AK Steel (NYSE:AKS) operates eight steel factories, two steel tube plants, and two coke plants. The firm is focused on the production of specialty, value-added steel products, electrical coated, cold rolled and tubular steel. The company is highly exposed to the automotive sector, with sales to car manufacturers accounting for just over 50% of total revenue. The last few years have been a struggle for the firm, not only due to the stress in the US steel market but also due to an aborted attempt by management at vertically integrating operations. The stock is now trading at a 10-year low, below even the levels it sunk to in 2008-2009 period. Given the lows to which it has fallen, investors must ask themselves if the risk now priced into the stock has become excessive, and if AKS has become a "good buy."
Despite a history of struggles, which is unsurprising for a US Steel company, AKS's most significant struggles seem to have only started a few years ago when management decided to integrate vertically with the goal of making AKS 50% self-sufficient in regards to both met coal and iron ore needs. The move to vertical integration resulted in several ill-fated investments and poor capital allocation on the part of management. The most significant investment was Magnetation, a company focused on producing high-quality iron ore pelts from scrap. Magnetation filed for Chapter 11 last year, and AK Steel has since written off the investment entirely at a cost to the firm of $256 million.
After backtracking on vertical integration, management appears to have refocused on manufacturing steel with the purchase of blast furnace operations in Dearborn Michigan from Severstal. Given the continued investment that vertical integration would have required, the efforts of management to refocus are a positive, but are still a cause for concern. Blast furnaces have been losing market share in the US to Electric Arc furnaces since the 1980s (See Chart: US Steel Production by Mill Type) and for good reason, the EBITDA and EBIT per ton for Blast furnace producers are weak in comparison to Electric Arc (See Chart: US Steel Sector EBITDA and EBIT Per Ton). As the Chart of EBITDA and EBIT per ton shows, AKS and its blast furnaces are producing supposedly value-added steel but are achieving poor margins on product in the process.
AKS suffers significantly from its strategy of taking two steps forward and one step back at every turn, in Q4 of 2014 it appeared as if the company was beginning to turn the corner, and although the first three-quarters of 2015 proved increasingly positive on a cash flow basis, they were nevertheless difficult quarters. Q3 of 2015 again appears a possible turning point, although only the next few quarters (4th Qtr 2015 results will be released next week on the 26th) will validate the truth of the positive cash flow trend.
Management guidance for the fourth quarter, released in early December, indicated a net loss of $0.33 to $0.38 per diluted share of common stock. On the surface, this guidance implies another step backward for the company, but management guidance includes approximately $0.42 per diluted share of charges related to the unannounced idling of the blast furnace and related steelmaking operations at its Ashland, Kentucky Works facility. The company also said that it expects to record a higher income tax expense largely because of year-to-date effects of an increase in the company's estimated LIFO income. Taking both of those variables into account and it remains a possibility that the company will maintain some of the positive momentum it has created over the last few quarters.
Management has also forecasted a 14% decline in shipment volumes, which is certainly a disappointment, but given the forecasted 2% increase in the average sale price per ton, combined with the lower iron ore, metallurgical coal and natural gas prices it is hard to interpret the impact of the decline. Complicating the forecasted guidance is an increase in average sale price, which is due in large part to management's emphasis on selling value-added products to the automotive sector. Selling value-added steel products to the auto industry has been a strength for the company, but it will not always be a strength. If weakness in the steel market continues and weakness in car demand occurs, all before AK Steel management strengthens the balance sheet, there could be even more pain to come.
Quarter by Quarter LTM Financial Review
Revenue held steady in 2015 at between $1.6 to $1.7 billion a quarter for AKS but was down from $1.9 billion in Q4 of 2014. Gross margins have improved over the LTM, with LTM Gross Profit growth of 35.34% versus a comparables' average of -4.23%. Comparables include STLD, X, NUE, CMC, RS, CLF, ATI, WORA. Although the general trend over the last four quarters has been one of operational improvement that progress has not been without volatility, in particular, Q2 of 2015 proved troublesome.
Not only where margins off significantly in Q2 of 2015 but revenue was down significantly. Interestingly enough, nothing of note happened in the Q2 as compared to the Q1 when the company took a $256 million impairment related to management's investment in Magnetation. Struggles in Q2 appear largely the result of pressure on steel prices, a useful reminder of the fact that regardless of operational improvement, AK Steel is a price taker on both the input and output side of operations.
The balance sheet has long been a concern for those that follow AKS, as has the ability to of the company to service the debt it has taken on. Of note in 2015 is the improvement in the EBITDA/Interest coverage ratio over the last four quarters. Although the ratio has been variable for the company over the past 10 quarters, Q3 2015 represents the 2nd highest coverage ratio the company has achieved in the last ten quarters. If management can maintain the operational improvements and continue to strengthen the company's ability to cover debt expenses, it would be a noteworthy development.
