Global Economics

Posco's Case for a Takeover


The persistent market chatter that South Korean steel giant Posco (PKX) is mulling a takeover of Daewoo Shipbuilding & Marine Engineering underscores two divergent trends in the global heavy industries arena. The steel sector is suffering from a glut of gargantuan proportions, thanks to a flood of exports from China. On the other hand, Korea's world-leading shipbuilders are experiencing an order backlog that will keep them busy until near the end of the decade. So wouldn't it make sense for a cash-rich steelmaker like Posco to buy a shipbuilder, secure a captive buyer of its products, and slip out of its current jam?

Posco, the world's fourth-largest steel company, reported on July 12 a profit decline for a third straight quarter as fierce competition from its Chinese rivals has sent prices falling amid surging iron ore costs. Its net profit for all of this year is expected to plunge 30%, to $2.91 billion, from $4.16 billion last year, according to Daishin Securities in Seoul.

The worry is that steel prices could fall further, particularly if Beijing is really serious about wrestling down the Chinese economy that is expanding at a breakneck pace. China, which produces a third of the world's steel demand, will have to accelerate its export push if its domestic economy really needs cooling off. As a result, Posco, the largest supplier of steel to Korean shipbuilders and carmakers, will likely face tougher competition from Chinese steel providers to grab orders.

HEADED TO AUCTION. Under such circumstances, locking in a big customer such as Daewoo Shipbuilding, which devours about 1 million tons of steel plates annually, could be an attractive business proposition. What makes such a deal more palpable is the killer profit outlook going forward for the Korean shipbuilding industry. Hyundai Heavy Industries, Daewoo, and Samsung Heavy Industries dominate the market for mega-container ships, huge tankers, and most advanced carriers of liquefied natural gas—all of which are enjoying brisk demand (see BusinessWeek.com, 5/12/06, "Korea's Shipbuilding Industry Sails Ahead").

The consensus among Korea's brokerage houses is that Daewoo Shipbuilding will likely report a return-on-equity (ROE) exceeding 21% next year, well above the 14% ROE projected for Posco in 2007. "Of course, any deal will depend largely on pricing. But if Posco could take a controlling stake in Daewoo Shipbuilding at a fair price, it could catch two rabbits with one stone," says steel industry analyst Moon Jeong Up at Daishin. At the current market price, buying a 50% stake in Posco will cost just a bit more than $3 billion.

Daewoo Shipbuilding is expected to go on the block soon as major shareholders Korea Development Bank (KDB) and Korea Asset Management plan to cash out their investment made as part of an earlier government-arranged bailout of the shipbuilder. The two state-controlled bodies ended up with huge credits when Daewoo Heavy's parent, Daewoo Group, collapsed in 1999 under $70 billion in debt. They swapped their debt for equity in the following year. KDB owns a 31.1% ownership stake in Daewoo, while Korea Asset Management has a 19.1% piece of the shipbuilder. Freed from Daewoo Group, the shipbuilder pulled off a quick turnaround to become the leader in such higher-value vessels as liquefied natural gas carriers.

BUILDER'S MARKET. For now, Posco says it is not actively pursuing such a takeover. "With Daewoo Shipbuilding & Marine Engineering being an important client of us, we are certainly monitoring with interest implications of a possible change of ownership," says Posco spokesman Hugo Bae. "But so far, we have not considered acquiring Daewoo Shipbuilding."

Yet corporate analysts believe Posco could become a serious bidder, given the precarious prospects of the steel demand. In contrast, Daewoo Shipbuilding, along with leader Hyundai Heavy Industries and similar-sized Samsung Heavy Industries, is cruising at full steam. The three largest shipbuilders in the world have won so many contracts in the past year that their dry docks are fully booked until late in 2009.

True, Daewoo Shipbuilding was in the red in the first quarter of this year, posting a net loss of $46.7 million on sales of $1.22 billion. The poor performance was due to the weak market conditions in 2003, because many of the ships contracted back then were delivered in the first half of this year. Ship prices jumped in 2004 and have since stayed strong. (Ship prices were up 33.7% in 2004 from the average price of the previous 10 years for tankers, up 28.2% for container vessels, and up 27.9% for gas carriers, according to London-based market researcher Clarkson.)

BACKLOG BILLIONS. That means Daewoo will have a profit windfall at least over the next three years. Shipbuilding analyst Jerry Kang at Korea Investment and Securities forecasts Daewoo will post a net profit of only $68.5 million for all of this year in view of the disappointing results in the first half. But he expects profits to soar to $570.5 million in 2007, $809.1 million in 2008, and $933.6 million in 2009.

The bright future explains why Daewoo Shipbuilding's stock price has risen 56% in the past year, despite poor financial results in the first quarter of this year. Of course, the boom that began in 2004 won't last forever in the cyclical shipbuilding industry. Profits after 2009 will depend on contracts signed from now on. "With Korean dry docks fully engaged for the next three years, they won't take on more jobs at bad terms," says Yoon Pil Joong, shipbuilding analyst at Samsung Securities. "But growth won't continue at a pace we've seen in the past three years."

There's no sign the trend is reversing for Daewoo, at least for now. In the first six months of this year, it won new orders to build 30 ships worth $5.3 billion, the same value it secured for all of last year. On top of that, Daewoo won $1.87 billion in contracts to build offshore drilling rigs in the first six months, up from $1.5 billion for all of last year. At the end of June, it had a backlog of contracts worth $20.9 billion. That and overheating worries in China look like good enough reasons why the market keeps talking about a possible takeover by Posco.


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