Description

Price: ADR: $68, Ordinary shares (005490:KS): 297,500

Market Cap: KRW 23.935T, $21.701B USD

Cash, Bonds and Securities: KRW 11.2T

Debt: KRW 8.663T

EV: KRW 21.402T

Korea's largest steel company, Posco, trades at the lowest valuation in at least the past 19 years, measured by price to book value which is a good metric to compare Posco’s valuation over time which currently stands at .54x compared to a 19 year average of 1.2x and a high of 2.3x. If Posco returned to its historical average price to book ratio of 1.2x, the shares would be worth $159 per share or 134% upside from today’s price. Additionally, Posco is currently trading for less than 50% of replacement value which is the largest discount in its history and is even greater than in 2009, when it traded at 60%. If Posco traded at the replacement value of its steel assets (which is in line with where its traded on average historically) it would be worth $169 per share (151% upside). Finally, a sum of the parts analysis yields a price of $155 per share (130% upside). I believe the reason for the mispricing is twofold. First, investors have been pulling significant sums out of emerging markets with $29B removed in 2013 from emerging market mutual funds and $30B in the first 6 weeks of 2014 alone. Second, the world steel industry is facing low capacity utilization and squeezed margins caused by falling steel prices and increasing iron ore prices. However, the world steel industry is showing many indications of a cyclical trough and an improvement in the oversupply issues caused by China. Investors are overly focused on near terms issues such as the oversupply situation in China and I believe this is more than priced in today. Posco’s trading price implies that steel margins will remain at all time lows in perpetuity, an outcome that is certainly not going to transpire.

Posco is the world’s best steel maker and investors seem to be ignoring a number of major positives unique to them. First, Posco has an enduring low cost advantage and is one of the most technologically advanced steel companies in the world. Posco’s net margins have exceeded its main competitors by 7.2% over the past 19 years. Posco has a more reliable cash flow stream and continues to make money despite the oversupply situation in the world steel industry, even as most of its peers lose money.

Second, iron ore represents the largest cost input and the current price appears unsustainably high with significant new supply coming onto the market in the near future. The largest iron ore market, Australia, is set to increase iron ore production from 554 MTPA to 831 MTPA over the next 5 years.

Third, Posco has a poor history of capital allocation. However, new management is much more shareholder friendly and investors have not taken notice. In March 2014, Kwon Oh-joon became the first CEO at Posco that wasn’t appointed by the Korean government. One of his major initiatives is to divest Posco of its non-core investments and return the cash to investors. Under the previous management team, Posco invested in a trading business, insurance company, healthcare, IT outsourcing and other non-steel businesses. If Posco were to sell just its four largest publically traded subsidiaries (which collectively are near breakeven) that would generate KRW 4.25T or nearly $13 per share in value (19% of the current market cap). Cash, bonds and marketable securities equal 47% of the market cap and are 10% of the market cap when netted against debt. Better capital allocation going forward is a big plus for shareholders and is being totally ignored by the market.

Fourth, Posco has steadily increased the percentage of high margin steel it sells and management is looking to increase the portion of higher margin steel going forward from 41% of production in 2013 to 48% in 2016. This will result in a higher EBITDA per ton over time.

Finally, Posco has hidden real estate value in its two ports. Posco has two of the largest steel facilities in the world – Pohang Steel Works with 17.3 MTPA of capacity and Gwangyang Steel Works with 20.8 MTPA of capacity. Both of these facilities are located on ports that the South Korean government gave to Posco. I believe the land of these two ports and buildings is conservatively worth at least KRW 7.6T or 34% of the market cap and likely much more.

Well known value investors have taken notice. Berkshire Hathaway owns 5% of Posco and Charlie Munger through Daily Journal has a stake in Posco. Mohnish Pabrai initiated a stake in Posco in Q2 2014 and the stock has declined since then.

