Why It's Time To Buy AK Steel

Apr.21.14 | About: AK Steel (AKS)

Summary

The stock is trading 20% under its 52-week high.

Management believes business conditions are improving enough to justify raising steel prices.

Assuming that the company expands operations in overseas markets, this presents more reasons to be excited about the stock.

Commodity companies have struggled with growth, given the economic weakness we have seen over the past couple of years in areas like Europe and Asia. And when you factor unfavorable business conditions in North America, investors have plenty of companies to choose from that is trading below their fair-market value.

However, in the steel sector, where valuations have not suffered as badly, making a decision of which stock to buy is not as cut and dry. Valuations of leaders ArcelorMittal (NYSE:MT) and South Korea's Posco (NYSE:PKX) have held up pretty well. So to find value, I've turned my attention to AK Steel (NYSE:AKS), which manufactures flat-rolled carbon, stainless and electrical steels, and tubular products in the United States and internationally.

The stock is trading 20% under its 52-week high. Not only does this spread present less risk than Posco, which is the world's third-largest steel producer, but I believe AK Steel should benefit long term from management having recently raised the price of its hot roll carbon to $700 per ton. This means that the demand for steel have turned positive and management believes that it can capitalize when sentiment fully turns for the better.

And assuming that this price increase comes along with key efficiency and technological improvements, AK Steel should eventually command the same level of respect that Posco and ArelorMittal enjoy today. Accordingly, investors will be wise to AK Steel ahead of the company's first-quarter earnings result, which will be released Tuesday before market opens.

Despite a recent drop in expectations, analysts seem broadly positive about AK Steel's results. The consensus analyst estimate calls for a loss of 43 cents per share. But don't confuse this for anything other than an industry-wide issue. Consider, on the basis of net income growth from the same quarter one year ago, AK Steel's results have outperformed the S&P 500.

In fact, in the most recent quarter, net income increased by 115.3% year over year, rising from -$230.40 million to $35.20 million. This came after two consecutive quarterly losses. Accordingly, analysts project full-year profits of 4 cents per share.

Revenue is projected to be $1.40 billion for the quarter, 2% above the year-earlier total of $1.37 billion. As with the recent profit improvement, AK Steel posted revenue growth in the fourth quarter after two consecutive quarters of declines. For the year, revenue is expected to come in at $5.81 billion.

The main issue within this entire sector has been shipment volumes, which has been soft. But as noted, management believes conditions are improving enough to justify raising prices. During the conference call, I expect management to be pressed for more detail about demand expectations, particularly in areas like autos, shipbuilding and appliances. These markets have not been as robust as they once were.

The good news is that AK Steel appears to be getting some relief from operational improvement like input costs, which has helped the company achieve profit growth in the recent quarter. What's more, management has discussed ways to become more self-sufficient, which usually means a focus on margin expansion. As much as I like the progress the company has made, I want to see better profit margins than the 11.23% posted in the January quarter.

While this still represents a significant increase year over year, the company's net profit margin of 2.40% is still below the industry average. This means that there is plenty of room for improvement. From my vantage point, the stock is trading on the assumption that these improvements won't be made, or that it will take significantly more time than the market would like.

All told, on the basis of these improvements, which I expect will come in a shorter time than expected, this stock should trade higher over the next 12 to 18 months. If nothing else, value will be extracted from management's recent price increase. And assuming that the company expand operations in overseas markets, this presents more reasons to be excited about the stock.

As it stands, this is an undervalued top-notch steel company that the market is taking a wait-and-see attitude on. But once the market wakes up, it may be too late for investors on the sidelines to make profit.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Wall Street Playbook's financial sector analyst. Wall Street Playbook is not receiving compensation for it (other than from Seeking Alpha). Wall Street Playbook has no business relationship with any company whose stock is mentioned in this article.