, Movie 3,433 3,773 4, Animation Broadcast 11,176 12,752 14, Advertisement 10,323 12,173 12, Character 5,897 7,210 7, Knowledge/information 7,243 9,046 9, Total 2,360 2,867 3, Total 73,322 82,968 87, Note: Movie and animation theater sales excluded Source: Ministry of Culture, Sports, and Tourism, KOCCA, Korea Investment & Securities 9

10 Guide to Korea Investment & Securities Co., Ltd. stock ratings based on absolute 12-month forward share price performance BUY: Expected to give a return of +15% or more Hold: Expected to give a return between -15% and +15% Underweight: Expected to give a return of -15% or less Korea Investment & Securities does not offer target prices for stocks with Hold or Underweight ratings. Guide to Korea Investment & Securities Co., Ltd. sector ratings for the next 12 months Overweight: Recommend increasing the sector s weighting in the portfolio compared to its respective weighting in the Kospi (Kosdaq) based on market capitalization. Neutral: Recommend maintaining the sector s weighting in the portfolio in line with its respective weighting in the Kospi (Kosdaq) based on market capitalization. Underweight: Recommend reducing the sector s weighting in the portfolio compared to its respective weighting in the Kospi (Kosdaq) based on market capitalization. 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