Steel Giant POSCO at Bottom of Counter-Cycle; Cheapest Since 1993

POSCO is one of the frontrunners in the steel industry. Its numerous low cost advantages help it maintain that stature and enable it to grow and prosper. POSCO's stock is undervalued due to recent low profits caused by the escalation in raw materials costs coupled with the decline in steel prices (caused by the oversupply of steel). Investors seem to be fixated on these temporary setbacks while POSCO has great long term prospects and solid fundamentals. POSCO has an intrinsic value of $129.35/share along with a 49.175% margin of safety. I recommend a long position for this company.

Opportunity:
The steel market is suffering from high input costs and low selling prices. The oversupply problem in China caused steel prices to contract, and gave a negative outlook on the industry. This caused a lot of steel companies including POSCO to suffer. However, the long term looks bright for POSCO, and a recovery coupled with an increase in earnings is forthcoming due to the rise in demand of steel, future reductions in supply of steel, and the company's recent diversification ventures. POSCO's market price is $65/share (as of 03/20/14). It's trading at 14x earnings and has an intrinsic value of $129.35/share (49.75% Margin of Safety), based on the reproduction cost of its assets.

The Consensus View:
There are several reasons why POSCO is cheap, and out of favor in the market. The Chinese overcapacity problem has left many investors afraid to invest in POSCO, fearing a halt in the capex-led boom in china that would lead to a flood of underutilized steel in the market, which will in turn hurt all steel manufacturers including POSCO. Revenues and profits fell, as result of a world-wide structural overcapacity in steel and a recent upsurge in the price of iron ore and coal. Foreign currency fluctuations also affected POSCO's profits. Competition from global steel manufacturers, and new market entrants, pose a threat to POSCO's margins and profits, and were viewed as a disadvantage for POSCO. As a result, investors were skeptical towards the stock, and left it valued in the market at a discount.

My Variant View:
POSCO has been one of the best performing companies in the steel industry for the last 20 years. It has incurred consistent high returns and was also able to consistently incur higher profits and margins than its competitors. It was able to successfully do so due to its ability to maintain a low cost structure that no competitor has been able to emulate.

Demand:
Stable growth in consumer industries such as construction, infrastructure, auto manufacturing, and shipbuilding in Asia will result in a steel demand increase. Steel prices are expected to start rising again in the next 3-5 years. Steel price and demand could also increase in the short term, due to the improved economic prospects in Europe and the Americas. The price of steel is forecast to increase at rate of 2.2%/year in the next five years. In addition, Korea's Steel demand is projected to grow by 4.0%, and POSCO's demand is expected to increase by 3.5% in 2014.

China has not yet completed its industrialization and urbanization. In the next 5-7 years the demand for steel is expected to continue its growth. Moreover, even if Chinese construction slowed, and the capex-led boom decelerated, steel would still be in use as capital goods' (airplanes, trucks, engines, climate control and automation) demand for it would accelerate, as they are required for deployment.

Raw Materials:
Heavy exposure to the prices of iron ore, coal, and nickel, POSCO's largest cost components, creates a challenge to managing input costs. In the wake of rising raw material costs, POSCO has committed to raising its self-sufficiency in iron ore to 50% from the current 30% by the end of the year, mainly through its investments in the Australian Roy Hill and the Australian Premium Iron projects. Furthermore, overseas investments in Brazil, Vietnam, Indonesia, and a number of other emerging economies will pay off in the form of lower input costs for certain raw materials.

As the steel supply-demand ratio moves into equilibrium, steel prices will recover. The recovery in prices and the lower raw materials costs should result in higher profitability and margins in the long term. In addition to the supply-demand dynamic, POSCO also has other key drivers in the form business and global diversification.

Business Diversification:
POSCO decided to try to increase its competitiveness by diversifying its business. POSCO did this to increase its exposure to non-steel industries (energy, materials, & gas) in order to hedge its current situation and improve its current overall profitability.

Global Diversification:
POSCO has been expanding its operations around the world to try to increase its presence and tap new markets. The company has recently completed plants in Indonesia and Turkey. POSCO's recently completed subsidiary in Indonesia is projected to generate an additional $2.4 billion per year in sales. Furthermore, POSCO has also received final permission to construct a $12.6 billion FINEX plant in India that is projected to generate a lot of revenues. Finally, POSCO recently set up plants in Chile and Argentina for its upcoming lithium ventures.

Costs and Margins:
POSCO's margins were all down this year. They were all down mainly due to the decrease in revenues that was caused by the overall lower steel demand and prices last year. Revenues & COGS both decreased by a similar amount so the change in Gross Margins wasn't that big. A recent hike in Advertising costs along an increase in salaries by about 9% caused its Operating Margins to decline. The steelmaker recently focused its corporate resources on the promotion of its electrical steel sheets, and other related EV parts. POSCO's executives recently announced that they will voluntarily rescind up to 30% of their salaries until the company's profits begin to improve. This has the potential to improve future operating margins and it is also a sign of management's confidence in POSCO's future.

Competitive Advantages
POSCO's low cost advantage stem from its economies of scale, its low cost operations, advanced technology, intangible know how in operating large scale assets efficiently, the strategic location of its ports, and retirement costs.

Catalysts
New Management: POSCO has always been known for its excellent and efficient management team. The company made many advances in enhancing its corporate governance. Its management team has been able to link managers' and directors' compensations to shareholder returns effectively thus reducing the agency problem. In addition, its managements' emphasis on growth capital expenditures funded mainly through operating cash flow is also a great indicator of management's strict discipline and effectiveness.

Valuations
POSCO is currently trading at its lowest valuation since 1993 (Today: 0.62x book, 20 years average: 1.2x book). POSCO would realize a 123% upside if it reverted to its twenty year P/B average.

ARCELORMITTAL: 0.89x book, 7.25x EBITDA, 7.41x CF
US STEEL: 1.27x book, 9.23x EBITDA, 10.30x CF
NUCOR: 2.22x book, 12.20x EBITDA, 15.80x CF
NIPPON STEEL & SUMITOMO: 0.89x book, 9.45x EBITDA, 5.76x CF
Average: 1.32x book, 9.53x EBITDA, 9.82x CF
POSCO: 0.62x book, 6.64x EBITDA, 5.24x CF

All comps are based on trailing twelve months data. As can be seen above, all of POSCO's comps are less than the average of its competitors, a clear sign of undervaluation.

POSCO's EPV ($144.71/share) was computed based on a cost of equity of 12% and a WACC of 9.11%. The normalized earnings ($4,401 million) used in EPV were based on the average of the last 7 years' EBIT margins. POSCO can be classified as a Franchise since its EPV is greater than its reproduction cost of the assets ($129.35/share), and given its sustainable moats, this franchise can be safely protected.