Rocket Scientist Landlord

(The following was written on July 25 as the first part of an entry to the Value Investing Challenge.  It was just an exercise, as I didn’t meet the criteria for entry.  I never developed the figures to go along with the text.  Maybe you’ll find it useful.  Remember that it’s not about the stock, it’s about the stock and the price.  In other words, just because I liked it back then doesn’t mean I like it now.  This is not a recommendation for you to buy.  Caveat investor.)

The stock market is on a tear, having doubled in the last four years from the mid-recession lows of 2009.  But over the same period, steel stocks have suffered.  ArcelorMittal and US Steel, the first and 13^th largest makers by tonnage, are down 50% over the same period.  The cause surely lies among the 2^nd through the 12^th largest steelmakers, all of which are in Asia, seven of which are in China.  The Chinese government and others find it in their economic interest to increase steel capacity locally without regard to global demand.  In China alone, tonnage increased over 75% in the four years from 2007 to 2011.  Would that they were alone.  The same excess capacity plagues all steel companies, who continue to build new plants for greater efficiencies and lower costs.  ArcelorMittal are especially hard hit, as they must obtain government permission before mothballing any of their plants in the EU region.  Their per share earnings are down 160% since pre-recession mediums seven years ago, putting them solidly into losses.  US Steel is also losing money, with its per-share earnings down 110% from 2006 averages.

In the midst of this oversupply chaos sits a placid Korean company with an unassuming name: POSCO.  Averaging the previous seven years, which encompass both good times and bad, POSCO’s earnings margin has been 7%, roughly double that of ArcelorMIttal and seven times that of US Steel over the same period.  That margin would allow POSCO management to let prices drop 7% while doing nothing and still remain profitable.  But we can delight that their steadfast management have already taken action.  Unlike ArcelorMittal, who in their worst year had enough operating cash to pay only two-thirds of their interest, or United States Steel, who in their worst year dipped into the piggybank in a big way, POSCO has averaged more than twice the operating cash they need to pay their senior debt.  That’s a nice assurance for an equity holder.  Over the last seven years, they’ve brought in cash equal to almost 28 (twenty-eight!) times what they paid in interest.  Compare this to ArcelorMittal or United States Steel, the best of which brought in only six times what they paid in interest over that seven year period.

POSCO is unique among the steel companies listed on US exchanges in its prudent non-unionized management of employees.  Whereas “the majority” of the 245,000 employees at ArcelorMittal are unionized, and likewise for US Steel’s 49,000, only 10 (ten!) employees of POSCO’s 35,000 are.  It should be noted that this difference will be material over the long term.  Indeed, it’s already being felt.  In 2008, United States Steel recognized billions of dollars of “accumulated other comprehensive losses,” which per GAAP at that time did not appear on the income statement, due primarily to defined benefit pension obligations to union employees.  This weighs on their record of past performance, and given the industry headwinds and their high-wage, expensive-currency home country, should lead a careful investor to expect more trouble to come of this.

Steelmaker POSCO sounds like a relative beauty, but might we just be wearing beer goggles?  POSCO has historically earned most of its revenue in South Korea, a market they see as nearing maturity.  Also, they sit alongside one of the world’s last great lunatics, Kim Jong-un, who has his finger on a button that would write him into the history books for all time and destroy many of POSCO’s assets in the process.  And as far as the steel industry goes, the worst is yet to come.  By some estimates, demand won’t reach supply for another five years.  What will happen to our fair POSCO?  Let’s look at each fear in turn.

POSCO, as it turns out, is focused neither just on Korea nor just on steelmaking.  Management there have seen how their home market has matured and have taken steps to diversify.  In 2012, half of their revenue came from overseas.  Because they pair revenue and expenses in local currencies, they’ve been relatively immune to currency effects.  Surprisingly, they aspire to be more than a steel maker.  They acquired Daewoo International in 2010, giving them a global trading company for all kinds of things (cotton, for instance).  Daewoo matches buyers and sellers before it commits to any inventory, so it has very little inventory risk, and has to carry committed inventory during shipping for as little as 23 days until the buyer receives and pays.  Korea subsidizes the company to perform energy exploration, as well.  If they succeed in finding natural gas, for instance, they pay the government back as a simple loan.  And if they fail, they pay back nothing.  POSCO also uses its steel for construction projects.  Their 89.5% owned subsidiary, POSCO Engineering & Construction, performs jobs all over the world.  Last year, about a third of their profit came from non-steel activities.

What about North Korea?  While we can never know for sure, we can talk about certain mitigating circumstances.  Their large plants, Pohang and Gwangyang, are about as far from North Korea as you can be and still be in South Korea.  If you’re feeling lucky, that’s plenty of time for a rocket to go haywire.  Their construction project in India’s Orissa state is going ahead and will give them an overseas manufacturing capability.  When we look at the price of South Korean bonds, and compare that to the price of bonds in Belgium before the outbreak of World War II, we find no parallels whatsoever.  In fact, the market sentiment is that South Korea is pretty safe.  And overall, we know from history that markets and businesses continue to function even in times of war.  If it’s to come, we could do worse than to be invested in a steel maker that will be high on the government’s list of protectees.

Will the next few years be a steel industry bloodbath?  It’s impossible to say, but we can see that POSCO has the best financial position, in terms of high earnings margin and low debt, of any large steel maker on US exchanges.  More than that, it’s in an objectively good position.  We can also wonder and hope that Berkshire Hathaway, already a 5% owner, would act as a back-stop should any crisis occur.  I’d like to add that POSCO’s core steelmaking business may be the most advanced in the world.  As proof I cite the numerous anti-dumping provisions aimed at POSCO, which indicate that it’s better able to provide low-cost steel than many homegrown steelmakers. Their Gwangyang plant, for instance, is entirely automated and can make a hot rolled product in four hours, start to finish.  They’re also a good global citizen.  They’re complying with the Kyoto protocols.  They’ve had a chrome-free steel offering since 2006 (hexavalent chromium is a repeat offender in steel making and they’ve done away with it entirely).  They also hold interesting patents in processes like FINEX, which make steel cheaper with less nitrous oxide and sulfur dioxide.  And as if that weren’t enough, they keep about 1,000 scientists on staff at a local university finding ways to keep their plants operating with an environmental friendliness and far-sighted mentality that you don’t see in a company worried about surviving a few lean years.  If all this doesn’t convince you of their merits, let’s return to some hard facts:  their plants have been operating at over 100% capacity.  So when they reduce output, as they have said they would, it will be starting from above maximum.  That’s not a bad place to be.

An investor in the United States looking to purchase shares of POSCO can do so most readily through their American Depository Receipts, traded on the New York Stock Exchange.  These receipts represent one quarter of a share and come with fees to purchase, sell, and receive dividend payments.  They recently amended the fee schedule to increase fees paid on dividends.  There are also tax implications, because Korea withholds taxes even when dividends are paid to non-Korean investors.  Even with this factored in, investors seem to pay very little for the chance to own one of the world’s greatest steelmakers.