Fighting fire with fire

The author is an analyst for Shinhan Securities. He can be reached at ldh@sinhan.com -- Ed.

Materials/industrial goods industry outlook for summer 2023

We maintain our OVERWEIGHT view on materials and industrial goods industries for the summer (June-August) of 2023. We believe earnings will continue to improve this summer on solid client demand. Shares, which had remained sluggish vs. market conditions, staged an upturn as predicted in our spring report. The rally is expected to continue during the summer season.

By sector, we favor machinery, defense, auto, and shipbuilding the most, and retain an upbeat outlook for chemicals, steel/nonferrous metals, and utility. We keep our HOLD or BUY rating on oil refining and construction, while recommending a conservative approach to ocean shipping which fluctuates widely along with increasing economic volatility.

Sectors in order of preference: Machinery, defense, auto, chemicals, shipbuilding, steel/nonferrous metals, utility, oil refining, construction, ocean shipping

Shipbuilding/ocean shipping: Shipbuilding orders are declining on a YoY basis, but order backlog still stands solid. Newbuilding price hikes have led to strong share performance. Expectations remain for LNG carrier orders from Qatar and Mozambique in 2H23. With earnings on a recovery path, current share valuations appear undemanding. The ocean shipping sector is facing increasing volatility.

Defense/machinery: Shares have surged over the past three months. Demand for construction equipment and power equipment soared with the boom in infrastructure investment in North America and the Middle East. Earnings are on growth track thanks to ASP hikes and falling raw material costs. Despite weak order intake, expectations remain intact for the defense sector. With Poland orders beginning to contribute to sales, strong earnings are expected for 2H23.

Construction: A lull in momentum is projected for 3Q23, as price negotiations between clients and builders have dragged on due to falling margins. Orders are expected to flow in at home and abroad toward the year’s end given high alternative cost, limited room for order intake by builders, and clients’ commitment to projects. Builders that have already secured orders and cost competitiveness should be at an advantage.

Auto: Despite recession fears, auto sales in April and May came in solid in the US and other overseas markets. Product mix improvement and favorable forex should positively affect profitability. Sales of eco-friendly cars also look decent considering the IRA impact. Automakers’ earnings and valuations will continue to look attractive until we pick up clear signs that market conditions and earnings have passed a peak.

Oil refining/chemicals: Chemical plays rebounded amid expectations for reopening earlier this year, but again turned downward on slowing recovery in China demand. Still, expectations remain for an upturn in market conditions in view of stabilizing oil prices and China’s stimulus policy in 2H. Oil refining companies will inevitably see a dip in earnings in 2Q due to weak oil prices and refining margins. Supply-demand conditions should turn favorable going forward on an upturn in global demand led by China as well as production cuts by OPEC+ members. Refining margins are expected to strengthen in 2H23.

Steel/nonferrous metals: Prices of steel and nonferrous metals weakened in 2Q as many indicators of China’s manufacturing sector fell short of market expectations. Earlier this year, the directionality of the sector hinged on an upturn in demand which had been hit hard by pandemic lockdowns. For the rest of the year, supply control should again become increasingly important. Although regulations on crude steel production would not be as strict as in the past in order to promote the recovery of the manufacturing sector, there will likely be a cap on total annual output. The surge in crude steel output seen earlier this year raises a possibility of production cuts in 2H. We recommend POSCO Holdings and Korea Zinc which are expected to generate sales from new businesses along with mainstay businesses.

Utility: Despite electricity tariff hikes in 1Q and 2Q, KEPCO delivered poor share performance as the extent of tariff hikes was narrower than the market had anticipated. Korea Gas Corporation suffered share price correction after it decided to make no dividend payout for 2022 in an effort to improve its financial structure which deteriorated on the increase in accounts receivable. As electricity tariffs for 3Q will be determined in the near term, relevant expectations may result in a short-term surge in KEPCO’s share prices. But, we believe it will take more time before the shares stage a longer-term cyclical rebound owing to valuation burden.

Top picks by sector

HD Hyundai Infracore (machinery): The engine business has driven earnings gains, and the growth is widely expected to continue in 2H. In the long run, synergy with HD Hyundai Construction Equipment will be maximized, and the value of the engine business will increase further.

HD Hyundai Electric (machinery): Strong order intake likely continued into 2Q23 from the previous quarter. Room for order intake has expanded with deliveries set to be made over a long period of time on strong client demand. Earnings should continue on an uptrend thanks to ASP hikes and increasing shipments.

Hyundai Engineering & Construction (construction): Plant earnings will grow at an accelerated pace with orders from Saudi Arabia’s Amiral project to be booked in 3Q. New apartment subscriptions came in sluggish, but the resumption of the development project for the CJ complex site in Gayang-dong should add a boost to domestic earnings. Investment points include ample cash on hand and differentiated earnings driven by various projects.

DL E&C (construction): Earnings turnaround is expected on the back of plant projects at home and abroad. Ample cash reserves put the company at an advantage in securing projects based on equity investment as well as large-scale development projects, which will in turn lead to outstanding profitability.

Hyundai Mobis (auto): The electrification business continues on growth track along with the increase in EV sales at a group affiliate. Weak profitability issues will be resolved by mass production and automation.

Hyosung Advanced Materials (chemicals): Strong competitiveness of tire cords will lead to earnings gains in 2H. Growing earnings contribution from fast-growing and high-margin carbon fiber should continue to drive a re-rating of share valuations.

SK Innovation (oil refining): The mainstay business will remain solid on improvement in refining margins in 2H amid strong downside rigidity seen in oil prices. The value of the battery business should increase from 2Q with a full-fledged upturn in battery margins. Korea Zinc (steel/nonferrous metals): Earnings should stage a rebound from 2Q23. A re-rating of share valuations is expected with commercial production of copper foil and precursors to begin from 4Q23 and 2024, respectively.