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AK Steel Holding Corporation (NYSE:AKS)

Q3 2009 Earnings Call

October 27, 2009 11:00 AM ET

Executives

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

James L. Wainscott - Chairman, President and Chief Executive Officer

Analysts

Michael Gambardella - JPMorgan

Brett Levy - Jefferies and Company

Mark Parr - KeyBanc Capital

David Lipschitz - Calyon Securities (NYSE:USA) Inc.

Sal Tharani - Goldman Sachs

David Martin - Deutsche Bank

Mark Liinamaa - Morgan Stanley

Charles Bradford - Affiliated Research

Timna Tanners - UBS

Brian Yu - Citi

Kuni Chen - Banc of America/Merrill Lynch

David Katz - JPMorgan

Justin Fisher - Goldman Sachs

Operator

Good morning, ladies and gentlemen and welcome to the AK Steel Third Quarter 2009 Earnings Conference Call. At this time all participants are on a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions). As a reminder this conference call is being recorded.

With us today are Mr. James L. Wainscott, Chairman, President and Chief Executive Officer of AK Steel and Mr. Albert E. Ferrara Jr. Vice President of Finance and Chief Financial Officer. At this time I would like to turn the conference call over to Mr. Ferrara please go ahead sir.

Albert E. Ferrara Jr.

Thank you Fannie and good morning everyone. Welcome to AK Steel's third quarter 2009 conference call and webcast. In a moment I'll review our third quarter financial results as well as provide some guidance for the fourth quarter of 2009. Following my remarks, Jim Wainscott our Chairman, President and Chief Executive Officer will offer his comments and field your questions.

Today's call includes certain forward-looking guidance. Other than our comments on historic results, the remarks we make today constitute forward-looking statements within the meaning of section 21E of the Securities Exchange Act of 1934. These statements include our expectations as to our future shipments, product mix, prices, costs, operating profit and liquidity. While we believe that our expectations are reasonable, we cannot assure you that they will prove to have been correct, since they are based on assumptions and estimates that are inherently subject to risks.

Such risks include economic, competitive and operational risks, uncertainties and contingencies, all of which are beyond our control and based upon assumptions with respect to future business decisions that are subject to change. Except as required by law, the company disclaims any obligation to update any forward-looking statements to reflect future developments or events.

For more detailed information, we encourage you to review the discussion of risks effecting forward-looking statements found in our annual report on Form 10-K for the year ended December 31, 2008 as updated in our most recent quarterly report on Form 10-Q.

To the extent that we refer to material information that includes non-GAAP financial measures, the reconciliation information required by regulation G is available on the company's website at aksteel.com.

Earlier today, AK Steel reported third quarter 2009 results that reflect the significant improvement over the company's results in the previous quarter. Third quarter shipments, revenues, net income and operating profit per ton, each increased over second quarter 2009 levels. AK Steel reported net income of $6.2 million for the third quarter, representing an improvement of $53.4 million compared to a net loss in the second quarter 2009.

Third quarter 2009 shipments were 1,047,800 tons, an increase of 307,200 tons or 41% over the previous quarter. Our average selling price for the third quarter of 2009 was $994 per ton, roughly 7% lower than the prior quarter, primarily due to a less rich product mix.

Total revenues for the third quarter were 1.41 billion which is $248 million or about 31% higher than our revenues in the second quarter. Our non-US revenues in the 2009 third quarter were $194 million, about 19% of our sales for the quarter. During the third quarter we experienced increased demand from some of our customers, particularly on the carbon steel side of our business. While our shipping's improved for 3Q, 2009, shipment levels were about 29% lower in the third quarter, than in the third quarter a year ago.

Nevertheless AK Steel's substantial company wide cost reduction measures helped improve the company's operating performance quarter-over-quarter. Given the unprecedented market conditions that we continue to experience in the third quarter 2009, we are pleased with our overall results for the quarter.

Looking now at the cost side for the third quarter 2009, our results continue to benefit from lower raw materials, scrap and energy costs compared to the previous quarter, a trend that we expect to continue in the fourth quarter of 2009. Our results also reflect the LIFO credit of $106 million in the third quarter of 2009. Adding revenues and costs we achieved an operating profit of $15.3 million or $15 per ton for the third quarter. This represents a very solid improvement of $88 million or roughly a $113 per ton compared to our second quarter results.

Turning to the balance sheet, our continuing focus on cash, working capital management and maintaining our financial flexibility has allowed us to sustain a strong financial position. We ended the third quarter with a solid cash balance of 339 million and our credit facility remains untapped except for letters of credit. A key to AK Steel's business model is to maintain financial flexibility while improving the balance sheet and investing in targeted capital improvements.

Even during these challenging economic times we have maintained AK Steel's strong financial position, which provides us with the flexibility to take advantage of opportunities which may arise. And we have accomplished this without resorting to dilutive capital market transactions.

Now let me provide some guidance for the fourth quarter. We expect our fourth quarter shipments to increase by about 25% from the third quarter to approximately 1.3 million tons, largely due to the expected improvements in the carbon steel market. We expect specialty steel shipments to be flat quarter-to-quarter. As a result we expect our average selling price to decline about 2% reflecting the more carbon steel oriented product mix in the fourth quarter.

We expect operating and raw material cost to continue to trend lower in the fourth quarter. We expect our maintenance outage cost to increase by approximately $10 million quarter-over-quarter. And we anticipate another LIFO credit in the fourth quarter.

