Team 2 Project Progress Report: (U.S. Steel vs.

Financial Analysis: US Steel & POSCO

GROUP 2: Matt Dina, Rojmary Fernandez, Brian A. Joubran, Ryan Lamberg, George Rafal, Farhan Zamil

UC DAVIS GRADUATE SCHOOL OF MANAGEMENT – BAY AREA PROGRAM

MGB-260: CORPORATE FINANCE

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EXECUTIVE SUMMARY

INTRODUCTION

The following document provides a financial analysis between two steel corporations, US Steel Corporation (US Steel) and Korean POSCO Inc. The document is broken down into several sections that provide in depth insight into each company’s financials as well as corporate governance structure. The report consists of an analysis on each firm’s corporate governance structure, stockholders, risks and returns, measurement of investment returns, capital structure choices, dividend policies, dividend analysis framework, and valuations. It concludes with a general overview of each company’s financial health and future investment and financing recommendations. The following briefly summarizes the findings in this report.

KEY FINDINGS

1. Corporate Governance: There is a clear separation between management and ownership in US Steel’s Board of Directors, as only 1 out of 13 members are insiders and less than 1-percent of stock is owned by insiders; where POSCO has a near 50/50 split between insiders and outsiders, and a heavy academic influence in their Board makeup.

2. Investors: Institutions are the marginal investors (65%) for US Steel, while POSCO’s marginal investor is the public (71.69%), which includes 15.19 percent of ADRs.

3. Risks: US Steel and POSCO have a relatively high risk profile, as they have significantly underperformed market returns, but relatively low cost of debt and equity, 6% and 5.5% respectively for US Steel, and 4% and 5% for POSCO.

4. Investments: Based on Returns on Equity (ROE) and Capital (ROC), US Steel’s projects have returned negative values in the past three years and trending downward, while POSCO’s ROE and ROC have been relatively positive but also trending downward. Equity and Capital Economic Value Added (EVA) for US Steel are also negative, suggesting investments in poor projects, while POSCO’s Equity EVA is positive, but trending downward.

5. Capital Structure: US Steel relies heavily on debt to manage its operations with a mix of 54% debt and 46% equity, while POSCO has more equity on hand with a capital mix of 27% debt and 72% equity.

6. Dividends: While both companies currently pay dividends, neither US Steel nor POSCO have sufficient cash flow growth prospects to prudently return additional cash to shareholders. US Steel’s 0.75 dividend yield is less than half the S&P 500’s 2.0% yield. In contrast, POSCO’s dividend yield is nearly twice the broader Korean stock market’s yield.

7. Valuation: Both US Steel and POSCO were found to be overvalued. Both US Steel and POSCO’s valuation amounted to a Net Present Value (NPV) of $5.3 billion.

CONCLUSIONS

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BRIEF INDUSTRY OVERVIEW

The global steel industry faces massive excess production capacity. Governments in emerging markets, particularly China, have lavished generous subsidies on their domestic producers while erecting trade barriers to limit imports. As a result, even steel exporting powerhouses like South Korea are feeling the pinch. The impact is particularly acute for North American and Western European steelmakers including US Steel. By contrast, South Korean government largess in the form of tailored infrastructure, subsidized land, financial benefits (e.g., favorable credit terms, tax exemptions, and harbor fee waivers) and raw materials has benefited POSCO.1 Nonetheless, China’s rise from the world’s largest steel importer to the leading global exporter shifted the global dynamic. Indeed, South Korea was the largest importer of Chinese steel by 2012.2 As such, even world leading producer POSCO is not immune to the oversupply epidemic.

This sea change temporally corresponded with a capacity spike since 2000. Total production capacity and excess production capacity have more than doubled even as capacity utilization remained anemic after cratering the 2007-09 recession. See Figure 3.0. All the while capacity maintained its steady march upward. At bottom, it is nearly impossible for bona fide private sector firm to compete with an overtly state-sponsored enterprise with a core purpose of promoting sovereign policy interests without regard for profit optimization. This dynamic has exacerbated US Steel’s woes. The firm experienced steady decline since the late 1960’s as it lost market share to competitors and faced an overall decline in demand for steel goods in North America.

In the last two decades the steel industry has seen a great deal of consolidation. In the early 1990’s there were about a dozen major steel makers in the United States. Today, there are five. That being said, industry analysts believe this may still be too many due to the overcapacity and low profit margins in the market3. Some analysts have begun to question if US Steel will be the next steel producer to file for bankruptcy4. The company is vertically integrated, owning its own ore mines, coke producing facilities, steel mills with storage facilities, several steel finishing joint ventures, and transportation subsidiaries. Currently, the firm is expanding by joint ventures and acquisitions (2007-Lone Star Technology and Stelco Inc.)5. It is also using its three R&D divisions to develop new products; however, US Steel is also consolidating its operations. Us Steel has controlling ownership percentages in mines, long-term supply agreements (15 year coke supply Gateway Energy & Coke Company LLC, for example) and owns a host of subsidiaries to remain integrated. It started reducing capacity in response to oversupply by closing the Hamilton plant and two coke6 factories in Gary.

The firm relies on long-term contracts at fixed prices with high volume customers. The company also enjoys some protection from certain imports though import tariffs. Additionally, US

1“Surging Steel Imports Put Up To Half a Million U.S. Jobs at Risk” EPI. Com, by T. Steward, et al, May 13, 2014, http://www.epi.org/publication/surging-steel-imports/ , p. 37. 2See “Surging Steel Imports Put Up To Half a Million U.S. Jobs at Risk” EPI. Com, by T. Steward, et al, May 13, 2014, http://www.epi.org/publication/surging-steel-imports/ , p. 44. 3 The Economist, “An Inferno of Unprofitability,” Economist.com. July 6 2013, http://www.economist.com/news/business/21580458-worlds-overcapacity-steelmaking-getting-worse-and-profits-are-evaporating-inferno 4 Bloomberg News, “U.S. Steel Signals Risk of Default” Triblive.com, June 29, 2012, 12:01AM. http://triblive.com/home/2119157-74/steel-company-debt-percent-default-bloomberg-data-market-risk-bonds#axzz2vsyxHheO 5 “History of US Steel” United States Steel Corporation website. https://www.ussteel.com/uss/portal/home/aboutus/history 6 Greg Keenan, “U.S. Steel Ends an Era in Hamilton” Theglobeandmail.com. 29 Oct 2013 8:09PM EDT http://www.theglobeandmail.com/report-on-business/us-steel-to-shut-down-hamilton-works-ceo-says/article15142440/

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Steel has a natural advantage where there are legal requirements for domestically sourced steel in government construction projects. However, US Steel is mired down with old technology and legacy costs. These legacy cost include paying retiree benefits to approximately 140,000 former employees and environmental clean-up liabilities dating back up to 100 years of activity. As restrictions on imported steel products have relaxed over the years, more imported steel products can enter the U.S. market, thus reducing US Steel’s market share.

