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AK Steel Holding (NYSE:AKS)

Q2 2011 Earnings Call

July 26, 2011 11:00 am ET

Executives

Albert Ferrara - Chief Financial Officer and Senior Vice President of Finance

James Wainscott - Chairman, Chief Executive Officer and President

Analysts

Luke Folta - Jefferies & Company, Inc.

Arun Viswanathan - Susquehanna Financial Group, LLLP

David Martin - Deutsche Bank AG

Anthony Rizzuto - Dahlman Rose & Company, LLC

Mark Parr - KeyBanc Capital Markets Inc.

Richard Garchitorena - Crédit Suisse AG

Evan Kurtz - Morgan Stanley

Michelle Applebaum - Michelle Applebaum Research

Brian Yu - Citigroup Inc

Sal Tharani - Goldman Sachs Group Inc.

Michael Gambardella - JP Morgan Chase & Co

Operator

Good morning, ladies and gentlemen, and welcome to AK Steel's Second Quarter 2011 Earnings Conference Call. [Operator Instructions] As 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., the Senior Vice President of Finance and Chief Financial Officer. At this time, I will turn the conference call over to Mr. Ferrara. Please go ahead, sir.

Albert Ferrara

Thank you, Amy, and good morning, everyone. In a moment, I'll review our second quarter 2011 financial results, as well as provide some guidance for the third quarter. Following my remarks, Jim will offer his comments and field your questions.

Our comments today will include forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. Included among those forward-looking statements will be any comments concerning our expectations as to future shipments, products mix, prices, costs, operating profit or liquidity. Please note that our actual results may differ materially from what is contained in the forward-looking statements provided during this call. Information concerning factors that could cause such material differences and results is contained in our earnings release issued earlier today. Except as required by law, the company disclaims any obligation to update any forward-looking statements to reflect future developments or events. To the extent we will 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 net income for the second quarter of $33.1 million or $0.30 per share, representing another solid quarterly performance. The results include a $2 million charge or $0.02 per share related to state tax law changes in Alabama, Indiana, Michigan and New Jersey.

Shipments for the second quarter of 2011 totaled 1,497,000 tons, an increase of more than 5% compared to the prior quarter. Our average selling price was $1,185 per ton, an increase of approximately 7%, compared to the first quarter and consistent with our guidance.

Revenues totaled $1,792,000,000, an increase of more than 13% compared to the prior quarter. Sales outside the U.S. continued to be an important source of revenue for us, totaling approximately $273 million or an increase of 25% over the previous quarter.

Our second quarter results include one-time cost of approximately $1.1 million, associated with the shutdown of the Ashland Works coke plant. In addition, continued higher raw material cost resulted in a LIFO charge of $38.8 million for the quarter, which was higher than anticipated. Netting revenues and costs, we achieved an operating profit of $68.5 million or $46 per ton for the second quarter of 2011 compared to $19.5 million or $14 per ton for the first quarter.

Turning to the balance sheet. During the second quarter, we made capital investments totaling $30.7 million. I would point out that our capital spending has been front-end loaded this year.

During the first half, our capital investments totaled $66.3 million. However, we still expect that our total capital investments for 2011 will be approximately $85 million. As business conditions and shipments improved during the second quarter, we had an expected increase in working capital, approximately $99 million. We will continue to be focused on managing working capital throughout the year and anticipate that it will be roughly flat for the full year 2011.

During the second quarter, we contributed $140 million to our pension fund, bringing our year-to-date contributions to $170 million, which completes our funding requirements for 2011.

Looking at our results for the first 6 months of 2011, revenues for the first half were $3.4 billion compared to $3 billion dollars in the first half of 2010. Sales outside the U.S. totaled $491 million for the first 6 months, constituting roughly 15% of our revenues. Shipments for the first 6 months of 2011 were 2.9 million tons, an improvement of roughly 85,000 tons compared to our shipment level for the first 6 months of 2010. Our average selling price for the first half of 2011 was $1,148 per ton, which was more than 8% higher than for our first two quarters of last year. At the bottom line, we reported net income of $41.8 million for the first 6 months of 2011 or $0.38 per diluted share.

Moving to guidance for the third quarter, we expect shipments between 1.4 million and 1.45 million tons with the average selling price per ton declining about 1% from the Q2 level. We anticipate raw material costs will be up about $20 per ton quarter-over-quarter, with most of that increase attributable to iron ore. And we see planned maintenance outage costs decreasing by about $5 million from Q2 levels.

Bringing all those items together, we expect to generate an operating profit of about $15 per ton in Q3. It's important to note that those results do not include the financial impact of the incident with the new 5 EAF at our Butler Works in Pennsylvania. As we previously reported, number 5 EAF experienced extensive damage on July 1 when molten steel breached the furnished shell. We carry both property damage and business interruption insurance for all of our facilities, and while the total impact is still being assessed, today we believe that our financial exposure will be limited to about $10 million. Since the timing of the filing and resolution of our insurance claims is presently uncertain and could involve more than one quarter, the amount of cost that we incur in the third quarter cannot be determined at this time.

And now, for his comments, I'll turn it over to Jim.

James Wainscott

Thank you very much, Al. Good morning, everyone, and thanks to each of you for joining us on today's call.

AK Steel's second quarter of 2011 results represent a significant improvement over our first quarter of this year as we more than tripled our Q1 operating profit per ton performance. In many respects, it was our best quarter in quite a while.

