PKX - POSCO

[Peregrine]

Evidently their domestic steel business is improving and doing quite well. Op margin of 9.2% in each of the last two quarters compared to ~ 7% in the first half of 2014. Compare this to the other major steel producers in the region and it's quite impressive.

 

It's their various subsidiaries and equity-method affiliates that have struggled and have brought down POSCO's consolidated results. Management is finally announcing intentions of cleaning house and concentrating what they do best at, but they're also reaping some of the pains that previous management left behind.

 

I think the stock is cheap as hell.

[jawn619]

company has a $34B Enterprise value. Best steel company in the world is worth maybe 5-8x normalized EBITDA of $5B. Subsidiaries are worth pretty much nothing. I've heard that the parent doesn't guarantee the subsidiaries debt but it doesn't seem like it from what management is saying. 

[alwaysinvert]

company has a $34B Enterprise value. Best steel company in the world is worth maybe 5-8x normalized EBITDA of $5B. Subsidiaries are worth pretty much nothing. I've heard that the parent doesn't guarantee the subsidiaries debt but it doesn't seem like it from what management is saying.

 

They have just let Posco Plantec enter debt restructuring.

[RadMan24]

Evidently their domestic steel business is improving and doing quite well. Op margin of 9.2% in each of the last two quarters compared to ~ 7% in the first half of 2014. Compare this to the other major steel producers in the region and it's quite impressive.

 

It's their various subsidiaries and equity-method affiliates that have struggled and have brought down POSCO's consolidated results. Management is finally announcing intentions of cleaning house and concentrating what they do best at, but they're also reaping some of the pains that previous management left behind.

 

I think the stock is cheap as hell.

 

You see the slide on their 2Q presentation where they pointed out the gap between them and their competition has closed considerably since 08? I mean, everything comes in cycles, but it is hard to imagine this company not being able to pull away again if they re focus on their domestic steel business and technology, especially in this market. Chinese steel is one hell of a negative factor though. Maybe iron ore prices have to jump faster than steel prices to slow down those exports..but those iron ore producers have no signs of slowing down. yet.

[MrB]

http://www.theguardian.com/business/2015/jul/09/steel-cheaper-per-tonne-than-cabbage-in-china-as-iron-ore-hits-six-year-low

I sometimes wonder whether it is not more practical to figure out a solution whereby you encourage your local producers to stop producing and in this case import from China. If they are giving away their steel for free, why would I not want to buy it from them as long as it is not at the expense of my local producers? So maybe an import duty that translates into a bottom line gain for my local producers directly?

[Foreign Tuffett]

I couldn't get past long term head winds in the industry.

 

There is probably an opportunity to pick Posco up and make a few bucks on a few positive quarters before steel prices fully adjust to raw materials prices and margins are hit again.

 

I have been doing some reading and trying to get my head around the steel industry but some of the mid to long term trends in the industry are quite disconcerting.

 

I don't see a demand-side fix coming any time soon and there are major structural impediments to supply-side fixes such as consolidation and production cutbacks.

 

Several hundred million tonnes of capacity need to be removed from the market for sustainable profit margins by bringing utilisation up to a reasonable level. This is unlikely because of the high debt load in the sector and the need for many to maintain full load production, as well as the high level of state involvement and the political risks of destroying jobs.

 

China have mandated the removal of 80mt of capacity however this won't offset the growth in production capacity that has and is occurring.

 

The cost curve in steel has been flattened as the lower raw materials prices has reduced the costs for those without integrated Iron Ore operations and the high cost inflation i.e. labour cost increases have pulled up the low end of the curve.

 

This has the effect of increasing the sensitivity to movements in currency e.g. removing Posco from its position as the lowest cost producer due to the devaluation of the yen and rouble. It also reduces the likelihood of supply being removed from the market in response to lower prices.

 

It seems that historically steelmakers have not benefited that much from lower raw material prices as the spread between steel prices and raw material prices remains relatively constant. Although Posco have clear technological advantages they are not the only company looking increasingly to move away from the commodity products and into high margin niche products.

