In finance theory, the capital asset pricing model informs us that investors seek higher returns from riskier holdings. When it comes to steel, the market perceives a great deal of production uncertainty, labor disruptions, and brutal competition that is often out of touch with the fundamentals. As an investor relations consultant, I expect to see particularly high returns from smaller under-followed firms, like Haynes International (HAYN) and Keystone Consolidated Industries (OTC:KYCN), as press coverage turns more favorable. Towards that end, I plan on releasing more favorable reports that underscore just how undervalued these two players are.
In the meanwhile, the attention will be disproportionately policed on larger companies, like AK Steel (AKS). In this article, I will run you through my DCF analysis on AK Steel and will then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to U.S. Steel (X) and ArcelorMittal (MT).
First, let's begin with an assumption about revenues. AK Steel finished FY2011 with $6.5B in revenue, which represented an 8.4% gain off of the preceding year. Analysts model a 18.8% per annum growth rate over the next half decade as the company transitions into profitability.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 90% of revenue, SG&A as 3.5% of revenue, and capex as 3.8% of revenue. Taxes are estimated to hover around 10 - 25%.
We then need to subtract out net increases in working capital. I expect this figure to hover around 1% of revenue.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10.5% yields a fair value figure of $8.40, implying 14% upside. DCF models are, of course, highly sensitive to the discount rate. In my sensitivity study, I find that the standard deviation from various perpetual growth rates and WACCs is around $2.58. That represents 35% of value!
All of this falls within the context of limited visibility:
"While the future certainly feels better than it has in a while, our ability to forecast much beyond a month or 2 remains difficult. Many of the same issues that caused us to change our guidance practice in the fourth quarter of 2011 remain the same today, including a slow and uncertain economic recovery, the lack of visibility on spot market orders and pricing and the continuing volatility of input costs, albeit to a lesser extent than was the case a quarter or so ago".
Due to the sensitivity inherent in the DCF model for AK Steel, it is important to triangulate any result with other ways to calculate value. From a multiples perspective, however, AK Steel is attractive. It trades at only 5.9x forward earnings versus 7.7x for U.S. Steel and 5.9x for ArcelorMittal. Assuming a multiple of 7.5x and a conservative 2013 EPS of $1.17, the rough intrinsic value of the stock $8.76 - roughly in-line with my DCF result.
Consensus estimates for U.S. Steel's EPS forecast that it will turn positive at $2.56 in 2012 and then grow by 46.9% and 22.1% in the following two years. Assuming a multiple of 9x and a conservative 2013 EPS of $3.72, the rough intrinsic value of the stock is $33.48, implying that it is 16.2% undervalued. While I believe the company is led by top management, I fear the union's grip over operations. According to T1 Banker, the Street rates shares around a "hold", and all 6 estimates to EPS have fallen for a net change of -8.3%. This gives me pause that the company will not be able to execute when we are in a full recovery.
ArcelorMittal has been one of my top steel choices for some time. It already is profitable and thus is a safer investment. According to T1 Banker, the Street rates shares near a "strong buy" and 5 out of 6 revisions to estimates have gone up. EPS is expected to rise by 183.8% from 2011 to 2014. If ArcelorMittal can trade at just 7.5x and hit a conservative 2014 EPS of $3.60, the stock will gain 43.4%. We note that the last time the company rallied from the depths of the financial collapsed, it more than doubled. It has since fallen unreasonably below this high-point.