Our second quarter of 2011 shipments were their highest in 3 years since the second quarter of 2008 and our profitability, that is our operating profit, our net income and our EPS, were their highest in the past 6 quarters since the fourth quarter of 2009. Having said that, we did fall short of our own expectations and our guidance for the second quarter. The majority of our shortfall was due to higher-than-expected iron ore pellet prices with the balance of the miss due to lower carbon spot market shipments and prices that took place late in the quarter.

As global steel production set records during the second quarter, and thus, fueled demand for iron ore like never before, we continued to experience much higher iron ore prices than we had expected at the beginning of this year and at the start of the second quarter. And for that matter, it now appears that these higher iron ore prices will continue in the second half of 2011. This outlook resulted in a substantially higher-than-expected LIFO charge for us for Q2 of about $11 per ton.

Speaking of iron ore, perhaps it's worthwhile for me to take a moment or two to review how AK Steel's iron ore purchases are priced. 2011 is the first year that AK Steel has agreed with each of its 3 iron ore suppliers on a quarterly pricing mechanism that is largely tied to the IODEX index. For the IODEX component, the price we're paying for iron ore pellets for the third quarter of 2011 was established with reference to the average IODEX price for the months of March, April and May. And on top of that base price, there is added a pellet premium, a quality factor and freight charges as well. Similarly, the IODEX component of the price that we'll pay for iron ore pellets for the fourth quarter of this year will be set by referencing the average IODEX price for the months of June, July and August.

Simply stated, the IODEX has not fallen as far or as fast as we had previously anticipated or, for that matter, as all of the experts had anticipated as well. And as a result, iron ore pricing for third quarter is higher than we had anticipated. And we now expect that iron ore pricing for us in the fourth quarter will be higher than previously expected as well.

I want to assure you that we're not sitting idly by while these higher costs are impacting our bottom line. Quite the contrary. We're doing a number of things. For example, where possible, we're raising spot market selling prices and in addition, we're seeking to recover these higher costs in our customer sales agreements as old agreements expire and new deals are put in place. To be clear, as our agreements with contract customers come up for renewal, we are negotiating arrangements to recover these higher iron ore costs. Accordingly, by the end of 2011, we expect that each of our major contract sales agreements will have been renegotiated and that each one will contain a provision that either directly or indirectly allows for the recovery of a significant portion of the higher iron ore prices.

We're educating our customers about similar dynamics in the metallurgical coal market and as an alternative to paying a higher fixed price for our steel. We're also introducing pricing mechanisms in our sales contracts that would allow us to recover a significant portion of our increasing coal costs.

We also remain keenly focused on enhancing our vertical integration profile, especially as it relates to iron ore and coal in an effort to lower our operating costs. We hope to have more to report on the subject in the very near future.

Let me now take a moment to comment on the recent incident at the new #5 electric arc furnace, or EAF, at our Butler Works that Al referenced in his remarks. Following an outstanding start-up period, the new EAF experienced the breakout of molten metal on the 1st of July. Most importantly, no one was injured as a result of this incident. In fact, I want to take this opportunity to commend all of our employees and the emergency responders whose cool heads and quick actions prevented any injuries. We've now assessed the extent of the physical damage and we're making the necessary repairs and depending on lead times for certain items. We would expect that the new furnace would resume operations by about the end of September. At present, we're unable to say when all of the repair costs and expected insurance recoveries will take place, but let me reiterate Al's point that we do not expect the net exposure to AK Steel to exceed $10 million.

In the meantime, we've continued to meet the needs of our specialty steel customers without interruption. We resumed production of our specialty steel products at Butler Works within about 24 hours with the 3 existing EAFs that have been idled upon the startup of #5.

Suffice it to say this has been an exciting and an eventful quarter for AK Steel in many respects. We were honored to receive the Best Operational Improvement Of The Year award from American Metal Market, and we were pleased to be named as a finalist for the Environmental Stewardship Award as well. As planned, we safely and successfully shut down the Ashland coke plant during the second quarter, and I'm delighted that nearly every employee from the coke plant who wanted to continue to work at our company was provided an opportunity to do so at the Ashland Works steel plant.

In order to replace the lost Ashland Works coke production, we procured coke from several third-party producers to meet our short-term needs as we continue to determine the best long-term coke strategy to serve the Ashland blast furnace.

Speaking of coke, I'm pleased to report that the SunCoke Middletown project continues to move closer to completion, and I want to congratulate SunCoke's management team on their successful initial public offering last week. We believe that production at their SunCoke Middletown facility will begin early in the fourth quarter of this year and frankly, we can't wait.

In our constantly changing world, our focus at AK Steel continues to be centered around 3 things: First, taking care of our people and keeping them safe; second, serving our customers better than any other steelmaker and providing them with the best quality steel products available; and third, last but not least, creating value for our shareholders. That has not changed nor will it change anytime soon. And so with those things in mind, let me comment on how well we're performing in each case.

While we can always improve and we will, we have a continuous improvement philosophy. We're certainly making progress on the employee safety front. The most recent data available for industry comparisons are those from Q1 of this year. Those results show that AK Steel was performing at a level that was about 6x better than the steel industry average. Of particular note, our Zanesville, Ohio plant has now gone more than 3,000 days without experiencing a single loss time injury. That is a fantastic accomplishment. As solid as our safety performance has been across all of our plants, frankly, one injury anywhere in our company is one injury too many.

Moving from our employees to our customers, let me offer a couple of insights starting with product quality.

During the first half of 2011, our internal quality measures were simply outstanding. Our performances for internal rejections and retreated products each set new records for the second quarter and the first half. We appreciate the business we enjoy from all of our customers. And one of those customers, Flack Steel, chose to honor AK Steel during the second quarter with a Supplier of the Year Award. We're delighted to receive this honor and appreciate Flack Steel's confidence in our company.

