Hynix and Samsung FInancial Analysis
- Pages: 14
- Word count: 3381
- Category: Cash
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Term 1, 2011/2012
Corporate Reporting & Financial Analysis
Professor Andrew LEE
CHEW Chang Hong
GOH Chor Miang
LEE Hui Ying
SOH Cheng Yi
A SWOT analysis is performed to provide us an insight of Hynix Semiconductor Inc.’s business, of which the result highlights its strong market leading position and opportunities for growth in the memory chip markets. However, its risk of undiversified business and the need for rapid technological change in the semiconductor industry may be an area of concern for the company. Hynix and Samsung adopted several policies, mandatory or allowed by accounting standards, which led to accounting distortions. Our team identified capitalized development and interest costs, amortization of goodwill and operating leases as the accounting distortions. Financial statements with distortions do not truly reflect the firms’ underlying economic realities and instead make them less comparable. We adjusted the financial statements to better evaluate Hynix’s financial performance and health. Over the years, Hynix’s operating efficiency lags behind that of Samsung, notably in its weaker inventory and receivables turnover.
In 2008, at the peak of financial crisis, Hynix performed badly and had a negative operating income margin due to operating loss even though Samsung had positive margin. During the crisis, Hynix drastically increased its borrowings to keep the business going. High gearing and low interest cover, together with poor performance, impaired the firm’s ability to service debt. High credit and business risk increase the firm’s likelihood to default its debt. In 2010, with an economic upturn, Hynix had significantly better operating margin than Samsung. In the same year, the firm had outstanding performance in terms of generating high return on its net operating assets and shareholders’ equity. Hynix’s management promised to reduce the firm’s business risk by diversifying the firm’s business. From 2008 to 2010, the firm’s gearing substantially dropped and it had an increasing amount of free cash that could be used to service its debt obligations.
A decreasing credit risk and a possible reduction in business risk would mean that the firm is likely to be financially healthy in the future. Based on forecasted financial statements of Hynix, fundamental valuation models are used to determine the value of Hynix at 31 December 2010. Free-cash-flow-to-firm model is inapplicable in this case because our estimated sustainable growth rate is larger than weighted average cost of capital. Based on the residual income model (RIM), the value of Hynix is 27,649 won. Due to market’s reservation, Hynix was undervalued by 3,649 won. RIM and Price-Earnings multiples adopt different approaches and underlying assumptions in valuation of a firm, leading to valuations that yielded a huge difference of 49,721 won. Table of Contents
1. Company profile
Hynix Semiconductor Inc. (Hynix) is a South Korean semiconductor company that supplies semiconductor memories such as the dynamic random access memory (DRAM) chips and NAND flash memory chips. Currently, Hynix is the second largest manufacturer of semiconductor memory in the world and ranks 6th in the “2010 global semiconductor market share” survey. 1.1 Business SWOT Analysis
Market Leading Position
Hynix’s strong emphasis in penetrating the memory chip market, an essential component of many smart digital equipment in today’s era of digital revolution, results in the firm cementing its place as a global top 10 semiconductor company for 5 consecutive years since 2006. With its continual strategic initiatives to maximize profitability by improving its solid product portfolio in DRAM and NAND flash memory semiconductors to support next generation IT goods, Hynix further reinforces its market leading position. 1.1.2 Weakness
Over-reliance on the Asia Region & Litigation Liability
Given its pertinent risk in being overly dependent on the Asia region for a substantial percentage of revenue as well as a long-standing entanglement with legal proceedings, Hynix could face considerable liquidation risks, which will affect its financial position. Risk of undiversified business
Seemingly, Hynix’s vulnerability lies in its higher business risk for not having a diversified core business. This is evident during the 2008 financial crisis as Hynix was more badly affected because its core business comprises only DRAM and flash chips. In contrast, some firms within the industry had strong sales in their other core businesses. For e.g., Samsung sells mobile handsets and flat screen panels other than memory chips. In 2010, Hynix’s CEO acknowledged that the firm cannot survive with a sole focus in memory and that it will be substantially diversified into non-memory business by 2017i. 1.1.3 Opportunities
Growth of Dynamic Random Access Memory (DRAM) market
With the emergence of smart phones along with the usage of DRAMs in these devices, demand for mobile DRAM is likely to increase exponentially with the shipments likely to increase by 7 times from 2011 levelsii. Hence, with the production capacities and abilityiii, the company can increase the production of DRAM products, which would boost their revenue. Strategic collaboration with Original Equipment Manufacturer (OEM) market leader On 31
August 2010, Hynix had entered into a joint development agreement with Hewlett Packard Co. (HP), the top OEM semiconductor spender in 2010iv, to commercially develop a Resistive Random Access Memory (ReRam) which could replace Flash memory used in mobile phones and MP3 players. This collaboration would not only allow Hynix to tap on HP’s expertise, it also served to as a strategic move as Hynix could have a stable stream of revenue by providing such memory to HP’s mobile phones. 1.1.4 Threats
Rapid Technological Changes
Semiconductor companies are characterized by technology superiority, thus the one introducing the latest products using the most advanced technologies would normally be able to gain new market shares quickly. Therefore, Hynix has to constantly invest in research and development and yet be fast in implementing any new technologies. Failing to do so may affect the company’s market share. 2. Choice of competitor
Samsung Electronics has been identified as Hynix main competitor due to their overarching similarities in the following business components. 2.1 Market Share Samsung’s semiconductor segment revenue generation since 2002 qualify them as one of the only two largest semiconductor companies, besides Hynix, to hail from South Korea. Additionally, given their similar operations in graphics memory and storage electronics, they are faced with similar economic conditions in the industry which affect their business growth and risk. 2.2 Accounting standards
The adoption of similar accounting standards in K-GAAP and the adherence of geographical tax and listing rules will prevent earnings and book value numbers across companies to differ significantly for financial comparisons.
