Third-quarter earnings proved to be a cold shower for investors in international major steel producers. Nevertheless, some steel manufacturers came out better than others.
Among the major contenders, a couple stand out. The biggest player on the international market remains
Arcelor Mittal
(MT)
, which has a market cap of $66.3 billion. The recent collapse of the attempt by Arcelor Mittal to buy a major stake in Laiwu Steel, however, must have been music to the ears of
Posco
(PKX)
, the South Korean steel manufacturer that is one of Arcelor's biggest rivals.
This South Korean company, with a market cap of $47.3 billion, is already well-positioned in China, a key market for steel, but, as importantly, it is the first major steel manufacturer to set up operations in Vietnam, where a cold-rolling mill is being constructed, with operations slated to start in September 2009.
Existing operations in India and China, coupled with the fact that the South Korean conglomerate is active in IT services as well as engineering and construction activities, will allow it to tide over recent weakness in the stainless-steel market, as the following chart shows.
Posco's stock market performance has outdone that of Arcelor Mittal. The two-year returns for Arcelor Mittal and Posco are, respectively, 85% and 94%; the 52-week returns are, respectively, 92% and 105%.
For the most part, there are two countries that remain drivers for global steel production: China and India. Indian steel demand grew by 13.7% in 2007, while growth is expected to abate only slightly, by 11.8%, in 2008. Chinese steel demand grew by 11.4% over 2007. More importantly, the excess between production and consumption in China slowed down to 3.9% in August 2007, compared with an excess supply of 5.8% in the second quarter of 2007.
Given these trends, the fact that Posco has extensive bases in China, Vietnam and India, as well as Mexico (where the company has started construction of a continuous galvanizing line, with an estimated startup in June 2009), will allow it to effectively compete with the likes of Arcelor Mittal.
More importantly, Posco has also secured itself upstream, with equity acquired in a coal mine in Australia, Cockatoo Coal. As well, given recent gyrations in nickel prices, Posco has also invested in a ferronickel plant in New Caledonia, nickel being a key input in stainless steel.
Consequently, the increase in Posco's cost of sales was lower than that of Arcelor Mittal.
Regarding the different steel products that Posco manufactures, the company demonstrated considerable resilience to weaknesses in the construction and housing industries. Products that were used in growth sectors, however, such as shipbuilding and offshore oil and gas, showed the greatest potential.
Such was the case for sales in steel plates, used in the above-mentioned industries, where sales increased by 13% over the third quarter of 2007. Growth in electrical steel was also strong, at 21.6%, while stainless-steel sales declined by 38%. Two important segments, hot-rolled and cold-rolled steel, used in building and automobiles, exhibited weakness, with sales declining by 9% and increasing by 10%, respectively.
Nevertheless, the diversity of the steel products manufactured by Posco served to protect the earnings of the company, as the following table demonstrates.
| Posco Metrics vs. Arcelor Mittal Metrics |
| Company |
Price-to-cash flow ratio |
Gearing ratio |
EPS growth (year over year) |
Cost of sales growth |
Inventory growth |
Current ratio |
Operating margin |
| Posco |
8.5 |
11% |
-1% |
-3% |
23% |
2.2 |
20.40% |
| Arcelor Mittal |
6.1 |
38% |
-25% |
12% |
7% |
1.4 |
15.10% |
| Source: Third-quarter results for both companies and Reuters |
Except for the fact that inventories increased by a higher rate for Posco than for Arcelor Mittal, most of the metrics show it in a considerably more favorable light than its competitor. In particular, Posco has been able to control the increase in cost of sales, a key problem for steel manufacturers in the current situation of input cost inflation. Both companies have competitive price-to-cash-flow ratios compared with the industry norm of 9.6.
Taking a long position in steel manufacturers, given current trends in the housing and automobile sectors, especially in the U.S., involves considerable risks.
Given the low level of reputed corporate governance transparency in South Korean chaebols such as Posco, one positive aspect for the company is the level of dispersion of its share ownership profile: Foreigners own 63% of its shares, while employees own 1.5%. This is in contrast to Arcelor Mittal, which is well-known to be a strong family-run business.
I foresee a six-month appreciation potential for Posco, by at least 13%, to $175, over the next six months. Given past trends, I have put in a stop loss at $100.
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