And on a broader basis, once again, AK Steel faired very well in the Jacobson Independent Survey of our carbon and specialty steel customers. For the second quarter of 2011, AK Steel was ranked #1 in quality and on-time delivery. These performances translated into a #1 rating in overall customer satisfaction in our carbon market. And on the specialty steel front, we received a #1 ranking in the area of quality. These outstanding performances and service to our great customers don't just happen. Our people make them happen. So I want to take this opportunity to salute the employees of AK Steel on doing a great job, the best in the business for our customers.

While we're on the subject of customers, let me take a few moments to comment on what we're experiencing in the markets that we serve. As most of you know, AK Steel is unique among its peers in the steel business since we manufacture high value-added, well-diversified product mix of carbon, stainless and electrical steels to our customers. In terms of the carbon steel market, we continue to see strength from our automotive customers. Our automotive customers are experiencing higher sales, which is driving the need for increased steel shipments of both our carbon and ferritic stainless steels. Most of our customers who were impacted during the second quarter by the supply disruptions due to the Japan earthquakes are returning to more normal production schedules. For example, Toyota has indicated that they expect to return to full production by the end of September. Automotive inventories remain in good shape as well at the end of June. Light vehicle inventories of domestically produced vehicles stood at about 57 days compared to some 55 days a year ago.

Speaking of inventory levels, let me briefly comment on inventories at service centers. Historically, carbon flat-rolled inventories at service centers have averaged about 2.4 months of supply on hand. But as of June 30, that figure was 2.0 months of supply on hand. In other words, by historical standards, inventories are relatively low. I think it's fair to say that service center buying activity has moderated somewhat, particularly late in the second quarter as buyers had settled into a very cautious buying mode. With short lead times available at the present time, service centers are simply buying what they need and only when they need it, no more and no less.

The other large market that we serve at AK Steel is the I&M or Infrastructure and Manufacturing market. This market includes appliance and HVAC customers as well as other steel-consuming industries and it continues to exhibit signs of recovery. It's our sense that the general manufacturing environment took a short pause in the second quarter, but we believe that things have begun to pick up.

Let me turn briefly from Carbon to Specialty Steels. Our Specialty Steel products serving the automotive and appliance markets were in strong demand during the second quarter, and we expect that demand strength to continue into Q3. Commodity, 300 series stainless sales were held back a bit in the second quarter by the nickel surcharge, which fell effective July 1. Buyers simply waited on the sidelines but with nickel prices now beginning to head higher, we've recently seen an uptick in buying activity. As I mentioned earlier, our 400 series stainless steel used in automotive exhaust applications enjoyed another solid quarter, and the outlook for that product line remains positive. Some of our specialty stainless steel applications, including stainless products for appliance and industrial manufacturers, are in high demand with lead times out as far as the October timeframe. Stainless steel service center inventories have historically averaged about 3.8 months of supply on hand, and that compared to an actual figure of only 2.6 months of supply on hand at the end of June.

Staying with specialty steels for a moment, I'm particularly pleased about our progress in electrical steels. We've begun to see a rebound in this market, both domestically and abroad, with sales volumes and pricing both improving. In the second quarter, we actually set a company record for international sales of our green-oriented electrical steel products. Demand for our high-quality, low-noise product continues to be quite strong. As we move into the third quarter, we're also seeing increased domestic interest for electrical steel, restocking activities by the utility companies and rebuilding activities, particularly in the southeastern part of the U.S. following the rash of spring tornadoes, appear to be driving, really, the great increase in domestic demand.

Before taking your questions, let me briefly comment on one other subject that has been on the minds of a number of people lately, and that would be the increased capacity in the Steel business. Since I got in the Steel business some 30 years ago, including spending the past 16 here at AK Steel, this has been a common refrain. Fears of capacity increases from imports, mini-mill expansion or domestic integrated producers. Somehow, facing all of these fears, whether real or imagined, AK Steel has found a way to compete and win.

Although steel is frequently viewed as a commodity business, I would offer that not all steel is created equally, and that's a good thing if you're AK Steel. That's because we focus on serving the most demanding customers, the toughest product applications in the most difficult markets.

Currently, AK Steel is not the biggest steel maker, and that's just fine with us. We have no desire to be the biggest, just the best, and we make it our business to be the best in each of our products. So even though the additional capacity is coming online, we feel it's unnecessary, we will continue to compete, and I believe we'll fare quite well against the competition, both old and new.

Frankly, I'd be far more concerned if we had lousy customer relationships or consistently produced poor quality steel or delivered it in an unreliable fashion and provided inadequate or no customer service, but that's not who we are at AK Steel. And that's not how we garnered the top rankings from Carbon and Specialty Steel customers. So although time will tell, it always does, we're confident at AK Steel that we're well-positioned to continue to compete and to continue to win.

We have a great steel company, but our costs are simply too high, especially our steelmaking input costs. That's no excuse, that's a fact. We get it and I can assure you that we're working very hard to remedy this situation on behalf of our shareholders to unlock further value.

We know something about winning at AK Steel. Time and again, we faced adversity and emerged as the stronger company. I have no doubt that will continue to be the case.

Ladies and gentlemen, this concludes our prepared remarks. At this time, both Al and I would be happy to respond your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Michael Gambardella of JPMorgan.

