On AK Steel Vertical Integration And Whether It Will Create A Competitive Advantage

Oct. 7.11 | About: AK Steel (AKS)

By Lisa Reisman

Back in December of 2009, we ran a story entitled: “Vertical Integration Alive and Well in the Metals Industry,” and that statement has proven itself out several times. The latest announcements come from AK Steel (NYSE:AKS), a producer of flat-rolled carbon, stainless and electrical steel products, to form a JV to produce iron ore concentrate, a feedstock for iron-based steel-making raw materials, as well as an acquisition of a firm with 20 million tons of reserves of low volatile metallurgical coal.

Raw material price volatility has placed significant risk onto producers that lack captive sources of supply. Today, AK Steel buys close to 100 percent of its iron ore and 100 percent of its metallurgical coal. According to CEO James Wainscott in a call on Wednesday, the company wishes to have the ability to hedge at least half its iron ore and coking coal needs. AK Steel appears in good company. ArcelorMittal (NYSE:MT) has also vertically integrated, as have several other producers.

Game Changers

According to Wainscott, “these two transactions represent key pieces for our vertical integration plan to create raw material self-sufficiency and lower our cost position,” adding, “coal and iron ore have caused the purchase prices along with other steel making inputs to skyrocket. Margins have been squeezed.” The company purchased a 49.9-percent stake in a new joint venture, Magnetation LLC, that produces 441,000 short tons of iron ore concentrate, according to the AK Steel press release. A second plant will have approximately 1.1 million short tons of capacity and will eventually have four concentrate plants with 3.9 million short tons of capacity. By 2016, Magnetation LLC will build a 3.3 million-short-ton pelletizing plant.

“Magnetation does not mine iron ore per se. It removes the tailings and creates fines from tailings,” said Wainscott. AK Steel uses 6-6.6 million short tons of iron ore annually. Each year, the company has purchased all of its iron ore requirements at increasingly higher prices. With a 49% equity stake, AK can hedge half its iron ore needs, though it will take a few years to see the ROI. The investment will be accretive starting in 2012. The other part of the AK iron ore story involves the actual Magnetation LLC technology. The technology does not require mineral rights and access to actual iron ore. Rather, Magnetation pays a fee to the state of Minnesota for rights to the tailings themselves.

In addition, the company has acquired all of the stock of Solar Fuel Company with estimated reserves of 20 million short tons of low volatile met coal. The company will pay $36 million for the coal company, renamed AK Coal Resources. Met coal production will start sometime between 2013 – 2015.

Competitive Advantage?

The company believes that for metallurgical coal, it can access material for at least $100 a ton less than the current spot market price.

Do these deals provide AK Steel with a competitive advantage? We’d argue probably not — however, they certainly put the company in a more equal cost position vis-à-vis the competition. Whether or not they will undercut their competitors and gain share or increase margins remains to be seen. But at a minimum, we’d argue vertical integration has become an ante requirement for producers.