Chinese steel industry 2008 and beyond

Analysis of Chinese steel industry is critical to understand the macro-economic trend in the steel industry particularly east Asia market, as China accounts for the most of demand and supply increase. The competitive advantage of Chinese steel makers is cost. They have access to cheaper coal, labor and mostly importantly cheap capital. Coking coal still trades $100 per ton cheaper than global market recently. While labor is still cheaper in China, it is a much smaller percentage after recent rise in raw material price. The ion ore deposit in China is lower quality and difficult to mine, hence the majority is still being imported, which mean Chinese steel makers pay the same rate as their global competitors. In sum, Chinese steel makers still have lower cost structure than its competitors but it is much smaller now. The biggest driver of the growth in Chinese steel industry is actually cheap capital. In China, local governors are usually evaluated by local GDP growth and employment rate. Hence they have the incentive to subsidize new steel mill by selling land cheaper than the market rates or/and making loans available at local bank. Chinese banks have been hungry for growth in their loan portfolio due to the high saving rate in China. As a result, steel mills at various scales are burgeoning during and supply soon outstripped fast growing demand. Due to their low cost capital, the steel mills are willing to make modest profit on their products. The small mills often make as little as $10 EBITA/ton.

Chinese steel industry is hitting a tipping point now. The small steel mills in China which accounts for a significant share of Chinese steel production are facing tough headwinds. The critical cheap capital is gone. To fight inflation, Chinese central bank has raised reserve rate to 17.5%., up from 7.5% in 2004. The rising price of raw material effectively raised the requirement for working capital, which caused a capital shortage in smaller mills, which are not able to easily obtain loans from banks now. There is also a biased industry structure working against smaller mills. The small mills can not directly negotiate with foreign raw material supplier and have purchase from the state owned steel maker at a much higher price. As a result their already paper thin margin is now zero to negative. The central government also vowed to improve environment by shutting down high pollution small mills by 2010. There is a nation wide consolidation going on. The state owner integrated steel makers are acquiring the suffering small makers and then shun down the low efficient plants. The new build capacity in 2008 will be around 5100M ton, while at the same time 2400M ton capacity will be shut down (1100M ton was shut down in 2007). So the net capacity increase is 2700M ton, which represent a 5.3% increase. The demand for steel in China is projected to be inline with 10% GDP growth, although certain housing related area is likely to slow. The supply/demand of steel in Chinese local market will move toward balance from overcapacity in 2008

Meanwhile Chinese have raised export tax on steel products. The following chart shows Chinese export raise from less than 10M ton in 2004 to close to70M ton in 2007, while the export tax was reduced from 15% to 0-5% depending on specific products. The export volume reached a tipping point in 2007 when the export tax was raised to 5-10%, which coincide with Chinese government’s move to shut down smaller steel mills. This further puts pressure on Chinese steel export.

POSCO (PKX) is the fourth largest integrated steel maker in the world. The shares of most of its competitors have done quite well in the past 6 month, while the shares of POSCO have been under pressure. Why? Pricing! Investors have been criticizing POSCO’s hesitance to raise their price. Weak pricing power usually turns me down especially when the cost inflation is high. In the case of POSCO, this is not because of weak pricing power. In fact, major domestic and Asian competitors have aggressively raised price. POSCO choose to sacrifice near term profit to keep a good long term customer relationship. The market took this strategy negatively which is reflected in POSCO’s stock price. I do not have a value for the intangible customer relationship. As POSCO trades in line with its global competitors at 11 times earning, the market apparently gives no value for the improved customer relationship, which I believe will pay off in the long run.

POSCO’s management team is best of the breed in the steel business. POSCO operates its steel business in a tough environment. 1, rapidly growing Chinese steel producing capacity intensifies price competition in east Asian market. 2, POSCO is heavily exposed to stainless steel, which has been very volatile in the recent years. 3, POSCO has less internally supplied raw material. POSCO also prices their products below domestic competition. Yet they generate better gross margin (21% in the most recent quanter vs Mittal’s 12%, and US steel’s 7%). This is achieved after POSCO exprense its massive R&D in COGS. The ROE of POSCO has been in low 20s and high teens in spite of lower than average financial leverage and massive cash and equity investment on its balance sheet (15% of Equity is in Cash and equivalent and 32.2% in equity investment). Its long term debt to equity ration is 23.7% vs Mittal’s 74.5% and US steel’s 121%

POSCO’s strategy is to leverage its technology innovation to achieve lower cost and product differentiation. Due to its scale, POSCO has successfully leveraged its R&D spending. An interesting figure to look at is 2005-2007 average capex per ton of major steel maker, which I pulled from US steel’s presentation. POSCO spends almost twice the average to improve efficiency of their steel mill and invest in better technology.