Michael Gambardella - JP Morgan Chase & Co

I just have a question, Jim, about what you're saying in terms of the miss on the guidance that you had given. I guess in late April, it was related -- you had said related to higher-than-expected iron ore pellet prices and the weakness in the spot prices in the quarter, weaker than you thought. But I mean, I just don't understand this pellet issue because when you are sitting there in late April when you gave the guidance, you should have already known what the pellet prices were based on the contract lags because the second-quarter pricing of pellets was based on February, January and December. You were already almost two months past that date.

James Wainscott

Michael, let me help out there. Much of the miss is not so much the cost that we incurred for the second quarter but, rather, the outlook going forward for the second half. And so we have this situation because of last-in, first-out accounting that we have to then go back and true up. So if your ultimate year-end estimate, if you will, of iron ore prices, are not coming down as far or as fast, then you have to actually go back and true up, and that's really the biggest piece of the LIFO hit. I think that's something like $8 of the $11 or something.

Albert Ferrara

Right. Michael, the LIFO impact is driven off our expectation for our fourth quarter pricing which is June, July and August, if you will. In other words, that was what driving the bus in terms of the ultimate miss from a LIFO perspective. It wasn't that we were looking just of that one quarter, we had to look out further than that. Candidly, we expected prices to be coming down more sharply than they're appearing to the right now.

James Wainscott

I think a lot it had to do, Mike, as well with the outlook at that time that, for example, China was a bit sluggish, the recovery was a little bit slower than expected. Again, all of the experts' inputs that we got indicated that prices would be falling. As it turns out, as you know, in the month of June, for example, China produced more than 2 million metric tons per day. And we've look very closely at correlation between Chinese steel production and the IODEX index, and it's really spot on. So it's simply the way things evolved versus the way we thought things would evolve. And as a result of that, we've trued up for the second quarter and updated our outlook for balance of the year.

Michael Gambardella - JP Morgan Chase & Co

So are you trued up enough now to withstand the current level of iron ore prices in the world being in place for the rest of the year? Is that it?

James Wainscott

There is still an anticipation that iron ore prices will decline slightly but not nearly as much as we had previously expected.

Michael Gambardella - JP Morgan Chase & Co

Okay. So the true up in the quarter was $8 million?

Albert Ferrara

Well, the total LIFO charge, Michael, in the second quarter was about $39 million, and our first quarter impact from LIFO was about $23 million. So if you'd sort of normalize that, if you will, our normal LIFO charge should have been say, $31 million and $31 million. So the impact of the second quarter of the first quarter true up is about $8 million.

Michael Gambardella - JP Morgan Chase & Co

Okay. And what about true up going forward relative to what you thought?

Albert Ferrara

Well, the thing is, as you know, LIFO is calculated, predicated on our expectation for the full year. We've taken 1/2 of our expected LIFO charge in the first 6 months. And so, net-net, we should be expecting, all other things being equal, that our LIFO charge in the second half of the year should decline in the third quarter versus the second quarter because the second quarter included the true up.

James Wainscott

I'll just offer, not to confuse matters further, but LIFO is always a bit of a challenge. We don't really know our results until we close the books because it depends on, not just iron ore, it depends on things like coal and coke and scrap and gas and nickel and everything else, not only the expected year-end values but the expected year-end volumes. So all of that goes into the mix. Most of it moved against us, unfortunately, as commodity prices remain very high.

Operator

Our next question comes from Evan Kurtz of Morgan Stanley.

Evan Kurtz - Morgan Stanley

Just a question for you, first, on your volume guidance for the third quarter, your $1.4 million to $1.45 million target. In your commentary, you sound pretty bullish on how markets are improving as far as autos and general manufacturing plus inventories being low. Just wondering how you kind of reconcile those 2 views.

James Wainscott

Let me just offer, this is Jim, a couple of thoughts there, Evan. The fact of the matter is, we continue to see strength primarily in our contract markets. The spot-market activity is less robust, some of that is a function of the typical seasonality that we face in the third quarter, little bit of import pressure. We've seen actually a fair amount of increased imports last quarter and then the first half. And then this ongoing perception of increased supply, we'll be continuing to move as much as we can, as quickly as we can, more towards the contract arena. But I think it simply recognizes those factors when we guide.

Evan Kurtz - Morgan Stanley

Okay. And then maybe one question on electrical steel. It sounds like, internationally, prices are starting to move up, you mentioned that a little bit in your comments, but we're hearing kind of 300 to 500 Japanese producers and it seems like, in OM case [ph], of about $700 a ton this year. How much of that opportunity you think you've captured to date? I know a lot of your international contracts are quarterly. Is there a chance that we can see another reset higher in the fourth quarter?

James Wainscott

We're doing everything we can to recover higher prices as quickly as we can. Many of the deals that we have though, and we're predominantly a contract player here, are reset annually. So we'll capture what we can when we can. I think the good news is that as we look at that market, as I'd mentioned in my prepared remarks, it is indeed improving. I think previously we'd said, at one point, we thought it would be up 10%, and we upped that to about 15%. I would say that we would now be comfortable indicating that it's probably going to be somewhere closer to 18% to 20% higher year-over-year. And the vast majority of that growth, again, has been in a non-NAFTA variety, in other words, international. So we're capitalizing on that where we can. And then just more recently, again a function of the utilities, restocking, the rebuilding after the tornadoes and very recently, with the heatwave that we've had that has resulted in the failure of a number of transformers that need to be replaced. We're seeing, thankfully, some domestic growth there as well. So all those factors, I think, are going to speak well to increased volumes and increased pricing.

Evan Kurtz - Morgan Stanley

Of the increases in volume, what sort of opportunity is there on the high-perm side or is most of that going to be -- are you running full there already? Is most of that going to be commodity, kind of M2 to M6 grades?