Both firms will continue to face the threat of substitution. For decades, manufactures have been moving away from steel in favor of alternative products such as plastic and aluminum. Recently, Ford announced that it would begin making its F-150 trucks with aluminum beds and bodies thereby reducing the weight and making the truck more fuel efficient7. Other automakers are likely to follow. The rivalry among existing competitors is intense. The steel market is heavily saturated with many giant competitors, all of which have excess capacity8. In addition to the supplier strengths, steel makers have to operate with the bargaining power of steel buyers. The steel industry has its customer base in the thousands and the products they make are even more numerous. Nonetheless, they have several factors that give them negotiating power with the steelmakers. The largest factor is that steel is a standardized product.

This results in a high level of threat from competitors and competitive intensity rarely seen in high fixed cost industries. Further price cuts are therefore inevitable barring unforeseen explosive economic growth. Against this backdrop, the following backward looking risk quantitative risk metrics significantly understate the downside for steel producers.

FIGURE A: GLOBAL CRUDE STEEL PRODUCTION, CAPACITY, AND UTILIZATION, 2000–2013

7 Marsha Robe, “U.S. Steel: Tough Road to Recover,” Seekingalpha.com. Feb 6, 2014, http://seekingalpha.com/article/1999681-u-s-steel-tough-road-to-recovery 8 Seeking Alpha, “The Steel Industry’s Imminent Correction,” Seekingalpha.com. Dec 27, 2013, http://seekingalpha.com/article/1917881-the-steel-industrys-imminent-correction?source=google_news.

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I. CORPORATE GOVERNANCE STRUCTURE

1.1 THE CHIEF EXECUTIVE OFFICER

US STEEL:

US Steel Corporation’s (US Steel) Board of Directors elected Mario Longhi President and Chief Executive Officer (CEO) in June 2013. . He first joined the company in 2012 as the Executive Vice President and Chief Operating Officer. Prior to this position he served as president of Gerdau Ameristeel Corporation in 2005 and 2006, and additionally as CEO from 2006 to 2011. Prior to this, he spent 23 years at Alcoa Inc. and has been in the metals industry for over 25 years. A U.S. citizen since 2007, he serves on the Executive Committee of the World Steel Association. According to US Steels 2014 proxy statements, Mr. Longhi’s received $933,377 in base salary for 2013 and received $4.7 million in options, making his total executive compensation $5.64 million for 2013.9

POSCO:

Oh-Joon Kwon was officially confirmed as POSCO CEO and Representative Director in March 2014. While he has 25 years with the company, this is his first executorship with the organization. His term expires in Mach 2017. POSCO reports do not identify Mr. Oh-Joon’s prior POCSO experiences. Mr. Kwon graduated from Seoul National University with a degree in Metal Engineering, and holds a Master’s degree in Materials Engineering from the University of Windsor, and a Ph.D. in Material Science and Engineering from the University of Pittsburgh. He also serves as the CEO of the Research Institute of Industrial Science & Technology (RIST). Due to Mr. Kwon’s recent election, POSCO only provides executive compensation paid out in 2013, of which former CEO Joon-Yang Chung received W1,954 million. POSCO’s current CEO, however, recently announced that he will return 30 percent of his recent pay until the company’s profits begin to rise.10

1.2 THE BOARD OF DIRECTORS

US STEEL:

Current President and CEO, Mario Longhi is the sole insider on US Steel’s 13 member Board of directors. Eleven of the Directors are current or former CEO of other large corporations. All directors hold over 10,000 shares of US Steel stock, with retired chairman and CEO, Charles R. Lee, owning the most at 33,399 shares.

9 http://xnet3.uss.com/corp_portal/investors/proxy/2014/index.html#tx656544_30 10 http://www.koreatimes.co.kr/www/news/biz/2014/03/123_153668.html

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LIST 1.1: US STEEL’S BOARD OF DIRECTORS, PRINCIPLE OCCUPATION, AND SHARE OF STOCK No. Board Member Title Principal Co Shares

1 David S. Sutherland (Chair) Retired President and CEO IPSCO, Inc. 28,305 2 Dan O. Dinges Chairman, President and CEO Cabot Oil & Gas Corp. 11,035 3 John G. Drosdick Retired Chairman, CEO & President Sunoco, Inc. 24,147 4 John J. Engel Chairman, President and CEO WESCO International, Inc. 10,066 5 Richard A. Gephardt President and CEO Gephardt Group 18,997 6 Murry S. Gerber Retired Chairman and CEO EQT Corp. 6,297 7 Thomas W. LaSorda President Lasorda Group LLC 3,669 8 Charles R. Lee Retired Chairman and Co-CEO Verizon Communications 33,399 9 Mario Longhi President and CEO US Steel 25,900 10 Robert A. McDonald Ret. Board Chairman, President & CEO Proctor & Gamble 0 11 Glenda G. McNeal Executive VP and GM AmEx Co. 15,192 12 Seth E. Schofield Retired Chairman and CEO USAir Group 27,737 13 Patricia A. Tracey Vice President H.P. Enterprise Services 15,192

POSCO:

POSCO’s twelve board members are fairly balanced between five inside and seven outside members. In contrast to US Steel, however, only three have held, or have current, titles of president or CEO with outside organizations. While board member affiliations do not seem to have any direct conflict of interest with POSCO, it is interesting to point out that POSCO’s Board contain more of an academic influence and have less stockholdings, with CEO Oh-Joon Kwon owning the majority shares at 1,250. A stark contrast to US Steel, which consist of corporation affiliations and a large amount of stockholdings.

