SK Hynix’s 32% Mystery: Why the Shares Trade at a Huge U.S. Premium

There are peculiar patterns developing in the shares of stocks on either side of the Pacific. Asian trade proceeded smoothly Thursday with a rise for most markets —­ and the standard slip for India — before U.S. markets opened.

Now strong earnings from Alphabet (GOOGL) are feeding into a selloff. The reason? The strong sales did not disappoint. But the company is burning through cash at an alarming rate even while pledging increased capital expenditure to back investment into Artificial Intelligence (AI).

The Google parent burnt through $5.9 billion in Q2, causing negative cash flow for the first time on record. And investors are fretting that the company raised its capex plans to between $195 billion and $205 billion. That’s up $15 billion on either side of the range.

That’s even as its cloud-computing division saw its best-ever quarter for growth, with revenue at Google Cloud up 82%. Analysts polled by LSEG expected a 64% rise.

Actually, the cash burn did impact the bottom line. Alphabet’s earnings of $2.85 per share fell below the $2.89 forecast by the LSEG average. Sales hit $119.8 billion, above the expectations of $116.9 billion.

Different Pattern From Dot-Com Boom

Still, during the dot-com boom, stocks shot up regardless of earnings. Companies were funded on a premise and a promise of future profits.

Now we have the opposite situation, where stocks sink regardless of earnings, even slipping on improved earnings forecast as happened with Samsung Electronics earlier this month. Profitability is strong, even at record levels? Well, you’re burning through cash. Must do better …

The odd trading pattern is most noticeable with the shares of SK Hynix (SKHY) (KR:000660), which raised $26.5 billion with a U.S. initial public offering, the largest-ever on Wall Street by a non-U.S. company, on July 10. They rose 4.9% in Asian trade Thursday, and are up 4.7% in U.S. on Thursday, as I write. But that’s not always the case.

Korean and U.S. Trading Can Diverge

Korean and U.S. shares frequently diverge. What’s more, the U.S. stock of Hynix is currently trading at a significant premium to the Seoul shares. At today’s prices, the premium is 32.0%, since each Seoul share is equivalent to 10 U.S. shares, and given today’s exchange rate of $1 to 1,474 Korean won.

Why so high? Institutional investors have indicated strong demand for the U.S. shares. In a “friction-free” market, we would see traders make an arbitrage play by buying the undervalued Korean shares. But these markets are anything but friction-free. There’s a big wall in the way instead.

This translates to trading in the Roundhill Memory ETF (DRAM), too. Today, we saw Hynix rise 4.9% in Korean trade, with Samsung Electronics (KR:005930) up 3.7%. Micron Technology (MU) is now up 3.6% in early U.S. trade, too.

Those three names make up around 75% of the Roundhill Memory ETF. Yet DRAM fell as much as 1.3% in early going. It has now recovered to trade 1.0% higher but is not reflecting the moves in its biggest names.

While Alphabet may be falling due to its capex intentions, those plans are very good news indeed for the memory makers. Besides Hynix, Samsung and Micron, the fourth-largest memory maker in the world is planning to list next week.

As I explain in my last column, China has thrown its backing behind CXMT — full name ChangXin Memory Technologies — which will start trading on Shanghai’s STAR Market on Monday. It has priced shares at C¥8.66, which will raise C¥66.6 billion ($9.8 billion) if its overallotment is exercised, as is likely. That would make it the largest listing in Asia so far this year.

Cap on Hynix Conversion

Hynix has capped the amount of its South Korean shares that can be converted into U.S. American depositary receipts (ADRs) at just a tiny 2.5% of total shares outstanding, according the Korea Securities Depository (KSD). That renders arbitrage is virtually impossible.

In fact, the entire 2.5% allocation was already used up in the U.S. initial public offering, KSD CEO Rhee Yunsu told Bloomberg in a phone interview. The KSD is the central securities depository in South Korea, and in that capacity oversees any issuance or cancellation of the depositary receipts linked to Korean stocks.

The upshot is that would-be arbitrage traders cannot convert Seoul shares into U.S. stock unless existing holders of the U.S. ADRs first convert them back into Korean shares. If that were possible, you’d expect any arbitrage gap to shrink, depending simply on news flow on the two sides of the Pacific and what happened in today’s trade in Seoul or New York.

For now, U.S. Hynix shares have a huge “convenience premium” since they are the stock that U.S. investors can access. The premium has gapped as high as 51% but will remain wide so long as the shares can’t be converted.

First Hynix Earnings as U.S. Listing

Hynix is due to report earnings on the morning next Wednesday, July 29, Korea time. The books are closed for the issuance and cancellation of shares until then. We must see if there’s any announcement out of earnings to rectify the strange situation.

Hynix declined to comment on why it is allowing only such a small degree of conversion between its two listings. But it stipulated that the company would not sell shares outside the IPO for a 90-day lockup period after the offering. Hynix may expand the conversion allocation once the U.S. shares have built a trading track record.

Unlike companies listed in Hong Kong and Japan, very few Korean companies have ADRs. It’s a roster of around a dozen stocks, other notable names including the steel producer POSCO Holdings (PKX), the telecom SK Telecom (SKM), the utility KEPCO (KEP) and the screen and display maker LG Display (LPL). That compares with close to 300 Chinese companies that have company-sponsored ADRs that are listed on Wall Street.

We can note that the existing Korean companies listed on Wall Street tend to be in pretty prosaic industries: power generation, shipbuilding. They will therefore have predictable earnings and fewer arbitrage opportunities between Asian and U.S. trade.

Test Case for Korean Cross-Listing

Hynix will be a test case of a highly volatile stock that is in high demand both in Seoul and New York. The arbitrage gap between its Korean shares and U.S. stock is also creating downward pressure on the Seoul shares, as institutional investors sell the Korean stock to account for their new U.S. holding in Hynix.

We do have an example of a similar company with a long and exemplary track record. Taiwan Semiconductor Manufacturing Co. (TSM) (TW:2330) has had company-sponsored ADRs on Wall Street since 1997, three years after its September 1994 listing in Taiwan.

TSM is today trading at an 11.7% premium over the Taiwan shares, with 1 U.S. ADR worth 5 shares in Taiwan. We can perhaps therefore expect Hynix to narrow its premium gap to around 10%.

U.S. investors are willing to pay slightly more when securing the shares on Wall Street, even if volume in Taiwan is normally at least double that for TSMC on the New York Stock Exchange. There’s the convenience factor of trading in real time instead of waiting for the Asian trading day to start.

The 90-day lockup for Hynix will end on October 8. We can expect an exaggerated premium on the U.S. shares until it’s easier for arbitrage players to convert SKHY to the stock in Seoul. After that, we may see the conversion premium narrow to around 10%.

At the time of publication, McMillan was long TSMC and DRAM.