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Tuesday, March 29, 2011

Posco - Warren Buffett's favorite steel company

I recently saw an interesting write up on Posco. I have long admired this company as have Warren Buffett and a number of other illustrious investors. They are one of the best run outfits in the world and given the increased need for infrastructure build out both globally and potentially in Japan and other areas rocked by recent natural disasters I felt this was rather timely.

The write up was done by Milestone Capital Management. While I am not terribly familiar with them, the write up is decent.



Posco currently trades at 1X book value. Over the past ten years, Posco has traded in a range of .8X book on the low end (2008) to 1.7X book at the high end. We view Posco as having a low risk of loss with significant upside. Based on projected earnings for 2011 and 2012, at the end of that period, at today’s price Posco would be trading at a book value of .8X and an EV/EBITDA of 4.5X. Applying an average of the last four years price to book of 1.3X at the end of 2012 would yield a stock price 50% higher than today. Posco also pays a dividend of 2.0% .
Posco is one of the best steel companies in the world due to enduring low cost advantages. Posco’s stock is cheap because their margins are being squeezed by rising raw materials costs while steel prices aren’t rising fast enough to compensate because of oversupply. Investors seem to be focused on issues over the next six months while Posco has great long term fundamentals and the ability to withstand tough markets better than competitors. Posco currently trades at a discount to almost all peers and it’s historically valuation. At the same time, Posco has plans to build facilities that will be the lowest cost in the world and will boost net income substantially in the future.
Posco engages in the manufacture and sale of various steel products in South Korea and internationally. It offers steel for general structures and welded structures used in bridges, ships, and automobiles; atmospheric corrosion resistant steel for used in the production of containers, special vehicles, and building structures; hot rolled steel used in automobile frames and wheels; and hot rolled steel for special applications. The company also provides cold-rolled sheets used in cold-rolled products, such as CR, GI, and color plates; steel for structural pipes, general pipes, special pipes, and carbon steel pipes for machines; steel used in high-pressure gas containers; steel for oil well pipes; and steel for pipelines. It has a strategic alliance with Nippon Steel to exchange slabs and cooperate on by-product recycling. The company was founded in 1968 and is based in Seoul, South Korea. Posco has 43% market share in South Korea.

One of Best Steel Companies in the World: Posco Sells Its Products at a Premium to Some Competitors and Its One of the Lowest Cost Producers
Posco is one of the world’s lowest cost steel producers. Posco’s cost structure is approximately 10% below peers in Asia. Posco’s low cost structure derives from how the company was created. The Korean government created and owned Posco until it went public in 1994 and was completely privatized in 2000. Posco received its land and ports for free as well as large government subsidies during its creation. Its ports are very deep and their Pohang facility was built in a U shape that allows ships to drop their raw materials off and then pull forward to pick up finished product. Posco has a huge advantage with its facilities being on ports. Many of their competitors have to ship their raw materials and finished products across land to ports. In the early 2000s, it was estimated that Posco paid $25 per ton for delivery of its iron ore (most of which came from Australia), while US companies paid about $50 a ton. This difference in cost gave Posco a competitive advantage over Western companies.
“I’d love to have a seaport, paid for by the government, just like Posco,” said Thomas Usher, the chairman of US Steel.
In addition to its advantage in location, low cost facilities and government support, Posco has developed technology that allows them to use lower priced raw materials that other mills cannot use. This technology is called FINEX. FINEX also allows Posco to use lower temperatures in its mills, saving energy costs, and to use a smaller production facility—making FINEX plants cheaper to build and maintain on an output basis. Posco is continuously working on lowering costs and this will allow them to maintain their cost advantage in the future. Posco constructed its first FINEX plant in 2004 after spending $362 million in the research of FINEX since 1992. At the time it was estimated that FINEX reduced Posco’s costs by 17% and was much more environmentally friendly.
Posco’s goal is to go from a self sufficiency level of 18% with raw materials to 30% by 2012 and 50% by 2014. This will further reduce costs.
In addition, Posco also has an advantage with retiree costs. Posco is relatively younger than most of its competitors. But more importantly, retirement benefits in South Korea are quite different from those in developed countries. Companies have a contributory fund, where workers and their companies contribute to a national pension fund that begins paying out when the worker turns sixty. When a worker retires at Posco, they receive a sum equaling one month’s pay for each year worked. Once the worker retires, the company is no longer responsible for medical coverage. This results in lower retirement costs for Posco compared to its competition. A WSJ article on January 26th mentions that retiree costs have been a negative factor for American steel companies.