LIST 1.2: POSCO’S BOARD OF DIRECTORS, PRINCIPLE OCCUPATION, AND SHARE OF STOCK No. Board Member Title Principal Co. Shares

1 Oh-Joon Kwon CEO POSCO 1,250 2 Jin-Il Kim President of Steel Production POSCO 300 3 In-Hwan Chang VP of Steel Business POSCO Unknown 4 Dong-Jun Yoon VP of Corp. Infrastructure POSCO Unknown 5 Young-Hoon Lee VP of Finance & Investment POSCO 178 6 Chang-Hee Lee (Chair) Professor Seoul Nat’l Univ. Unknown 7 James B. Bemowski Vice Chairman Doosan Co. Ltd. Unknown 8 Chae-Chol Shin Former Chairman and CEO IBM Korea Inc. Unknown 9 Myoung-Woo Lee President Dongwon Industries Unknown 10 Il-Sup Kim President Seoul School of Integ. Sci & Tech Unknown 11 Young Sunwoo Lawyer Rhi & Partners Unknown 12 Dong-Hyun Ahn Professor Seoul Nat’l Univ. Unknown

1.3 SHARE VOTING STRUCTURE

US Steel and POSCO each issued a single class of common stock, and each share carries identical voting rights.

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1.4 FINANCIAL MARKET CONCERNS

US Steel is followed by 38 analysts, and has an average trading volume on the NYSE of 5.3

million, with a Morningstar credit rating of BB-i. POSCO’s average trading volume of ADRs on the NYSE is 270,730, with a total of 7 analysts following and a Morningstar credit rating of BBB-ii.

1.5 SOCIETAL CONSTRAINTS

Steelmakers absorb significant public disdain for imposing substantial costs on stakeholders. Iron ore mining operations have displaced indigenous people on every inhabited continent, smelting entails combustion of carbon-intensive fuels (typically meteorological coal) and generates waste product replete with caustic chemicals, and transport and installation of finished goods requires primarily diesel-powered vehicles and heavy equipment. The environmental externalities are incalculable. Moreover, global steelmakers are frequently criticized for using heavy-handed, exploitive labor practices. While U.S. and Korean law does much to remediate these undesirable byproducts of steel production, US Steel and POSCO are cognizant of their perennial public relations problem.

Each has embarked on an ambitious if largely ineffectual corporate social responsibility (“CSR”) campaign remediate the toll of their industry’s unsavory legacy.

US STEEL:

US Steel instills in each employee a personal responsibility to comply with all environmental laws and regulations as well as environmental policies, practices, procedures by requiring employees to report immediately any actual or potential violation of environmental laws or regulations to supervisors and to the Environmental Control Department. US Steel also manages its image well by hosting United Way Employee Giving events, which are considered the largest one-day fundraising event for the United Way of Allegheny County. US Steel also displays exemplary corporate citizenship, innovation and business practices in the Slovak Republic, where it was recently honoured with a Corporate Excellence award for exhibiting the qualities of conscience, character and integrity.

US Steel has also long prided itself in having been a trailblazer in good corporate governance, as it touts being the first corporation to publish an annual report (in 1903); hold an annual meeting for its shareholders (1902); create and apply a code of business conduct (circa 1909); introduce benefit programs, medical and pension plans (1902-1908); adopt the eight-hour workday (1923); recognize the steelworkers' union (1937); and establish an employee stock program (circa 1903). It also touts it commitment to supporting Continuing Education programs throughout the years, by providing funding to students and faculty in the development and execution of service-learning projects and internships that provide support to non-profit organizations and businesses through grants that created the United States Steel Program Fund for Engineering, Business and Technology Projects.

POSCO:

POSCO touts its building a sound corporate eco-system by adopting a better sense of partnership with employees, stakeholders and the surrounding environment. POSCO has adopted a unique corporate philosophy of Society, Partner, Investor, Customer, Employee and Environment (SPICEE), which emphasizes building stronger relationships with each SPICEE element. These efforts earned POSCO several awards for corporate social responsibility in East Asia in 2013. POSCO was

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recently acknowledged as a leading company in governance structure for its company’s unique separation of CEO and Board Chairman.

1.6 GOVERNANCE RISKS AND OPPORTUNITIES

US STEEL:

External observers are skeptical of US Steel’s governance practices. GMI Ratings (“GMI”) recently observed that US Steel as a “Very Aggressive Accounting & Governance Risk (AGR®),” placing it in the sixth percentile AGR® among North American firms.11 See GMI Accounting & Governance Risk Overview, United State Steel Corp., dated April 4, 2014. The GMI Report cited recent executive suite changes as a governance concern. Despite immediately implementing numerous strategic shifts calculated to cuts costs and improve productivity, only time will determine whether Longhi will succeed.

Further, GMI “flagged” several areas of concerns that its models indicate potential misreporting. The flagged corporate governance issues include CEO and CFO compensation, tenure and recent officer changes. GMI also cited several concerning accounting metrics that correlate with subsequent financial reporting problems. GMI nonetheless vested US Steel with the highest Equity Risk Factor rating, which places US Steel in a peer group that has outperformed.

POSCO:

POSCO’s history as a state sponsored enterprise provides instructive insight into its governance regime. The South Korean Government divested completely in 2000. POSCO’s articles of incorporation require outside directors to comprise a majority of the BOD. Unlike NYSE listed firms, however, POSCO has “not established a separate nomination corporate governance Committee.” Nonetheless, POSCO’s executive Compensation Committee is composed of four Outside Directors, who convene privately and deliberate behind closed doors. POSCO has improved governance with independent directors and executive compensation tethered to shareholder returns. These improvements have yielded a disciplined focus on expansion-focused capital expenditures financed with operating cash flow. Morningstar vested POSCO with its default “Standard” stewardship rating. GMI similarly rated POSCO with an “average” AGR® with respect to governance, and cited relatively few “flags” that give rise to potential misreporting concerns.

II. STOCK HOLDER ANALYSIS

2.1 STOCK OWNERSHIP

POSCO and US Steel contrast significantly when analysing their stockholders. In the case of POSCO, institutions hold about 17% of POSCO holdings while institutions hold approximately 65% of US Steel. In addition, the public owns about 72% of POSCO while the public owns about 35% of US. Steel. Perhaps most telling is that POSCO retains about 11% of its own ownership, while US Steel is almost entirely owned by others. Table 2.1 and 2.2 below list the percentage of insiders, institutions

11See GMI Accounting & Governance Risk Overview, United State Steel Corp., dated April 4, 2014 (obtained courtesy of Fidelity Investments, LLC).

