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Dr. Duru, One-Twenty Two (112 clicks)
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The shorts finally nailed AK Steel (AKS) (shorts are about 17% of AKS’s float). On July 26, AKS reported it will be squeezed by lower steel prices and higher input costs – especially iron ore. The stock opened down 4.8% and sold off all day for a closing loss of 17.5%. The day’s carnage delivered AK Steel’s largest one-day loss since a 19.8% loss on November 20, 2008.

All quotes and information in this post come from Seeking Alpha transcripts for the earnings conference call:

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 …

This translated into very poor guidance with profits taking a severe beating. AKS guided to $15/ton in Q3 while profits last quarter were $46/ton and $14/ton in Q1.

Ironically, AKS noted that Q2 was its “best quarter in quite a while” and noted that

Our second quarter of 2011 shipments were their highest in three years … and our profitability, that is our operating profit, our net income and our EPS, were their highest in the past six quarters …

Unfortunately, AKS had even higher expectations for its second quarter performance: $60/ton in profit. The company explained that “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.”

During the Q&A session, analyst Michelle Applebaum got more information out of management regarding the source of the miss and chided management for not including the details in the press release. Basically, there was a $5/ton non-recurring charge in Q2 that should not appear in Q3; $5/ton came from a change in inventory-related charges that were higher than expected, and another $5 (or $6) per ton from lower shipments and lower prices at the tail-end of the quarter.

Not only have iron ore prices remained stubbornly higher than AKS’s expectations and even the expectations of experts, the company now anticipates higher prices to persist for the remainder of the year (prices may decline, but not as much as expected earlier). Demand for iron ore has been exceptionally strong due to Chinese demand. AKS indicated that iron ore could surprise to the downside, but tread very carefully around that hope. Management even mentioned that it is in talks to establish equity interest in iron ore and metallurgical coal properties as one effort to control those costs. On the Q&A, analysts spent a large amount of time pelting management about questions on iron ore costs.

By the end of 2011, all AKS customer contracts will include a provision for recapturing higher iron ore prices. AKS is also facing higher prices for metallurgical coal. The company plans to attack these price pressures by passing along the higher costs to its customers whenever possible. Higher prices for coating materials, natural gas and electricity costs are all squeezing margins as well. Nickel prices have actually declined but AKS already passes those costs through to its customers via surcharges.

Interestingly, some parts of the demand side of the business appear very strong. Automotive customers are generating strong production numbers and giving AKS robust order levels for carbon steel and specialty steel. Appliance customers are also expected to continue strong orders for specialty steel into Q3. Last quarter, AKS set a record for international sales of its green-oriented electrical steel products. Domestic demand continues a strong rebound and pricing continues to firm up. AKS believes that the the Infrastructure and Manufacturing (I&M) market will pick back up after a “pause” last quarter. Finally, service center demand moderated.

Management provided a huge caveat to its generally positive comments on demand when it talked about softness in the general carbon steel 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.

On the competitive front, AKS noted that additional steel-producing capacity is coming into the market and recently imports have increased strongly. Management expressed little concern over the extra capacity, citing that capacity concerns are always running in the background in the steel industry.

In the end, this earnings report was a big wake-up call to the margin pressures being felt in the steel industry. Given how input costs have been increasing for quite some time, I am actually surprised it took this long for things to come to a head like this. AKS is now at nine-month lows and at this rate could easily retest 2010 lows around $11.50 (AKS is at $12.73 at the time of writing). Earlier this month, I sold calls against my position anticipating that AKS was hitting the top end of a trading range, but I figured the bottom of that trading range would stay around $14. I will continue to hold here with the expectation that AKS is close to its worst case scenario – absent a new global recession.

Source: AK Steel Suffers Largest 1-Day Loss in 3 Years on Poor Earnings