James Wainscott

I don't know that we really get into individual grades. But I would say that because of our ability to produce some high-end, that has been a product that's been more in demand. We'd never say that we're at "capacity" in any of our particular grades. But we're pushing the edge of the envelope there, and we'll try and eke out more as we can.

Operator

Our next question comes from Brian Yu of Citi.

Brian Yu - Citigroup Inc

I want to go back to Michael's question earlier, just about your iron ore costs. I think, Al, in your prepared remarks, you said that raw materials will be up about $20 per ton to your iron ore. So if you're trued up through 2Q and the IODEX adjusted for contract lag is down in 3Q, what else is driving it?

Albert Ferrara

Well, Brian, as you know, under our contracts with our iron ore suppliers and the price we pay for pellets is adjusted quarterly. For example, our third quarter pellet cost is based upon our average IODEX price for say, March, April and May. However, the pellet cost that hits our P&L is also impacted by the cost that we have in inventory as we consume pellets, on an average, on blended-cost basis. And as we consume pellets during the year on a year-over-year basis, the cost of pellets is going up. So in effect, we're consuming less and less of the lower-cost pellets and more and more of the increased-cost pellets. And so even though there's been a moderation in the price in that IODEX index, if you will, we continue to push through our cost of goods sold, if you will, more of those increased cost pellets that we're getting in this year.

Brian Yu - Citigroup Inc

Okay. So that $20, does that refer to quarter-on-quarter or year-on-year?

Albert Ferrara

Well, that's not all iron ore, of course. The bulk of it is iron ore, but we're also being hit by increased natural gas and electricity costs. We've had some purchased lab costs work their way through there. And obviously, coating materials and things like that. Now nickel is going the other way, but of course, because of the surcharges, we, in effect, pass that through. So it's not all pellets, but frankly, the proponents of that increases is on the pellet side.

Brian Yu - Citigroup Inc

Okay. And can I ask you a question on the contracts? Last quarter, you indicated that you weren't comfortable giving out expectations about your iron ore prices because your contracts have variable price mechanisms that's supposed to offset it. And now I think this quarter, the positioning is a little bit different where you mention you still have some fixed-price contracts. Can you give us a sense of what percent of your contracts are fixed and therefore, don't quite allow for that cost recovered mechanisms yet versus those that already have that built in?

James Wainscott

This is Jim Wainscott. I would say that we're in the midst of renegotiating a number of deals. We have a couple that are cooking right now, as we speak, that are not done. We've got a few done already, but they expire throughout the course of the year. And I wouldn't necessarily say that it's half and half. I'd step back first and say that somewhere around 55% of our business would be contract business, about 45%, if I had to ballpark it, would be spot. Of the 55%, probably less than 1/2 still would have had renegotiated deals, plus or minus. So we still got a ways to go, and it's going to be an ongoing process as we go through this. Not only are we talking about recovering iron ore, but also we're introducing coal, which we need to do as I mentioned earlier. So really as we turn the calendar to '11 [ph] of '12, we would hope, in some fashion, to have all of those contract deals reflect iron ore. So that really hasn't changed from any earlier commentary. I know it's an interesting and unique concept, all we're trying to do is to make sure that we price our products appropriately to generate a margin to sustain the ongoing viability of the business, nothing more, nothing less. But we can't do that, we have to honor the existing contracts that we have until those come up for renegotiation.

Operator

Our next question comes from Mark Parr from KeyBanc.

Mark Parr - KeyBanc Capital Markets Inc.

Most of my questions have been answered. I am curious if you could provide a little more color on how much low -- Al, you were talking about lower-priced pellets and higher-priced pellets, how much of that process has unfolded? And is there a potentially more of the mix shift that we could expect in the fourth quarter?

Albert Ferrara

It's a process, Mark, of just mix. As you get -- we purchase close to 6 million tons of pellets a year. We get about -- I think this year, we're expecting around 5.8 million tons of pellets. They come in somewhat ratably during the year. We'd probably get it a little bit more in the second quarter and the third quarter because of the shifting seasons and things like that. But it's just sort of as we're consuming them at both of our blast furnaces, if you will, your average cost, if it was going to be affected not only by what you're consuming but also what you're accepting. And so all it was a sort of an indication that even though the price that we're getting in is maybe moderating somewhat, the fact that, that price is still higher than what our post for last year is an indication that our average cost might be going up.

Mark Parr - KeyBanc Capital Markets Inc.

And I was just wondering how much more of that we might have to unfold for the fourth quarter and into the first part of next year?

Albert Ferrara

Well, I think, they're not -- I mean clearly, the amount of pellets that we have left over from last year is diminishing or will diminish certainly after the third quarter. That number will moderate somewhat. I think we got hit or we're expecting to get hit in the third quarter probably harder than most. But it will moderate, I guess, starting in the fourth quarter and into the next year, again, depending upon where the price of pellets goes.

Mark Parr - KeyBanc Capital Markets Inc.

Okay. And if I can ask just one follow-up question. I think, Jim, you had talked about improving demand momentum, both in the carbon and stainless markets. Could you give a little color in terms of how ores look now compared to, say, earlier in the second quarter? Or you've seen things, they were okay then they've eased off, now they're picking up. Give us some idea of what that pickup means in terms of the downdraft we've seen.

