Tuesday, October 18, 2016

Samsung (and other Chaebols) has to Embrace the Future

Fairly or unfairly, South Korea, whose official name is the Republic of Korea, is often pejoratively called the Republic of Samsung. However, seeing how Samsung Group generates up to 20% of South Korea’s GDP, that name may not be entirely inaccurate.

As such, when Elliott Management, a US-based hedge fund management group, made its first serious attempt at shaking up Samsung Group last year, things were expected to get ugly. After all, South Korea
s economic fate is inextricably tied with Samsung’s fate. Essentially, Elliott Management opposed the US$8 billion merger of two of Samsung Group’s companies - Samsung C&T Corp and Cheil - because it believed that Cheil’s offer was too low and that there was not much evidence for Samsung Group’s “aggressive” claims that the merger would be profitable in a few short years.

For its part, Samsung stated that it needed the merger to streamline its corporate structure and to eliminate redundancies in order to cut unnecessary costs. Also, Samsung needed the merger to take place because it would have given Lee Jay-yong, the still current heir to Samsung’s chairmanship, more control over the company.

Things got uglier than anticipated. So much so that the language used in some Korean media outlets took on severely anti-Semitic tones. The decision whether to accept or reject the merger deal was pitted as one between a besieged group of noble Koreans (sound familiar?) fending off foreign vultures, specifically Jewish ones, whose sole purpose is to devour weak companies for all the money that they are worth and to leave them (and the countries that depend on those companies) to rot.

Samsung Group narrowly won that vote by 3%. For its part, Elliott Management demanded that Samsung C&T buyout its stake in the company. It was never publicly revealed how much Elliott Management was compensated.

It was assumed that that was that but more than a year later, Elliott Management seems to be ready to face off against Samsung a second time.

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After a series of explosions, recalls, continued explosions, and worldwide derision, Samsung Electronics finally decided to discontinue the Galaxy Note 7. The timing couldn’t have been worse. There are already signs that the international smartphone market is sputtering and increased competition from Chinese smartphone manufacturers are threatening the dominance once enjoyed by Samsung and Apple. The cost of recalling the troubled phones alone is estimated to exceed US$5 billion; not to mention the incalculable cost of tarnishing one’s reputation. Furthermore, considering how Samsung is still embroiled in a series of billion-dollar-lawsuits with Apple, the Galaxy Note 7 debacle couldn’t have come at a worse time.

Enter (or re-enter) Elliott Management.

Sensing an opportunity to strike while the iron is still hot, Elliott Management once again voiced its desire to see a shakeup in Samsung’s governance structure. Having learned from its previous bout with Samsung, Elliott Management appears to have put aside its brash demeanor and penned a relatively gentle proposal letter which would most likely be welcomed by both Korean and foreign shareholders and stakeholders for their own reasons.

Elliott Management
’s biggest four proposals are:

  • Split Samsung Electronics from Samsung’s wider corporate holdings.
  • List the newly-split Samsung Electronics on public stock markets such as the Nasdaq Stock Exchange.
  • Commit Samsung Electronics to a US$27 billion stock buyback program and, in line with international corporate standards, return 75% of its annual free cash flow to investors.
  • Improve transparency in Samsung Electronics’ corporate governance by adding three independent directors to its board.

The third proposal is likely to be met with approval by both Korean and foreign shareholders (and likely tacit approval by the Korean government for the stimulative effects it would have on the overall Korean economy) considering the fact that Samsung Electronics’ cash reserves is estimated to be around US$70 billion, a sum that Elliott Management and many others classify as being “significantly overcapitalized.”

For its own reasons, however, aside from splitting Samsung Electronics from Samsung’s wider corporate holdings, Samsung will most likely not at all consider Elliott Management’s other three proposals.

Perhaps as a result of Elliott Management’s toned down proposal, the Korean media’s defense of Samsung has not taken on the ugly anti-Semitic tone that some took up last year. However, that is not to say that the Korean media has abandoned its nativist strategy to defend Samsung; and the unintended (or perhaps intended) side effect of such a defense strategy may be to prevent Korean investors from seriously considering the possible benefits of Elliott Management’s proposals.

Case in point, a few days ago, Hankyung (aka The Korea Economic Daily), one of the most respected business/economics news outlets in Korea, penned an editorial about Elliott Management’s proposal. After stating what the four main proposals were, the editorial went on to excoriate 
foreign corporate raiders that seek to maximize short-term returns for shareholders (namely themselves) at the expense of sustainable growth for the businesses they descend upon. The editorial then goes on to say that the Korean government needs to help Korean corporations to defend themselves from “the wolves” and one of the best ways of doing so would be to allow Korean corporations to issue Differential Voting Right (DVR) shares.

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Typically, DVR shares are traded in the same way as ordinary equity shares except these provide fewer voting rights to the holder. Investors who purchase these types of DVR shares tend to be passive investors who are not much interested in the decision making process but are merely interested in financial gains i.e. the exact opposite of activist shareholders. Consequently these types of DVR shares are usually traded at a discount and may offer higher dividends to shareholders who choose to purchase them in exchange for accepting highly weakened voting rights.