 

I am also concerned about consolidation occurring in isolated parts of the industry, e.g. China improving its competitive position without a major net reduction in capacity and placing additional pressure on producers in other geographies.

 

There may be an opportunity for Posco to divest non-core assets and capture sufficient market share in high margin products for the growing needs of China such as automotive components. I don't see a margin of safety in the price just yet however, I think it might look cheap on predicted FY15 numbers but I am not convinced the windfall from arbitraging low raw material prices won't close in FY16 as steel prices rationalise.

 

 

This (in my opnion) is a spot on description of the current situation in the steel industry.

[karthikpm]

I couldn't get past long term head winds in the industry.

 

There is probably an opportunity to pick Posco up and make a few bucks on a few positive quarters before steel prices fully adjust to raw materials prices and margins are hit again.

 

I have been doing some reading and trying to get my head around the steel industry but some of the mid to long term trends in the industry are quite disconcerting.

 

I don't see a demand-side fix coming any time soon and there are major structural impediments to supply-side fixes such as consolidation and production cutbacks.

 

Several hundred million tonnes of capacity need to be removed from the market for sustainable profit margins by bringing utilisation up to a reasonable level. This is unlikely because of the high debt load in the sector and the need for many to maintain full load production, as well as the high level of state involvement and the political risks of destroying jobs.

 

China have mandated the removal of 80mt of capacity however this won't offset the growth in production capacity that has and is occurring.

 

The cost curve in steel has been flattened as the lower raw materials prices has reduced the costs for those without integrated Iron Ore operations and the high cost inflation i.e. labour cost increases have pulled up the low end of the curve.

 

This has the effect of increasing the sensitivity to movements in currency e.g. removing Posco from its position as the lowest cost producer due to the devaluation of the yen and rouble. It also reduces the likelihood of supply being removed from the market in response to lower prices.

 

It seems that historically steelmakers have not benefited that much from lower raw material prices as the spread between steel prices and raw material prices remains relatively constant. Although Posco have clear technological advantages they are not the only company looking increasingly to move away from the commodity products and into high margin niche products.

 

I am also concerned about consolidation occurring in isolated parts of the industry, e.g. China improving its competitive position without a major net reduction in capacity and placing additional pressure on producers in other geographies.

 

There may be an opportunity for Posco to divest non-core assets and capture sufficient market share in high margin products for the growing needs of China such as automotive components. I don't see a margin of safety in the price just yet however, I think it might look cheap on predicted FY15 numbers but I am not convinced the windfall from arbitraging low raw material prices won't close in FY16 as steel prices rationalise.

 

 

This (in my opnion) is a spot on description of the current situation in the steel industry.

 

+1

[Peregrine]

I couldn't get past long term head winds in the industry.

 

There is probably an opportunity to pick Posco up and make a few bucks on a few positive quarters before steel prices fully adjust to raw materials prices and margins are hit again.

 

I have been doing some reading and trying to get my head around the steel industry but some of the mid to long term trends in the industry are quite disconcerting.

 

I don't see a demand-side fix coming any time soon and there are major structural impediments to supply-side fixes such as consolidation and production cutbacks.

 

Several hundred million tonnes of capacity need to be removed from the market for sustainable profit margins by bringing utilisation up to a reasonable level. This is unlikely because of the high debt load in the sector and the need for many to maintain full load production, as well as the high level of state involvement and the political risks of destroying jobs.

 

China have mandated the removal of 80mt of capacity however this won't offset the growth in production capacity that has and is occurring.

 

The cost curve in steel has been flattened as the lower raw materials prices has reduced the costs for those without integrated Iron Ore operations and the high cost inflation i.e. labour cost increases have pulled up the low end of the curve.

 

This has the effect of increasing the sensitivity to movements in currency e.g. removing Posco from its position as the lowest cost producer due to the devaluation of the yen and rouble. It also reduces the likelihood of supply being removed from the market in response to lower prices.

 

It seems that historically steelmakers have not benefited that much from lower raw material prices as the spread between steel prices and raw material prices remains relatively constant. Although Posco have clear technological advantages they are not the only company looking increasingly to move away from the commodity products and into high margin niche products.