In addition, we expect to incur a non-cash charge, approximately $5 million or $0.05 per share of common stock, due primarily to a decrease in the value of the company's deferred tax assets resulting from a tax law change in the State of Pennsylvania. Overall, we expect to generate an operating profit in the fourth quarter of 30 to $35 per ton. This would represent AK Steel's best quarter for 2009, reflecting a continuous improvement in our operating results for each successive quarter of the year.

Now for his comments, here is Jim Wainscott, AK Steel's Chairman, President and CEO. Jim?

James L. Wainscott

Thanks very much Al. Good morning everybody. Although business conditions remain challenging, I'm delighted that AK Steel was able to return to profitability for the third quarter of 2009. This represents our first quarterly profit since the third quarter a year ago.

Getting back into the black during these difficulty economic times is really a testament to the hard work and dedication of all of AK Steel's employees and I am certain that our shareholders greatly appreciate as I do, what all of our people have endured and accomplished to restore the company to profitability. We overcame obstacles and adversity in posting a much improved third quarter, a more than $50 million improvement to the bottom line in fact compared to our second quarter of 2009 results.

In short we rolled on, during the depths of the downturn we learned a lot of about ourselves and about our company and through it all we stayed true to our customers and to our people and maintained our focus on our core values of safety, quality and productivity. Fortunately we acted early and decisively in the Autumn of 2008. We communicated the concerns we had to our employees, about what we saw ahead. And we told them that this recession was going to be a tough one. Little did we know at that time that it would become the great recession with the deepest downturn in some 75 years. That's it.

We were up to the challenge. Following the downturn, which began by this fall we renewed our intension, on the three Cs; customers, costs and cash. We took good care of our customers despite shifting production capabilities we met their every need. We cut our costs further. We reduced headcount, overhead, compensation and benefits. We worked closely with our suppliers to find ways to reduce our input costs. And we lowered our operating costs. We also managed cash very effectively in balancing our raw material requirements with reduced order intake rates, we successfully renegotiated raw material minimum purchases.

In addition, we reduced our inventories. And in total we generated an excess of $315 million in working capital improvements. Unlike most of our peers we did not issue equity to stay afloat and even at the bottom of the cycle, we didn't draw a single penny from our credit facility. We maintained our dividend levels, attracted new investors and regained a portion of the equity value loss when the recession first took hold. Where possible we capitalized on the chaos in the economy and then our markets we've completed a major maintenance job at the Middleton works, the first of its kind in 25 years at that location.

We also took advantage of an opportunity to secure an additional long-term supply of cost effective, environmentally friendly coke produced that the SunCoke Haverhill North Coke facility. As part of that deal we also secured a significant hedge against future electricity cost increases. And I'll have a bit more to say about the SunCoke deal in just a few minutes.

In addition we strengthened our balance sheet by repurchasing debt and continuing to make early pension contributions. We continued our commitment to our retirees and we showed that we cared about our people. For example even in the depths of recession we continue to our provider our laid off employees with healthcare coverage.

At the peak of or rather I should say the trough we had about 1200 of our employees on lay off status but at present I am delighted to report that but 200 of our total work force of some 6300 people have returned to work.

And overall, I believe that AK Steel is emerging as the stronger company from the recession. Although we demonstrated that we can survive when we shipped only 700,000 tons in the second quarter of this year. And we can make a little bit of money, when we ship about a million tons as we did in the third quarter. We want to make a lot more money for our shareholders. Our ability to do so will continue to depend in large measure on this state of the economy consumer confidence and bank lending practices going forward.

In terms of the economy things are better, but they're certainly not great. Technically speaking, we may be out of the recession, but it certainly doesn't feel that way, not if you're part of the 10% of the work force in the United States that's unemployed. Suffice it to say that we've bounced off the bottom, but we've got a long way to go from here. Progress, but not prefect, not by a long shot.

With that let me give you a sense of what we're seeing in our market starting with automotive. As a result of the cash for clunkers program the supply of light vehicles and inventory felt to only 29 days by the end of August. A more typical inventory level is about 65 days and that figure peaked at 121 days at the end of January of this year. Now surprisingly with dealers having such limited poor stocks, September sales fell significantly.

However, encouraging news is that vehicle inventories remained roughly 40% lower than a year ago with some of the most popular models in especially short supply. The need to replenish inventories coupled with production increases by auto makers for 2010 models has improved demand for a flat-rolled carbon and stainless steel used in vehicle applications. And in fact auto production actually rose in September by more then 13% compared to August and more production is needed in order to replenish the over stocks. And I also mention that compared to only a few months ago the swift and successful emergence from bankruptcy by GM and Chrysler has restored a great measure of stability to the automotive steel sheet market.

Having said all that, the key question I think is, will vehicle sales rebound in the fourth quarter. In the coming months consumers now comped to about 70% on U.S. GDP will answer that question for all of us. However based on what automotive manufactures tell us about boosting their output to meet increasing demand, it appears that the higher pull rate for automotive steels will continue at least through the end of 2009.

Last quarter I stated that based on what our automotive customers were telling us, we expected our second half shipments to automotive customers to increase by as much as 40% compared to the first half of this year. In hindsight I was too conservative, because now we expect our second half shipments for automotive customers to increase by 60% compared to our first half shipments.

