We think that AK Steel's (AKS) expensive valuations, declining margins, a weak balance sheet and exposure to Stainless Steel make it a perfect short candidate for those who are bearish on the outlook of steel industry. Since we last did an update on AKS, the company has issued a combination of debt and equity because of which the stock is down 30 percent.
Before we get to it, we would like to update our readers on the latest developments in the Steel Industry.
World Steel Association Update
The World Steel Association (WSA) released its October 2012 crude steel production figures on November 20th. The global steel production of 126.1 million tons had increased by 1.3 percent YoY; however, sequentially, production had declined by 1.5 percent on a daily average basis (after increasing by 3.3 percent in September).
Production in China, which accounts for approximately 47 percent of global steel supplies, grew by 8.1 percent YoY to end up at 59.1 million tons. However, production declined by 1.3 percent MoM on a daily average basis. Both the US and European production figures declined YoY. US production for October stood at 6.9 million tons, down 3.3 percent YoY and 1.7 percent MoM on a daily average basis. The October US weekly capacity utilization rates of ~70 percent (September's was 74 percent) were the lowest YTD, therefore, the decline in US production did not come as a surprise.
Production by the EU, led by the Czech Republic and Poland (both down 23.2 percent each MoM), Belgium (down 12.1 percent MoM), and Spain (down 8.9 percent MoM), dipped 6.1 percent YoY and 1.7 percent MoM to end up at 14.2 million tons.
Brazil's sequential production, on the other hand, was up 6.6 percent; however, Instituto Aço Brasil said on Tuesday that it expects Brazilian raw and rolled steel production to decline by 1.1 percent this year.
US Architectural Billing Index (ABI)
The US Architectural Billing Index, a primary indicator of construction activity in the US, rose for the fifth consecutive month. The index, which gives the expected construction spending in the coming 3 quarters or full year, rose by 1.2 points to end up at 52.8, driven by demand from apartment builders. October showed the strongest rate of growth since December 2011. Although every reportable region showed an increase in billings, at 52.8 the South was the strongest and at 50.8 Midwest was the weakest region in terms of billings.
Moreover, new project inquiries, a leading indicator of economic growth, rose 2.1 points to end up at 59.4, marking the indicator's 45th straight month above the 50 level. In the early stages of a project, clients contact many architectural firms, which is why the new projects index is typically higher than the billings' measure. While utilization rates and low production figures do not bode well for the steel companies, the Architectural Billing Index is showing signs of improvement.
Since we last wrote on AK Steel, the stock is down by more than 30 percent. Since then AKS has improved upon its balance sheet through a combination of equity and debt issuance. Before underwriting fees and other expenses, the company successfully completed securities' offerings of $588 million. The offerings include 22 million common shares with a total value of $88 million, $350 million of 8.750 percent senior secured notes due in 2018, and $150 million of 5 percent exchangeable senior notes due in 2019. These actions have improved the overall liquidity situation of AKS. However, the greater interest expense drives further free cash deterioration.
We maintain our sell rating on AKS. Although the company ended 3Q12 with total liquidity of $605m, and, according to Barclays Capital estimates, these three transactions would increase total liquidity to approximately $1.0-$1.1 billion, yet AK Steel's balance sheet is still highly levered. Depressed market conditions for Stainless Steel and weakness in the historically lucrative Electrical Steel market remain headwinds for the company (both sectors provide 36 percent of the company's revenue).
We believe AKS will continue to witness downward pressures on its margins. Its operating margins have declined from 1 percent in 2011 to -0.8 percent in 3Q12. Moreover, the company ended the last quarter with a negative operating cash flow of $213 million and a free cash flow of negative $92 million.
The company is trading at a forward P/E of 16.5x. The stock has lost a whopping 56 percent of its value YTD. The company has a negative profit margin (TTM) of 16.5 percent.
US Steel (X)
Forward P/E (1 year)
PEG ratio (5 year expected)
Long-term earnings growth rate
Share price Performance (YTD)
Source: Yahoo Finance
In conclusion, AKS's outlook remains negative. The near term outlook for Carbon Sheet and Stainless Steel markets remains weak too. The company is not expected to generate any free cash flows in the near term. Among the other steel stocks under our coverage, we have a buy rating on Nucor Corporation (NUE).