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and public shareholders for each company. Figures 2.1 and 2.2 show a graphical representation of institutional investors for each company as well as by category.

TABLE 2.1: US STEEL SHAREHOLDERS BREAKDOWN Shareholder Shares Percent

Insiders 709,226 0.49% Institutions 94,081,000 65% Public 49,949,774 34.51% Total 144,740,000 100%

TABLE 2.2: POSCO SHAREHOLDERS BREAKDOWN Shareholder Shares Percent

National Pension Service 5,937,323 6.81% Nippon Steel Corporation (ADRs) 4,394,712 5.04% SK Telecom 2,481,310 2.85% Pohang University of Science and Technology 1,905,000 2.18% Directors and Executive Officers as a Group 20,251 0.02% Public (Including 15.19 ADRs) 62,505,848 71.69% POSCO (Treasury Stock) 7,449,117 8.54% POSCO (Treasury Stock Fund) 2,493,274 2.86% Total 87,186,835 100%

FIGURE 2.1: US STEEL VS. POSCO SHAREHOLDERS BY CATEGORY

FIGURE 2.1: US STEEL VS. POSCO INSTITUTIONAL INVESTORS

Insiders0%

Institutions65%

Public35%

Insiders

Institutions

PublicInvestors

6.83%

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4.25%

3.21%

1.77%

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1.46%

1.36% 1.31%Vanguard Group, Inc. (The)

JP Morgan Chase & Company

State Street Corporation

Capital Research Global Investors

BlackRock Institutional TrustCompany, N.A.Van Eck Associates Corporation

Dimensional Fund Advisors LP

Shaw D.E. & Co., Inc.

Citadel Advisors LLC

BlackRock Fund Advisors

6.81%

5.04%

2.85%

2.18%National Pension Service

Nippon Steel Corporation

SK Telecom

Pohang University ofScience and Technology

POSCO US Steel

Insiders0%

Institutions17%

Public 72%

Company Owned

11%

Insiders

Institutions

Public

Company Owned

POSCO US Steel

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2.2 INSIDER HOLDINGS

Of the major individual investors in either company, none own more than 1% and therefore insider influence is minimal. The US Steel stock is held by less than 1.38%12 of employees overall while POSCO employees own less than 2.25% 13 of the shares. Tables 2.3 and 2.4 provide a breakdown of major individual shareholders for each company.

TABLE 2.3: US STEEL: MAJOR INDIVIDUAL SHAREHOLDERS Shareholder Title Shares Percent

John Surma Former CEO 389,232 <1%

Murry Gerber Board Member 136,088 <1% Gretchen Haggerty Retired CFO 128,402 <1% David Burritt CFO 95,890 <1% Total 144,740,000 100%

TABLE 2.4: POSCO: MAJOR INDIVIDUAL SHAREHOLDERS Shareholder Title Shares Percent

Noi-ha cho Senior Executive VP 3,500 <1%

Joon-yang chung CEO 1,714 <1% Joon-sik kim Senior Executive VP 1,177 <1% Hag-dong kim Senior Executive VP 940 <1% Total 7,331 100%

III. RISK AND RETURN

3.1 ESTIMATING HISTORICAL RISK PARAMETERS (TOP DOWN BETAS)

In analyzing the risk profile of both US Steel and POSCO, a regression of each firm’s stock was run against the returns on their corresponding market index using monthly data and 5 years of observations. S&P 500 returns averaged 5.21% over the previous 10 years and averaged 18.60% over the last 5 years (Figure 3.1). US Steel’s cost of equity capital is therefore extraordinarily rich compared to the greater history. For the KOSPI, the annualized return for 10 years was 8.47%, lower than the 5 year to date of 10.48%. As a result an argument can also be made that the cost of equity capital for POSCO is also slightly elevated given the higher 5-year market environment.

12 10-K, page F-50, filed with the SEC on Feb. 25, 2014 13 Form-20-F Y/E 2011 Page 62

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FIGURE 3.2: US AND SOUTH KOREAN MARKET RETURNS (ANNUALIZED)

US STEEL:

US Steel’s regression-beta was estimated at 2.23, suggesting that for every 1-percent increase in the market, US Steel stock will increase 2.23 percent. However, this regression-beta is unrealistic as it exceeds the typical beta range for most companies. Additionally, the standard error translates to a 95% chance that the Beta will be between 1.56 and 2.90 (Table 3.2). These observations indicate that there is variation in the data and a single point estimate for Beta may not convey the whole picture. The data for US Steel shows that 43% of the variation can be explained by the market (Figure 3.1).

TABLE 3.2: US STEEL VS. MARKET LINEAR REGRESSION DATA Coefficient Std. E t Stat P-value Lower 95% Upper 95% Intercept -0.02 0.014 -1.36 0.180 -0.05 0.01 S&P 500 2.23 0.334 6.69 0.000 1.56 2.90

POSCO:

POSCO’s regression-beta was calculated at 0.87, suggesting less sensitivity to market returns. The regression ranged between 0.58 and 1.14 approximately 95% of the time (Table 3.3). The coefficient of determination 0.39 suggests that 39% of the variation in the POSCO’s return data can be explained by the market. (Figure 3.1).

TABLE 3.2: POSCO VS. MARKET LINEAR REGRESSION DATA Coefficient Std. E t Stat P-value Lower 95% Upper 95% Intercept -0.01 0.007 -1.23 0.224 -0.02 0.01 S&P 500 0.87 0.141 6.16 0.000 0.58 1.15

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FIGURE 3.1: US STEEL VS. POSCO REGRESSION TRENDS

3.2 COMPARING TO SECTOR BETAS (BOTTOM UP BETAS)

US STEEL:

In an effort to identify a more realistic beta for US Steel, a comparison of sector betas of relative comparable companies similar to US Steel’s structure were averaged, unlevered and re-levered with US Steel’s leverage structure. Table 3.3 lists the values of these comparables showing US Steel’s bottom-up beta to be 1.64, a more reasonable value compared to its regression-beta of 2.23.