 

I am also concerned about consolidation occurring in isolated parts of the industry, e.g. China improving its competitive position without a major net reduction in capacity and placing additional pressure on producers in other geographies.

 

There may be an opportunity for Posco to divest non-core assets and capture sufficient market share in high margin products for the growing needs of China such as automotive components. I don't see a margin of safety in the price just yet however, I think it might look cheap on predicted FY15 numbers but I am not convinced the windfall from arbitraging low raw material prices won't close in FY16 as steel prices rationalise.

 

 

This (in my opnion) is a spot on description of the current situation in the steel industry.

 

It's interesting because it's not actually POSCO's core steel business that has been bringing down results of the company as a whole. The parent steel business is making relatively healthy operating and EBITDA margins of 9% and 17% respectively within the context of a horrible steel environment.

 

Rather it's the investments that the company made in its previous crusade to diversify away from the maturing Korean steel industry that has really hurt the company.

 

So let's not confuse the company's stock price and its horrible string of results for weakness in its core steel business. It remains to be seen whether management can effectively re-focus.

[tylerdurden]

I agree that we should look into Posco as a more diversified company rather an a steel company only but this makes life even more challenging for them. I realized that there are lots of moving parts for posco other than the steel business in each quarter. FX movements, natural gas prices, performance of other businesses etc. Not sure the management would exit the energy business for example in order to focus on steel. I think they are probably getting more profitable by focusing on higher margin steel products on that business so I am sure one day that value is going to show itself but hard to know when that's going to happen with the China thing going on...

[AJB96]

I wrote an updated summary on Posco for my own notes and thought I'd share it with the board:

 

In the 2nd quarter of 2015, Posco’s operating margin was 9.2% which is quite remarkable given many of Posco’s peers in the steel industry are losing a lot of money. Posco’s steel business is doing very well. In the Q2 earnings release, Posco management made a further commitment to sell non-core assets and pay down parent debt among other shareholder friendly initiatives. The 19 businesses they plan to sell will eliminate a combined 290 B won in losses in 2014. By selling these money losing businesses, Posco will not only eliminate losses but they will raise money to pay down debt in the process. They expect to get 2 T won in proceeds from the sale of these businesses and that would save 100 B a year in interest costs. Furthermore, Posco plans 500 B in annual cost savings. All of these initiatives will boost earnings in the absence of any improvement in the global steel industry.

 

In 2014, Posco had net income of 557 B won. Included in those results are impairments on investments of 393 B won and a tax penalty of 353 B won. When these onetime items are added back, Posco earned 1,224 B won in after tax earnings.  Over the next year Posco will be selling non-core assets that will improve earnings by 290 B, paying down debt (100 B in interest savings) and implementing cost initiatives (500 B). This would bring after tax earnings to 1,936 B won with no improvement in the steel industry which is near an all time low.

 

At today’s price of 197,500 won per share, Posco has a market cap of 15.7 T won. Thus Posco is trading at 7.5x trough earnings and less than 37% of tangible book value. Posco is undervalued even if the global steel market never improves. Conditions in the global steel industry are severely squeezing marginal players with utilization sub 70%. A large portion of the global steel industry is now unprofitable and that is a powerful catalyst for steel companies to take capacity out and makes it less likely that new capacity is added. 

 

Posco is trading for 15.7 T and has cash, bonds and securities (at current market value) of 9.5 T and the value of Posco E&C and Posco Energy is an additional 5.5 T. The total value of those assets equals the current market cap of 15.7 T. Net of parent debt (6.5 T), cash, bonds, securities and non-steel assets totals 8.5 T.  At today’s price, investors are paying only 7.2 T for the world’s best steel assets that earned 2.4 T in operating income in 2014 and have a book value of over 34 T (which understates replacement value significantly). Based on the current enterprise value (when net cash, securities and other assets are netted against debt) the best steel assets in the world can be purchased at 21% of tangible book value.