One of the world’s lowest cost and most technically advanced steelmakers

Posco benefits from an enduring low cost advantage due to locational advantage of its two ports, intangible know how in operating large scale assets effectively, efficient plant design, superior technology and low labor costs. In addition, Posco’s high capacity utilization (99.3% in 2012 and 93.5% in 2013) when the industry is at 78%, increases its cost advantage because maintenance capital expenditures are divided over more tons of production. Posco has advanced to a point where it cannot be replicated even with billions in investment. Even in a commoditized steel market such as steel, certain businesses such as Posco can create enduring competitive advantages and are high quality businesses.

Posco has also continually invested a relatively higher amount in technology and the result is technology and factory automation that is superior to competitors. For example, Posco has spent $362B in R&D on a technology called FINEX since 1992 and opened its first facility with this new technology in 2004. FINEX allows them to substitute relatively more expensive coking coal and lump iron ore with cheaper iron ore fines that other mills cannot use and employ lower temperatures in the furnaces that reduce energy needs. A FINEX facility has 17% lower capital expenditure needs compared to the standard technology and lower operating costs by at least 20%.

Posco also has a culture of continually increasing efficiency and pursuing cost cuts. For FY ’14, Posco management has called for KRW 603B in costs cuts in its steel business driven by lower cost raw materials coming on line and improving operating technology.

Posco’s technological advantage is sustainable because management makes continued innovation a huge priority. Posco spent KRW 563B on R&D in 2013, which is more than any other steel company in the world (however it has been speculated that China’s Baosteel spends more than this). This is 10% more than both Japan’s Nippon Steel and Sumitomo Metal spent and twice ArcelorMittal’s R&D. The new management team is shifting Posco’s focus from diversifying its operations back to Posco’s core competency in steel. It’s developing advanced steel that can compete with rival materials such as aluminum and composites. Posco is also working on a technology that would reduce the production cost of stainless steel by 20% among other new technologies.

Much has been written about Posco’s low cost advantage including a Harvard Business Review case in 1997. Multiple factors contribute to Posco’s cost advantage. Posco’s two main facilities, Pohang Steelworks which was constructed in the 1970s and Gwangyang Steelworks which was constructed in the 1980s are each located on major ports given to Posco by the South Korean government.

Posco’s state of the art logistics infrastructure allows them to operate with 50% less raw material on hand (17-20 days) than its Chinese competitors. Posco also has an advantage in retiree costs. Posco is younger than many of its competitors and its retirement program works differently than those in developed countries. When workers turn 60, they are paid one month’s pay for each twelve worked. In addition, Posco is not responsible for medical costs once a worker retires.

The numbers support this thesis. Posco’s cost per hot rolled coil was $175-$180 in the early 2000s according to Harvard Business Review. This is the lowest of all its competitors that have costs that range from $210-$250 per ton. And over the 19 year period from 1995-2013, Posco had 7.2% higher net margins on average per year compared to its top competitors and Posco also never lost money during this period. The competitors Posco is compared against are Hyundai Steel, Nippon Steel, JFE Holdings, Baoshan Iron, ArcelorMittal, and US Steel.

Posco’s cost advantage can be seen in a distressed period such as 2009 when it made KRW 3.23T in net income and had four consecutive quarters of profitability and nearly all of its major competitors, Nippon Steel, Dongkuk Steel, Arcelor Mittal and JFE reported quarterly losses.

Overview of world steel industry supply and demand

Since 2001, world steel production has grown from 851 MTPA to 1,602 MTPA in 2013. China has increased production substantially and now produces over 50% of the world’s output at 779 MTPA in 2013. As a result of expanding capacity, the world steel industry has a capacity utilization of 78% today and industry margins are worse than 2009 levels. Factors such as declining steel prices, low capacity utilization, all time low margins are all signs of a cyclical trough.

