Downside risks in 2H earnings; cut POSCO and Hyundai Steel to Hold

Deutsche Bank Markets Research Asia South Korea Resources Metals & Mining Industry Korea Steel Date 30 April 2016 Recommendation Change Downside risks in 2H earnings; cut POSCO and Hyundai Steel to Hold Turning neutral on the Korean steel sector ________________________________________________________________________________________________________________ Deutsche Bank AG/Hong Kong Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 057/04/2016. Sanghi Han, CFA Research Analyst (+82) 2 316 8900 sanghi.han@db.com Dianna Kang Associate Analyst (+82) 2 316 8901 dianna.kang@db.com Key Changes Company Target Price Rating 005490.KS 230,000.00 to 245,000.00(KRW) Buy to Hold 004020.KS 61,400.00 to 62,800.00(KRW) Buy to Hold Source: Deutsche Bank Companies Featured POSCO (005490.KS),KRW240,500.00 Hold 2015A 2016E 2017E P/E (x) 114.3 12.9 11.3 Price/book (x) 0.35 0.50 0.48 Hyundai Steel (004020.KS),KRW62,900.00 Hold 2015A 2016E 2017E P/E (x) 9.6 9.1 9.6 Price/book (x) 0.44 0.53 0.50 Source: Deutsche Bank Operating profit change 10.7%10.7%5.7%3.9%0%2%4%6%8%10%12%20162017POSCOHyundai Steel Source: Deutsche Bank estimates Why not Sell but Hold? We are downgrading POSCO and Hyundai Steel to Hold from Buy as we expect steel cycle to peak in June, leading to earnings downside in H2 and relative attractiveness such as dividend yield/strong FCF compared to regional peers disappears. In addition, Korean steel companies could face downside pressure from weak orders from the shipbuilding sector. POSCO has rallied 43% YTD (vs. +3% Kospi), the best performer among regional steel names, and we believe the stock is fairly valued at current levels. Our Hold rating is counter consensus, with Bloomberg data showing 81% of the Street with a Buy rating. Regional steel market recovery is not structural Our regional steel team forecasts the steel market could peak in June, similar to the previous cycle in 2H12-1H13. Historically, Korean steel stocks’ performance has been highly influenced by Chinese steel prices at a positive correlation of 0.72. Demand: After seeing a 5% demand retreat in 2015 in China, our team expects demand to decline further in 2016-17 at around 1% per annum. Supply: Despite the so-called ‘supply-side reform’, on which we are skeptical, the Chinese steel industry’s utilisation rate is unlikely to recover to 80% until 2019E. Korea demand/supply likely to deteriorate, especially from shipbuilding There is no further scrappage in capacity, while domestic demand could face downside pressure, especially from the shipbuilding sector. Without new orders along with delivery delays, we cut shipbuilding demand by c.38% to 10.2mnt in 2016-18E from 16.4mnt. Korean steel mills’ run rates should not improve in the next three years. Despite rising iron ore and regional steel prices, steel companies are still struggling to get price hikes from shipbuilders. Capacity could shrink from the government-driven restructuring in the shipbuilding industry, which is in financial trouble. Our net profit estimate for POSCO is 33% below consensus for 2H16 2H16 Street earnings expectations could be disappointing as well as regional and Korea demand/supply outlook. Consensus provided by Bloomberg Finance LP has been lifted by robust 1Q figures, which anticipate a longer recovery than our base case. A reversal of a weak dollar in 2H in line with our view could lead to a depreciation in emerging currencies. It could harm non-operating items (foreign-denominated debt, assets abroad) of Korean steel companies. We expect 2H operating profit and net profit to miss consensus by 24% and 33%, respectively. Earnings and assumption revisions; valuation and risks We align our ASP and OP/t assumptions to match our regional steel views published in April 14, leading us to raise both assumptions by 1/6% in 2016 and 3%/6% in 2017. Our earnings estimates are revised in line with the assumption changes. POSCO: higher export portion could lead to benefit from overall recovery, but other businesses are restricting upward revision in 2016. Hyundai Steel: two-thirds of earnings come from captive customers. Therefore, earnings estimate changes are relatively limited. We use Gordon Growth Model (PBR/ROE) for deriving our target prices. Upside risk: longer-than-expected steel price recovery. Downside risk: a sharp retreat in industry dynamics. Please see figure