3. Accounting Distortions & Adjustments
3.1 Capitalized Development Costs
Under the preceding Korean-GAAP, both Hynix and Samsung are required to expense development costs in the period they are incurred. By 2011, all listed companies are required to adopt Korean IFRS. This allows companies to
capitalize development costs that meet certain criteria, mainly the feasibility of the developing product or asset. Hynix and Samsung started capitalizing certain development costs in 2010 and 2009 respectively. As defining feasibility requires substantial subjectivity, treatment of development costs varies across companies. This leads to comparability issues in assessing companies’ operating performance. Therefore, to facilitate comparability between Hynix and Samsung, adjustments are made to expense off capitalized development costs. 3.2 Capitalized Interests
Hynix and Samsung factor interest costs in their valuation of property, plant, and equipment (PPE). However, capitalizing this interest expense will not faithfully represent the expense incurred in that period. As such, adjustments are made to expense off these capitalized interests in period incurred to better reflect the true operating performance of Hynix and Samsung. Interest capitalization before 2005 would not be adjusted due to impracticability. 3.3 Amortization of goodwill
In 2005 to 2008, Hynix amortized its goodwill before disposing it in 2009 to 2010. Similarly, Samsung amortized its goodwill in 2005 to 2007 under Korean GAAP. However, when Samsung adopted the Korean FRS in 2008, it stopped amortizing but tested for impairment annually. Adjustments are made to reverse the amortization of goodwill. Unlike PPE, goodwill is not a declining asset that will reduce in value gradually. Predicting its amortization schedule and the useful life would not be appropriate. Therefore, adjustments have been made to reverse the amortization of goodwill to better reflect Hynix and Samsung’s true financial position. 3.4 Operating leases
K-GAAP and K-IFRS do not require companies to recognize an asset and a corresponding debt for future obligations under operating leases. The only requirement is to disclose this information in the footnotes. However, an operating lease fulfills the criteria of a liability. Thus, accounting standards mask the true debt level of a company. A company with more operating leases would appear to be performing better than it should be. For both Hynix and Samsung, adjustments have been made to capitalize operating leases, treating them as finance leases. This would better reflect the firms’ underlying economic realities and improve comparability between the firms. 4. Historical Operating Performance
4.1 Operating Efficiency
Although Hynix benefited from its extended payable period over Samsung, its operating efficiency is undermined by its comparatively weaker inventory turnover and days receivables outstanding. On average, Hynix’s inventory turnover average 1.5 times lower than its competitor. A consistently lower inventory turnover could negatively impact Hynix’s ability to capture market share in the highly competitive semiconductor industry. Days receivables outstanding were particularly longer between 2006 to 2009. Hynix may have lost out in re-investment opportunities, as it was unable to convert receivable to cash as quickly as Samsung. Despite the potential pitfalls, there are positives to be drawn from Hynix’s improved efficiency in collecting its sales in 2010. The optimistic outlook for semiconductors eases fear of non-collection as improving market conditions create corporate demand for electronic products.