 

There are a number of very positive tailwinds for Posco’s business. The restructuring actions management is taking are depressing earnings short term, but are very good for shareholders in the long run. Posco will benefit from numerous positive tailwinds going forward.  1) The world steel industry is near all-time low profitability and this significantly disincentivizes new capacity growth and may even lead to capacity closures. Both of which will lead to higher industry capacity utilization. 2) Most of the world’s economies outside the US are doing very poorly (Russia, South America, Europe, China etc). Many of these countries have strong long term fundamentals and Posco will be a big beneficiary of improvement in world economic conditions. 3) Posco is focusing on increasing the portion of high margin steel it produces. They’ve gone from 25% to 40% in just a couple years. And in the next few years their goal is to reach 50%. This will boost Posco’s margins because specialty steel is more profitable. Posco has also begun to license its FINEX technology to other steel companies and receives royalty revenue with little to no investment. 4) The new management team has been taking many shareholder friendly actions. Most of which seem to be going unnoticed.  Selling non-core assets (many of which are losing money) and using the proceeds to pay down debt is very good for shareholders. The new management team has reduced the number of affiliate companies from 74 to 47 in two years and has a goal of reducing the number to 22 by 2017. The plan also calls for reducing overseas affiliates from 181 at the end of 2014 to 117 by 2017.

 

Posco is priced as if steel margins will remain at an all-time low forever – which is almost certainly not going to be the case.  Posco is extremely undervalued and when the steel market improves Posco is likely worth $140-$180 per share (3-4x the current price). Downside is very limited because Posco is the lowest cost producer and they have a very conservative balance sheet with net cash and securities at the parent level.

Posco_Q2_earnings.pdf

[tylerdurden]

Thanks for your update on Posco Alex. I think there is no question that Posco is extremely cheap right now. I am not sure but it is even lower than Berkshire's entry point from more than a decade ago I guess. As some of the folks on this board raised before though, something which is extremely cheap could stay cheap for a very long time so that timeframe that you have to wait on this name is questionable with all the excess capacity.

 

I haven't followed their new announcement for asset disposal plans. What is the difference from last year regarding that? They have been thinking about selling assets for sometime now, correct?

[gary17]

I think to invest in POSCO you should understand the korean / Asian business culture and be comfortable with certain risks that normally do not exist in a north american business.  i can't really elaborate any more here, other than that some of the past scandals may be just the tip of the iceberg...  are you sure there are no better opportunities in north america  where only 1 or 2 things need to go right for you to obtain the same return, without having to understand a foreign company , the currency risks, etc ?  investors don't get paid for solving difficult problems; we get paid for a few simple ideas that play themselves out in a timely and predictable fashion...     

my 2 cents !

Gary

[cubsfan]

Alex - fantastic - thanks for sharing your update.

[portfolio14]

I wrote an updated summary on Posco for my own notes and thought I'd share it with the board:

 

Great stuff!

 

1) The world steel industry is near all-time low profitability and this significantly disincentivizes new capacity growth and may even lead to capacity closures. Both of which will lead to higher industry capacity utilization.....

 

Posco is priced as if steel margins will remain at an all-time low forever – which is almost certainly not going to be the case.  Posco is extremely undervalued and when the steel market improves Posco is likely worth $140-$180 per share (3-4x the current price). Downside is very limited because Posco is the lowest cost producer and they have a very conservative balance sheet with net cash and securities at the parent level.

 

The wildcard is China maintains its output regardless of the prices for non-economical reasons for a prolonged time.

[jason]

Thanks for your update on Posco Alex. I think there is no question that Posco is extremely cheap right now. I am not sure but it is even lower than Berkshire's entry point from more than a decade ago I guess. As some of the folks on this board raised before though, something which is extremely cheap could stay cheap for a very long time so that timeframe that you have to wait on this name is questionable with all the excess capacity.

 

I haven't followed their new announcement for asset disposal plans. What is the difference from last year regarding that? They have been thinking about selling assets for sometime now, correct?

 

I dont think its the same company that Berkshire purchased a decade ago however.  For instance the gap in technology appears to be narrowing, Chinese tailwinds are slowing, the next big opportunity India looks like a no go, they have increased their debt and are trading at still around 20x earnings.