Now we shift to our largest market from a standpoint of tons shipped, that would be distributors and converters or the service center market. As with the automotive market, inventory levels at service centers for carbon and stainless deal are at extremely low levels by historical standards. Over the past 12 months their supply chain was drained to generate cash and that pipeline now needs to be refilled. The destocking programs at carbon steel service centers and distributors are complete. And inventory levels for carbon flat rolled steel products stood at 1.9 months of supply on hand at the end of September, compared to a more typical level of about three months supply.

The data suggests that service centers are now buying at levels that are essentially inline with their shipments and that they have not yet moved to build or to restock inventories to any large degree. We think that's a good think since it provides us with a sustainable level of demand. Further, it supports our belief that the improved levels of carbon steel orders that we have experienced lately and that we continue to realize were not a pull head, nor are they part of an inventory build.

We're also encouraged by a recent increase in buying activity from services centers for stainless steel products. We've seen steady but cautious customer buying activity in our nickel products as service centers evaluate the movement of the price of nickel and its impact on future surcharges.

Auto exhaust stainless business strengthened in the third quarter as the auto pull rate increased. We expect to continue to see reasonably solid demand of this product line for the fourth quarter as well. As expected Q3 electrical steel shipment felt as global demand slumped. In naphtha markets demand reflected lower housing starts. However, as we've previously stated and I reiterate we are very bullish on the long-term demand for electrical steel. As the global economic recovery takes shape and as customer inventories are replenished, as we work through the Chinese trade case situation we're confident that we will see improved electrical steel demand and shipments in the year 2010.

With that overview of our markets, let me take a moment to mention a couple of items that are especially meaningful to our employees and our customers. In particular I'm speaking about safety and quality.

On the safety front we completed our best ever nine months. In the third quarter nearly all of our plants had their best ever performances. A special mention during the quarter, AK Tubes, Columbus Indiana facility, established a new record for days without an recordable injury of 1,269 days. Recently our Haynesville work set a new record of 2,366 days getting all the way back to April 21st of 2003 without a loss time or restricted work case. Well done. Safety continues to be AK Steel's highest priority at these and at all of our locations.

On the quality front we continue to perform quite well. Fact was that third quarter we took our performances in terms of product quality, delivery and service up the notch. The very latest Jacobson's surveys for both carbon and special steel indicated that AK Steel, was ranked number one in quality and number one in overall customer satisfaction.

As promised I wanted to spend another moment or two on the deal that we reached during the third quarter with SunCoke to provide us with coke from its Haverhill North facility. Under terms of the agreement SunCoke will provide AK Steel with up to 550,000 tons of coke annually as well as a financial interest in the electricity co-generated from the heat-recovery coke battery.

Let me add that the SunCoke Haverhill deal in no way lessens our need for the coke and electricity from SunCoke's proposed Middletown Coke company projects which remains in the permitting process. The SunCoke Haverhill deal enhances AK Steel's long term supply of cost competitive coke and energy in the most environmentally responsible fashion. And it furthers our strategic goal of better insulating the company from volatile world market prices of our key commodity and energy inputs.

Before taking your questions, let me simply close by saying that the challenges ahead are numerous, but in that same vein, the opportunities are limitless for our company. There are many who predict that the economic recovery will take a couple of years and I suppose we're also in that camp. It's one of the things that makes this recession different because the previous nine recoveries, as recently reported by BusinessWeek happened far more quickly, in fact the average number of quarters, not years, per GDP to regain its business cycle peak in the past nine recoveries was 1.9 quarters, not four or eight or 12 as many economists predict for this recession.

In any case, AK Steel will continue to navigate through the challenges of the great recession and the great recovery as we focus on strategic items that can bring significant long-terms value to our business. Because of that despite the significant near-term challenges are remained extremely confident in the long-term prospects for AK Steel.

Thanks again to all of you for joining us today. With that let's open up the phone lines for questions.

Question-and-Answer Session

Operator

Thank you, Mr. Wainscott. We'll not begin the question-and-answer portion of our conference call. (Operator Instructions). Our first question comes from Michael Gambardella of JPMorgan.

Michael Gambardella - JPMorgan

Hey, good morning Jim and Al and congratulations on going back into the black.

Albert Ferrara Jr.

Good morning Michel.

James Wainscott

Hi Mike, I just want to congratulate you as well on your top ranking.

Michael Gambardella - JPMorgan

Thank you. I have two questions, one Jim your outlook on the market seems to be a bit more optimistic or bullish from some of the previous commentary referred from some of your competitors. Can you elaborate a little bit more on that? And than second question for Al, can you give us an idea of what you're assuming for the LIFO position in your fourth quarter guidance?

James Wainscott

Mike, I really can't compare my comments to the others. I have been a little bit to busy focusing on our own business. It wouldn't be the first time I suppose that we've been a bit more optimistic. One of the great things about AK Steel as you know is, really the uniqueness of our mix and we're able to play in carbon, stainless and electrical. And I think that diversity has helped us. We are also, I think uniquely positioned to benefit from an improving market environment, particularly in carbon.

We're certainly enjoying increased levels of automotive business as I've said in my prepared remarks and I think the service center dynamics also plays well under who we are. Beyond that again we're just trying to run a good business here and hopefully put some more numbers up on the board.

Michael Gambardella - JPMorgan

Okay. And Al now on the LIFO?

Albert Ferrara Jr.

Michael, with respect to LIFO, with our $106 million credit through the first nine months, we have now booked $266 million through first nine months. And that of course is three quarters of what we expect for that year. But as you know, LIFO can change and will likely change between now and then, but as I indicated we expect the LIFO credit, it would be obviously significant in that area but we don't have a specific number from the fourth quarter.