There are some encouraging signs that China is beginning to rationalize its steel industry. In November 2013, China’s top bank regulator Shang Fulin said, “Banks must seek channels to clean up bad loans by industries with overcapacity to prevent new risks from brewing.” China is set to cut production by 100 MTPA in the next 5 years based on guidelines issued by the State Council in October 2013. It began to follow through by demolishing 16 oxygen furnaces and 10 blast furnaces (a total of 6.8 MTPA) in China’s Hebei province and the Jiagsu province has pledged to cut steel production by 7 MTPA over the next five years. In addition, on March 5^th at the National People’s Congress session, Premier Li Keqiang announced plans to curb pollution by trimming 27 MTPA of steel capacity in 2014, equivalent to 2.7% of China’s total capacity. He also said the government will take all steps necessary to meet the capacity shutdown target. This is alongside China’s plans to cut 100 MTPA of capacity by 2017 or 25 MTPA per year. Going forward, China is likely to have a substantial decline in net additions to steel capacity and it’s even likely that they will have a net decrease in capacity.

At some point the deteriorating fundamentals of Chinese steel companies will force production to shut down. In just the past year, profitability has declined significantly for Chinese steel companies with only 45% of steel producers in China operating at a profit in January of 2014, falling further to 35% in March of 2014. In the first quarter, utilization of Chinese blast furnaces was near 40%. Furthermore, in the first quarter of 2014, steel prices in China have fallen to production costs which indicates that a further fall in price is unlikely. Indications are that the historically low margins of steel producers is beginning to force unprofitable mills in China to close. In March of this year, Haixin Steel defaulted on its debt and suspended five furnaces located in the Shanxi province. This is the first time a Chinese steel company was allowed to default of its debt. Haixin was the largest steel producer in this province with capacity equal to about 1% of China’s capacity.

At some point the world steel industry will begin to rationalize as the supply demand imbalance improves as unprofitable steel companies close capacity. It addition, global steel demand is forecast to continue growing at a healthy rate. Zacks estimates that steel demand will grow by 3.3% in 2014 driven by emerging markets and improving automotive and nonresidential construction markets in the United States.

Although Posco does have direct exposure to China, I believe this risk is mitigated for multiple reasons. First, Posco trades at the cheapest level in its history and any risk posed by China is priced in. Second, the majority of Posco’s steel sold in China is higher margin cold rolled steel for the automotive industry. Selling to the automobile industry in China is a far better place to be because the automobile industry is likely to continue growing even if the real estate market faces further contraction in China. Third, Posco is diversified into a number of industries such as trading (27% of revenue), construction (10% of revenue), and others which include the power business (8% of revenue). And finally, the world steel market is in distress with many companies losing money. This is even more pronounced in China where only 35% of steel companies make money. Margins cannot fall much from today’s level without large losses industrywide and large amounts of capacity being shut down. Posco is less affected in this situation due to its lower costs. Taking into account the potential for a real estate slowdown in China is important, but this risk is more than justified by the discount Posco is trading at today.

Why Posco vs. other steel companies?

“I would argue that what POSCO does is not a commodity business at all – it's a high-tech business. They learned from Nippon Steel and they’re now even more advanced. I'd argue that if you have the most technologically advanced steel company in the world making unusual, [non-commodity] stuff, then business can be quite attractive for a long time.”

-Charlie Munger 2007 Wesco annual meeting

Posco is currently the cheapest of all its peers and it will be able to withstand poor market conditions if its peers face unprofitability or possible bankruptcy due to higher costs of production and higher leverage. Posco’s low cost advantage will be enhanced as it continues to invest in R&D, making its operations even more efficient as its competitors are forced to cut back to conserve cash. In a poor market environment like today, Posco will continue to have reasonable free cash flow while its peers operate at breakeven or in many cases a loss. For example, AcelorMittal lost $3.7B in 2012 and the entire Chinese steel industry (50% of world capacity) is operating at a net margin of less than zero.

Many of its competitors have financial challenges in terms of thin balance sheets and this suggests the odds are skewed towards Posco going forward. Posco has near the lowest leverage of all its peers. In addition, with iron ore prices potentially falling in coming years due to new capacity coming on line, the specialist low cost producer is poised to best benefit.

