Third Avenue Fund Comment on POSCO (PKX) and Henderson Land Development Co. and Cheung Kong Holdings
POSCO – 5-YEAR REVIEW One of the largest detractors to the Fund’s 2010 performance has been our investment in Posco’s American Depository Receipts (“Posco Common”), which were down 21% year to date through July 31, 2010. Posco is a leading Korea-based steel producer. Like the 2010 common stock price declines of several of our other Asian blue-chips (e.g., Henderson Land, Cheung Kong and Wharf ), Posco’s reported business results have been strong. Specifically, Posco recently reported that second quarter operating profit increased by more than 10 times compared to the second quarter of 2009, driven by a 25% increase in revenues and a 23.1% operating margin (parent company), up from 2.7% a year ago. Apparently, the weakness in the stock so far in 2010 has been primarily driven by a less robust near-term earnings outlook.
Owing primarily to rising raw materials costs, Posco’s full year 2010 operating margin is projected to decline to 17%, from 22%, in the first half of 2010. As long-term investors, we usually view stock declines owing to weak near-term earnings outlooks as buying opportunities, rather than reasons to sell. We initially invested in Posco Common in early 2005. Along with Posco’s strong financial position and compelling valuation, one of the primary attractions of the investment was the company’s impressive track record as a low cost steel producer. Notably, during the Asian crisis in the late 1990s, Posco’s operating margin never fell below 10%. During the five and a half years that TAVF has been a shareholder, Fund Management has been very pleased with Posco’s business performance. During the global recession in 2009, when many steel companies lost money, Posco was profitable every quarter, reported a double digit operating margin and generated approximately $2 billion in free cash flow. As a result, Posco did not have to raise dilutive equity the way other steel companies did (e.g., US Steel issued equity in April 2009, resulting in dilution of more than 20%). As the chart below indicates, Posco’s book value has grown at an 18% compounded annual growth rate (CAGR), including dividends, over the last five years.
Although the price of Posco Common has more than doubled since the Fund initially invested, the shares remain attractively priced. As the following table indicates, Posco trades at only 8 times earnings over the last 12 months and 1.2 times book value, despite the best margins and strongest balance sheet among its peer group.
Posco also appears to have an attractive long-term growth outlook. The company plans to increase steel production to 65 million tons in 2018, from 33 million tons currently, driven by the following:
• Growth of domestic capacity to 41 million tons, from 33 million tons. Posco began expansion of both its Pohang and Gwangyang integrated steel mills in 2008, and the projects should be complete by the end of this year.
• Posco is planning new integrated steel mills in India (12 million tons) and Indonesia (6 million tons). These projects are expected to be completed in stages using Posco’s proprietary FINEX technology, which generates significant savings in raw materials.
• The company also has been working on several smaller downstream projects, including a cold rolling mill in Vietnam and automotive steel plants in Mexico and India.
• In May 2010, Posco was named the preferred bidder to acquire a 68% stake in Daewoo International, a leading Korean trading and investment firm. If completed, this transaction would enhance Posco’s steel export business and access to raw materials.
Fund Management has often viewed political risk as the biggest problem with the Posco investment, and the recent report of the sinking of a South Korean ship by North Korea is unsettling. If a steel company like Posco were based in the U.S., its common stock would be a preferable investment if available at a similar valuation. However, as the table above shows, there is a massive disparity in cost structure, valuation and balance sheet between US Steel and Posco. Additionally, Posco appears to have a much better long-term growth outlook. Finally, as the table below shows, the macroeconomic statistics for South Korea seem to be more favorable than those in the U.S.
On Henderson Land Development Co. and Cheung Kong Holdings Ltd.
The Chairmen of companies whose common stocks represent the largest two positions in the Fund, Lee Shau Kee at Henderson Land Development Co. (“Henderson Common”) and Li Ka Shing at Cheung Kong Holdings Ltd. (“Cheung Kong Common”), have continued to purchase shares of their respective company’s common stock during the three months ended July 31, 2010:
• Lee Shau Kee purchased approximately 9 million shares of Henderson Common for HK$432 million (US$56 million) and elected to receive stock (17 million shares) instead of cash for the company’s final 2010 dividend. Lee Shau Kee owns approximately 54.3% of Henderson Common.
• Li Ka Shing purchased approximately 2.5 million shares of Cheung Kong Common for HK$230 million (US$30 million). Li Ka Shing owns approximately 42.1% of Cheung Kong Common.
We view these purchases as a sign of their continued confidence in the future successes of their companies. Additionally, Martin Whitman and I, the Co-managers of the Fund, each made substantial additional purchases of TAVF Common during the quarter.
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