Company Cost ($per hot rolled coil)
Posco 175-180
Arcelor 210
Nucor 210
US Steel 210
Nippon 240
Corus 250

Posco has consistently thrived in good and bad times because of its low cost structure. Most recently in 2009, Posco’s profit fell 37%. Posco’s competitors fared worse. Nippon Steel lost money in the first half of 2009. Dongkuk Steel also had an unprofitable quarter in 2009. ArcelorMittal just barely broke even in 2009. JFE Holdings, which is the second largest steel company in Japan behind Nippon, lost money in the first 3 quarters of 2009. US Steel just reported its 8th straight quarterly loss and Nucor lost money in 2009.
As a testament to Posco’s low cost advantage, Posco has never had an unprofitable year over at least the past 12 years.

Posco FCF Comparison with Asian Mills ($ Billions)
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Posco 1 .2 1.34 1.8 2.15 2.33 .5 2.14 .2 1.9
JFE 0 0 .9 2 2.6 2 2 2 (.5) 1.7
Nippon 1.1 .05 1 1.1 3.1 1.7 2.1 2 (1.8) 1
Baoshan .9 .05 1 1.1 .9 1.1 .1 (1.5) (1.9) .7

In addition to being the lowest cost producer, Posco has been able to sell its products at a slight premium to their competitors. The historical premium for hot rolled coils has averaged approximately 10% over Baosteel’s price and a smaller premium over Dongkuk Steel, Japanese steel producers, China Steel and other Chinese producers according to a UBS research report.

Posco Is Cheap Compared To Its Historical Valuation and Competitors:
At an ADR price of $112 Posco is trading at $32 billion USD and $36.1 trillion KRW.
At the lowest the stock hit in 2009 Posco was trading at a P/B of .8X. At today’s stock price the company is trading at a P/B of 1X. Posco should be trading for a P/B of around .8X by the end of 2012, based on an average of analyst’s estimates. The four year average p/b is 1.3X. According to BNP Paribus PKX has traded at 1.5-1.9X P/B during up cycles and between .8X and 1.7X P/B over the past 10 years. When Buffett was buying in late 2006, Posco was trading at .8X of book value. He continues to hold his shares in Posco according to the 2010 annual report. Over the past 10 years the P/E ratio has ranged from 14 to 4. Posco’s P/E based on 2010 earnings is 8.6 and should be around 7 by 2012.
Posco is currently trading near trough levels of its historical premium/ discount to replacement cost. According to a Citigroup report, Posco is trading for a 27% discount to its replacement value.

Historical Valuation*
P/E P/B Replacement cost EV/EBITDA
Historical 4-14 .8-1.7 60-120% 2-8
Current 8.6 1.0 72% 5
Est. YE 2012 7 .8 - 4.5

In addition to trading at a discount to its historical valuation, Posco is trading for a discount to its peers. Posco has also demonstrated that its low cost operations allow it to remain profitable throughout very tough markets unlike their competitors. PKX has the highest EBITDA per ton in Asia but at the same time it has one of the cheapest valuations.
Valuation compared to competitors:

P/E EV/EBITDA P/B Debt/Equity
Nippon Steel 14 5.8 1 .7
JFE Holdings 23 5.6 1 1.03
Arcelor Mittal 12 8.8 .9 .4
Hyundai Steel 12.5 10.4 1.5 1.35
China Steel Avg 16.1 6.2 1.1 .53*
Japan Steel Avg 12.2 5.9 .8 .70*
Asia ex Japan and China Avg 10.6 7.8 1.5 .73*
Posco 8.6 5 1 .26 approx. zero

*Net debt to equity
Produced with figures from a UBS Research Report and company financial statements.

(Billions USD)

Market Cap $32
Debt $8.2
Cash $2.90
Investments: $4.60
Enterprise Value Core: $32.70

Proj Proj
2010 2011 2012
Revenue $29.20 $34.40 $35.70
EBITDA $6.50 $6.75 $7.35
Depreciation $1.98 $2.06 $2.06
EBIT $4.52 $4.68 $5.50
Other Income $0.20 $0.40 $0.47
Net Interest $0.10 $0.27 $0.28
Tax $0.85 $1.06 $1.21
Net Income $3.76 $3.76 $4.27
Net Income Per Share $12.20 $12.20 $13.86
EV/EBITDA (core) 5.0 4.8 4.5
EV/EBIT (core) 7.2 7.0 6.0
Book Value $31.40 $34.50 $38.10
Book Value Per ADS $102.00 $111.00 $124.00