Posco also has an advantage in that it has right sized its operating footprint and is able to maintain higher capacity utilization in all market conditions. This is a huge advantage to have and results in strong recurring cash flows because Posco is able to spread certain costs such as R&D and maintenance capital expenditures over higher capacity utilization rates than peers. This is why Posco has been solidly profitable for a least the past 19 years. This results in less operating leverage when demand picks up but the advantages are clear and the downside is less in poor market conditions when competitors may face bankruptcy if conditions persist.

Korean importers find it very tough to compete with Posco and this has resulted in steadily increasing market share in Korea (2013 market share was 43% up from 39% in 2008). The advantage Posco had in the 2009 recession is even more pronounced. In 2009, steel tonnage demand dropped by 22% in Korea and the worldwide utilization rate fell to 58%. However, Posco’s utilization rate only dropped to 90% as Korean importers were unable to compete with Posco and incurred volume declines of 50% or more.

Posco has a natural advantage by maintaining capacity utilization near 100%. Maintenance capital expenditures should average about 7% of the installed cost for an integrated steel mill (less for a steel mini mill). Less competitive steel companies are forced to dedicate a larger portion of the sales price to maintenance capital expenditures and with the world steel market at a capacity utilization of 78%, Posco has a big advantage. Because of this Posco actually has an additional advantage in tough market conditions. If industry fundamentals were to erode further from here, Posco would be impacted less than its less competitive peers due to its cost advantage and high capacity utilization. Many of Posco’s competitors today are operating on thin margins and over leveraged balance sheets. As this causes some of these less competitive steel companies to under invest in maintenance capital expenditures, Posco’s advantage long term will be further enhanced. In a weak steel environment Posco’s advantage is clear. It’s able to expand production and take market share from weaker rivals that are forced to cut back with less efficient facilities.

Iron ore capacity will significantly outpace demand in the next few years

Posco uses 1.7 tons of iron ore per ton of steel and this represents 20% of its gross cost per ton of steel produced. Since 2009, iron ore prices have increased significantly. Prior to the big run up in iron ore beginning in 2009, iron ore represented 13-15% of Posco’s cost per ton of steel produced. High iron ore prices have caused a wave of planned supply that will be hitting the market in significant quantities over the next few years from miners such as BHP Billiton, Vale and Rio Tinto. Based on the cost curve of iron ore producers and the historical average ratio of steel prices to iron ore, the price is likely to remain at the lower level it’s fallen to this year. Iron ore prices are currently around $70 per ton vs. $135 per ton in December of 2013. There is a 9-12 month lag time before Posco will benefit from these lower prices.

According to Deutsche Bank, big miners such as BHP, RIO and Fortescue are in the process of adding 80-100 MTPA of supply in 2014. Additionally, India placed a ban on iron ore mining in 2012 that displaced 46 MTPA in exports. The government has asked the Supreme Court to revisit the issue and this could lead to overturning the ban. In October of 2013, Vale’s head of Ferrous and Strategy Jose Carlos Martins said iron ore supply is expected to grow faster than demand going forward. By as early as 2015, the market will be in oversupply. According to Goldman Sachs, the world iron ore market will be in oversupply in 2014 by 82 MTPA. Many large projects are expected to begin coming online including a $20B project built by Vale in Brazil. This will be the world’s largest iron ore complex and will add 90 MTPA of capacity expected to begin production in 2016. Australia is the world’s largest iron ore exporter and over the next five years, Australia’s iron ore exports are expected to increase from 554 MTPA to 831 MTPA.

Valuation

Sum of the parts

Steel has seen operating income decline from KRW 4.92T in 2011 to KRW 2.34T in 2013. In a normal environment, the steel business should achieve 11% margins vs 2% currently. Furthermore, over the past 10 years, Posco has achieved an average EBITDA per ton of KRW 195,700 ($190 USD). Posco is currently operating at about 50% of this level. At the current level of capacity, using historical margins this business will earn EBITDA of KRW 7.9T. Steel is worth KRW 44T based on 5.5x normalized EBITDA. This value equates to $982 per ton or slightly below the replacement value of the assets. Capacity is also likely to continue growing at 4% per year.

