POSCO Looks Cheap, Even Factoring In Risks (NYSE:PKX)

Among the steel companies I regularly follow, Korea’s POSCO (NYSE:PKX) has become more and more of an outlier, and not in good ways. While there have been steel companies whose shares have done even worse since my last update on the company, the performance is still notably bad compared to companies like ArcelorMittal (MT), Nippon Steel (OTCPK:NPSCY), Nucor (NUE), and Steel Dynamics (STLD).

Some of this underperformance can be explained by margin pressures from input cost inflation and uncertainties in the demand outlook, but POSCO also stands out from the crowd with its desire to pursue empire-building – if management has its way, steel will only be around half of the business in eight years and the company will have extensive operations in areas like battery and hydrogen production.

I don’t necessarily think that reinvesting the cash flows from the steel operations into new businesses is a bad idea, but POSCO has a bad historical track record outside of steel (even if that record was built by other managers) and investors these days tend to want their steel companies to be steel companies. While POSCO does screen out as quite cheap on fundamentals, it’s hard to say when sentiment will turn around.

Ambitious Plans, In And Out Of Steel

POSCO has always operated businesses outside of steel, but historically these operations have been more of a hinderance than a help. Undeterred by that legacy, today’s management team is looking to significantly expand these operations – a plan that’s not exactly new, but where management has more recently filled in details that show just how far those ambitions go.

Management is looking to triple its enterprise value by 2030, with most of that growth coming from outside the steel business. I’ve written previously about management’s intention to grow POSCO Chemical by investing heavily in assets related to xEV batteries (lithium mines, anode/cathode production facilities, et al) and hydrogen, but those ambitions look even larger, with the company looking to be a top player in lithium and hydrogen within a decade. On top of that, the company is also planning to enter the nickel value chain at multiple points (mines, recycling, et al).

POSCO’s management expects most of the increase in enterprise value to come from these non-steel ventures, with the steel operations shrinking from around 80% of revenue to 50%. That’s a dramatic change in a relatively short period of time, and it’s one that will require substantial capital investments to support.

None of that is to say that the company doesn’t also intend to grow its steel operations. Management is looking to increase its steel production capacity by almost 50% between 2021 and 2028, taking capacity to around 68Mtpa.

Within this capacity growth plan are some interesting details. Management is looking to add meaningful capacity in cleaner steelmaking, including replacing coal with hydrogen where possible and focusing more on electric arc furnaces. I’ll be curious to see the extent to which management closes older, more polluting capacity and whether capacity additions will actually exceed the implied change in net capacity, as the company may look to replace older plants with new facilities. Management is also looking to continue growing outside of Korea. The company is actively pursuing opportunities to grow in Indonesia and India, as well as build EAFs in the U.S.

On the surface, I can’t see these plans as intrinsically flawed. Adding more value-added capacity in markets like the U.S. would make sense, as well as leveraging the growth in markets like India and Indonesia. That said, when steel companies start talking about significant capacity expansion, investors get nervous.

Uncertainty Rules The Day In Steel

Steel prices have spiked since the Russian invasion of Ukraine, but I don’t think it will be enough to drive EBITDA growth for POSCO in 2022. The cost of critical inputs like coal and iron ore has squeezed margins and I think POSCO is likely to see EBITDA margins shrink by around three points in 2022 and another 50-100bp in 2023.

The auto industry is a major market for POSCO’s output, and I think inventory-building there is going to limit volume growth later this year as semiconductor component capacity drives improved build rates. I also see China as a hard-to-predict variable in all of this. While China has been keeping a lid on production, helping pricing for POSCO, China could well loosen some of the constraints if the government feels they need to cool inflation domestically.

The Outlook

As negative as that all may seem, the market is even more negative on the shares, and the valuation suggests either utter disinterest in the shares or a much more dire outlook for steel prices and margins than for other steel companies.

Using the next year/full-cycle EBITDA estimate approach I use with most steel companies, and using multiples of 3.5x and 5x, I get a fair value in the mid-$80’s. Likewise, the once-tight relationship between ROE and price/book has broken down, as either POSCO is going to be much less profitable in FY’22/23 than expected or the shares are significantly undervalued below 0.75x book.

The Bottom Line

I understand that the Street may be intensely skeptical regarding POSCO’s non-steel growth plans, to say nothing of adding substantial capacity at or around what may prove to be a multiyear peak in steel prices. Additionally, I understand concerns about inventory-building with customers and the outlook for lower margins due to input cost inflation.

Still, all of that is hard to reconcile relative to the price/valuation today. I don’t actually like this company so much that I want to vigorously defend it, but the valuation, particularly when compared to other steel companies, just doesn’t make that much sense to me. I won’t dismiss the risk that I’m missing something significant here, but this looks like a meaningfully undervalued catch-up opportunity now.