Result? POSCO has decreased their coal ratio from 850kg/THM to 700kg/THM. (chart is cited from POSCO’s 1Q 2008 presentation). Given the fact that coal price has increase almost five folds during last 4 years, the value of such efficiency improvement worth a lot more now.

POSCO also leads the industry in production efficiency. (adopted from 1Q 2008 presentation.)

POSCO also invest heavily to produce high value added products to defend its margin from Chinese competition. Although this strategy backfired in 2006 when its stainless steel business recorded a negative margin, product innovation will help them to sustain higher-than-average gross margin.

The competitive advantage of POSCO

The biggest hidden value of POSCO is its leadership in FINEX technology. FINEX is designed to produce molten iron directly using iron ore fines and non-coking coal, eliminating the costly preliminary process of sintering and coke making. Thanks to the reduced iron making process, the overall construction cost will be slashed by 8 percent compared to that of conventional furnaces. The $1.1bn furnace is expected to produce steel about 17 percent cheaper than the conventional ones since it can use cheaper and more abundant coal fines instead of the previously used high-quality sticky coal lumps. As the skyrocketing coking coal price, the cost advantage of new steel mills build with FINEX technology will be even wider.



In the $140 barrel of oil world, being close to customer is a significant advantage. The undergoing urbanization in India and China will sustain the growth in steel demand for the near future. POSCO is well positioned to ride this trend. Chinese government has ordered to close low efficient and high polluting steel mills by 2010, which effectively reduce supply. POSCO will build a 12M ton steel mill in Orissa, India using the FINEX technology. FINEX technology + low cost ion ore will ensure the cost leader status of POSCO India giving a boost to their bottom line. The new steel mill will serve as a significant base for POSCO to expand into India and Middle East market.

POSCO have good long term relationship with its customers and often hold equity investment in their customers. Although POSCO has more pressure to raise their price in a strong market, it will benefit from the customer relationship during tough time. This is evidenced by the 100% utilization rate in its two major mills from 2002-2006, when other domestic producers suffered influx of steel imports..





The disadvantage of POSCO

Both Korean and Japanese steel makers do not have as much cheap self-supplied raw material as their global competitors (Mittal, US steel). The Chinese competitors have access to lower cost coal, while the Indian Competitors have access to cheaper ion ore. Steel price in Asia is lower than those in North America or Europe, while high shipping rates make it more expensive to sell products in US.

Disclosure: I currently have long position in PKX.

Recent weakness in MCOs present an good entry point for long term investors

Whenever I am attracted to a business that is trashed by the market and trades at a dirt cheap valuation, the first question is to be answered is why it is cheap...

Same applies to the MCOs. They are trading at 7-10 times P/E over their already lowered earning forecast. Why are they cheap? After I listened to 4Q 07 and 1Q 08 of most of the major MCOs (UNH, WLP, AET, CI, HUM and CVH), the most popular questions from the street analysts is the rising medical cost in the form of both unit cost inflation and utilization rate. UNH and WLP have been quite honest on this issue, while others deny. I have no doubt about the higher than expected cost trend. People tend to use more health care service before they lose their job. It is not unexpected that the utilization rate is lagging the economy. The street seems to equal higher cost to lower profits. This view is supported by the rising Medical Loss Ratio (MLR) from the first quarter earning report from the major MCOs.Thus the theory of underwriting downturn is spreading.

It is rather the lack of pricing discipline than the higher cost that leads to an underwriting downturn. As long as the insurers pass the cost onto consumers, higher cost means higher revenue. The managements of the major public MCOs have acknowledged their willingness to protect the margin, even if they are to sacrifice membership growth. I would take managements comment with a grain of salt. Since healthcare insurance is priced annually on a rolling basis, the expected higher trend will certain eat into margin until it is repriced. A positive note from several 1Q 08 call is that the major not-for-profit players who have been driving the price competition are backing off, because these players more heavily rely on investment income and have more exposure to equity investment. Their balance sheets are certainly worsened in the current environment. Hence I expect the pricing discipline will come back as the underwriting capacity of not-for-profit is limited by their balance sheet.

Although I do not have clear view of the profit margin of the MCOs in 08, the valuation is compelling enough to take a hard look. When stock price is depressed by short-term uncertainty not the long term change in fundamental of the business, it often present an attractive investment opportunity.The big picture is still bright for the MCOs. 1, the population in US is growing and getting older; 2,longer life expectancy increases the total medical service to be consumed over one's entire life; 3, advancing in medical technology increase cost; 4,consolidation in the space will continue, especially in the current environment where smaller MCOs are squeezed. If we think the MCOs as a retailer of medical service (as I mentioned in my previous post), these predictable trends are all working for their benefit.