TABLE 3.3: US STEEL BOTTOM-UP BETA Company Comparable βL βu %Debt %Equity Tax Rate U.S. Steel 2.23 1.37 49% 51% 35% Reliance Steel & Aluminum Co. 1.16 0.92 29% 71% 35% Cliffs Natural Resources 1.74 1.09 48% 52% 35% Steel Dynamics 1.22 0.92 33% 67% 35% Allegheny Technologies 1.28 0.95 35% 65% 35% Carpenter Technology 1.03 0.92 16% 84% 35% Commercial Metals Co. 1.24 0.88 39% 61% 35% U.S. Steel (bottom-up beta) 1.64 1.01 49% 51% 35%

NOTE: %Debt and %Equity are relative to the firm’s total capitalization.

POSCO:

Alternatively, POSCO’s bottom-up beta was also calculated using a smaller set of industry comparable first due to the major industry dominance of POSCO in the Korean arena, limiting comparable set to only four companies other than POSCO: Hyundai Steel, Hyundai Hysco, and Dongkuk. The calculation yielded a beta of 1.02 (Table 3.4).

y = 2.2335x - 0.0194

R² = 0.4353

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TABLE 3.4: POSCO BOTTOM-UP BETA Company Comparable βL βu %Debt %Equity Tax Rate POSCO 0.87 0.50 49% 51% 24% Hyundai Steel 1.50 0.69 61% 39% 24% Hyundai Hysco 1.25 0.86 37% 63% 24% Dongkuk 1.79 0.31 86% 14% 24% POSCO (bottom-up beta) 1.02 0.59 49% 51% 24%

NOTE: %Debt and %Equity are relative to the firm’s total capitalization.

3.3 CHOOSING BETWEEN BETAS

Based on the two beta calculated for each firm, the sector beta provides a better insight into each firms performance, as the bottom-up beta captures a better indication of the industry’s performance, removing any historic anomalies that may have negatively skewed data. In this case, it is likely that the 5-year regression calculations failed to take into account the market reaction to the bounce back of the financial crisis in 2008, explaining the high regressions for US Steel. Because of this deficiency, the bottom-up beta is a better value.

3.4 ESTIMATING DEFAULT RISK AND COST OF DEBT

Based on the outstanding yield to maturity of US Steel’s debt maturing in 2022, the cost of debt is estimated to be 6%, which results in a total cost of capital of 5.5% (5.27% rounded to the nearest 0.5%). Alternatively, POSCO’s cost of debt is estimated at 4%, consistent with POSCO’s corporate debt maturing in 2021. This results in the total cost of capital being 5% for POSCO.

3.5 ESTIMATING COST OF CAPITAL (WACC)

US STEEL:

Over the past five years, U.S. Steel has significantly underperformed the broader U.S. economy (6.22% return for U.S. Steel vs. 18.60% return for S&P 500). This period however represented a strong bull market for the economy as a whole as it coincided with the depths of the Great Recession followed by the subsequent run-up in the equity markets. As a result, the cost of equity capital is estimated to be 7% for U.S. Steel in the current market environment. Using the industry beta cost of debt and equity capital, a Weighted Average Cost of Capital (WACC) was calculated at 5.5%.

POSCO:

Over the past five years, POSCO has also considerably underperformed the broader Korean market (-2.63% return for POSCO vs. 10.48% return for the KOSPI). The cost of equity capital for POSCO is also estimated to be 7%. Using the industry beta cost of debt and equity capital, a Weighted Average Cost of Capital (WACC) was calculated at 5.0%.

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IV. MEASURING INVESTMENT RETURNS

4.1 ACCOUNTING RETURNS ON PROJECTS

US STEEL:

Table 4.1 provides a breakdown of US Steel’s performance measures used to calculate Return on Equity (ROE) and Return on Capital (ROC), which was estimated at -49.94% and -21.15% respectively for 2013. Such poor numbers suggest bad executive management and poor investment choices made in the past few years. Of particular influence on such dismal ratios is US Steels negative Net Income for the past three years. These values grossly skew the tax rate calculations as US Steel deferred tax payments for several years, causing their Income Tax Expense to far exceed its Earnings Before Interest and Taxes (EBIT). Should US Steel look to increase these ratios, it must consider altering its current project investment strategies.

US STEEL – RETURN ON EQUITY AND CAPITAL (IN MILLIONS) 2013 2012 2011

Net Income -$1,672 -$125 -$53 EBIT -$2,232 $6 $27

Income Tax Expense -$560 $131 $80

Tax Rate 25.09% 2183.33% 296.30%

Shareholders’ Equity $3,348 $3,477 $3,500 Long-Term Debt $3,616 $3,936 $3,828 Interest Expense $266 $214 $190

Total Capital $6,964 $7,413 $7,328 (1-t) 74.91% -2083.33% -196.30%

After-Tax Interest $199 -$4,458 -$373 Return on Equity (ROE) -49.94% -3.60% -1.51%

Return on Capital (ROC) -21.15% -61.83% -5.81%

POSCO:

In contrast POSCO’s performance measures are substantially more positive, with an ROE and ROC of 2.99% and 5.44% respectively, but trending downward. Such trends suggest investing options for the steel industry are profitable but sparse. In comparison to US Steel’s values, it can be argued that POSCO’s management is better in tune with industry investments and strives to bring value to its shareholders.

TABLE 4.2 POSCO – RETURN ON EQUITY AND CAPITAL (IN USD MILLIONS) 2013 2012 2011

Net Income $1,297 $1,632 $2,117 EBIT $1,844 $3,192 $4,531

Income Tax Expense $560 $931 $1,012 Tax Rate 30.37% 29.17% 22.34%

Shareholders’ Equity $43,421 $39,613 $35,316 Long-Term Debt $14,719 $13,455 $13,891 Interest Expense $2,681 $2,612 $3,353

Total Capital $58,140 $53,068 $49,207 (1-t) 69.63% 70.83% 77.66%

After-Tax Interest $1,867 $1,850 $2,604 Return on Equity (ROE) 2.99% 4.12% 5.99%

Return on Capital (ROC) 5.44% 6.56% 9.59%

Page 14 of 23

4.2 ECONOMIC VALUE ADDED

US STEEL:

Cost of Equity and Capital and Book Value of Equity and Capital were used to calculate the Equity Economic Value Added (EVA) for US Steel to be -$1,906 and -$1,856 million, respectively for 2013 and trending downward (Table 4.3 and 4.4). These values suggest poor investment inefficiencies by US Steel.