Daewoo International is Posco’s trading subsidiary that imports and exports products and commodities such as non-ferrous metals, steel, iron, automotive parts, machinery, plant equipment, textiles, electronics etc. Posco owns 60.3% of Daewoo which is worth KRW 2.3T on the public market.

Other public subsidiaries include 29 other public subsidiaries that Posco owns. Collectively, Posco’s ownership in these companies is worth KRW 4.52T on the public market.

Posco Energy is the largest domestic provider of energy in South Korea. Posco owns 89% of this business which is worth KRW 4.5T based on 9x 2014 EBITDA.

Posco Engineering and Construction, is engaged in the planning, design and construction of architectural works, industrial plants and civil engineering projects. This is hidden gem within Posco. Posco E&C grew 47.5% in 2013 to KRW 10.8T in revenue. This business has become a leader in South Korea and I believe this business could have orders of over KRW 50T by 2020 and revenue in excess of KRW 30T. Posco E&C is likely to have profit of KRW 550B in 2014. I value this business at KRW 5T and Posco owns 89.5%.

Sum of the parts. In total, Posco’s 3 operating businesses (steel, energy and E&C) are worth KRW 52.5T. Adjusting for cash, bonds and investments of KRW 11.3T and total parent debt of KRW 6.8T, brings Posco’s intrinsic value to KRW 55.1T or $155 per ADR (upside of 130%).

Book value and replacement value

Book value is a rational lens to analyze the value of Posco over time. Purchasing shares in the world’s best steel company at its lowest valuation in history is a no brainer. Posco trades at .52x book value compared to a 19 year average of 1.2x. If Posco simply traded at its historical price to book it would be worth $159 per share or 134% upside. Even if this takes until the end of 2016 to achieve, that would result in a 40% annual return when the dividend is included. And since Posco is profitable, book value will continue growing.

Posco’s discount to replacement value also stands at an all time low. Valuing Posco’s steel assets at KRW 1.086M ($1,066 USD) per ton or KRW 46.7T. The value of Posco’s land is conservatively worth KRW 2.241T just in Posco’s steel businesses as of March 31^st 2014. This is the value of the land carried on Posco’s books that was acquired over 40 years ago at below cost and I believe this value could be much larger. In total, the steel business has a replacement value of KRW 48.9T. When this value is added to the value of Posco’s other businesses (Posco E&C and Posco Energy = KRW 8.480T - see below) and cash, securities and bonds minus debt which adds another KRW 2.6T, Posco is worth KRW 60T or $169 per share (151% upside). Posco trades at less than 50% of replacement value, a valuation cheaper than the distressed period of 2009 when it traded at 60% of replacement value.

In Summation

Posco’s new management team is much more shareholder friendly than the previous management team. This is a game changer and investors have not taken notice. The previous CEO’s focus was on empire building and this resulted in Posco acquiring a trading business, a biotechnology company, a gas field based in Myanmar and the list goes on. Shareholder value was destroyed by doing so. However, the new management team lead by CEO Kwon Oh-joon is focused on enhancing the existing business via organic growth and reducing leverage. In addition, four out of five board members have been replaced and three new independent board members have been added. He is also planning to sell, IPO or spin-off non-core assets. Selling or spinning off some of these non-core divisions would unlock a significant amount of value. For example, Daewoo International is worth $8 per ADR alone and in 2013 barely broke even (profit was KRW 10B), less than 1% of Posco’s overall profit. In total, Posco’s publically traded subsidiaries are worth $19 per ADR (27% of the current market cap). Cash, securities and bonds are worth KRW 11.3T or 47% of the market cap and are greater than parent debt of KRW 8.663T. Management has signaled that additional assets will be divested such as Posco Energy, Posco Engineering and Construction, and Posco Specialty Steel. Based on my analysis of price to historical book value, price to historical replacement value and sum of the parts, I believe Posco is worth $155 - $169 per ADR compared to a market value today of $68 (upside of 130-151%).

Catalyst

1) Improving steel market from trough EBIT per ton, 2) lower iron ore prices, 3) better capital allocation and sale of non core assets, 4) increasing production of higher margin steel.