James Wainscott

Again, I think if you look at the spot market, as I mentioned before, which is driving spot prices lower, it's a little sloppy right now. I would say that in our own case, order intake rates have been lower in recent weeks and the pricing has been under pressure. That condition really has not abated just yet. It's a function of a number of things I mentioned. But as we look sort of year-over-year, comparable quarters, we've probably got a few more tons to sell now than we had a year ago at this time. So I think that gives us some sense of the spot market. Our products can certainly go into the spot market, but we'd probably have a better home for them and can make all the quality and on-time delivery demands of the contract business, and that's where we'll continue to migrate, as I've said. Automotive being a case in point, I think we were negatively impacted, probably in the 25,000 to 30,000 ton range in the second quarter as a result of the Japan effect. But I think that has indeed abated, and we should benefit as we go forward as everybody ramps up. Just a couple of data points, you recall last year, automotive came in at about 11.9 million just under 12 million in terms of the sales trend. But through the first half of this year, I think we're on pace at about 12.5 million, and most of the prognosticators now say it's going to be north of 13 million units. So we continue to participate in that in a nice way. The infrastructure and manufacturing market has been kind to us as well. And again, we're seeing an updraft in the Specialty Steel business in a variety of places. 300 is just starting to come back, 400 has been strong for us in the Specialty component, a lot of the products we make out of Coshocton has been very, very solid so. And I think we're doing all of that in what is clearly still a very slow economic recovery with a lot of uncertainty. So I'm happy about all of that. I think directionally, we'll do the right things in terms of moving some of our Carbon business into contract, and then we'll see where she goes from here. Clearly, the longer-term issue, the longer-term challenge for us has nothing to do with our customer relationships or quality or delivery and anything else. Really, it's about fixing the cost side of things. And as I mentioned before, we're very much about that.

Operator

Our next question comes from Tony Rizzuto of Dahlman Rose.

Anthony Rizzuto - Dahlman Rose & Company, LLC

Just a follow-up question here. When I look at the IODEX, it's a little more or less stable, I guess this January. There's been some movement around there. But could you share with us what your expectation of iron ore pricing is by year end? Perhaps, to help us understand this a little bit in how you guys have kind of modeled out the LIFO situation? And then I've got a follow-up on electrical steel.

Albert Ferrara

All we'll say Tony is the LIFO is actually not going to be driven by year-end, actually it will be driven by the price at the end of August because that will set our fourth quarter number. And again, if you look at the IODEX going back to -- if you go in terms some of the pellets that we've received, you talk about it this year and we agreed that it has been rather flat. But if you go back to the first quarter, which is being set September, October, November, the IODEX and again, please keep in mind this is just the base load, in other words, the base of the IODEX and then frankly, there's calculations made above that to get to our pellet price, fair enough [ph] $150 whereas, clearly, it's moved up into the $170, $180-ish area. But like I said, what would drive our LIFO calculation is really the fourth quarter calculation, which is June, July and August for us, not December 31.

Anthony Rizzuto - Dahlman Rose & Company, LLC

Okay. And then just a quick follow-up on the electrical steel market, and I want to make sure I heard this correctly, when Jim mentioned up 18% to 20%, were you talking about your view of your volumes or is that more of a global consumption? And then just to get a better feel for the rough percentage of your contracts, which are readjusted quarterly versus annually.

James Wainscott

Tony, when I speak about the 18% to 20%, that's really referencing AK Steel, specifically. That would not reference what's going on more broadly. I think that, obviously, there were some production disruptions around the world. So some might be up and some might be down, but we certainly enjoyed a benefit in things. And then in terms of the resets, again, it's really a function of what is contract and what isn't. There is a, in all of our agreements for specialty products, a variable adjustor with respect to materials. So while that can change, the base prices with respect to the vast majority of our business from electrical steel are set and then the spot market will be what it will be. Al you want to?

Albert Ferrara

No, no. I think that's right. And again, what Jim's talking about 18% to 20% is our yearly shipments year-over-year.

James Wainscott

That's correct.

Albert Ferrara

Yes. Let me just so there's no...

James Wainscott

'10 to 2011.

Albert Ferrara

Yes.

Operator

Our next question is from Michelle Applebaum of Steel Market.

Michelle Applebaum - Michelle Applebaum Research

I just want to make sure that this is really clear because I have it, and I'm glad that money I paid for an MBA in accounting during inflationary times is paying off really big these days.

James Wainscott

The opportunity to use it today.

Michelle Applebaum - Michelle Applebaum Research

So you had $23 million of a LIFO charge in the first quarter, anticipating a full year LIFO charge of $92 million. On the basis of a change in your forecast for iron ore prices at year-end, what your inventory would be at year end, you raised your full year LIFO charge from $92 million to $124 million. In order to do that, you had a true up for the six months and take a $39 million charge for LIFO versus the $23 million in the first quarter. Of the $39 million, $8 million is a first quarter retroactive and the remainder, which is another $8 million, is your new increased charge. So you're ongoing LIFO charge will not be $39 million a quarter, it will be only $31 million a quarter.

Albert Ferrara

Michelle, you're exactly right. Except all we would say is that the LIFO charge in the third quarter will be dictated by our expectations at that time.

Michelle Applebaum - Michelle Applebaum Research

I know it changes every quarter.

Albert Ferrara

Things could change but...

James Wainscott

I would give you an A for your summary.

Michelle Applebaum - Michelle Applebaum Research

So plenty of time to figure it out while I was waiting for my turn. So there was a $5 a ton nonrecurring prior-period charge that won't be there, everything else equal, in the upcoming quarter, okay?

Albert Ferrara

The thing is, is that guide, that true up is true, yes.

