POSCO Stock: Focus on steel and non-steel businesses (NYSE: PKX)
Summary in seconds
I downgrade my investment rating for POSCO (NYSE: PKX) [005490:KS] actions from buy to hold. I have already reviewed the financial performance of PKX in the third quarter of 2021 in a previous article published November 2, 2021.
It is necessary to focus on both steel and non-steel business for POSCO in stock analysis. On the negative side of things, the short-term and long-term financial performance of POSCO’s core steel business could be negatively affected by weak steel prices and stricter environmental regulations, respectively. On the bright side, PKX’s new holding company structure should help ensure that its non-steel businesses receive the attention and resources needed for future growth. I also like POSCO’s changes to its policies for returning capital to shareholders. Considering both the positives and negatives associated with the company, I consider POSCO’s stock to be a hold.
Weak steel prices could hurt the near-term performance of the steel business
A recent June 18, 2022 Nikkei Asia article pointed out that “the price of hot-rolled steel coils reached a 14-month low in East Asia” due to unfavorable supply and demand dynamics in China, and it was noted that “many market watchers expect low (steel) prices to persist for at times.”
According to the company’s 2021 20-F tax filing, POSCO’s core steel business segment accounted for 84% of the company’s gross profit last year. As such, it is reasonable to conclude that weak steel prices will negatively impact the company’s earnings for fiscal 2022.
South Korean stockbroker NH Investment & Securities released a research report (not publicly available) for POSCO on June 10, 2022, and the NH analyst covering the stock chose to cut its earnings forecast by operating for FY2022 for PKX by -5% to KRW 7.4 trillion. which translates into a contraction of -20% year-on-year. This confirms my view that weak steel prices will weigh on the financial performance of POSCO and its core steel business.
Steel business could be affected by long-term regulatory issues
In addition to weak steel prices in the short term, POSCO’s steel business also faces long-term challenges due to regulatory and political issues.
According to a April 4, 2022 article Posted in The Korean Business Daily, the “price of carbon permits (in South Korea) has increased by more than 20% in one year”, following the implementation of “stricter emission standards”. Based on information derived from ReutersSouth Korea’s 2030 “greenhouse gas reduction target” has been reduced from 26.3% to a more demanding level of 40.0%.
In a meeting with The Financial Times which was published on June 5, 2022, “Cho Ju-ik, head of POSCO’s hydrogen business” reportedly said that “our competitors in China and India face looser national (environmental) regulations” and noted that “it may put us at a disadvantage” in terms of costs. POSCO’s export sales contributed about 57% of the company’s steel business revenue for fiscal 2021, according to its filing 20-F In other words, POSCO could potentially lose market share in overseas and international markets, due to higher costs compared to its competitors in other Asian countries.
In the same FinancialTimes article, it was also noted that “decarbonizing its steel operations (POSCO) will cost about 40 billion won ($32 billion)” as part of plans to “use hydrogen to replace coal in processes steel industries by 2050”. As an indication of the significance of this KRW 40 trillion investment, PKX’s FY 2021 net profit attributable to shareholders was KRW 6.6 trillion. Fiscal 2021 was a bumper year for POSCO, as the company made profits of KRW 1.9 trillion and KRW 1.6 trillion in fiscal 2019 and 2020, respectively. This suggests that POSCO must spend several years of profits to comply with environmental regulations in South Korea.
Diversification commitment validated by the creation of a holding company
It is vital for POSCO to diversify more aggressively into non-steel businesses, given the challenges facing its core steel business, as discussed in previous sections of this article.
On March 2, 2022, The Korean Business Daily reported that PKX “launched a holding company” to support its goal of “increasing non-steel business operating profit to 50% (from 20% now) of the profit of the entire group”.
POSCO’s New Holding Company Structure
In the business meeting with investors, POSCO explained why the new holding company structure will help drive growth in its non-steel business. PKX noted at the investors’ meeting that its steel and non-steel businesses have never “enjoyed the level or intensity of support and interest” they deserved in the past. Indeed, “the steel business (the ‘old’ POSCO which played the dual role of operating and holding company) had to spend time ‘getting involved in the management of the Group’ and ‘a system of steel-centric management” inhibited the growth of the company’s non-steel divisions.
Among the non-steel activities, attention should be paid to the lithium and hydrogen subsidiaries of POSCO. According to his investor presentation slidesPKX has set ambitious goals to become one of the world’s top three lithium producers and among the top 10 hydrogen producers by 2030 and 2050, respectively.
Positive drivers of return on capital for shareholders in 2022
At the beginning of the year, POSCO announcement some changes in the company’s return on capital policies, which should provide some support to its share price.
Although POSCO’s current policy of paying out 30% of its profits is decent, the dividends in absolute terms can vary from year to year depending on the company’s results. A key change to the company’s shareholder return policy is that PKX has committed to “a minimum dividend above KRW 10,000 per share in line with enterprise value” as per its January 2022 announcement. This roughly equates to a 3.8% dividend yield for POSCO by my calculations.
The other key change is that POSCO has guided a cancellation of 11.6 million treasury shares (or 13.3% of its total treasury shares) which will take effect by the end of this year. It should be noted that while the company has bought back its own shares, the last time it canceled its own shares was in 2004.
POSCO is now considered a Hold. The outlook for the company’s core steel business is not great, given weak steel prices in the near term and substantial investment needed to comply with South Korea’s environmental rules in the long term. . On the other hand, I am positive about the changes to POSCO’s return on capital policies and the company’s diversification efforts. This explains my mixed view of PKX, which in turn supports a Hold rating for the company’s stock.