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A Steelmaker Stealing the Spotlight
04/04/2012 8:00 am EST
Plenty of bad news has been priced into this steelmaker, and given its history of finding a way to adapt and grow through challenging situations, this is a great buying opportunity, writes Elliott Gue of Global Investment Strategist.
POSCO (PKX), formerly known as Pohang Iron & Steel, is South Korea’s largest steel producer with a 41% share of Korea’s domestic steel market in 2011. Last year, the company produced 37.325 million metric tons of steel, exporting just under 39% of that total, with the remainder destined for Korea’s domestic market.
POSCO continues to benefit from the fact that Korea has a large domestic manufacturing base that requires large quantities of steel, including a significant domestic auto and truck production market, as well as vast shipbuilding capacity. Not surprisingly, the company’s largest export market is nearby China.
POSCO’s 2011 results reflect the headwinds for the global steel industry last year. In tonnage terms, steel production jumped 10.7% in 2011, and sales of finished steel products increased 9.6%, led by a more than 20% increase in steel exports.
Steel prices also were reasonably robust for the full year; POSCO’s average steel sales price increased 10.5% year over year compared to 2010. The increases have stemmed from strong product demand, as the global economy improves, and higher raw-materials costs.
Indeed, the jump in raw-materials costs last year posed a problem for POSCO. The cost of iron ore jumped 47.1% in 2011 compared to 2010, while metallurgical coal prices increased 43.7%, in both cases more than four times the pace of the increase in steel prices.
That hit the company’s profit margins hard, with overall operating margins falling to 7.9% in 2011, from 11.3% in 2010 and 10.5% in 2009.
At the company’s CEO Forum hosted in early February, management suggested that the biggest concern in 2012 has shifted from rising raw-materials prices to slower demand growth. In particular, management is forecasting just 3% year-over-year growth in steel demand, compared to the World Steel Association’s current outlook for 5.4% growth.
The main driver of POSCO’s less sanguine outlook is a weaker growth outlook for the Chinese market, led by a slowdown in sales to the construction industry.
The good news: the more than 20% drop in POSCO’s shares since the end of 2010 has already priced all of the gloom concerning weakness in global steel demand in 2012. Even better, POSCO’s strong leverage to higher margin value-added steel products, lessened focus on commodity steel products used in the construction industry, and strong cost-control discipline mean it’s well placed to benefit from the cyclical turn in the industry in the second half of the year.
Management sees the steel industry’s recovery beginning in the second quarter of 2012, as steel prices bounce off their recent lows, and the cost of key raw materials such as iron ore and met coal fall on a year-over-year basis. It appears that POSCO’s high-priced raw materials inventory, acquired earlier in 2011, will have worked through its operations by the end of the first quarter, underpinning an improvement in operating margins and earnings.
Investor sentiment towards POSCO and the industry as a whole should also improve in the second half of 2012, as continued monetary easing in China takes the possibility of a hard landing for the company’s key export market off the table.
POSCO’s product mix is an advantage compared to many of its competitors, which are more focused on construction-related steel products. In 2011, for example, about 7.5 million metric tons of the company’s total steel sales—more than 20% of total steel sales by volume—were to the automobile industry.
Sales to the auto industry jumped 7.8% in 2011, and growth will likely remain healthier in 2012 relative to Chinese construction end markets. Shipbuilding was another bright spot in 2011, with sales of 4.25 million metric tons, up 42% compared to 2010.
POSCO continues to target higher value-added products that management calls World Best World First (WB WF) products. Last year, sales volumes of WB WF products jumped 18.2% compared to 2010, about double the pace of overall steel tonnage sold.
What’s even more impressive are the profit margins in WB WF products, which jumped to 17.8% from 16.2% in 2010, despite the big run-up in raw-materials costs. That means that profit margins in these products are more than twice those for the company as a whole.
POSCO plans to ramp up sales of WB WF products, and has boosted its research and development (R&D) budget by nearly 29% year over year, introducing a total of 33 new products in 2011 alone, with more due out this year.
POSCO also is working to bring down costs and increase profitability through the cycle. The firm is upgrading and expanding manufacturing capacity using the latest technology that cuts demand for key raw materials such as coke.
We also like the company’s use of strategic investments and joint ventures with mining companies around the world to increase its self-sufficiency in raw materials supply. Overall, management expects to boost raw material self-sufficiency from about one-third of sales in 2011 to more than half by the end of 2014.
That will prove a major boon to profitability the next time iron ore and met coal prices spike. POSCO rates a buy under $100.
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