Michelle Applebaum - Michelle Applebaum Research

Okay. So that explains, if you came out at $45.76 and you're looking for $60, that explains $5 of that was last quarter, so you take that away. So the real shortfall was only $10 and then $5 was your change in LIFO, which is real, which is real. So then we still have $5 for you to tell us what happened. Was that the almost 100,000 ton shortfall?

James Wainscott

We guided again in terms of shipments at the same conference call, 3 months ago, $1.5 million to $1.550 million. As you know we came in only $1.497 million. That's it in a nutshell, but there's the production volume associated with that, there is the lack of the margin on those shipments and then there is just what happened at the tail-end of the quarter to the lower prices. And so you put all of that together, that's worth about $5 or $6 as well.

Michelle Applebaum - Michelle Applebaum Research

Okay. So this was nowhere near as big a miss as it appeared on the face of it, not clear why you didn't put that information into the press release. Maybe you like giving us a challenge because it's kind of fun to figure this stuff out, but I think it might have been helpful if it had been in the press release. And I wanted to make a big deal out of this because if you remember a 1 1/2 year ago, it went in your favor and I beat you up real bad on that. So anyways...

James Wainscott

Appreciate it. Look, we're never happy about delivering expectations or results that are below expectations. We believe, as I think, most public companies do, that one should meet or exceed expectations. And I think if one looks, historically, we've done that. I'm also not in the business to give excuses, but I think the clarity that you brought to the discussion is good and insightful and thank you.

Michelle Applebaum - Michelle Applebaum Research

Yes. Well, I also teach securities analysis. So I give you an A for the ultimate explanation and an A- for not putting it in the press release.

Operator

Our next question comes from Dave Martin of Deutsche Bank.

David Martin - Deutsche Bank AG

Had a couple of follow-up question. First, on electrical steels. So if you assume your volumes are up 20% this year, where does that put your tonnage this year versus your capacity?

James Wainscott

I don't know that we've really stated our tonnage, but let's just ballpark a number, I don't know, 250, 260-ish. And capacity is an interesting question in this sense, David, I would just offer that the capacity depends on a variety of factors, not to be evasive, but it depends a lot on what it is that customers want, therefore, what we're making. It depends on where it's being shipped. For example, certain products don't necessarily transport well overseas. And a lot depends on what continues to be an ever-evolving quality standard that's expected of international -- or by rather international customers and domestic customers increasingly as foreigners have made inroads onshore. So we still have a fair amount of capacity from here. Rather than sort of give a specific number, I'll be kind of that general about it.

David Martin - Deutsche Bank AG

Okay, that's fair. And then, Jim, coming back your comments on cost and ion ore provisions in your contracts, you noted that in some cases, you have now the capability to capture higher iron ore costs both directly and indirectly. I think the directly comment is self-explanatory, I'm just curious on what you mean by indirectly?

James Wainscott

More precisely, it would be in those instances where customers simply have an aversion to sharing in that risk in terms of the volatility that we've seen in the marketplace and therefore, they agreed to a higher base price would be my definition. It really is a matter of the end of the day, David, of making sure that we're there to serve our customers for the long run and that they understand that we have, on their behalf, and have been delighted to do so until this up, up and away process has occurred with raw materials in recent years, notwithstanding the global recession and the ongoing U.S. recovery that we need to recover those higher costs. And there's different ways that you can do that, and each customer's arrangement's different. We value their input immensely, and we try and work with them to come up with an amenable solution for both parties. But there has to be some method here to recover those costs or we'll simply price ourselves out of business, which does nobody any good. So the indirect is really more an opportunity then to just say the base price is higher.

Operator

Our next question comes from Arun Viswanathan of Susquehanna.

Arun Viswanathan - Susquehanna Financial Group, LLLP

I just had a -- so a little bit more on the iron ore issue. I know that the companies are trying to move to a more market-based quarterly pricing scenario. Can you, I guess, explain how those discussions have gone and is there any chance of potential positives that could pop up in the second half or even next year? Because I think it would take you quite a while to establish any kind of self-sufficiency there.

James Wainscott

Let me offer it this way, sort of big picture. Again, right now, we are purchasers of 100% of our iron ore pellets, that's all we need, that's all we can consume is pellets. And candidly, the producers of pellets have had their way with us and with others who are completely dependent upon them. We've moved this year, as I mentioned, from this annual process, which we didn't get settled in 2010 until October, which didn't give us the opportunity to recover any of the higher costs or any meaningful costs to this quarterly mechanism. Obviously, we're still trying to explain it the best we can to all of you. We think it's the right thing because it does allow us the ability to better match our costs with our revenues and recover those as we negotiate, recover those higher costs as we negotiated them -- those deals rather with our customers. What can change going forward? Well, perhaps, one of these days, supply and demand will come more into balance. Perhaps, the veracious demand from China will decline somewhat for iron ore, we'll see. Any number of things I think would cause one to look at the long-term outlook for pellets and probably, say that they're pretty high and they're likely to come down, that's a good guy and so I suppose one day, we'll have a conference call like this and discuss that we're going to have a LIFO credit. I know it's unimaginable, but that could actually happen. In the meantime, as I mentioned, I don't mean to tease you with this, we have been in dialogue with the parties around the globe about taking an equity interest in iron ore properties or iron ore substitute ventures. I think we've made excellent progress along those lines, both with respect to iron ore and coal. But unfortunately, we don't have an announcement to make today. I think we will in the near-term, which will, again, begin to balance the scales here rather than being 100% the spot market. We don't want to be 100% ownership of our raw materials, but there's probably a number or a percentage somewhere in the middle that we'll move towards, and we'll get about that very quickly.

