With economic weakness stretching from Europe to Asia to North America, there is no shortage of resource and commodity companies that appear to be trading below fair value. That's not quite so true in the steel sector, though, where valuations have seemingly held up a little better. Unlike global steel giant ArcelorMittal (NYSE:MT), which does appear to be meaningfully undervalued, South Korea's POSCO (NYSE:PKX) appears to be enjoying a relatively healthy benefit of the doubt from the Street. While I certainly wouldn't argue that POSCO will go along for the ride when investor sentiment on steel turns more positive, I think the margin of error here is too slight to make this a compelling buy today, even with the stock near a 52-week low.
When Good Is Bad
I think the biggest problem with POSCO is that it's such a well-run steel company and that fact is so widely known. POSCO is not only the world's third-largest steel producer, but it's well-known for having/developing superior technology and operating with exceptional efficiency. Accordingly, investors are happy to assign above-average multiples to the stock, not unlike the above-average multiples that American mini-mill operators Nucor (NYSE:NUE) and Steel Dynamics (Nasdaq:STLD) have long enjoyed due to their efficiency and technological sophistication.
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It sounds twisted, but the reality is that better operators have less to gain (relatively speaking) when conditions improve. As POSCO already operates so efficiently, it's not as though better prices will “rescue” the numbers and inferior producers will see much better improvement in their profits and cash flow during the next up cycle. To that end, a company like AK Steel (NYSE:AKS) could ultimately offer more leverage/upside to a steel rebound.
It's All About Pricing Now, And That's Not Helping
Shipment volumes are pretty soft for much of the steel industry, but not soft enough to underpin any sustained price increases. While POSCO has reported good demand for sheet steel used in autos, shipbuilding is pretty weak and demand for appliances has softened as well.
POSCO is getting some relief from input costs, but not enough to really drive improved results. Not unlike ArcelorMittal, POSCO has made it a priority to become more self-sufficient. The company has ownership stakes in more than 20 mining operations around the world, and is looking to go from roughly 30% self-sufficiency in coal and iron back in 2011 to almost 50% in 2014. That's not always as easy as it sounds, though, and POSCO is seeing some of the same production cost increases that have impacted coal and iron companies like Peabody (NYSE:BTU) and Vale (Nasdaq: VALE).
There is also the question of whether POSCO's rivals will remain rational. POSCO has about half of the South Korean steel market and Hyundai Steel and Hyundai Hysco seem to be acting pretty responsibly with respect to capacity. The bigger concern, not surprisingly, is China. More than a quarter of POSCO's exports go to China and I would argue that even in this downturn there are still many operators behaving in pretty irrational ways.
The Bottom Line
I suppose the real question for investors is just how much they are willing to pay for what POSCO offers. Certainly the company deserves a premium valuation for its demonstrated efficiency, technology (including technology that allows them to use inferior grades of iron and coal), and growing self-sufficiency. Likewise, I do believe the company should be rewarded for its efforts to expand into markets like India, Indonesia, and Vietnam.
But how much? ArcelorMittal looks notably undervalued at about 6.5x forward EBITDA, but a 7.5x multiple for POSCO only produces a target in the low $60's. If you go as high as 8.5x the resulting target price starts to get interesting (close to $80), but that's a pretty steep multiple for the sector even if you include companies like Nucor as peers. With that, I have a hard time getting excited about POSCO shares today – I think this is a top-notch steel company, but the market already knows that and has priced it accordingly.