Steel These Stocks Soon

07/03/2012 10:30 am EST

Focus: GLOBAL

Yiannis Mostrous

Editor, The Capitalist Times

Two steel companies are taking different approaches to a slowdown in demand and both are coming up with good results notes Yiannis Mostrous of Global Investment Strategist.

After a year under its new CEO, Murilo Ferreira, Vale (VALE) is focusing more on profitability than on growth.

The Brazil-based diversified metals and mining company is pursuing this strategy in response to global uncertainty, particularly the slowdown in China. Governments around the world (e.g., Australia and Peru) have been raising royalties and mining taxes. In Vale’s case, there’s also the added burden of litigation with the US government over $15 billion in overdue income taxes.

Until a year ago, the company was mainly investing in growth projects and merger and acquisition transactions, to take full advantage of the fast growth in commodity demand. However, it’s now clear that the new management team is emphasizing profitability and disciplined capital allocation. This strategy will benefit the stock over the long term.

The company was been investing heavily in greenfield projects that are expected to produce solid returns. Its iron ore project in Carajás Serra Sul in Brazil and its Moatize coal project in Mozambique have been receiving the bulk of these investments.

The company has also been looking into divesting some of its non-core assets. Among those are coal assets in Australia, oil exploration assets in Brazil, and the company’s stake in Norsk Hydro. Vale’s potential sale of a stake in its general cargo logistics business also is in the cards. Vale is expected to net about $9 billion from these transactions.

The company has been gradually adopting a more shareholder-friendly approach. Last year, Vale returned around $12 billion to shareholders in the form of dividends and buyback programs. For 2012, the company has announced a minimum dividend payment of $6 billion (an all-time high), which represents a dividend yield of 6% at current prices.

Given the company’s strong cash flows and stronger management team, investors should expect the company to start paying a dividend yield of around 5%, on a sustainable basis.

Slowing global growth will be offset by the continuing need of China’s domestic steel producers for imported iron ore. Vale’s relatively low valuation offers investors a good entry point. We continue to recommend the stock with one caveat: a poor performance by the Chinese or global economy could drive the stock price down further. Buy Vale up to $35.

Steel Gets Hot
Portfolio holding Posco (PKX), formerly known as Pohang Iron & Steel, is South Korea’s largest steel producer with a 41% share of the country’s domestic steel production 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 South Korea’s domestic market.

The company’s sales have been adversely affected by weak steel prices in China. However, the company trades at relatively appealing prices when compared to its peers, and remains a great defensive play.

Posco should surprise on the upside when it reports in July its numbers for the second quarter of 2012. Analysts are looking for second-quarter operating profits to touch $900 billion, a great performance by any measure. Operating margins should also surpass 10%, up from 4.5% in the first quarter. Driving this robust performance is the increase in sales of higher-priced premium steel products, rather than the lower-priced slabs.

In addition, the weakness of the South Korean won coupled with the rise in export prices will allow Posco to perform well. Japan is of particular importance to Posco, beyond the advantages of the stronger yen. Posco shipped 7 million tons of auto steel sheet in 2011, with 11% destined for Japanese carmakers.

If Posco becomes a main supplier to the Japanese auto companies, it could take more than 10% of the market, with its shipments of auto steel sheet surpassing 1.5 tons over the next two years. The three major Japanese automakers consume around 13 million tons of steel sheet annually.

Facilitating this opportunity is the forthcoming merger between Nippon Steel (Tokyo: 5401) and Sumitomo Metal Industries (Tokyo: 5405). Japanese automakers historically have not purchased more than 40% of their steel from one supplier, but the merger will increasingly force them to meet their needs from one, consolidated source.

Posco, technologically savvy and with a strong foothold in the Japanese market, will be the logical supplier. This development is a huge growth opportunity for Posco, but so far investors seem to have missed the story.

Posco’s product mix also gives it an advantage over many of its competitors, which are more focused on construction-related steel products. In 2011, about 7.5 million metric tons of the company’s total steel sales—more than 20% of total steel sales by volume—came from the automobile industry. Shipbuilding was another bright spot in 2011, with sales of 4.25 million metric tons, up 42% compared to 2010.

Posco also continues to benefit from South Korea’s large domestic manufacturing base. The country requires large quantities of steel for its significant domestic auto and truck production market, as well as for its vast shipbuilding capacity. Posco rates a buy under $90.

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