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Morningstar | Posco’s 3Q18 Largely Within Expectations; FVE Lowered to KRW 300,000 on Capex Outlook Concerns. See Updated Analyst Note from 24 Oct 2018

We have lowered our fair value estimate for Posco to KRW 300,000 per share (from KRW 336,000) or USD 66 per ADR (from USD 75 per ADR) after factoring in our latest commodities price deck, where we increased raw material prices in the near term, and a higher capital expenditure assumption. We remain conservative on our capital expenditure forecast and are only modeling around half of the announced KRW 45 trillion capital expenditure plan over the next five years, as we acknowledge that there is some reserve amount being set aside for future investments and uncertain market conditions may lead to management being more prudent in actual capital expenditure. Our no-moat and stable moat trend ratings are intact. We think the shares are slightly undervalued at the current price, as the company continues to benefit from higher earnings in the steel division this year, while investors' concerns regarding the aggressive capital expenditure plans might be overdone.

Posco’s third-quarter 2018 EBIT increased by 36% year over year to KRW 1.53 trillion, largely within our expectations. This is mainly due to stronger contribution from its steel, engineering and construction, and chemicals, materials, and other divisions, and partly mitigated by weaker contribution from its trading and energy divisions. Meanwhile, in September management announced a KRW 45 trillion five-year capital expenditure plan from 2019 to 2023 (significantly higher than the estimated capital expenditure of around KRW 15 trillion from 2014 to 2018) that will mainly focus on investments in steel, battery materials, and energy and infrastructure (clean energy power plants construction, LNG storage facilities, and Myanmar gas field). This aggressive capital expenditure plan was a concern to investors, as the last round of huge capital expenditure from 2009 to 2013 failed to achieve projected returns. This is evidenced by the firm's EBIT declining from KRW 5.5 trillion in 2010 to a low of KRW 2.4 trillion in 2015 before improving in the past two years. To ease investors' concerns, management stated in the third-quarter results conference call that it would focus on areas where the firm is competitive and investments would be implemented after reviewing the value of the different businesses. As such, the actual increase in capital expenditure could be back-loaded and come in after 2021. Additionally, the large KRW 45 trillion capital expenditure plan includes some reserve amount that is being set aside for future investments, which may lead to actual capital expenditure being lower than the KRW 45 trillion.

In terms of guidance for full-year 2018, Posco increased its revenue guidance to KRW 64.8 trillion from KRW 64.1 trillion on the expectation of higher steel prices and better contributions from other divisions. That said, the year-over-year increase in steel shipments forecast is lowered to 1.1 million tons from 1.4 million tons. In terms of steel demand outlook, management has seen an improvement in demand from the shipbuilding industry in third-quarter 2018 and expects this trend to continue in the fourth quarter. Demand from the automotive industry in the third quarter was affected by General Motors' closure of a plant in Korea. However, management expects demand from the automotive industry to recover in the fourth quarter, following a reduction in the special consumption tax for car purchases that will last until the end of the year. On the other hand, demand from the construction industry is expected to remain weak in the fourth quarter. In view of the firm's improving profitability, management has also stated that there could be a chance of higher dividends, which will remain as a catalyst for the stock.

We still 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 the right moves going forward. However, we think the company should remain prudent on its capital allocations and expand in a more moderate manner. Owing to our bearish long-term view on the steel sector, we think the positive impact from these initiatives will be partly mitigated by the weak performance of the steel division. In the long term, we think the midcycle EBIT margin will drop to 5.7% in 2022 from 7.6% in 2017, mainly due to a decline in the steel division, as competition in the steel industry remains intense in an overcapacity environment.