Bonds on Sale at Buffett's Favorite Steel Company
Korean steelmaker Posco's bonds look like a bargain at today's prices, say Morningstar's Dan Rohr and Bridget Freas.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Ahead of the Berkshire Hathaway Annual Meeting, we thought we'd take a look at Warren Buffett's favorite steel company. I am here with analysts Dan Rohr and Bridget Freas to take a look at Posco and see if its bonds are attractive. Thanks for joining me today.
Bridget Freas: Thank you.
Daniel Rohr: Thanks, Jeremy.
Glaser: So Bridget, let's talk a little bit about why Warren Buffett likes Posco so much, we give it a narrow economic moat. How has it earned a competitive advantage in this commodity business?
Freas: So Posco is a South Korean steelmaker that is surrounded mainly by Chinese steel companies. Obviously that area of the world has been very strong in terms of steel demand, but for Posco, what really stands out about the firm is its cost structure. It has much more efficient, low-cost steelmaking operations. It also has a dominant position in South Korea, which tends to be a little bit more stable market, and then naturally Posco has exposure to China, which constitutes 50% of all steel consumption. So it's really the combination of those two things that we give Posco a narrow economic moat.
Glaser: When we look at Posco's expansion into China, how has it really entered into that market?
Freas: Well, it's mainly through exports. Posco does have some joint ventures and some smaller projects within China, but its largest export market is to China, so that's been a huge growth factor for the firm over the past few years. Posco also has focused on adding capacity to its operations in South Korea and other places. It is looking to build a major steel mill in India, which is expected to be the next major growth region. So Posco is really ramping up a growth phase right now.
Glaser: How is it able to keep those costs lows relative to its Chinese counterparts?
Freas: Well, the problem has always been on the raw-material side, and Posco is just as exposed to that as all steelmakers in terms of the costs of iron ore and coking coal, which have gotten really high particularly in the last couple of years. But the firm's main advantage comes in its technology. Posco is known to be an innovator; its steel mills have been built more recently than a lot of its close peers', so in terms of just its output per man hour or how much it costs the firm outside of the raw material to make a ton of steel, Posco comes out ahead.
Glaser: Now, we take a look at Posco's financials, has the firm been able to leverage this low-cost advantage into a strong balance sheet?
Freas: Yeah. Surprisingly, particularly given how much Posco has invested in its business. But given a strong history of operating cash flow and profitability, its leverage really isn't that high, especially when you look at the fact that the firm is one of the top ten largest steelmakers globally. So even though it has quite a bite of debt and quite a bit of capital-expenditures spending, on a relative basis it actually looks pretty attractive.
Glaser: Dan, you look at the credit side in Posco, where does its credit rating shake out for the firm?
Rohr: We assigned Posco a BBB+ issuer rating, which ranks as one of the strongest in the metals and mining space. And there is a few things underpinning that relatively strong rating. It's the structural competitive advantages that Bridget noted that underpin our narrow moat as well as the relatively clean balance sheet. Posco ended 2010 with debt in the neighborhood of 1.25 times trailing EBITDA, which is very strong.
Glaser: Taking a look at individual bond issues, do you think any look particularly attractive today?
Rohr: We'd recommend folks take a look at the 2020s and the recently issued 2021s. I think they offer both, a pretty good bang for the buck, trading in the neighborhood of 175 basis points to 185 basis points over comparably dated Treasuries. That's indicative of a BBB- credit. So there is, in our view, plenty of room to tighten toward a BBB+ range, which at present is in the neighborhood of 135 over Treasuries.
Not only on an absolute-value basis, but we like these guys on a relative-value basis, as well. If you take a look at, say, Nucor, one of Posco's steelmaking peers, we rate the firm a little bit higher at A- but its bonds trade a whole heck of a lot tighter at 85 basis points. So that's 100 basis points inside of Posco. So needless to say with only a one notch difference in credit quality, we think there is plenty of room for Posco bonds to tighten and plenty of upside in the price.
Glaser: Bridget, on looking at equities, do you think that the equity is attractively priced today?
Freas: Not really. It's trading a little bit below my fair value estimate, but I think the market recognizes the potential in Posco. So I don't think it's a steel where it's trading right now.
Glaser: So for investors looking to getting on Posco seems like fixed income is the place to be?
Rohr: That'd be our view.
Glaser: Dan and Bridget, thanks for talking with me today.
Dan: Thanks, Jeremy.
Freas: Thanks, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.
Jeremy Glaser does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.