The volatility in historical results quarter to quarter raises questions about the ability of management to maintain the operational progress though. Somewhat reassuringly, changes have had a positive impact on the cash flow yield each of the last four quarters, suggesting that perhaps "this time is different." Not only has the company achieved positive levered and unlevered free cash flow yield for four straight quarters, the first time the company has managed that since 2009, but the AKS has also increased the levered and unlevered cash flow yields each of the last three-quarters.
Cost controls appear to be working, although very slowly. According to a review of the cash flow for the last four quarters, management has kept capital expenditures controlled, presumably keeping CapEx to nothing more than maintenance CapEx. Management also appears to have renewed their focus on paying down debt, repaying $140 million in debt over the last two-quarters. Despite the kudos management deserves for paying down debt, $140 million does little to dent the $2.38 billion in LT debt that the company has outstanding. Paying down the debt is better than the trend from the previous five quarters when the AKS added debt to the balance sheet each quarter, but that is not saying very much. It is very unfortunate that the significant debt that the company took on in 2012 was so poorly utilized, management either wasted it on poor investments or used it to fund continuing operations, which have generated multiple years of negative cash flow until just recently.
One can say very little that is positive about management stewardship in recent years.
Despite paying down a modicum of debt, the balance sheet remains fragile. AKS still maintains a Debt to Capital ratio of 125% and total liabilities to total assets ratio of 111%. Unsurprisingly, the Altman Z-score is an abysmal 1.19. Industry comparables have an Altman Z-Score of 2.5 and a debt to capital ratio of 38.87 on average in the last fiscal quarter.
A significant question for AKS is the overall environment for steel in the US going forward. The company recently hiked prices $30 a ton, suggesting that the firm believes the market may be firming up. Additionally, inventory levels are starting too looked mixed, depending on where you look, with a less clear oversupply in the US. Inventory drawdowns are likely the result of the low utilization rates at many US Steel Mills, though, which according to Bank of America are in the range of 65% to 75%. Commercial construction and automotive demand have remained stable throughout the year, but as might be expected commodity related demand from agriculture and energy remain low.
Those looking at AKS must ask about the strength of the US Automotive sector in the next few years given the exposure AKS has, this begins with asking what will happen to auto volumes in 2016? The crash in commodity prices and energy would seem to increase the affordability of driving both for domestic US consumers and global consumers, at the same time the fall in commodity prices is a two edge sword for AKS as it drives down the price of steel and hurts margins. In the US the picture is complicated, US dealer inventories ended the year up 2.0% vs. 2014, but sedans were over stocked (up 6%) and truck inventories ended the year below normal levels for this time of year. Weak sales demand for sedans could be offset by strong truck and SUV demand but that is speculation. Additionally, the inventory situation has occurred in the context of the best sales year (by volume) the US has ever had, with a total of 17 million new cars sold in 2015. Is that a sign of strength in the US economy or the result of record-low-interest rates that have made borrowing to buy a car easier?
A weak economy in the US in 2016 could drive demand down, and automotive demand for steel could still shrink further (even in a robust sales environment) as car manufactures replace steel parts with aluminum parts. The degree to which this shift hurts AKS is hard to gauge, a principal value added product in AKS's product quiver is galvanized steel, which is difficult to replace with aluminum. At the same time, AKS may need to drop prices on non-galvanized automotive products to avoid car manufactures switching from heavy steel to lite aluminum. In short macro abound, none of which are easy to answer or likely to yield to answers that one can have confidence in. We like uncertainty, but there seems to be a little too much surrounding the macro environment for AKS.
We return to the primary question...has the price of AK Steel fallen enough to offer deep value investors an opportunity at a "good buy", does the 10-year low offer significant enough margin of safety for the risks? Although it appears that cost savings and limited CapEx have driven an improvement in cash flow one has to ask if the lack of investment in facilities may come back to hurt AK Steel, furthermore how much more juice can management squeeze out of cost savings? Pressure from competition will remain fierce in the near future, as will efforts by other steel manufacturers to take market share in the appealing value-added products space that AKS occupies. Despite the minor improvement in the balance sheet, debt is still very significant, and the debt is not the only major liability, as AKS has an underfunded pension fund that it must address in the future. From a bottom up fundamentals perspective the risks seem significant, even at the current price level.
The combination of overcapacity in the US Steel sector (see utilization rates estimates from BofA above) and the deterioration in steel prices are both significant negatives. Inventories appear to be firming up but perhaps not fast enough to drive prices higher quick enough to be very helpful to AKS. Furthermore, as a result of the recent weak pricing high-cost US steel producers have been driven out of the market, blast furnaces have been shut down and expensive supply taken out the market. This has the effect of flattening the cost curve, making competition within the market all the more fiercer. The macro environment seems dreadful.
Better steel pricing and more demand for some of AK Steel's value-added products, such as electrical steel or galvanized auto products, may improve the picture in the near term but will it be enough in the long run? We think not, deep value bargain hunters should keep looking around, even at these lows the difference between AKS value and current price is not enough to compensate for the risk. This is not a bad asset that can be well bought, this is just a bad asset. Interested investors should keep moving, other opportunities in the steel sector await investigation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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