EUR 850.00 For Business Accounts Only

Morningstar | Posco’s 2Q Largely in Line With Expectations; FVE Cut to KRW 280,000 on Higher Raw Material Prices. See Updated Analyst Note from 23 Jul 2019

Posco’s second-quarter 2019 EBIT decreased by 14.6% year over year to KRW 1.07 trillion from KRW 1.25 trillion in the same period last year, largely within our expectations. This was despite a 1.5% year-over-year increase in revenue to KRW 16.3 trillion. The fall in EBIT is mainly because of a decline in profitability in its parent company (which is predominantly its steel business), its engineering and construction subsidiary Posco E&C, and its chemical business Posco Chemical. This is partly mitigated by a stronger contribution from its trading subsidiary, Posco International, because there was an improvement in its Myanmar gas business. For its steel business, EBIT was affected by 1) higher costs on the back of an increase in iron ore prices since beginning of 2019 because of supply disruptions caused by the accident at Vale’s mine in Brazil and a cyclone in Australia; and (2) lower shipment volumes because of a maintenance shutdown. 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 280,000 per share or $59 per ADR (from KRW 285,000 per share or $62 per ADR). Our fair value estimate for its ADR is also affected by the strengthening of the U.S. dollar against the South Korean won. Our no-moat and stable moat trend ratings remain intact. We think 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 raised its revenue forecast to KRW 66.8 trillion (from KRW 66.3 trillion) and KRW 31.1 trillion (from KRW 30.1 trillion) on a consolidated basis and for its parent company, respectively. Guidance for steel shipments was also raised to 36.2 million metric tons from 35.7 million metric tons. Management continues to guide for a year-over-year increase in capital expenditures up to KRW 6.1 trillion in 2019 (of which KRW 1.6 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 they will remain prudent in their capital allocation. In terms of steel demand outlook for third- quarter 2019, management expects that demand from the shipbuilding (driven by new orders) and construction industries (driven by infrastructure projects) should improve slightly while demand from the autos sector is expected to decline because of weak consumer sentiment. Although Posco will be trying to pass through the higher raw material prices to its customers, we think 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.

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 the company should remain prudent on its capital allocations and expand in a more moderate manner. Because of 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 its steel business. In the long term, we think the midcycle EBIT margin will drop to 5.0% in 2023 from 8.5% in 2018 mainly because of a decline in its steel business as competition in the steel industry remains intense in an overcapacity environment.