It’s also important to recognize that Posco’s unconsolidated investments don’t flow through the net income line (until they are sold) and instead the income or loss affects comprehensive income. At year end 2009 $4.6 billion in investments were accounted for as non controlling interests. Posco’s competitors have a lower percent of unconsolidated investments to total equity, adjusting for this would make Posco even cheaper than competitors. Total investments grew 60% from the end of 2009 to the end of 2010. The financial statements for the year end 2010 haven’t been published so it can only be assumed that the unconsolidated investments accounted for under the equity method have increased significantly. Adjusting for the increase in unconsolidated investments would reduce EV attributable to the core business and make Posco even cheaper compared to peers and on certain valuation ratios.
In 2011, oversupply levels are likely to stay similar to 2010 levels. PKX plans to further reduce costs by $716 million in 2011.
Posco’s 2010 4th quarter earnings fell 50% because raw materials prices are climbing and steel prices haven’t kept up partly because of oversupply and worse than expect demand from China. This type of environment has occurred twice after past recessions and the stock price was depressed and eventually recovered once steel prices rose and margins recovered. In this environment, Posco is in the best position because it’s the lowest cost producer. We are not experts on projecting a steel market recovery and 2011 is likely to bring further oversupply. Raw materials prices have continued to increase, which will most likely squeeze profit margins in 2011. But, Posco is cheap and we believe the chances are good that in the next few years Posco will return to a least the middle of its historical valuation range, providing solid investment gains from today’s price.
In two previous instances, PKX stock fell after raw materials prices skyrocketed and then price increases followed which boosted the stock price. It will be a challenging environment for steel producers over the next few quarters. Steel mills will report differentiated earnings depending on the cost structure of each mill. This may help Posco in the long run because it has more resilient earnings and it may allow them to boost international market share. Again, Posco is the only steel company we are aware of that has been profitable every year for at least the past 12 years.

Promising growth prospects ahead
Posco has 3 mills planned for India in various stages.
Posco and the Steel Authority of India are building a 1.8mmt ton a year facility that will be one of the lowest cost/ highest return mills in the world offering further growth potential for years to come. SAIL has land available and access to low cost coal and Posco has production technology to produce the steel at the lowest cost. The new plant will produce steel 20% cheaper and the cost of construction will be 15% less. It’s very tough to build new mills in India because mineral rich areas are densely covered with forest and this has caused many projects to be held up over environmental and demographic issues. This project is projected to boost net income by around 5% when it’s finished. India is projected to have 8-9% CAGR in steel demand over the next 8-10 years. In the December press release it noted: “The cold rolling mill, which will be built in Vile Bhagad Industrial Complex in Maharastra, will produce 1.8 million tons of high-quality cold-rolled steel plates per year, concentrating on automobile steel plates. Construction for the mill will start in November 2011 and end in December 2013. The supply of cold-rolled plate for automobiles is expected to be short by 850,000 tons in 2015, and 1.78 million tons by 2018, making the future prospects for the market very bright.”
The largest proposed plant will be a 12 million ton/ year plant to be built in the Orissa state at a cost of around $12 billion. Posco received approval for the facility on January 31st. Posco plans to begin construction by the end of 2011 and phase one will be complete in 2014 with the entire facility complete by 2020. This project is the single largest foreign investment in India. Posco produced 34 million tons of steel last year, so this project is very large.
Posco's third project is a 6-million-tonne steel plant in Karnataka, India. The company is waiting for land, which it has already paid a partial sum to the state government, Sharan said. "We have been assured land," Posco said.
The first stage for a facility in Indonesia was signed in early 2010. During the 4th quarter of 2010 Posco broke ground on the Indonesia facility. This facility will produce 3mmt/ year by 2013 and expand to 6mmt/ year in the future.
Posco is expanding its production capacity in Gwangyang. The press release said, “Gwangyang No.4 hot-rolling mill will produce 3.3 million tons of hot-rolled steel products per year. Construction is to commence in September 2011 and be completed by January 2014.”
Posco has a goal of producing 40mmt of steel by 2012 from 34 million tons in 2010.
Export subsidies removal in China:
Korea will be one of the biggest beneficiaries of the removal of export subsidies in China. This will make Posco’s products more competitive. Posco was competing with Chinese exports that were subsidized by the government. This is a very positive development for Posco because Chinese producers received a 9% tax rebate on exports. The rebate ended on June 14th 2010. In the short run this will actually cause oversupply and depress prices but in the long run it will benefit Posco and other foreign producers. 45% of Korea’s steel comes from China, this new policy should help Posco’s competitive position as Chinese exports decrease.
Other Notes:
Note: The financial results that are discussed in this report are prepared in accordance with Korean GAAP. US GAAP figures result in a slightly different net income figure. Net income under US GAAP was 11% higher in 2009.
Any further changes to unpeg the Chinese currency to the dollar will help Posco be more competitive and hurts Chinese producers.
China’s plan to transition to a consumption based economy is a positive change.