Coventry Health Care lowers its guidance

Another shoe dropped in the managed healthcare space. Coventry(CVH) lowered its full year guidance to $3.65 to $3.75 from $ 4.39-$4.49. Higher than expected MLR is cited. The revision of Private Fee For Service (PFFS) seems to be firm specific driven by a negative development of its reserve (delayed claim submission is cited as the cause.). While the higher than expected MLR of its commercial business is quite a concern. Looking back to its 2008 1Q call, CFO, Shawn M. Guertin, confirmed a "stable trend at the neighborhood of 7.5%", after many of its major competitors (UNH, WLP) reported higher than expected inpatient unit cost. The management also backed its original guidance given the fact that most of its competitors lowered theirs. Management's credibility aside, this revision come barely as a surprise. It is merely a catch up with its competitors......

managed care organization (MCO) is getting interesting

I always like to take a careful look at business that possess a strong balance sheet and yet experienced significant drop in share price....MCOs apparently qualify....I will post a series review of MCO industry on this blog...

Industry Overview

The managed care organization (MCO) is basically a retail business (purchasing medical service in bulk and sell to individual customer) and an insurance business (additional compensation is rewarded for the risk assumed). It creates value for its customers by purchasing medical service in bulk at a lower price and by helping customers using their healthcare service more efficiently. The market divides into three major categories: Commercial Risk Management, Individual market and government sponsored program (Medicare, State Children's Health Insurance Program and Medicaid).The government and large corporations in the commercial risk management segment have a strong bargaining power and more price-sensitive. The individual and small businesses are generally price-taker and have very low bargaining power.

There are usually two or three major MCOs competing in a local market. The high market concentration renders the big firms strong bargaining power when negotiating reimbursement rates for healthcare providers. The rivalry in the industry is decreasing because of the on-going consolidation. I expect the consolidation to continue into the future, as the smaller players can not compete against the low cost large MCOs, especially in this tough economic environment. Due to the slower economy, commercial business is under pressure (both on pricing and membership growth). Higher unemployment rate will result in lower membership enrollment. As corporation customers trying to cut their medical cost, the smaller and high cost MCOs will take a harder hit. Healthcare insurance is largely a commodity business, therefore being a low cost producer is critical to the success of the company. The market share leader can always attract more doctors and negotiating for better rate by committing volume to the doctors. In turn more membership is attracted by low price and larger doctor network. The moat of the market share leader grows by widening gap in the membership counts. Due to such economics of scale in the MCO industry, the entry barrier is high.

In addition to favorable industry characteristics, the demand outlook is bright. The demographic trend driven growth is highly predictable. Healthcare cost is increasing at 7.5%-8% annually, driven by higher unit cost (more expensive new therapy, as medical technology advances) and utilization rate (more frequently using healthcare service). This rate will likely to increase because as the boomers get older, the utilization rate will be higher. Higher cost will be translated to higher revenue for the MCOs given their ability to pass cost inflation onto the end consumers. As people will live longer life, the total medical cost during one’s life will be certainly higher. Secondly 18% of the population are still uninsured, which represents a growth opportunity for individual market. Individual business is more profitable for the insurers since the consumers have less bargaining power, but the selling cost is also higher than dealing with big custromers. Companies who can achieve low selling cost, such as online direct sale, will likely to benefit the most from this opportunity. The fix cost (G&A) is pretty scalable in this business. There is more cost leverage as the topline keeps growing. Hence the bottom line should grow even faster.

The biggest concern in the industry is increased government regulation and uncertainty regarding universal converge policy. I believe universal coverage could be slightly positive for the industry. Although margin is likely to be depressed, it is likely to be compensated by greater volume influx from currently uninsured. Low cost provider will be likely to benefit. Massachusetts already operates under a universal coverage policy, under which insurers have demonstrated their ability to operate profitably. Auto Insurance industry has proven profitability under universal coverage model. Guaranteed issuance will certainly increase the premium, because those with pre-existing conditions that are not able to obtain coverage will be covered. Essentially healthy people are paying to cover the sick. If you think MCO as medical service retailer, larger volume is actually a good thing. Credit Suisse has a nice state-by-state analysis showing a strong positive correlation between government regulation and insurance premium. Given the market power of the insurance companies the higher regulation cost will be eventually passed on to consumer in the form of high revenue.

To be continued….

Please tell me want do you think.

Durian Investing

Finally decide to restart my investing blog.....Many have been leaned from years of successful and unsuccessful trades....

Durian is a fruit with formidable thorn-covered husk and terrible smell...Only people who really what's underneath the appearance and have the gut to take a bite will be rewarded with its sweet and tasty fresh.... Just like value investing....hunting treasures covered by unappealing looks....

So...I call my new blog...Durian Investing