Michael Gambardella - JPMorgan

Okay, thank you.

James Wainscott

You bet.

Operator

Our next question comes from Brett Levy of Jeffries and Company.

Brett Levy - Jefferies and Company

Hey you guys. Good job turning things around here in this quarter.

James Wainscott

Thank you, Brett.

Albert Ferrara Jr.

Thanks Brett.

Brett Levy - Jefferies and Company

Can you guys talked about working capital guidance for the fourth quarter and then also as you guys look at coal price next year dropping down to par on your bonds, are you guys are starting to think that may be it's time to stop generating negative spread on your cash in some way.

Albert Ferrara Jr.

Well first of all Brett with respect to working capital we've generated about a $176 million for first three quarters. As you know we have a goal every year of being at least flat with respect to working capital this year obviously we are comfortable exceed that as we should, we would expect working capital to be a source of cash in the fourth quarter. Our expectations is we should be somewhere around $250 million for the year, which would assume another $75 million in working capital as a source of cash in the fourth quarter.

With respect to our bonds, our bonds are trading at or near par. We selectively repurchased some last year and also this year and we don't have any expectation of doing that any time soon. We'll continue to look at it. The bonds are recoverable at par in June of next year. But we'll be proactive in looking at other options and making sure whatever we do with our cash will be to enhance shareholder value.

Brett Levy - Jefferies and Company

What are you guys doing on automotive contracts for next year? Have you started with those discussions and which way are they leaning?

James Wainscott

Brett, we're in discussions in a number of arenas, including automotive as well as some of our electrical steel business. But I would say that as a broad statement, it's a little bit too early to say. We have I think given our quality and delivery position with customers, distinguished ourselves and therefore the discussions are going well. And we have the opportunity I think to increase our position at a number of locations. But I think it's a little bit too early to comment on price.

Brett Levy - Jefferies and Company

Thanks very much guys.

James Wainscott

Thank you.

Operator

Our next question comes from Mark Parr of KeyBanc Capital.

Mark Parr - KeyBanc Capital

Hey thanks very much. Good morning guys and congratulation on returning to profits.

James Wainscott

Good morning, Mark, our place to be.

Albert Ferrara Jr.

Thank you, Mark.

Mark Parr - KeyBanc Capital

Yeah, absolutely. Hey I had a just a couple of quick questions. First, just to get into the LIFO a little more. Just to follow up if I could Al?

Albert Ferrara Jr.

Sure.

Mark Parr - KeyBanc Capital

You had I think, what was it? 106 million in LIFO credits in the third quarter?

Albert Ferrara Jr.

In the third quarter compared to 94 in the second quarter.

Mark Parr - KeyBanc Capital

All right. Yeah 94. So it was up a little bit. But if you take the year-to-date number which is 266.

Albert Ferrara Jr.

Right.

Mark Parr - KeyBanc Capital

And assume that 75% of the full year that would imply something lower in the fourth quarter than the third quarter.

Albert Ferrara Jr.

Well but again, one of the things we caution and we consistently caution is the fact that it is certainly a moving target. That was our calculation at the end of the third quarter and of course our expectation as the prices change and certainly inventory levels. And so one of the things that we try not to do is to specify a specific LIFO number, because frankly it changes literally on the daily basis.

Mark Parr - KeyBanc Capital

But and I certainly wouldn't take that away from you for a minute but at least a guidance commentary that you made would have assumed that the nine months number represented 75% of the full year amount.

Albert Ferrara Jr.

That is correct.

Mark Parr - KeyBanc Capital

All right. So I just want to make sure that we set the baseline there. And then another question, Jim, I was wondering if you could go into a little more detail on this trade case with China regarding the Geo market or the electrical steel market. Also I thought there was an interesting article on today's Wall Street Journal about grid upgrades in the U.S. involving 200,000 new transformers and is there any way that you could give us some color or quantify what incremental grain-oriented electrical steel demand might be generated from that?

James Wainscott

As far as the trade case is concerned, sort of taking it in the order of your questions; we may have mentioned this on our previous call, but back in June, the Chinese Ministry of Commerce initiated anti-dumping and countervailing duty investigations of exports of grain-oriented electrical steel from Russia and the U.S. and they are proceeding and they are doing their information gathering.

We believe strongly that there is no merit to the case. And for that matter we are still selling into China, but as I mentioned at reduced levels given the chilling effect. We may hear something further on this case, Mark, as early as this quarter or perhaps in early 2010. Beyond that it's probably why as not to get in to it. One could start to get into politics and I'd prefer not to do that on the call.

With respect to the modernization or the upgrade of the grid, I think a number of people including ourselves are really focused on what's going on. And I think there is certainly going to be opportunities for AK Steel to capitalize on this. We don't necessarily believe that there is going to be a new grid per se, but rather that the existing grid is going to be upgraded modernized, most of, I think that America's grid is not entirely connected.

So it's really about sort of plugging in more power to the existing grid. And that's where I think we can play a pretty significant role because as you in the article reference today, more transformers will have to be built and as far as we are concerned that's a very, very good thing. And so as things like new wind farms and other aspects of the energy explosion occur we will play into that. I think that's going to be very positive as well as the growing use of hybrids or electric motors and so forth. I think all of that evolution will provide significant opportunity to a company like AK Steel.

