Investors warmed up to the idea of upcoming recoveries in many industrial markets in the second quarter, but that love didn’t extend to the steel sector to nearly the same extent, even though mining companies like Rio Tinto (RIO) and BHP (BHP) have done quite well. I think there are valid reasons for this (overcapacity, weak pricing power, input cost pressures, et al), but I do think sentiment should start to bottom out relatively soon.
I had mixed feelings about POSCO (PKX) after the first quarter. I think this is a pretty good steel company, and the shares looked considerably undervalued. Still, I was worried about that sentiment issue. Since then, POSCO has done better than most other steel companies (including ArcelorMittal (MT)), but not as well as the S&P 500, and certainly not as well as the miners. At this point, I like the prospects for meaningfully better financial results in 2021 and 2022, and I don’t think that’s reflected in the share price. This will never be a buy-and-hold call, but I think this is a time to consider the name as cyclical rebound story.
Weak Results In A Tough Environment
No steel company is reporting good results now, and POSCO is no exception, as the company has had to deal with COVID-19 shutdowns, protectionism, and a volatile input cost landscape. While consolidated results were considerably better than expected (a 60%) beat, the steel business generated its first loss in decades (possibly ever; I couldn’t find reliable numbers beyond a couple of decades), and the loss was quite a bit bigger than the sell-side had expected.
Revenue at the unconsolidated (parent company) level declined 21% yoy and 16% qoq on volume declines of 11% and 10%. While POSCO has been trying to upgrade its mix and shift more business to Korea during this period of protectionism (aiming to take share from imports in Korea), domestic shipments declined 16% yoy and 10% qoq, while exports declined 5% and 9%, respectively.
Pricing was no help, with realized prices down 16% yoy and 7% qoq in won. Hot-rolled was down 16% and 7% (20% and 9% in U.S. dollars). Plate fared better (down 4%/flat in won), but it was a weak price deck across the board.
Gross margin fell about 11 points year over year and eight points sequentially, staying just barely positive. EBITDA fell 66% yoy and 56% qoq, with per-ton EBITDA down 61% and 52%, respectively. As I said, operating income went into the red.
The company’s non-steel businesses fared better, with revenue down 15% and profits down 10%, but still staying slightly positive (margin of 2.5%). The chemicals business was quite weak on lower oil prices and an inventory charge for the cathode business, but the energy, engineering, and oil/gas businesses did comparatively better with strong gas sales in Myanmar in the oil/gas business (POSCO International).
Waiting For End-Market Recoveries
While the businesses and markets are certainly different, POSCO is in many respects in the same boat as ArcelorMittal, Nucor (NUE), Steel Dynamics (STLD) and other local, regional, and global steel companies. COVID-19 shutdowns (and the subsequent recession) have hammered all manner of steel-using industries, with auto production down approximately 50% in the second quarter.
The auto market is a particularly important one for POSCO, as the company sells a range of higher-price, higher-margin products, including cold-rolled sheets. To that end, sales of high-margin auto steel panels were down about 40% qoq, meaningfully undermining POSCO’s realized pricing and margins.
Non-residential construction activity has generally held up better, but that doesn’t help POSCO much, as the company doesn’t have a lot of leverage to the long steel products used in construction. At the same time, markets that make use of plate steel (a higher-margin subtype) like energy and shipbuilding have been pretty soft (some marine businesses have been strong, but not basic shipbuilding).
The good news for POSCO is that I believe the worst is over for the auto sector. The third quarter is likely to still see a sharp year-over-year decline in production, but there should be a meaningful sequential improvement, and production should improve in 2021. POSCO should also benefit from its leverage to the Chinese auto market as well as its leverage to specialty steels used in hybrids and EVs.
As for other markets, I’m skeptical that energy or shipbuilding will be strong in 2021 and may only just be starting to recover in 2022. “General industrial” use and appliance demand should improve, though, and I think, on balance, about 65% to 75% of POSCO’s end markets should be recovering in 2021.
I’ve detailed some of the savvy moves that POSCO has made to improve its steel product offerings and its global positioning in recent years, and I think those improvements will pay dividends across the next cycle. I also see upside in non-steel operations like lithium batteries, but I do still fundamentally dislike the “conglomerate” aspect of POSCO. It’s not likely to change, though, so investors need to make their peace with it.
I do expect significantly better revenue, EBITDA, and FCF performance in the next few years, but this is still a steel company and the cycle is unlikely to change fundamentally. To that end, I wouldn’t expect more than low single-digit revenue growth, as POSCO will always be pressured by global competition (including improving steel grades from China). I do expect some improvement in long-term margins and FCF generation, but I think we’re still talking about a low-to-mid FCF margin on a long-term basis.
The Bottom Line
Whether I use discounted cash flow or ROE-driven price/book, POSCO looks meaningfully undervalued. That’s true for many steel companies, though, and investors need to be prepared to wait a bit for the cyclical rebound to take hold. Once it starts, it’ll probably go quickly. Although you often make more money holding inferior companies in up-cycles (I know, it sounds weird…), I think POSCO has the potential to do pretty well, and I think it’s worth a look now.
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.