 

 

[vjrao]

Hi all,

  Though I'm new to the forum, I've been on the sidelines following PKX rather intensely over the past 6 months or so, with a view to taking a position. After doing a lot of diligence on Posco, I've concluded that:

 

[*]Posco has the best management team and operating assets in the steel business.

[*] Posco (by any measurement) is very cheap right now compared to almost any other US equity of similar size.

 

However, it's also clear to me that in general, the steel business is a terrible business. It is very commoditized and is plagued with substantial over-capacity that won't disappear from the marketplace for political reasons. 

 

This situation actually reminds me quite a bit of Warren Buffett's quote:

 

"When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact."

 

I'm going to remain on the sidelines for this one, but I wish everyone in this forum the best of luck. I used this forum quite a bit in my diligence process to learn the basics about Posco before diving into the filings. Special thanks to AlexBossert and alwaysinvert for spending so much time explaining the fundamentals of Posco's business to newbies like me...

[spark411]

I finally got into PKX at $40 a share.  i'm surprised it's going lower.  Please share what you think the lowest price you think it can go in 2 years.  I think it's a bit crazy how far below book value pkx is selling.  just the real estate they own must be worth billions.  with that said, i don't want my stock going down 50%.  Pls advise.

[jawn619]

I finally got into PKX at $40 a share.  i'm surprised it's going lower.  Please share what you think the lowest price you think it can go in 2 years.  I think it's a bit crazy how far below book value pkx is selling.  just the real estate they own must be worth billions.  with that said, i don't want my stock going down 50%.  Pls advise.

 

When you buy Posco, you are mainly buying the steel business. The "Bet" is that Earnings/Operating Income/FCF is depressed, and they should return to normalized historical levels. Right now Market cap is around $12.5B, with consolidated debt around $40B, so the enterprise value is around $52B. What do you get for $52B? Off $60B of steel sales, right now they are achieving 5% operating margins or about $3B of operating income. So if steel prices stay at where they are for a long time, Posco trades at 17X operating income, which is actually a pretty high price to pay for a cyclical commodity business, even if it's the best in the world. Let's say they can return to 10% operating margins and generate $6B of operating income, then they are trading for 8.5x operating income which is far more attractive but still not a large margin of safety, especially since Posco is pretty capital intensive and needs to reinvest a lot just to stay competitive(meaning FCF is lower).

 

To answer your question about Posco going down 50%, I think it could still be possible, because right now a large portion of Posco's enterprise value is debt, the equity portion could swing wildly and the enterprise value wouldn't move as much. I've heard the argument that a lot of the debt does not have to be paid by the parent, but I'm not sure how accurate that is.

 

Also a statement on book value. Companies trade often trade below book value if they're not using their assets effectively or generating an adequate return, and above if they're generating above average returns. Posco right now falls into the former, so some discount is warranted.

 

Hope this helps.

[peter1234]

I finally got into PKX at $40 a share.  i'm surprised it's going lower.  Please share what you think the lowest price you think it can go in 2 years.  I think it's a bit crazy how far below book value pkx is selling.  just the real estate they own must be worth billions.  with that said, i don't want my stock going down 50%.  Pls advise.

 

When you buy Posco, you are mainly buying the steel business. The "Bet" is that Earnings/Operating Income/FCF is depressed, and they should return to normalized historical levels. Right now Market cap is around $12.5B, with consolidated debt around $40B, so the enterprise value is around $52B. What do you get for $52B? Off $60B of steel sales, right now they are achieving 5% operating margins or about $3B of operating income. So if steel prices stay at where they are for a long time, Posco trades at 17X operating income, which is actually a pretty high price to pay for a cyclical commodity business, even if it's the best in the world. Let's say they can return to 10% operating margins and generate $6B of operating income, then they are trading for 8.5x operating income which is far more attractive but still not a large margin of safety, especially since Posco is pretty capital intensive and needs to reinvest a lot just to stay competitive(meaning FCF is lower).

 

To answer your question about Posco going down 50%, I think it could still be possible, because right now a large portion of Posco's enterprise value is debt, the equity portion could swing wildly and the enterprise value wouldn't move as much. I've heard the argument that a lot of the debt does not have to be paid by the parent, but I'm not sure how accurate that is.

