It looks like a new day for POSCO (NYSE:PKX), Korea's giant steel company, as new management has made it clear that the empire-building of the past is going away in favor of a greater focus on margins, returns on capital, and businesses with long-term competitive advantages. The shares look like a decent enough value on near-term EBITDA, but the long-term potential is more attractive if the company can get back to mid-single digit ROEs in a year or two and double-digit ROEs down the road.
Big, But Not Always The Best
POSCO is the world's fifth-largest steel producer on a production basis, trailing world leader ArcelorMittal (NYSE:MT) by a very large margin, as well as #'s 2-4 (Nippon Steel, Heibei, BaoSteel) by more than 20%. POSCO holds around 50% of the Korean domestic market and has largely focused on cold-coiled, hot-rolled, and plate steel used in applications like autos, shipbuilding, and appliances.
POSCO produces the overwhelming majority of its steel in blast furnaces, but has stood out from the global crowd with superior technology. To name just one example, the company's FINEX process (an advanced smelting and reduction technology) allows the company to produce pig iron with fine iron ore and non-coking coal, both of which are cheaper. POSCO has also developed a number of processes to produce higher-quality premium steels that carry substantial margin advantages over crude steel products (mid-teens margins versus low single digits).
On the supply side, POSCO has kinda-sorta followed in the path of ArcelorMittal and other integrated steel companies in terms of supply integration. POSCO doesn't control its iron ore supply, but it does hold minority stakes in a number of mines and sources almost 45% from these mines. Management has been comparatively less aggressive in vertically integrating its coal needs, though its ability to use cheaper coals mitigates some of that.
While POSCO is a pretty well-run steel company, management's past adventures in diversification have diluted the benefits. Only about 50% of the company's revenue (but more than two thirds of operating profits) come from the steel operations and the company owns stakes in a variety of non-core operations, including POSCO Energy (a power generation company), Daewoo International (a trading company with a sizable E&P operation in Myanmar), and lesser operations like a department store.
New Management, New Discipline
POSCO appointed a new CEO in March of this year and he has wasted little time in setting out a different direction for the company. Back in May, he laid out a set of restructuring plans that will see POSCO focus not only on higher-margin steel products, but also the exit/sale of unprofitable and non-core businesses.
Management would likely prefer to take POSCO Energy and POSCO Specialty Steel public via IPOs, and both look like viable candidates for such a move. POSCO Energy operates more then 3.3GW of electrical generation capacity in Korea, Indonesia, and Vietnam and recently acquired Tongyang Power and the right to build two 1GW coal plants.
Ideally management will move forward with sales of stakes in Daewoo International and M-Tech. Owning a trading operation isn't necessarily illogical for a steel company, but POSCO management made it clear that they only want to retain businesses that are #1 in Korea, globally competitive, and support the core steel operations. With that, the company's future forays outside of steel are likely to be centered around source materials and clean energy.
POSCO has just given further evidence that it's serious about value creation, or at least avoiding its destruction. The Korean Development Bank was pressuring POSCO to acquire certain operations of Dongbu Steel, a struggling small Korean steelmaker, and POSCO announced on June 24 that it had decided against the move. As it would have likely been a waste of nearly $1 billion, I am pleased to see that decision.
Looking For A Recovery Trade
As part of its restructuring efforts, POSCO talked of trying to increase its percentage of sales from high-quality premium products from 31% in 2013 to 41% in 2016. POSCO isn't the only steel company to be competing for business in sectors like autos and energy (sizable users of that specialty steel), but it would be a strong aid to margins.
All in all, I like the recovery/restructuring theme at POSCO. It has definitely helped the shares of ThyssenKrupp (OTCPK:TYEKF), up 50% over the past year, and POSCO has been a laggard when compared to ArcelorMittal and its Korean rival Hyundai Steel. I believe a recovery in the global steel market and upgrading the volume mix can support mid-teens annual EBITDA growth over the next three years and a 7.5x multiple to 2014 EBITDA is not out of line with this point in the cycle (suggesting a $75.50 fair value).
Add in the potential of overseas projects in Indonesia and India (a project which has seen years and years of bureaucratic problems and setbacks) and the prospect for improving ROEs and I believe these shares can move closer to their regular multiple of 0.8x to 0.9x book value (versus 0.55x) today. Clearly, such a re-rating would be significant for the shares, taking them closer to $100.
The Bottom Line
Just because ThyssenKrupp has enjoyed a good run on the back of substantive restructuring, that is no guarantee that POSCO will follow that path. Nevertheless, I like the vision laid out by POSCO's new CEO and the early test of its discipline with respect to Dongbu Steel.
Assigning the "right" multiple to a steel stock definitely involves a lot of subjectivity; past cycles, ROE, and growth guidance can give some general guidelines, but it's an imprecise exercise. With that, I'll note that ArcelorMittal offers more upside at a 6.5x multiple to 2014 EBITDA estimates than POSCO does at 7.5x, while Ternium (NYSE:TX) and Gerdau (NYSE:GGB) likewise offer more upside on lower assumed multiples. I would argue that reflects a more challenging near-term outlook for the Korean economy, and I believe that POSCO is a worthwhile stock to consider for those investors who have the patience to watch the steel recovery cycle play out.
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