1. Depreciation of KRW
2. China Short Thesis: Housing/ property oversupply and speculation. China accounts for 49% of global steel demand and growth is slowing due to new construction restrictions. However, the construction market only accounts for 15% of PKX sales.
3. Delays in foreign investments
4. If oversupply in the world steel industry takes longer to correct

Wednesday, March 23, 2011

Glenview Capital Management 2011 Letter

Below please find Glenview Capital Management's 2011 letter. Larry Robbins is a savvy investor and his impressive numbers prove that. The letter has some great detail on their forward outlook, their position in McKesson, their position on the managed care space, their view of Laboratory Corporation, Viacom, Goodrich, Expedia, Tyco, AON, and Pfizer.

As you can see there is a lot of good nuggets to chew on here.


Glenview Capital Management - 3-23-11

Silver Arbitrage Trade Idea

I have been meaning to post more ideas and in depth commentary. Without further ado, here is one of my more recent musings.

Silver Arbitrage.

Short: PSLV
Long: SIVR

PSLV is Sprott Physical Silver. It is an ETF that is backed by physical silver. SIVR is ETF Securities ETF that is also backed by physical silver.

PSVL has a NAV of $14.18 versus its current trading price of around $17.39. This means that it is trading at an approximate 23% premium to NAV. SIVR on the other hand has a NAV of $35.77 versus its current trading price of around $35.96 (premium to NAV of 0.5%).

These two securities are tracking the same thing. PSVL has an expense fee of 45bps versus SIVR has an expense fee of 30bps. So annually all things being equal SIVR should outperform PSVL by 15bps (in the sense of lower tracking error). Both ETFs offer physical delivery options. PSVL has an advantaged tax structure in that it is taxed at the capital gains rate as opposed to SIVR which is taxed at the collectibles rate.

The arb here is pretty simple. I can argue due to the tax structure there should be some slight premium on PSVL vs. SIVR. That premium should be closer to the tax differential (assuming long-term rates 15% tax rate for PSVL and 28% for SIVR. So we can make an argument for a slightly less than 13% premium to NAV on PSVL (less due to management fee tracking error). This leaves us with approximately 10% of excess NAV that can be shorted away in risk free return.

PSVL has actually had its NAV widen recently as can be seen from the chart below:

A 10% risk free spread is fairly attractive. The key to executing the trade is making sure you are 1:1 on NAV. So you can't do it via 1:1 on shares of the ETF. The ratio actually needs to be around 2.5:1 shares short of PSVL to shares bought of SIVR. Once executed you will be completely hedged to the underlying movement of silver and will be able to capture the excess premium to NAV. It makes no sense why PSVL would trade at this much of a premium to NAV. Investors are begging to lose money at these prices.

This situation reminds me a lot of a similar trade put on with GLD (StateStreet gold) and PHYS (sprott gold)

At the time PHYS was trading at a steep premium and GLD was pretty much spot on NAV (like SIVR). Since that time GLD has traded up around 17% whereas PHYS is just up 5% so this is a 12% spread. This can be seen from the chart below:

I think PSLV and SIVR has a similar potential. This could potentially be realized very soon for a real high IRR. Even if it takes a year a risk free 10% is still very attractive.

If anyone has any questions or feedback let me know.

Tuesday, March 22, 2011

John Paulson on Risk Arbitrage

Hat tip to Marketfolly for posting this interesting piece by John Paulson on risk arbitrage. In case you were wondering he wrote this chapter around 2000 so long before the markets deemed him the modern day King Midas. Below is an excerpt from the book, Managing Hedge Fund Risk: From the Seat of the Practitioner: Views From Investors, Counterparties, Hedge Funds and Consultants by: Virginia Reynolds Parker. In the excerpt Jon Paulson discusses his views on risk arbitrage. Remember Paulson & Co was and is a risk arb shop, so this is JP's bread and butter. To be honest I haven't read this book yet but if the other chapters are as rich on content as the one below it may be worth a read.


John-Paulson-Risk-in-Risk-Arbitrage -

Wednesday, March 16, 2011

Mary Meeker / KPCB - USA Inc.

For those who haven't seen this yet its a pretty interesting presentation by Mary Meeker (formerly of Morgan Stanley) now she is a partner at Kleiner Perkins (KPCB) on the current state of affairs for the US. Suffice it to say its not the prettiest picture. Enjoy.

Mary Meeker - USA Inc.

Monday, March 7, 2011

Howard Marks / Oaktree - 2010 in Review

Below please find Howard Marks (Oaktree) annual letter for 2010. As always it is pretty good reading. I personally am quite excited for his upcoming book. Enjoy:

2010 in Review_Memo from Howard Marks