Mark Parr - KeyBanc Capital

That's something you think could happen in 2010 or start in 2010?

James Wainscott

I think you can see the beginnings of that, certainly the administrations that focused on number of things, but unlike energy in the context of what you're talking about with the emissions programs will be a natural outgrowth. I think there's a discussion today of a plant that's going to be announced in East, maybe in the Vice President's home. So there's a lot of activity that is emerging. And I think we could begin to see it, but it's a little early. It's probably going to be beyond 2010 before we really feel it.

Mark Parr - KeyBanc Capital

Okay. Hey, thanks very much and great job.

James Wainscott

Thank you, Mark.

Operator

Our next question comes from David Lipschitz of CLSA.

David Lipschitz - Calyon Securities (USA) Inc.

Yeah, thanks guys.

James Wainscott

Hello, David.

David Lipschitz - Calyon Securities (USA) Inc.

Hey. A question for you on your raw materials, where do you stand for next year from either on an iron ore or coke and coal position? Have you started negotiations on the coke and coal fund? I just want an update on that.

James Wainscott

I can just offer a couple of thoughts with respect to coal. Most of our coal deals are set to expire at the end of this year. but I would also say that we have tried to get ahead of what made may be increasing prices and taking advantage really of the bottom of the market we have already secured our 2010 metallurgical coal and PCI coal requirements.

Don't know but I go into a lot of detail on pricing just because I don't want give selective guidance for next year, but I am very pleased with how all that came out and we don't look for any significant increased there.

David Lipschitz - Calyon Securities (USA) Inc.

And just quickly just back to the steel market, your shipments are going to be up, in terms of production your utilization is going to be up or is any of that come out of inventory or how is that working for the fourth quarter.

James Wainscott

We are matching our production with the level of orders that are coming in. We make independent decisions in that regard. Our operating rates for the third quarter were up slightly from the second quarter. We ran and again it depends on great deal on the product and on the location. But on average we ran at about at 55% to 60% capacity in the third quarter and as we look out to Q4 our operating rate will probably be around 65% or so all in the company.

David Lipschitz - Calyon Securities (USA) Inc.

Thanks, thank you.

James Wainscott

} Thank you David.

Operator

Our next question comes from Sal Tharani of Goldman Sachs.

Sal Tharani - Goldman Sachs

Good morning guys

James Wainscott

Good morning Sal.

Albert Ferrara Jr.

Good morning.

Sal Tharani - Goldman Sachs

Just wanted to get your feel on the demand side of the equation. You mentioned, Jim that it appears that supply and demand is more in balance now and destocking is behind us. So just assuming 1.3 million shipments you are forecasting versus 1.70 you've done in peak, that's about 25 to 27% decline. You think this is a correct level to think that demand from peak is round about less than 30%.

James Wainscott

Sal, right now it's, the visibility is still little difficult beyond this quarter. But I think we're all moving to what many have referred to as the new normal. And I think that's going to take a while to really settle in. One has to sort of ask oneself for example in automotive, what will be level of automotive builds and sales be. I think most they are taking in terms of 12 million units for next year, that's certainly up from nine unchanged this year. And that's pretty good but down from what had been 16s or 25% reduction there.

On the housing side of things, I think we have seen some positive signs here lately although we would once again acknowledge that maybe due to some incentives that are rescheduled to expire, maybe further extended for home sales but those were down and down substantially far more than 25%.

In our case again, given our diverse product mix or reliance not just on anyone market but several markets and the global economy for that matter I would say that we're up off the bottom as I've said, but whether the new normal is a million, 1.3 million or a 1.4 million is just still a little bit early to tell for us.

Sal Tharani - Goldman Sachs

Okay. And on your coke deals at SunCoke can you remind us how does it work? You actually pay a conversion cost to them or who takes the prices from the coal side?

James Wainscott

We're bearing that to a large extent. It is -- we have a deal, whereby together, we will look at the purchasing of the old ones and try and do some of those deals that advantage both of us. But we have essentially and agreed upon a conversion cost with a pass through or flow through as it relates to the coal.

Operator

Our next question comes from Luke Folta of Longbow Research.

Unidentified Analyst

Hi guys this is actually Rob filling in for Luke.

James Wainscott

Hello Rob.

Unidentified Analyst

Regarding your guidance on shipments growth for 4Q, the 25% that you guys have out there. Can you give us a little bit of color on maybe what end-market that's coming from or what's driving that?

James Wainscott

Yeah, I would just say that the bulk of it is really driven by the carbon business that when we talk specialty, that includes of course stainless and electrical and I think we may see a bit of a bump in the stainless arena as well. But the majority of it would come from carbon; I think that's reflected as well. I announced earlier our guidance about why prices are moving south.

We have in fact experienced higher prices, but when one looks at the average prices if you will for carbon versus specialty products given the increase is predominant carbon, that's bringing the average price down.

Unidentified Analyst

And is there a particular end-market that's looking stronger?

Albert Ferrara Jr.

It's really split between the automotive and DNC markets are the ones that are sort splitting that increase of 300,000 tons and the specialty shipments which were about a 180,000 in the third quarter remained flat quarter-over-quarter. So, those are the two markets that we're finding that have the increase.

James Wainscott

Well I think a number of people have incorrectly assumed that the clunkers program was sort of the artificial injection and you wont continue to see strong activity there. That's really not our view and I think as we've talked to others who do research and analyze this sort of thing, there may have been some 700,000 to 800,000 vehicles that were sold under the clunkers program and our suspicion is that something like 30 to 35% of that may have been people that in fact would have bought nay way but that two-thirds are probably people that bought because of the incentives and that otherwise would not have bought.