TABLE 4.3: US STEEL EQUITY ECONOMIC VALUE ADDED (EVA) (IN MILLIONS) 2013 2012 2011

Cost of Equity 7.00% 7.00% 7.00% Book Value of Equity $3,348 $3,477 $3,500

Equity EVA -$1,906 -$368 -$298

TABLE 4.4: US STEEL CAPITAL ECONOMIC VALUE ADDED (EVA) 2013 2012 2011

Cost of Capital 5.50% 5.50% 5.50%

Book Value of Capital $6,964 $7,413 $7,328

Capital EVA -$1,856 -$4,991 -$829

POSCO:

While POSCO’s Equity EVA is also a negative value at -$1,742 million, its Capital EVA is a positive $257 million, suggesting its actual value added after all variables taken into consideration is still positive and substantially better than US Steels. Although this value is positive, however, it has been trending downward, suggesting that in time, POSCO may suffer the same negative values as US Steel as the steel industry begins to dramatically shift.

TABLE 4.5: POSCO EQUITY ECONOMIC VALUE ADDED (EVA) (IN USD MILLIONS) 2013 2012 2011

Cost of Equity 7.00% 7.00% 7.00%

Book Value of Equity $43,421 $39,613 $35,316

Equity EVA -$1,742 -$1,141 -$355

TABLE 4.6: POSCO CAPITAL ECONOMIC VALUE ADDED (EVA) (IN USD MILLIONS) 2013 2012 2011

Cost of Equity 5.00% 5.00% 5.00%

Book Value of Equity $58,140 $53,068 $49,207

Equity EVA $257 $829 $2,261

Page 15 of 23

V. CAPITAL STRUCTURE CHOICES

5.1 CURRENT FINANCING MIX

US STEEL:

US Steel has a majority of debt funding its capital structure with a mix of 54% debt and 46% equity and a total capitalization of $7.29 billion in 2013 (Figure 5.1). Their high degree of leverage exhibits the highest book debt to capital ratio for the United States steel sector as of 2014. This

contrasts with the average value of 32.91% or median value of 37.36%.14 The US sector average is relatively close to the South Korean sector average of 36.53% and median of 39.02%.15

FIGURE 5.1: US STEEL DEBT AND EQUITY COMPARISONS 2011-2013

Source: US Steel 2013 Annual Report, Financial Highlights

US Steel’s 45% fixed asset to total asset ratio during 2013 is materially below the 72.79% USA Steel sector average ratio of 72.97%. Here one can see the high degree of fixed assets in the Steel industry, as the overall US market exhibits a fixed assets to total assets ratio of 17.5%. This high concentration of fixed assets leads to the industry sector supporting higher debt levels than some other industries, as the fixed assets serve to secure the debt borrowings against risk of default. US Steel has issued a variety of debt instruments, with a BB- credit rating from both Morningstar and Standard & Poor's as of May 2014, which indicates a junk bond status (Table 5.1).

TABLE 5.1: US STEEL DEBT INSTRUMENTS (IN USD MILLIONS) Interest Rate Maturity 31-Dec-13 31-Dec-12

2037 Senior Notes 6.65% 2037 350 350

2022 Senior Notes 7.5% 2022 400 400

2021 Senior Notes 6.875% 2021 275 —

2020 Senior Notes 7.375% 2020 600 600

2018 Senior Notes 7% 2018 500 500

2017 Senior Notes 6.05% 2017 450 450

2019 Senior Convertible Notes 2.75% 2019 316 —

2014 Senior Convertible Notes 4% 2014 322 863

Province Note (C$150 million) 1% 2015 141 151

Environmental Revenue Bonds 5.38%-6.88% 2015-42 549 549

Recovery Zone Facility Bonds 6.75 2040 70 70

Fairfield Caster Lease N/A 2022 35 35

14 http://www.stern.nyu.edu/~adamodar/pc/datasets/emergcompfirm.xls data for Emerging Markets firms as of January 2014 15 http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/dbtfund.htm accessed on May 28, 2014

54.06% 53.11% 52.37%

45.94% 46.89% 47.63%

0%

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80%

100%

2013 2012 2011

Debt Equity

Page 16 of 23

Interest Rate Maturity 31-Dec-13 31-Dec-12

Other capital leases and all other obligations N/A 2014-20 — 1

Amended Credit Agreement Variable 2016 — —

USSK Revolver Variable 2016 — —

USSK credit facilities Variable 2015-16 — —

Total Debt N/A — 4,008 3,969

Less Province Note fair value adjustment N/A — 15 23

Less unamortized discount N/A — 54 8

Less short-term debt and long-term debt due within one year

N/A — 323 2

Long-term debt N/A — 3,616 3,936

Source: US Steel Form 10-K Note 14, Effective: 12/31/2013, issued: 2/25/2014

POSCO:

POSCO exhibits a much lower leverage level, with a mix of 27.2% debt and 72.8% equity comprising its total capitalization of $54.8 billion as of 2013 (Figure 5.2). Thus POSCO exhibits a lower leverage ratio than the South Korean steel sector average level of 36.53% and median level of

39.02%.16 Additionally, POSCO shows a fixed assets to total assets ratio of 42.3% in 2013, which is relatively close to the 45% ratio US Steel employs. POSCO also has a variety of debt instruments comprising its capital structure (Table 5.2). It carries a BBB- rating from Morningstar, and a BBB+ rating from Standard & Poors.17 This indicates POSCO is just maintaining its classification at the minimum level to have its debt considered investment grade.