4.2 Operating Margin
Figure Operating Income Margins
The operating margins of both Hynix and Samsung declined in years 2007 and 2008, with Hynix making a substantial loss in 2008. In the same years, the global financial crisis reduced consumer spending on electronics and PC, leading to a significant drop in demand for DRAM and NAND flashv. As a result, Hynix and Samsung decreased chip prices and experienced declined sales volumesvi. Without a corresponding cut on variable costs associated to the production and selling of the chips, the firms’ operating margins fell. Hynix was more badly affected because of its higher business risk of having an undiversified business (as in Section 1.12). Going forward, if Hynix’s management diversifies the firm’s business, the firm’s trend of operating margin is expected to be less volatile in the future. The operating margins of Hynix and Samsung gradually improved when the world economy started recovering from year 2009 onwards. Notably, Hynix had higher operating margins than Samsung in the pre-crisis and post-crisis years (2006 and 2010 respectively). Thus, Hynix’s management did well in terms of being highly
profitable under normal economic conditions. 4.3 Returns
Return on Net Operating Assets (RNOA)
Return on Equity (ROE)
In calculating RNOA, the firms’ net operating profit after tax (NOPAT) have been adjusted to include returns and losses from net operating assets. Cash and debt are considered financing items and are therefore not included in net operating assets. Net operating assets include recurring and non-financing items such as investment properties, trade receivable, financial instruments and equity method investments. Hence, items such as rental income, bad debt expense, gain on disposal of available-for-sale securities and gain of valuation of equity method investments are adjusted into NOPAT to better reflect returns and losses associated to the operating assets.
Hynix’s ROE of 38% differs quite significantly from Samsung’s 21%. ROE can be disaggregated into: ROE= RNOA+ Spread*Financial leveragevii. Both firms have larger ROE than RNOA because they both have positive spread1 and financial leverage. Hynix’s leverage is much higher than Samsung’s, resulting in a significantly higher ROE. Nevertheless, such higher ROE due to higher leverage is acceptable because in the same year, Hynix’s financials indicated that it could service its debt. In 2010, in the absence of financial crisis, Hynix had a RNOA of 27%, higher than Samsung’s 20%. This shows that performance-wise, Hynix is better than its competitor in terms of generating returns from its net operating assets. Hynix’s ability to generate comparatively high RNOA and ROE, while being able to service its debt in 2010, indicates that its management performed well in generating profit with shareholders’ money.
5. Debt Servicing Ability
5.1 Capital Structure
Due to decreased sales and unfavourable economic climate, Hynix has increased its borrowings over the years up till 2008. Its capital structure seems to have too much debt, as its total debt-to-equity ratio was 9 times more than Samsung’s in 2009. High debts couple with bear market uncovers the first vulnerability of Hynix as it requires a bailout by Korean Exchange bank in 2008. However, the firm significantly reduced its debt-to-equity ratio from 1.42 in FYE 2008 to 0.72 in FYE 2010. This shows that Hynix’s leverage, although higher than Samsung’s, may continue to decrease in the future. 5.2 Short-term Debt Servicing Ability
Working capital such as cash and receivables are important to meet short-tem debt obligations. Cash and cash equivalents see the most considerable decrease amongst all current assets, which signals a greater possibility on defaults. It is also important to note that Hynix experienced a 130.52% surge in receivables in 2009 in comparison to a mere 15.96% increase in sales. The more relaxed credit policy might be a cause for concern as the firm may incur higher bad debt losses. Moreover, Hynix’s long cash conversion cycle of 77 days in 2009 is indicative of the potential financial constraint it might face in funding its operations if it is not careful in managing its working capital. 5.3 Long-term Debt Servicing Ability
Figure 4 EBITDA Gross Interest Cover Figure 5 FCF to Total Debt (PPE Capex) In 2010, Hynix left behind 4 straight years of unsatisfactory EBITDA gross interest cover. In 2010, Hynix’s EBITDA gross interest cover overtook Samsung for the first time in 5 years, which might be attributed to Hynix’s effort to increase revenues and decrease its borrowings. Revenues increased 16% and 53% while borrowings decreased 24% and 16% from 2008 to 2009 and from 2009 to 2010 respectively. Hynix’s free cash flow to total debt shows a consecutive increase over the past 5 years, increasing from -0.38 in 2006 to 0.44 in 2010. The negative free cash flow to total debt from 2006 to 2008 is mainly due to the large capital expenditures in those years. Capital expenditure reduced significantly for the past 2 years from 2009 to 2010. Coupled with a decrease in total debt, free cash flow to total debt moved from red to black. 6. Future Prospects
Relying solely on the analysis of the historical performance of the company, the improvement in performance experienced in 2010 may not be a sufficient indicator of future growth and prospects of the company. However, coupled with the SWOT analysis, which highlights the company strengths and opportunities available to them, it seems likely that the high profitability and returns on operating assets and shareholder’s equity will be sustainable in the future. Moreover, the firm outperformed Samsung in its cash flow to total debts ratio and significantly reduced its leverage in 2010. If the management were able to continue its good practices and reduces the firm’s business risk as promised, the firm would have an optimistic financial performance and health in the future. Therefore, in line with our analysis and optimism of the company’s future, we have forecasted Hynix’s financial statements using sales revenue growth as per Reuter’s figure of 15.22%.
