POSCO's Share Price Seems To Be Predicting A Lot Of Doom And Gloom

Summary

• In addition to generalized anxiety over steel prices and spreads, POSCO may well be suffering from the current weakness in global auto production - a large and higher-margin market.
• POSCO's capex plans suggest significant spending increases (including investments in new ventures outside of steel) and not much emphasis on shareholder returns.
• POSCO shares look exceptionally cheap by many metrics, but the market sentiment on steel stocks is pretty awful right now.

Add POSCO (NYSE:PKX) to the list of steel stocks with a confounding valuation, as investors seem to be pricing in a dire future that doesn’t seem fully justified by the financials. The trouble with cheap-looking valuations in commodity stocks is that you can be generally right about a “it won’t be that bad” thesis, and still see significant near-term declines as investors bail out of the sector on weaker prices and spreads.

POSCO shares look exceptionally undervalued now, so much so that I really have to second-guess what I’m missing in my modeling and analysis. While POSCO’s exposure to a weakening auto industry is a worry, as is the company’s new capex-heavy strategic plan, the market seems to be pricing in a pretty dire future for what I believe is at least a decently-run global steel major.

Weak Auto Trends Not Helping

I’ve talked a lot about recent steel price weakness in articles on Steel Dynamics (STLD), Nucor (NUE), ArcelorMittal (MT), and Ternium (TX), and those pressures do also apply to POSCO to some extent, though POSCO ships very little steel to the U.S. (where prices are still very strong on a comparative basis), and much more than these other companies to China (where prices have been weaker).

What also may be hurting POSCO is its particular end-market exposures. POSCO is uncommonly leveraged to auto production, with more than a quarter of its steel going to global automakers (and POSCO supplies more than 50% of the sheet steel needs for over a dozen automakers). Not only does the auto end-market account for more of POSCO’s mix than any other steel company I follow closely (except stainless specialist Voestalpine (OTCPK:VLPNY)), POSCO is more heavily leveraged to higher-value steel varieties, which means that its operating profit exposure to autos is even higher than its revenue exposure.

Right now, that’s not such a good thing. While unit volumes in the U.S. haven’t been so bad (down 1% in November), Europe has seen a high single-digit drop, while China has now seen four straight negative months, with unit sales down 12% in October. With 70% of the steel that POSCO ships to China going to auto OEMs (and most of the rest going to manufacturing companies that are also seeing weakness), it’s not a great volume demand environment for POSCO at the moment.

Along similar lines, other than in plate steel, POSCO is not strong in the areas of steel that are generally holding up better. POSCO has relatively little exposure to long steel, and less than 5% of the company’s volume goes to the construction markets that have proven generally healthy for companies like ArcelorMittal, Nucor, and Steel Dynamics.

The New Strategy Is Not What Shareholders Wanted

POSCO previewed its future capex plans in early September, and the reaction was swift and negative. Management quickly backpedaled, trying to soften the blow, but has since repeatedly put out conflicting signals, apparently trying to appease all of its constituencies (shareholders, employees/unions, the South Korean government, et al) while forgetting that all of these groups can see/hear what they’re saying. Matters really didn’t improve much when the company followed up in early November with the new CEO’s comments on his strategy and priority for the company in the coming years.

On the capex side, POSCO floated the idea of spending KRW 45 trillion between 2019 and 2023 – an annual level of spending that would roughly double the average spend from 2015-2018 (using an estimate for 2018, of course). Management quickly tried to backpedal, explaining that KRW 15 trillion of that was “reserved” for possible future use and that it wasn’t necessarily committed to even spending the full KRW 30 trillion. Even so, the KRW 45 trillion number appeared to be split about 60/40 between supporting the existing business (capacity upgrades and the like) and expanding new businesses like EV battery materials (an area that could get around KRW 5 trillion of capital investment over the next five years).

Part of the capex plan, and again reiterated with the CEO’s strategy discussion, were several mentions of serving the “public interest” which the market has taken as a not-so-coded message regarding wages and personnel hiring initiatives meant to support the South Korean’s government to improve unemployment and earnings in the country. While large corporations always have to balance competing interests, shareholders didn’t like what they interpreted as a sign that POSCO may not be so disciplined on spending/efficiency in the coming years.

Management also came up short in terms of its strategic priorities. The company's goal of focusing more on high-end steel products is fine, and a continuation of what the company has already done in steels for markets like autos, appliances, and motors. Likewise, while the company’s decision to invest in EV battery materials is controversial and a step beyond its specialization in steel, it makes some sense to me.

What I didn’t like was that the company’s plans for further streamlining and simplification of the business were not even slightly ambitious. I also got the sense, and this is just my subjective opinion, that shareholder returns really aren’t a priority for management – that’s not really a new issue here (POSCO doesn’t have a great record of prioritizing the shareholders), but it certainly cools the hopes some investors had that this was starting to change.

The Outlook

POSCO’s core steel operations are doing relatively well right now – the third-quarter EBITDA margin of 14% isn’t bad compared to ArcelorMittal or Nucor, and Chinese curtailments during the winter should offer some support to pricing and spreads. I’d also note that POSCO is one of the few steel stocks I follow where the average sell-side estimates call for year-over-year EBITDA growth in 2019 and 2020. Although autos and manufacturing look a little weak now in many of POSCO’s core markets, I think the longer-term prospects for above average demand growth (above the global average demand growth for steel, that is) are good.

I’m only looking for around 2% to 3% long-term revenue growth from POSCO, with not much long-term improvement in FCF generation. While a discounted cash flow approach suggests POSCO is undervalued, that’s not a commonly-used valuation approach in the sector.

EV/EBTIDA and ROE-P/BV, though, also suggest that POSCO is undervalued. Even at 4x forward EBITDA (and 4x would be a low multiple for POSCO on an historical basis), the shares would seem to be about 25% undervalued, and a forward ROE assumption of about 7% would support a substantially higher fair value. The relationship between ROE and P/BV multiples has generally been consistent and reliable for steel stocks over the years, but has recently broken down for many global steel names, with the valuation suggesting a much worse outlook for steel company profits than even bearish analysts are projecting.

The Bottom Line

As I said in reference to ArcelorMittal (and some other steel stocks), there is a dichotomy now between what would otherwise seem to be a normal or fair valuation for these stocks and the reality that steel stocks often underperform when prices and spreads start falling. While capex investment plans have been accelerating, I don’t see today’s steel environment as a “bubble” and the very negative sentiment on the sector is a little more difficult to reconcile. While I do think POSCO shares look surprisingly cheap, I’m reluctant to argue with the market right now and I’m personally tempted to wait a bit longer to see how the next quarter or two develops before taking the plunge.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.