So we don't think that's really a significant issue. That we'll continue to see recently good activity growing forward. We also continue to have a much growing population becoming of driving age. People are living longer and we think in a long run this will be all positive for the auto business which has obviously now done the bankruptcy thing and moving forward.

Operator

Our next question comes from Dave Martin of Deutsche Bank.

David Martin - Deutsche Bank

Good morning and thank you.

James Wainscott

Hi, David.

David Martin - Deutsche Bank

Two follow ups on your comments regarding electrical steel contract discussions, given your contract discussions particularly on electrical steel at this point. Do you see the second half of this year is the bottom and would you expect to see some gradual improvement in the first half of next year. And then secondly coming back to your comment on GM regarding you could potentially see some share pick up next year. Is that in the auto business or is that in the electrical steel business?

James Wainscott

Very good question. Thank you, David. I would just say in terms of volumes for 2009, we previously indicated that our volumes of electrical steel typically grain oriented electrical steel would be down by some 15 to 20% compared to a year ago. And I would say that, that figure has widened a bit. It's probably closer to 25 to 30% on a year-over-year basis. As I mentioned, the destocking programs kicked in and projects were delayed or cancelled. As we look ahead and again, we're pulling together our next year plan but just to give you a sense of things with the global economic recovery underway and in particular, in the emerging market we would expect to increase shipments of our grain-oriented electrical steel next year in a fairly meaningful way.

The contract pricing question, this has been unusual year. Typically we would give little bit more guidance right now. But this year, because it is such unique year it really is too early to say what 2010 contract prices will look like with respect to electrical steel works still in the midst of our U.S. and global contract price negotiations with customers. So I think they would respect. And I know, you would understand us not giving anymore to tails with respect to that.

I'll just offer a couple of other pieces of color commentary before commenting on our market share activities. And that is this that, as a reminder more than half of our grain oriented electrical steel shipments are currently being exported. And while the international demand is declined as it has here in the naphtha market it's actually (ph) held up a lot better overseas. And we think going forward the weak dollar will continue to continue to afford us an opportunity to increase shipments abroad.

We are emphasizing as we have for years, making the most energy efficient grades of electrical steel. I think as most of you know we've increased our capacity three times and are in the midst of our fourth expansion project. And for us it's not just about making more tons, it's about increasing our capability to supply more of the most energy efficient grades which is good for our customers and good for the world and this really gives us the opportunity to provide a richer product mix to sell around the world.

I don't know that I comment at this time really on market share with respect to electrical steel I would say that recently on the automotive sector just given some of the issues and concerns that have been out there and the travails that our customers have experienced we've been trying meet the very high level of emergency needs that they face and our goal is not just to serve them under the short run, but to secure that business for the long term.

David Martin - Deutsche Bank

Okay thanks for the color.

Operator

Our next questions comes from Mark Liinamaa of Morgan Stanley.

Mark Liinamaa - Morgan Stanley

Hi Al.

Albert Ferrara Jr.

Hi, Mark. How are you doing?

Mark Liinamaa - Morgan Stanley

Good. Thanks. How are you? Also on the auto and changing just a little bit similar to David I guess. But you had auto shipments, so now you are expecting 50% increase versus the first half year, you were calling for 40% before. How much of that was market share was the sale to existing customers or was it simply moving rather with what the industry did?

Albert Ferrara Jr.

I think you have seen a number of announcements that have come out with the sort of existing domestics and in particular the new domestics. We have grown in both cases. And we are also knocking on some doors that we haven't been in, in a very big way. So it's a combination.

Mark Liinamaa - Morgan Stanley

And then okay thanks for that. And then on the electrical business presumably a lot of this stuff is very long-tail projects, long-tail approval process by your customers. Is there any real tangible you can point to, to support the expectation of increased volumes?

Albert Ferrara Jr.

Again, we're hearing that a lot of the projects that were delayed will be re-looked at. Of course as is the case in our country, that will depend on funding and credit has been a bit of a challenging issue, not just for those of us in the States, but abroad. It is a function of projects, but it's also a function of growing infrastructures.

And in the United States in particular, it's a combination of not just growth for residential and residential relate industrial parts as such, it's also the replacement business which has continued to be reasonably good, although not wonderful in the most recent quarter. So the visibility is improving, I'd say it's still away but from what we are hearing, things will be better next year than this year. Perhaps not quite as good as the year we experienced in 2008. But certainly well off the trough here in 2009.

Mark Liinamaa - Morgan Stanley

So conversations are picking up to some degree?

Albert Ferrara Jr.

Yeah

Mark Liinamaa - Morgan Stanley

Thank you.

Albert Ferrara Jr.

Thank you.

Operator

Our next question comes from Chuck Bradford from Affiliated Research.

Charles Bradford - Affiliated Research

Good morning.

James Wainscott

Good morning Chuck.

Charles Bradford - Affiliated Research

I want to get back to the automotive question, if I could. In looking at next year contracts because General Motors has already told us what they want to do. But looking at your current year contracts, you have talked in the past about some kind of an indexation or cost relationship in a lot of these contracts. Can you break out for us what kind of percentage of your contracts first of all, have flexibility built in and is the flexibility mostly something like a CRU index or is it some kind of a cost related index.