7.1 Fundamental Valuation
7.1.1 Free-cash-flow-to-firm valuation model (FCFF)
Using the forecasted figures, we have computed the sustainable growth rate (SGR) of 13.99% by multiplying the 2015 ROE of 14.47% with the plowback ratio of 99.66%. The weighted average cost-of-capital (WACC) of 12.51% is obtained from Bloomberg. The value of the firm’s equity per share calculated under the FCFF valuation model is a negative 30,207.80 won. A negative value arises because the SGR is larger than the WACC. 7.1.2 Residual income valuation model (RIM)
The cost of equity of 14.77% is obtained from Bloomberg and the value of the Hynix’s equity per share calculated under RIM valuation model is 27,649 won. 7.1.3 Comparisons between the two valuation models
On a standalone basis, the result from the FCFF model doesn’t seem to provide any insights on the value of the firm except that Hynix seems to have a positive future outlook as its SGR is larger than the WACC. Nevertheless, the results from the FCFF model can be used to support the results from the RIM. Both models are consistent and paint a positive outlook of Hynix’s future. However, since only the RIM can ascertain a specific value of Hynix’s equity per share, we would base our sensitivity analysis using the RIM.
7.1.4 Sensitivity Analysis
Sustainable Growth Rate
Cost of Equity
Figure 6 Sensitivity Analysis
To stress test our results, we further tested the RIM using different SGR at different level of cost of equity. The worst-case scenario points to a value of 15,799 which represents a 43% downside from the value derived under RIM. 7.1.5 Comparisons of values derived under RIM with market price The value per share arrived at using the residual income valuation model is 27,649 won. Hynix’s stock appears to be undervalued by 3,649 won as its stock price closed at 24,000 won as at 31 Dec 2010. According to a recent report by iSuppli’s market researchviii, the semiconductor industry would grow over the next five years. The main contributor quoted was the increase sales of products such as tablet PCs and smart phones. Despite the positive outlook, investors are still wary of the semiconductor industry, as the industry has just recovered from the economic crisis. It seems that investors are still having some reservations, which is why the share price did not reflect the positives outlook of the industry. In conclusion, our valuation using the residual income model seems to be in line with future expectations of Hynix’s financial performance. If Hynix’s is able to shrug off its debt and litigation woes, the value of Hynix’s could be even higher than our estimates using the residual income valuation model. 7.2 Relative Valuation
The trailing Price-Earnings (P/E) multiple of Samsung Electronics is used as a benchmark for relative valuation given its similar stature in market capitalization and emphasis on semiconductor products with similar growth and risk characteristics. The computation of a Price-Earnings-Growth ratio for each firm accounts for differences in earning growths between companies.
Figure 7 P/E Multiple
The adjusted P/E multiple of 17.248 and value per share computation of 77,370 won per share underline a significant undervaluation of Hynix share relative to its nearest comparable peer in the market. In comparison to residual income model, a huge variance of 174% in valuation can be noted.
7.2.1 Accounting for the difference in equity values
The huge difference in equity values between both models is largely attributed to the different approaches and objectives in valuation methods. The objectives behind a RIM is to determine the intrinsic value of Hynix based on its ability to earn a rate of return on equity above its cost of equity capital.
On the other hand, relative valuation of Hynix is based on the bold principle that comparable firms within the same industry should trade at comparable levels that, in practice, is flawed. This is because Samsung, as a comparable firm would have differences in risk, growth and cash flow characteristics not representative of Hynix’s. As such, the use of Samsung’s P/E multiple as a relative measure to compute Hynix’s value will result in an inaccurate interpretation of its equity value.
In addition, the RIM is based on fundamentals while the P/E multiple derived for relative valuation is affected by the incorporation of irrational market sentiments which are mainly based on intuitive observations. Thus, values derived from these two models will be different.
Appendix A: Adjustments made to Hynix
Appendix B: Adjustments made to Samsung
Appendix C: Key Forecast Assumptions
Appendix D: Hynix’s Statement of Comprehensive Income
Appendix E: Hynix’s Statement of Financial Position
Appendix F: Hynix’s Statement of Cash Flows
Appendix G: Hynix’s Financial Ratios
Appendix H: Samsung’s Statement of Comprehensive Income