Operator

Our next question comes from Luke Folta of Jefferies.

Luke Folta - Jefferies & Company, Inc.

Couple of questions. First thing, when I think about your selling price for the third quarter, kind of down 1%, which is about $12 or so. Obviously, quite a bit better than what we're seeing in the carbon steel market. And I sense that some of that's due to improved mix with more Specialty less Carbon and then some is due to the lagging contracts that you have. Just trying to get a sense of how much -- what the bigger driver of that is. And maybe a way to think about is, if you look at just your Carbon business sequentially, what sort of movement do you think we'd see in the selling price there?

James Wainscott

Luke, there are obviously many moving pieces and parts here, because we're really reducing our guidance or updating our guidance, I guess, or providing our guidance 1.4 million to 1.5 million. Much of the tonnage that would have come out would be in the lower-end, the lower-priced tonnage. So that has the effect of maybe overshadowing what's really going on in the carbon market. The carbon market's depressed. We're seeing numbers here that I don't think many people can sell at and make a profit at, and I think that argues for really an end to this madness hopefully pretty soon. But clearly, we're benefiting from a mix standpoint, we're benefiting from increased automotive, increased electrical volumes and pricing. And that's sort of overshadowing what is a larger decline in the carbon spot market business.

Luke Folta - Jefferies & Company, Inc.

Okay. And then just secondly on your Electrical Steel sales. I mean when we look at third quarter expected results, does that reflect any improvement in green-oriented electric steel base pricing? I understand you're probably not seeing that on the domestic business, but at least on the export side?

James Wainscott

There's a little bit of that in there. I wouldn't say it's a great deal, but again, our guidance takes into account all the things that we have said and that would include a little better outlook for green-oriented.

Operator

Our next question comes from Sal Tharani of Goldman Sachs.

Sal Tharani - Goldman Sachs Group Inc.

Jim, you have done a good job in doing a further in terms of lining up your sales contracts to the iron ore price changes. Obviously, the next big thing will be the coke and coal price increases, which I think coke and coal global price remains at $300 a ton, that will be a fair [ph] increase. Are you in negotiation with your customers? And also, how much of your coke and coal is multi-year contract, which we may not see that kind of escalation if coke and coal prices were to remain at the global level where they are right now?

James Wainscott

Sal, let me take it this way, thank you for your question. Coal is really the next big thing, if you will, and we have a similar dynamic at our company as we have with iron ore. We see that coming at us, and we're dealing with it proactively the best that we can. I think we have commented earlier this year that we got our coal deals done early in the year, well before the Australian floods, which obviously impacted supply and drove prices to very, very high levels. The spot market for met coal, as you know, I don't know, a $240 per ton, I mean it's a big, big number right now. Certainly, higher than what we paid this year, and so we'll see where that goes. As a result of that phenomena, we are indeed in discussions as our contract agreements come up about including, not only an iron ore mechanism, but the mechanism to incorporate some sort of recovery with respect to metallurgical coal. And as I said, in the meantime, we're also looking at not just putting all of this on the backs of our customers but investing to improve our lot in life so that we're not entirely dependent on the spot market.

Albert Ferrara

But most of our contracts that we're negotiating now, we're exposed to pricing next year in terms of the coal pricing. We have some commitments for tonnage but virtually, all of our pricing is open for negotiation for next year, Sal.

Operator

Our final question comes from Richard Garchitorena of Crédit Suisse.

Richard Garchitorena - Crédit Suisse AG

Most of my questions have been answered. But one quick question. Just looking at next year versus this year on the cost side, mill time is obviously coming up. Are you going to be ramped up in Q4 and into 2012, will that have any impact on costs going forward? And then also, the shutdown of Ashland, how does impact coke costs going forward as well?

James Wainscott

Richard, first, congratulations on your new role at Credit Suisse. With respect to our costs, as I said, in my closing prepared remarks, and I'll wrap up our Q&A session with this, we have a great company at AK Steel. I think we do a terrific job of utilizing the assets that we have safely, efficiently and serving customers, we hope, better than anybody else. But our costs are simply too high. We acknowledged that, and that has been driven in recent years by a number of things, mostly by skyrocketing input costs and that will moderate in the future and we'll take steps to deal with that. Some of the other things that we're doing though, as you mentioned, we did, sadly, permanently idled the Ashland coke plant. We did so largely for economic reasons, and I think that the economic benefits will be substantial. I'd prefer not to quantify them at this time, but you have that going on, you also have, I think, you meant the Butler #5 EAF, the benefit of that coming on, we'll have the Middletown SunCoke facility that will come on, and that will obviously be beneficial to us. And we'll continue to look at the best long-term configuration from a cost-effective standpoint for AK Steel. We do have a continuous improvement mentality. Our operators, our purchasing people, really every discipline that we have in the company is focused on lowering our costs. We'd like to think that we do more with less in terms of headcount and efficiency, but this is a never-ending challenge for anybody who's in the steel business, and we understand that. So we're not done, we have a long way to go. We think we have a very, very bright future, notwithstanding the bumps in the road that will inevitably occur in this type of an economic recovery.

Operator

This concludes our question-and-answer session. I would now ask Mr. Wainscott for his closing comments.

James Wainscott

Just a couple of comments as we sign off today. I want to thank you all for joining us on the call and for your continuing interest in one of America's premier steelmakers, AK Steel. We very much look forward to having you join us again in about 3 months for our Third Quarter 2011 Conference Call. In the meantime, have a great day and have a wonderful summer.

Operator

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

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