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Korea Primary Metals: Weak Results Expected For Q2, Price Hikes Unavoidable In H2

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Includes: HYNSY, PKX
by: Hyundai Motor Investment & Securities
Summary

Lackluster 2Q19 results expected. Conditions to become ripe to raise domestic steel prices in 2H19.

Valuations attractive with steel shares trading at historically low P/Bs.

Overweight on the sector, top picks are POSCO, Korea Zinc, and Hyundai Steel.

2Q19 review: plate cost hike burdensome, rebar makers outperform

The combined parent operating profit of the primary metal companies in our coverage in 2Q19 will likely come down 8% YoY but up 6% QoQ. Our forecasts are mostly in line with consensus estimates.

We believe blast furnace names and flat product makers weighed on 2Q19 earnings, as steel prices could not keep up with rising iron ore prices. This is mainly due to the quarterly/half-yearly contract structure, weakness of Chinese dealer steel prices, and anemic domestic demand. On the other hand, electric arc furnace players and rebar manufacturers probably enjoyed a modest quarter thanks to favorable seasonality and a sound rebar spread amid steel scrap price corrections.

2H19 outlook: improving Chinese market and growing need for Korean players to raise prices

We maintain Overweight on the steel and nonferrous metal sector for 2H19 for the following reasons.

First, Korean steelmakers are expected to increase their domestic steel prices. The sharp rise in iron ore spot price (USD123/tonne as of July 4, up 73% from USD71/tonne seen at the beginning of the year) is believed to have raised the blast furnace production cost by KRW50,000/tonne. Bound by three/six-month contracts, these companies were unable to raise steel prices in 1H19 so steel price hikes are unavoidable in 2H19. Japanese steelmakers have announced a steel price increase of JPY5,000/tonne in 2H and US steelmakers are doing the same.

Second, Chinese dealer steel prices are expected to rebound in 3Q19. Despite strong seasonality, Chinese dealer steel prices have suffered corrections since mid-April due to weakening demand and increased production from small blast furnace names. However, these small Chinese players’ production volume is unlikely to increase further in 2H, so the possibility of price distortions is limited.

Third, while production activities in major downstream industries in China are sluggish (with the exception of the real estate sector), government-led efforts to stimulate the economy, such as increased issuances of local government bonds, should boost demand from the infrastructure and machinery sectors in 2H19.

Fourth, assuming the US Federal Reserve goes for an interest rate cut, nonferrous and precious metal prices are expected to rebound too. Historically, when the Fed lowered interest rates, the USD weakened while nonferrous and precious metal prices strengthened.

Fifth, further downside is limited for steel shares, with stocks trading at the lower end of their historical P/B bands. As sector fundamentals improve, their attractive valuations will be highlighted.

We present POSCO (PKX), Korea Zinc, and Hyundai Steel (OTC:HYNSY) as our top picks.

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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.

Additional disclosure: Hyundai Motor Company is a passive shareholder in our bank.