It's been a tough period for POSCO (PKX 0.70%). The South Korean company is a world-class steel producer, but it's also a conglomerate that produces revenues from commercial and residential property, a trading business, operation of power plants, and the distribution of energy. Now a new CEO, Kwon Oh-joon, is switching the company from a growth model to a business focused on operational efficiency and profitability.
Amidst this shift in business strategy, shares have crumbled over 70% in the past 5 years and now trade for a fraction of tangible book value. This fact, coupled with the following key factors that the market is missing, are all strong reasons long-term Foolish investors should give POSCO strong consideration.
Global leader in steel production
POSCO has a 41% market share in South Korea, which accounts for 45% of its revenue. It's among the world's largest steel companies, producing 37.7 million tons of steel annually, and has one of the most technologically advanced integrated steel facilities on the planet. Cold rolled products account for 39.1% of revenue, hot rolled for 25.6%, plates for 15.3%, stainless steel for 8.7%, wire rods accounts for 7.9%, and silicon steel sheets for 3.4%. The company holds significant market share in each product, giving it a significant advantage over competitors that attempt to make inroads on its business.
POSCO's Roy Hill mine in Australia. Image source: POSCO website.
POSCO's South Korean market share is even larger than it appears at first glance because imports make up one-third of domestic steel demand. The company continues to outpace its global competitors in a global steel industry with excess capacity and pricing pressure. Its market share, relationships, and scale give it significant low-cost competitive advantages over the competition, and that advantage gives it the ability to generate higher operating margins and pay down debt more quickly.
Management is shareholder friendly and competent
There are numerous catalysts for the company over the coming years, such as spinoffs or outright sales of non-core assets. Some investors remember POSCO as a destroyer of shareholder value with the old management team loading up on debt to purchase non-core businesses and increasing the amount of shares outstanding. But the new management team is much more shareholder friendly.
For example, Kwon Oh-joon, who took control in March of 2014, is focused on growing the core steel business and reducing leverage, and selling or spinning off the company's non-core assets is likely to generate immense shareholder value in the coming years. The proceeds of the non-core asset sales will help immensely to paying down debt. The "commodity" business that will remain is a low-cost, high-quality business trading at an incredibly low valuation level because of the uncertainty of global steel and iron ore demand and the execution of the divestitures of those non-core assets.
Investors can also look forward to likely share repurchases and the potential for special dividends from the sale of assets .
Debt level is manageable
I'm not saying POSCO has a fortress of a balance sheet by any means. However, management's actions should alleviate a significant portion of the company's obligations. Equity of $34.66 billion still outstrips long-term debt of $11.53 billion and the debt-to-equity and debt-to-assets ratios are 0.66 and 0.32 respectively. In addition, the company is beginning to generate excess free cash flow. This trend, if it continues, will help pay down debt in the coming quarters.
Pricing pressures and excess capacity have indeed put the pinch on the global steel industry. However, operating margins appear to be performing relatively well for POSCO, remaining stable at 4%. The company is in a very manageable financial position , especially when you take the future sales of non-core assets into consideration. Moreover, POSCO is widely held as the world's best steelmaker. The quality of the company seems to be ignored, as the market remains focused on all the intermittent negatives surrounding.
Shares are extremely undervalued
POSCO is trading at its lowest valuation in the past 20 years, as measured by price-to-book ratio. In fact, it's priced for dead at only 39% of its tangible book value of $83.64 per share and less than 200% higher than current levels of around $33.00 per share.
Also, on a price-to-free cash flow basis, the company is trading well below that of its peers. I find this interesting given the company's operating history versus that of its peers. POSCO has continuously generated better gross and operating margins versus their peer group.
PKX Price to Free Cash Flow (TTM) data by YCharts
Investor takeaway
POSCO is a long-term play -- its shares aren't for those looking to make a quick buck . PKX has fallen 50% over the past 12 months alone and sits at 10-year lows. They've undoubtedly taken a beating along with stocks in the rest of the commodity-related sectors. However, POSCO has the size, scale, technological, and local advantage versus many of its competitors in South Korea and abroad to withstand a period of excess supply in the market.
The market appears to be missing the bigger picture as iron ore and coal prices continue to hit new lows, but let's not forget that commodities are very cyclical. Sentiment is weak right now, but steel will always be needed as the world continues to grow. The long-term potential looks very attractive at current levels.