DVR shares with higher voting rights can also be simultaneously issued by a company’s promoters to themselves or their own family members. This is done to increase their control in the company’s decision making process, which would of course be in excess of their financial holding of the company. Therefore, the sale of DVR shares to 
“outsiders would not weaken the promoters’ voting rights and would also make hostile takeovers difficult to achieve, if not outright impossible.

Currently, Korea’s Commerce Law prohibits the issuance of DVR shares.

The problem with such editorials is that they keep Korean investors and shareholders in the dark about the benefits that are being proposed by these “foreign vultures.” To explain, they don’t explain why Elliott Management wants to see Samsung Electronics split from the parent company or the events that led to such a proposal to be made. It also doesn’t bother to do anything more than simply mention in passing that one of Elliott Management’s proposals is to have Samsung Electronics publicly listed on the Nasdaq Stock Exchange, which would subsequently help to significantly raise Samsung Electronics’ market value - not unlike what happened for Alibaba.

It goes without saying that being publicly listed and traded in international stock markets would certainly pose a challenge for the existing management teams and the systems that they have in place. After all, publicly traded businesses face extra scrutiny from investors, regulators, and the media from all over the world. That is to be expected once they begin to play on a much larger stage. Once publicly listed, Samsung Electronics would no longer be able to rely on a fawning local media or local regulators who may (or may not) have conflicts of interests with Samsung Electronics. In other words, international exchange markets, whether those in New York or Hong Kong would further be able to help to steer Samsung Electronics’ governance and corporate structure into a more internationally respectable one.

Especially important for international investors is that such a public listing would significantly streamline the investment and share-buying process. Currently, due to Samsung’s refusal to be publicly listed and traded, international investors need to jump through a series of hoops just to be able to buy a basket of Korean companies’ shares - only some of which is actually Samsung’s shares. In fact, Samsung has dedicated an entire page on its website - full of bullet points, tables, charts, and legal disclaimers - to help international investors purchase Samsung’s stocks.

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Of course, the problem is that the chaebols’ main priority is not having their stock indexes properly evaluated, but rather to maintain the control they have over their own business empires. The reasons are simple. The first and most obvious reason is that they have been able to retain control over their own businesses and they have no desire to lose that. The second (and related) reason is that not being publicly traded in international exchange markets has meant that chaebols have been able to exploit cross-shareholding for many years.

So what is cross-shareholding? Cross-shareholding is a practice that has often been used by chaebol chairmen and their family members with the sole purpose of securing their control over their business empires with just a handful of shares.

For example, when Company A makes an equity investment in Company B, which in turn buys a stake in Company C, which in turn secures a stake in Company A, a cross-ownership loop is created. This is what allows chaebol owners to have control over their business empires with just a handful of shares. It is also the very thing that has allowed chaebol families to facilitate father-to-son transfers of corporate control - something that would be anathema in Western markets.

An added benefit of cross-shareholding for Samsung’s owners and family members is that even if one of their subsidiaries loses money, Samsung Group can use the profits that have been generated by another subsidiary to cover the costs. Using this method, Samsung Group can undervalue their stocks, which is one of the key reasons for Korean corporations being so notorious for their relatively low dividend yields.

Yes, laws have been passed and the Korean government has put political pressure on the chaebols to ban new cross-shareholding investments (though not existing ones) but some practices take a long time to die out. As far as Samsung or the other chaebols are concerned, they have little incentive to take Elliott Management’s proposals seriously. They’re at the top of the world. Why would they give that up?

Decisions of this nature will always carry costs and benefits. The costs to the chaebols are obvious. They and their families would lose the iron grip they have over their businesses, jeopardize hereditary successions, and they would be at the mercy of extremely strict and demanding foreign investors and regulators. In short, they would their Shangri-La.

However, nothing lasts forever. Not even the joys of paradise. Economic uncertainty in Europe, modest job growth in the United States, and China’s economic slowdown and looming banking crisis have all significantly weakened external demand. Korean businesses have long complained that militant unions have long dissuaded foreign investors from investing in Korea and though that is true, that claim masks the role that low dividend yields have played in doing the same thing. Domestic consumption remains sluggish and further attempts to stimulate the economy via quantitative easing could inadvertently exacerbate household debts. Korea’s low rates of immigration combined with an aging population who will also have to someday face a real estate bust threaten economic contraction.

All indicators, from the short-term to long-term, are pointing to economic gloom and doom. And Korea is quickly running out of options and time to cushion the blow. The massive cash reserves that Samsung and other chaebols are holding on to may help them to weather economic recessions and survive where Hanjin failed to do so. However, a siege mentality is bound to fail over an extended period of time.

Samsung and other chaebol companies have a choice to make - adopt Elliott Management’s proposals (or at least some of them) while they are still gentle proposals and thus launch Korean corporations into the 21st century and compete with the rest of the world on an even footing and help to expand markets, both domestically and internationally, or someday be made to adopt them a la IMF diktats circa 1997~1998 when they were anything but gentle.

Choose wisely
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