South Korean Steel: All Fired Up
POSCO (NYSE: PKX), formerly known as Pohang Iron & Steel, is South Korea’s largest steel producer with a 41 percent 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 percent of that total with the remainder destined for Korea’s domestic market. The company is the fourth-largest steel producer in the world.
As with most other steel producers, POSCO has been suffering from weakness in steel prices and slowing demand, particularly in emerging markets. In the second quarter of 2012, the company reported earnings of 704 billion Korean won (USD630 million), down 44 percent from the same quarter of 2011 and below analysts’ consensus estimates. POSCO also cut its sales targets for the full year a second time in 2012, citing a volatile business environment and weaker-than-expected demand for steel from the construction and shipbuilding industries. Second-quarter profit margin was 11.5 percent, down from 14.9 percent in the same quarter a year ago.
However, news from POSCO was far from all bad and there’s growing evidence the company is at the bottom of the steel cycle. Management noted that while steel demand is likely to be weaker in the second half of 2012 than it had expected at the beginning of the year, falling raw materials costs are boosting profitability.
Although carbon steel prices were down slightly between the first and second quarters of the year, POSCO’s operating profit jumped from 4.5 percent to 11.5 percent, thanks to falling raw materials costs. The company is also benefiting from a cost-cutting campaign focused on altering its raw materials mixing ratios and reducing energy costs that’s expected to save this year over 1 trillion won (USD900 million).
In addition, the company indicated that China’s domestic steelmakers are experiencing extreme pressure on profitability, stemming from the steady downtrend in prices in the first half of the year. The result has been reduced output, a trend covered at length in today’s feature article on steel.
Finally, management is in the camp that the Chinese economy will begin to pick up later this year, aided by government stimulus that helps to boost demand. Their best estimate of timing for a steel price recovery is the end of the third quarter into the fourth quarter. Management also indicated that average selling prices for its steel products are expected to recover in the fourth quarter, boosting margins.
Another consideration is the type of steel the company produces. Flat, rolled steel products are primarily used in industries outside the construction sector, including appliances and vehicles manufacturing. Demand for these sorts of products is holding up better than demand in construction. Investors are likely to continue to favor steel producers focused on flat products over those oriented toward coil and rebar steel. South Korean steel producers such as POSCO tend to focus more on steel used in industries such as automobiles and appliances.
The company saw a solid rebound in steel sales into certain end-markets. For example, sales to the automobile industry jumped to 1,981 thousand metric tons, up 2.6 percent compared to the first quarter and 3 percent compared to the same quarter last year. Sales of steel for the home appliance market jumped 5.2 percent year-over-year.
POSCO is considered one of the lowest-cost producers of the types of steel used in automobiles and other value-added industries and has been gaining share in supplying steel to the Japanese auto and manufacturing industries. Moreover, the forthcoming merger between Nippon Steel Corp (Tokyo: 5401) and Sumitomo Metals (Tokyo: 5405), two major Japanese steel manufacturers, offers another business opportunity for POSCO. The merged entity would control 60 percent of the massive Japanese auto steel market, a level of supplier concentration that’s uncomfortable for manufacturers.
The most likely outcome is that suppliers will seek to diversify their supply chains by purchasing more steel from other manufacturers; as a leader in price and quality, POSCO is an obvious alternative. The firm also recently joined a group of subcontractors called Kyohokai that’s aligned with Toyota Motor Corp (TYO: 7203), giving POSCO an inside track with Japan’s largest automaker. Sales to the Japan auto sector would carry higher margins and diversify the business further away from its historic reliance on domestic sales.
With the steel cycle bottoming and POSCO trading around 0.4 times sales, the stock is already pricing in a great deal of bad news on steel prices and demand. If the steel market picks up even modestly in the second half, tremendous upside potential awaits the stock. Buy POSCO under 88.