FIGURE 5.2: POSCO DEBT AND EQUITY COMPARISONS 2011-2013

Source: http://finance.yahoo.com/q/bs?s=PKX+Balance+Sheet&annual

TABLE 5.2: POSCO DEBT INSTRUMENTS (IN USD MILLIONS) Bank Issuance Maturity Interest 2012 2013

Long-term borrowings (*1) Korean Bank 1/1983 – 12/13 2/15 – 12/2099 0.5%-11.2% $4,580 $6,409

Less: PV discount ($39) ($40)

Foreign loan (*2) NATIXIS 3/1986 3/17 2% $2 $1

Bonds (*1,3) Korean Bank 8/06 – 12/13 2/15 – 12/21 0.0%-6.3% $8,288 $7,846

Less: Discount on debentures issued

($56) ($41)

Add: Premium on debentures redemption

$14 $11

Total $12,789 $14,185

Source: Note 17 of POSCO Consolidated Financial Statements, issued May 12, 2014

16 http://quicktake.morningstar.com/StockNet/bonds.aspx?Symbol=PKX&Country=usa as of May 27, 2014 17 http://www.standardandpoors.com/en_EU/web/guest/ratings/entity/-/org-details/sectorCode/CORP/entityId/118979 as of May 27, 2014

$14,915 $13,692 $14,054

$39,841 $36,853 $33,295

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100%

2013 2012 2011

Mill

ion

s o

f U

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Page 17 of 23

VI. OPTIMAL CAPITAL STRUCTURE

INTENTIONALLY LEFT BLANK

VII. OPTIMAL CAPITAL STRUCTURE MECHANICS

INTENTIONALLY LEFT BLANK

VIII. DIVIDEND POLICY

8.1 HISTORICAL DIVIDEND POLICY

Both firms currently pay a dividend. See Figure 8.1Figure 8.1: US Steel vs. S&P 500 (Price and Dividend Yield 2009-13) (US Steel’s ~0.75% dividend yield is less than half the S&P 500’s ~2.00% yield) and Figure 8.2 (POSCO’s Dividend Yield is nearly twice the broader Korean stock market’s). Neither firm has repurchased shares or liquidated significant assets via a spin-off or carve out in recent years.

FIGURE 8.1: US STEEL VS. S&P 500 (PRICE AND DIVIDEND YIELD 2009-13)

FIGURE 8.2: POSCO VS. KOSPI INDEX (PRICE AND DIVIDEND YIELD 2009-13)

0.00%

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-

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Q1'09 Q4'09 Q3'10 Q2'11 Q1'12 Q4'12 Q3'13

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S&P 500… US Steel Avg Share Price… S&P 500 Divined Yield… US Steel…

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2009 2010 2011 2012 2013

YieldValue

KOSPI[KRX]

Posco Avg Share Price ($USD) KOSPI Dividend Yield (%)[KRX]

POSCO Dividend Yield2

Page 18 of 23

8.2 STEEL FIRMS’ BUSINESS REQUIRES JUDICIOUS USE OF CASH

The global production capacity glut and stagnating demand do not bode well for significant

cash flow gains. 18 Steel firms’ capital-intensive operations militate against either firm depleting its cash reserve. While neither firm faces a critical debt burden, neither is situated to increase its dividend for the foreseeable future. See Figure 8.3. Both firms face substantial working capital demands – U.S. Steel and POSCO, respectively, averaged over $2.3 billion and $10.5 billion in working

capital from 2010-201319 – and must remain sufficiently liquid to maintain and meet the perennial replacement cycle demands of costly, far-flung plant and equipment. Materials firms are particularly prone to systematic macroeconomic cyclicality and exogenous shocks (a/k/a, “Black Swan” events) owing to the magnitude of their operations, global supply chain, high fixed costs and sheer capital intensity. A sudden demand downturn, energy/ore price spike, financial/credit crisis and/or geological disruption could materially impact both firms’ cash flow dynamic. Both firms must maintain sufficient cash reserves to ride out such events. Accordingly, neither firm can realistically expect to deliver outsized periodic dividends indefinitely despite occasional short term cash accumulation.

FIGURE 8.3: COMPARATIVE EOY CASH BALANCES (2010-2013)

8.3 CONTINGENT CASH DISTRIBUTION RECOMMENDATION

If either firm were inclined or compelled to return additional cash to shareholders, a share repurchase would best enhance shareholder value. Share repurchases vest shareholders with greater discretion as to when and how to reap cash distributions than special dividends.

Dividends, including special dividends, often trigger a tax liability for certain shareholders who would just assume keep their value in stock. US Steel’s U.S.-domiciled shareholders who hold stock in taxable accounts (e.g., excluding pass-through entities, IRAs, pension funds, endowments and the like) pay 15% tax on long-term capital gains tax, 20% on dividends, and ordinary income tax up to 39.6% federal (plus state and local taxes up to 13.3%) on short term capital gains. All else equal, a share repurchases increases the share price – and therefore shareholders’ wealth via unrealized capital gains – thus imposing no compulsory tax consequences. Shareholders who wish to access liquidity can sell shares and pay the applicable capital gains tax. Further, shareholders can attempt to

18 See Appendix 1-2 (Pro Forma Valuation forecasts). 19 See Appendix 1-2 (Pro Forma Valuation forecasts).

$6,022.00 $5,700.00 $6,138.00

$6,799.00

$578.00 $408.00 $570.00 $604.00

$-

$1,000.00

$2,000.00

$3,000.00

$4,000.00

$5,000.00

$6,000.00

$7,000.00

2010 2011 2012 2013

POSCO CASH US STEEL CASH

Page 19 of 23

time their sales to optimize their tax circumstances. By contrast, dividends trigger a tax liability during the year in which they are paid.

The same reasoning applies to U.S.-domiciled owners of POSCO’s ADS subject to exceptions codified in the income tax treaty between Korea and the United State. Further, most Korean-domiciled POSCO shareholders are exempt from capital gains for provided the seller’s position in the company does not exceed ₩5 billion (approximately $4.5 million) or three percent of the firm’s equity. Holders with larger positions are subject to long and short term capital gains taxes, respectively of 20% and 30%. Dividends are taxed as ordinary income at progressive rates up to 38%. As such, a share repurchase would enhance POSCO’s shareholders’ value more than a special dividend.

IX. A FRAMEWORK FOR ANALYZING DIVIDENDS

9.1 CASH DISTRIBUTION DYNAMIC

Table 9.1 below underscores the firms’ divergent divined policies insomuch POSCO has distributed materially more of its average market capitalization since 2009.

TABLE 9.1: DIVIDENDS PAID VS. MARKET CAP Company Dividends Paid Avg. Market Cap % of Avg. Mkt. Cap US Steel $149,770,666.10 $4,765,754,323.52 3.14% POSCO $3,094,527,994.92 $27,880,530,000.00 11.10%

The dividend yield of US Steel is at 0.68% which is below the industry level of 2% (S&P 500) (Figure 9.1) and the United States steel industry average 2.08%.20

9.2 MANAGEMENT TRUST

US Steel maintained its relatively modest dividend against a backdrop of erratic share price performance since 2009. See Error! Reference source not found..

