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Morningstar | Posco’s 1Q 2019 in Line With Expectations; FVE cut to KRW 285,000 on Higher Raw Material Prices. See Updated Analyst Note from 25 Apr 2019

Posco’s first-quarter 2019 EBIT decreased by 19% year over year to KRW 1.20 trillion from KRW 1.49 trillion in the same period last year, within our expectations. This was despite a 1% year-over-year increase in revenue to KRW 16 trillion. The fall in EBIT is mainly due to a decline in profitability in its parent company (which is predominantly its steel business) and its Engineering and Construction subsidiary, Posco E&C. This is partly mitigated by a stronger contribution from its trading subsidiary, Posco International, as there was an improvement in its Myanmar gas business. For its steel business, it was impacted by higher cost on the back of an increase in iron ore prices in first-quarter 2019 due to supply disruptions caused by the accident at Vale’s mine in Brazil and a cyclone in Australia. After fine-tuning our model and updating our commodities and foreign exchange forecasts to factor in the higher iron ore prices, we lowered our fair value estimate for Posco marginally to KRW 285,000 per share or $62 per ADR (from KRW 295,000 per share or $66 per ADR). Our fair value estimate for its ADR is also impacted by the strengthening of the U.S. dollar against the South Korean won. Our no-moat and stable moat trend ratings remains intact. We think that the shares are slightly undervalued at the current price with long-term overcapacity issues in the steel industry factored in.

In terms of guidance for full-year 2019, Posco is keeping its revenue forecast of KRW 66.3 trillion and KRW 30.1 trillion on a consolidated basis and for its parent company, respectively. Guidance for flat steel shipments of 35.7 million tonnes was maintained as well. Management continues to guide for an increase in capital expenditure to up to KRW 6.1 trillion in 2019 (of which KRW 1.3 trillion acts as a reserve) from KRW 2.7 trillion in 2018. We do not expect management to fully utilize the budgeted capital expenditures in 2019 as we believe it will remain prudent in its capital allocation. In terms of steel demand outlook for second quarter 2019, management expects demand from the autos (driven by government measures) and shipbuilding industries to improve while demand from the construction sector is expected to decline. Although Posco is trying to pass through the higher raw material prices to its customers, we think that there will be a time lag before the higher steel prices are realized, resulting in its steel margins remaining under pressure in the near term.

Posco reiterates its plans to expand in the lithium ion battery materials business where a new plant to produce lithium hydroxide and lithium carbonate will be completed in 2021 and result in the revenue from this lithium business to increase significantly. We continue to view management’s strategy to increase sales of high-grade steel products and alloys, focus on technological advancement, and invest in new growth opportunities such as gas field and battery materials as moves in the right direction. However, we think that the company should remain prudent on its capital allocations and expand in a more moderate manner. Going forward, due to our bearish long-term view on the steel sector, we expect the positive impact from these initiatives to be partly mitigated by the weak performance of the Steel division. In the long term, we think that the midcycle EBIT margin will drop to 5.3% in 2023 from 8.5% in 2018 mainly due to a decline in the Steel division as competition in the steel industry remains intense in an overcapacity environment.