 

Also a statement on book value. Companies trade often trade below book value if they're not using their assets effectively or generating an adequate return, and above if they're generating above average returns. Posco right now falls into the former, so some discount is warranted.

 

Hope this helps.

 

+1

This is a great and short summary thesis. Might want to read a few times.

Small Equity value (25% of Enterprise value) means it is a highly levered investment. Leverage amplifies both up and down moves.

;)

[spark411]

the point about the $52B of which $40B is debt is a good one.  I was looking at it asking myself how the business could go down 50%, but the way i should look at it is if the business goes down 12%, then the equity goes down by 50%....

 

Thanks a bunch.

[valueyoda]

I have been short and still think it hasn't bottomed yet. Mean reversion in steel prices that are necessary to get to an attractive valuation is still far off, given China's descent into recession and global overcapacity. Given that the equity valuation is such as small component of total EV, optically cheap price-to-book ratios are irrelevant and even dangerous, unless a major change in steel pricing is around the corner.

[MrB]

I finally got into PKX at $40 a share.  i'm surprised it's going lower.  Please share what you think the lowest price you think it can go in 2 years.  I think it's a bit crazy how far below book value pkx is selling.  just the real estate they own must be worth billions.  with that said, i don't want my stock going down 50%.  Pls advise.

 

“Unless you can watch your stock holdings decline by 50% without becoming panic-stricken, you should not be in the stock market.” – Warren Buffett

[TwoCitiesCapital]

I finally got into PKX at $40 a share.  i'm surprised it's going lower.  Please share what you think the lowest price you think it can go in 2 years.  I think it's a bit crazy how far below book value pkx is selling.  just the real estate they own must be worth billions.  with that said, i don't want my stock going down 50%.  Pls advise.

 

When you buy Posco, you are mainly buying the steel business. The "Bet" is that Earnings/Operating Income/FCF is depressed, and they should return to normalized historical levels. Right now Market cap is around $12.5B, with consolidated debt around $40B, so the enterprise value is around $52B. What do you get for $52B? Off $60B of steel sales, right now they are achieving 5% operating margins or about $3B of operating income. So if steel prices stay at where they are for a long time, Posco trades at 17X operating income, which is actually a pretty high price to pay for a cyclical commodity business, even if it's the best in the world. Let's say they can return to 10% operating margins and generate $6B of operating income, then they are trading for 8.5x operating income which is far more attractive but still not a large margin of safety, especially since Posco is pretty capital intensive and needs to reinvest a lot just to stay competitive(meaning FCF is lower).

 

To answer your question about Posco going down 50%, I think it could still be possible, because right now a large portion of Posco's enterprise value is debt, the equity portion could swing wildly and the enterprise value wouldn't move as much. I've heard the argument that a lot of the debt does not have to be paid by the parent, but I'm not sure how accurate that is.

 

Also a statement on book value. Companies trade often trade below book value if they're not using their assets effectively or generating an adequate return, and above if they're generating above average returns. Posco right now falls into the former, so some discount is warranted.

 

Hope this helps.

 

How much of that consolidated debt is for the actual steel company? It doesn't seem fair to count the debt of all of the subsidiaries but not include their assets, revenues, operating income, etc. Especially if the debt isn't recourse to the parents (which was my understanding for a good amount of it). I certainly agree there are headwinds - the recent devaluation of the Chinese Yuan isn't going to be kind to them, but I think they'll come through and the industry will be more consolidated at the end of it pointing towards higher profit margins for those that remain.

[merkhet]

I finally got into PKX at $40 a share.  i'm surprised it's going lower.  Please share what you think the lowest price you think it can go in 2 years.  I think it's a bit crazy how far below book value pkx is selling.  just the real estate they own must be worth billions.  with that said, i don't want my stock going down 50%.  Pls advise.

 

That's not a question that anyone can answer for you. If we knew things like that then none of us would need to be value investors...

[stahleyp]

I'm being a d-bag here, but I'd think the lowest price it can go within 2 years is probably $0. I'd be very surprised if it went below that.  :P