James Wainscott

Chuck, it really does vary by customer. Of course some customers would prefer a fixed price arrangement just because they are not interested in sort of sharing in the risks and others understand that really that puts us in a very awkward situation. The vast majority of our agreements that contain some form of variable pricing, whether it is in the form of a surcharge or an indexation or a combination thereof. So it really would depend on the individual customers' risks and preferences, our overall relationship with them.

Charles Bradford - Affiliated Research

You don't have any kind of an overall average that you can give us, with category?

James Wainscott

We've consistently said Chuck, we have about 60 to 65% of your contracts have some form of a pass through. It's not all elements, but and that percentage has been increased.

Charles Bradford - Affiliated Research

I'm assuming you're talking cost factor.

James Wainscott

Yes sir.

Charles Bradford - Affiliated Research

Okay. And looking at your electrical contracts, do many of those have similar kinds of cost variability?

James Wainscott

Yes, they all do. And again I would just say that most of our NASA contracts are just that, they're long-term agreements. Our foreign or non NASA shipments which again is over half is the combination of contract and also lot of spot business. But they will contain cost pass troughs as well.

Albert Ferrara Jr.

No, and electrical steel contracts that have pass-throughs Chuck have both natural gas and scrap which are the two main components. So effectively we are passing through and benefiting during that periods of reduction in these costs.

James Wainscott

I'd just add as a footnote to Al's remark. This something that is not one sided again. This is what relationships are all about. And many of our customers have enjoyed the rundown in costs, just as they helped us on the way up.

Charles Bradford - Affiliated Research

Terrific. Thank you.

Albert Ferrara Jr.

Thank you.

Operator

Our next question comes from Timna Tanners of UBS.

Timna Tanners - UBS

Hi, good morning.

James Wainscott

Good morning.

Albert Ferrara Jr.

Good morning, Timna.

Timna Tanners - UBS

Just two question. One, if you could talk to us about the lower cost comment into Q4, if that's economies of scale or mix shift or is there something else going on there please?

James Wainscott

Timna, what we have going on there obviously is with the increased volume of about 260,000 tons. That will give us an operational benefit. In addition, we expect to continue to benefit by decreased raw material, particular in the pellet area and some purchased coal costs offset somewhat by natural gas.

When you roll in the lower selling prices if you will, we come to a net benefit of about $20 per ton.

Timna Tanners - UBS

Okay, great. Thank you. And then the other question, just curious that we did have a really big run-up in prices recently on better auto demand into the fourth quarter, but just seemed like there's been a bit of a pull-back off late. What's your assessment of the reasons for that? Are you concerned about excess supplies? Is there another reason maybe for the decline?

James Wainscott

Well, with our General Counsel sitting here in the midst of and I trust -- we'd probably going to comment very little about pricing. I'd just say that the prices are set by the market, we're meeting the market. I think that really all, but the most recent price increase that AK Steel announced and just as a refresher, the most recent one had our coated carbon products going up by about $60 a ton, our cold rolled by 50 and hot rolled by 40

We've gotten all the other ones. This one's run in to a bit of difficulty. We have gotten it where we can. But it's been a bit more challenging as to the reasons why we will leave that to you and the other analysts.

Timna Tanners - UBS

Fair enough, thank you.

Operator

Our next question comes from Brian Yu of Citi.

Brian Yu - Citi

Thank you. Jim can you comment on what's happening recently with your order entry rates in the light of competitive set. It's dropped off a bit, probably due to seasonal factors but interested hearing your thoughts on it.

James Wainscott

Well, I'd just say that we continue to book at very strong levels, that when we look out we also take a look at lead times for carbon steel products are greatest for our Coated products. Those are sold out into the second half of December, while hot rolled products are out into the second half of November and cold rolled, I suppose somewhere in between. And stainless less for us which might be a big unique compared to some of the others you're talking to and listening to. Some of those are out in the December time frame as well. So again not where we would like them to be but certainly a lot better than they were earlier this year.

Brian Yu - Citi

Okay. And with your guidance for about the 1.3 million tons and would that assume about how you fill out the rest of the order book into year-end.

James Wainscott

Well we are going to continue to operate at some what reduced levels, we're pacing ourselves and reduce based operating margin that order intake rate. We'll continue to pay very close attention as we have all year to inventory levels on the working capital. At our company we operate two blast furnaces and I would emphasize only two blast furnaces sort of an on and off decision but in order to meet the current quarter intake rates that we are seeing we need to operate both of them.

And again the guidance we've given is to increase shipments in Q4 by about 250,000 tons. So we will be running it at higher rates from that were last quarter

Brian Yu - Citi

Okay. And can I ask one more question. This relates to auto. I think we looking at North American light vehicle production tracking about 230,000 per week. Is that kind of what you would assume your customers are going to be operating at based on what you're seeing in orders?

James Wainscott

I don't know. If we look at the micro picture may be in the same terms that you do. But I would just say that every indication that we have got is that with the inventory levels as low as they are in the show rooms that the auto companies are building and rebuilding, restocking inventories and that think they probably be at least at those levels.

Brian Yu - Citi

Okay. Thank you.

James Wainscott

Thank you, Brian.

Operator

Our next question come from Kuni Chen of BoA-Merrill Lynch

Kuni Chen - Banc of America/Merrill Lynch

Hi, good day everybody.

James Wainscott

Good morning, Kuni.

Albert Ferrara Jr.

Kuni.