FIGURE 9.1: U.S. STEEL SHARE PRICE VS. DIVIDEND YIELD

20 Source: Prof. Damodaran’s industry data.

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Page 20 of 23

By contrast, the share price to dividend relationship (figure 9.2) illustrates POSCO management’s effective stewardship of shareholder value. Nonetheless, POSCO’s increasing dividend payout ratio (figure 9.3) signals that it is diverting a larger portion of its current earnings to cash distributions than may be prudent given the steel industry’s systemic exposure and capital intensity.

FIGURE 9.2: POSCO SHARE PRICE VS. DIVIDEND YIELD

FIGURE 9.3: POSCO MARKET CAP VS. DIVIDEND PAYOUT RATIO

US Steel’s dividend payout ratio, however, is an inconclusive indicator of the firm’s dividend policy owing to the firm’s frequent net loss (figure 9.4).

0.00%

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2009 2010 2011 2012 2013

DividendYield

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Q2 93 Q3 93 Q4 93 Q1 94 Q2 94

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Page 21 of 23

FIGURE 9.4: U. S. STEEL MARKET CAP V. DIVIDEND PAYOUT RATIO (MILLIONS)

9.3 CHANGING DIVIDEND POLICY

While US Steel’s erratic performance does not support its dividend policy, the firm should maintain the $0.05 per share payout as long as doing so does not impose critical operating constraints. Dividend cuts tend to destroy value because the market reflexively assumes that the firm faces an imminent liquidity crunch.

9.4. USE OF CASH RECOMMENDATION

Neither US Steel nor POSCO have sufficient cash flow growth prospects to prudently return additional cash to shareholders. POSCO’s fundamentals are materially less concerning. Nonetheless, the increasing dividend payout ratio in the face of declining net income may be a harbinger of trouble, particularly against backdrop of the steel industry’s tepid outlook. If either firm’s Board of Directors is inclined to return cash, however, share repurchases would provide superior shareholder value per dollar returned.

X. VALUATION

10.1 FREE CASH FLOW VALUATIONS

US STEEL:

Based on the historic Free Cash Flows (FCFs), US Steel has not grown in the last five years. In fact, the company has experienced losses for the last five years. 2013 has been the worst of the last five years with a net loss of $2.064 billion. By themselves, these losses are troubling but US Steel is lagging behind its competitors. Because of current market conditions and firm hyperbole as mentioned above, we can expect US Steel to reduce by at least 5% for the next five years. Longer-term trends are grim for US Steel. US Steel will need to focus more than establishing a new strategy to reverse historic trends. According to Yahoo Finance, US Steel has a current market Enterprise Value of 6.35 U.S billion. Using FCF with conservative industry forecasts, US Steel was found to be overvalued, perhaps by as much as a billion dollars (Table 10.1).

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Market Cap

Market Capitalization(Shares Outstanding * Share Price )

U.S. Steel Dividend Payout Raito(Dividend Payout/NI)

Page 22 of 23

TABLE 10.1: US STEEL 5-YEAR FORECAST AND VALUATION (IN $USD MILLIONS) 2014E 2015E 2016E 2017E 2018E PV $264.2 $210.7 $142.3 $95.2 $126.70 Terminal Value based on 5.27% (WACC) less 2.5% (GDP of US)

4,574.10

Total Value (NPV) $5,300.00

POSCO:

POSCO will likely continue to get government support and remain afloat. Due to the overcapacity and low profit margins in the market, we can expect that the industry may remain at or below this their current buoyed rate of 1.5% growth. Unlike US Steel, we assumed that POSCO would face declines of 5% revenue in 2014 and only 1% declines for subsequent years through 2018. According to Yahoo Finance, POSCO has a current market Enterprise Value of 47.3 U.S billion. We found with conservative industry forecasts, POSCO is overvalued, perhaps by as much as a 7 billion dollars.

TABLE 10.2: POSCO 5-YEAR FORECAST AND VALUATION (IN USD MILLIONS) 2014E 2015E 2016E 2017E 2018E

PV $3.333.56 $2,287.86 $1,424.58 $830.48 $248.39 Terminal Value based on 4.70% (WACC) less 4.0% (GDP of US)

354.84

Total Value (NPV) $5,300.00

10.2 CONCLUSION

In both US Steel and POSCO, the final valuation is extremely sensitive to the assumptions placed on future revenue growth. In the case of US Steel and POSCO, we assumed the revenue growth changes based on the persistently high overcapacity since 2008 that has sparked serious concerns in the Organization for Economic Cooperation and Development (OECD) Steel Committee. On December 6, 2013, the chairman of the committee noted excess capacity had reached “very high levels” (Nezu 2013). The statement continued:

“The financial performance of the industry could be viewed as worse now than during the crisis of the late 1990s. Recent trends in key financial indicators, such as profitability or indebtedness, raise serious concerns and suggest that the global industry is in a very difficult economic and financial situation … High levels of excess capacity cloud prospects for the industry’s profitability. As global steel demand is expected to grow slowly in the coming years and with many new investment projects coming on stream, excess capacity will continue to weigh on the operating profitability of the global steel industry. (Nezu 2013).”

Other participants agreed that excess capacity is “one of the biggest challenges facing the steel industry” (Silva, Daniel, and De Carvalho 2013). Our conservative forecasts are based on moderate declines of revenue growth. POSCO, with its government support and larger economic growth of Korea can expect less of a decline in revenue.

Page 23 of 23

TABLE 10.3: US STEEL VS. POSCO YOY REVENUE GROWTH FORECAST 2014E 2015E 2016E 2017E 2018E US Steel (-9.99%) (-9.99%) (-9.99%) (-9.99%) (-9.99%) POSCO (-2.25%) (-2.25%) (-2.20%) (-1.00%) (-1.00%)

In light of changing world demand and over capacity, these companies must act to reduce costs, diversify (or sell off vertically integrated activities), and streamline strategies. Essential for US Steel and POSCO sustainability and future growth will be their respective abilities to act quickly or they will certainly experience further value erosion.

i http://quicktake.morningstar.com/StockNet/bonds.aspx?Symbol=X&Country=usa ii http://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=pkx