Kuni Chen - Banc of America/Merrill Lynch

Good morning. Just on inventories, can you just give us an update there on where you are in the process of working those down, whether or not you've caught up at this point since you're running both glass furnaces and at what point you start to stockpile ahead for 2010?

James Wainscott

Our suppliers have worked very closely with us in terms of getting our supplies consistent with our operating levels. We've had a plan to reduce our inventory levels going into year-end. And frankly, that has not changed. We're looking at carrying about 1 million, 100,000 tons of pellets at year-end. And our increased operating levels are being met by increased shipments from our suppliers. We're working very closely with this. And so, we don't see any change in that factor. And we expect to have sufficient to carry us through the winter into the first quarter deliver system, delivery expectations late in the first quarter.

Kuni Chen - Banc of America/Merrill Lynch

Right, Okay. And then just as a follow-up perhaps you can comment on the M&A environment what you are seeing out there probably there could be facilities out there for sale, do you see potential acquisitions here, that could be of strategic value, can you talk about whether or not you could perhaps gain some synergies there.

James Wainscott

We hear there are things for sale and then we hear they are not for sales so, we are not sure exactly what to make of it all. I would say that we've always been interested in doing the deals not to get bigger but to make AK Steel stronger, and if the opportunity presents itself, we are willing participant.

Kuni Chen - Banc of America/Merrill Lynch

Thanks.

Operator

Our next question comes from Dave Katz of JPMorgan.

David Katz - JPMorgan

Hi. I believe you guys have originally said that in 2010 and 2011 you expected pension expenses of 200 or required contribution of 250 million each per year. With the market I guess increase over the past nine months, has that expectation changed?

James Wainscott

It has changed David, given a number of factors. We expect our pension contribution next year to be about $105 million, that's for 2010. And that's a function of a variety of factors, not only our increased level of contribution this year but also in terms of what's going with respect to interest rates and also some technical changes that treasurers put out. We would expect our contributions in 2011 to be somewhere around 280 million.

So net-net our contribution levels over the next two years, we would expect to decline, I would point out that we have consistently been contributing over 200 million a year on average. And wouldn't make any expectation about debt for 2010, but I think again from a flexibility point of view, we'll continue to fund the pension plan as it makes sense, consistent with the other goals for the company.

David Katz - JPMorgan

Okay and then secondly, I believe that strong cash position that you guys have was originally put in place, well you guys did it to guard liquidity in the face of the uncertain markets that we saw earlier in the year and the end of 2008. Given stronger markets, given the company's ability now to generate bigger earnings, can you anticipate using some of the cash moving to perhaps lower levels of liquidity?

James Wainscott

We've had to the very widest storage ship of our Board of Directors relatively decide how our cash should be used. We're very mindful of our cash levels, our ongoing cash needs and I think it's fair to say that we've done a very good job in years past and we'll be mindful of enhancing value with our cash going forward.

Operator

Our final question comes from Justin Fisher of Goldman Sachs.

Justin Fisher - Goldman Sachs

Good morning.

James Wainscott

Good morning, Justin.

Justin Fisher - Goldman Sachs

So, you have commented previously that the higher shipments in the fourth quarter would be just running the two bass furnaces at higher rates. But if demand doesn't pan out the way you guys were expecting and how what's the foot side of that? As that we have enter that question how would you guys under adjust your operations. So I am just trying to think about if general demand in the US is lower than people kind of expect in the fourth quarter now, how does the U.S. industry respond?

James Wainscott

Justin just a bit clear we already run the blast furnaces and really all about operations when the orders are coming in as appose to the counter. Some of there might choose with these products and find a home for, we don't do that. So given the fact that some probably 55%-60% of our business now is contract we have pretty good visibility into what that demand looks like for the fourth quarter we still have some unsold spot market business to place that we are out trying to secure as we speak but it is relatively small portion with respect to the guidance that we've given.

So I suppose it's always possible that we're optimistic by the same token perhaps we are too conservative, it's difficult to say. One of our, I think great strengths that we've exhibited as a company and as a management team is our ability to adapt changing circumstances, and that's the one thing that we are certainly seeing again in the last 12 months and been able to adapt too.

What if I could just before we sign off I know today is going to kick off the debate on some really rather high stakes legislation, cap on trade, global warming, et cetera. I would just offer this as we wrap up today and that is that it is very important for the sake of manufacturing in America that as this debate does kickoff that we get Climate Change Legislation right. If we don't, if we don't, as I say, its incredibly high stakes will harm the U.S. economy, will move our remaining manufacturing activities to China and elsewhere. And the global carbon emissions will actually grow, not decline and that's the exact opposite of the goals of Climate Legislation. So, I would just put that in the minds of all of you who follow our company, follow our industry because of its significance.

And finally as we signoff today, this is our final conference call for 2009. And I take this opportunity on behalf of Al and I, our management team and our Board to thank each of you for your interest in AK Steel in this, especially challenging year. Thank you for your support. This has been a challenging year, but it's been a great year, a year in which AK Steel has been able to distinguish itself once again, has been a year about been great or perhaps even good as far as our numbers are concerned. But it's been a year that, you simply got to put you head down, tighten up your chin straps, plough ahead and get thrown this tough times.

Rest assured that what we have done. That's what we'll continue to do on your behalf year day still. Thanks again. Have a great autumn.

Operator

Ladies and gentlemen, this concludes our conference call for today. Thank you for participating and you may disconnect at this time.

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