The Global Steel Industry Outlook
The global steel industry is facing significant headwinds in 2012 from increasing Asian output and decreasing global demand for steel. Over the last decade, Asia's share of the world market has grown from 42% in 2001 to 64% in 2010. While global production contracted in 2008 and 2009, Asian output has grown steadily by 10 to 12% per year, leaving American and European producers bearing the entire burden of absorbing the reduction in demand.
The Domestic Industry Outlook
North American steel producers face an additional headwind in the form of a strong US dollar. Over the last 12 months, the US Dollar has risen 14% against the Euro and 28% against the Brazilian Real and, making imported steel, particularly from Germany and Brazil much more competitive against domestically produced material.
This imbalance could worsen as growth continues to slow in these European and South American markets, resulting in increased emphasis on exports to the United States. A recent report by the US Department of Commerce illustrates this problem well.
The Highest Cost Producer - AK Steel (AKS)
The economic pain inflicted by these types of conditions is not evenly distributed through the industry. In commodity markets like steel, the brunt of slack demand from an economic downturn is felt disproportionately by the high cost producers. Below is a ranking of gross profit margin for the Iron and Steel industry:
AK Steel is a relatively small, unionized firm with staggeringly high labor and legacy costs, principally pension obligations. This combination drove General Motors (GM) into bankruptcy, and AK Steel may be in for the same fate. The company has lost money in eight of the last 10 years. Their pension and other retirement liabilities are $1.87 billion. Excluding plant and equipment, goodwill and their tax loss carry forward, that is more than the rest of the company is worth.
Within the troubled North American steel market, AK Steel is in a relatively weak position to deal with its competition. Furthermore, a close examination of the balance sheet and recent company actions suggests AKS may be facing serious liquidity problems in the near future.
Deferred Tax Assets
The company claims $933 million, 22% of total assets as "Tax deferred assets," $216 million of which is shown as a current asset. A deferred tax asset is a credit against future corporate taxes that can be taken as a result of prior year losses being carried forward. In order to properly list a "Deferred Tax Asset" as a current asset, "It must be determined that there is more than a 50% probability that the company will have positive accounting income in the next fiscal period before the deferred tax asset can be applied".
AK Steel lost $0.11 in the first quarter. With 110 million shares outstanding and a 37% tax rate, AK Steel would need to earn $6 per share in the next three quarters to collect on that asset. S&P is projecting $0.19 for the year, a figure that seems optimistic under current market conditions of slack demand and falling price for their finished products. The company did hint at this in its June 18th Q2 guidance:
Due to increased uncertainty and volatility with respect to near-term economic conditions. . ., including a recent deterioration in spot market pricing, AK Steel cannot provide reliable guidance at this time for the company's results for the remainder of 2012[underline added by author]. . .[And Further,] the company likely will record a non-cash charge to income tax expense in the second quarter of 2012 to recognize a valuation allowance against some or all of its remaining deferred tax assets.
The problem is that changing the short term portion of deferred tax credit to a long term asset would drop their current ratio from its currently reported 1.1 to 0.9, a level that could cause serious trouble with financing.
Suspicious Pricing Behavior
Oddly, AK Steel has been raising their selling price on the spot market as spot market prices decline. This amounts to a temporary withdrawal from the spot market. The most recent announcement was on July 6 when they announced a $40 per ton increase effective immediately. The only plausible explanation for this is that AK Steel's cost of production is close to or higher than the spot price. Most of their steel is produced under annual contracts.
Spot selling price for their products have declined 15% since a year ago, and the trends appears to be continuing. In 2011 AK Steel's gross profit was less than 7% meaning their average cost to produce a ton of steel may be close to or higher than today's spot price although input prices have fallen as well over the same period.
It should also be noted that AK Steel's $0.20 annual dividend amounts to a payout ratio of 105% of S&P's projected earnings of $0.19 this year. Liquidity problems stemming from a write-down of their deferred tax asset would make a cut or elimination of the dividend a possibility.
AK Steel is a weak player in a difficult market with specific conditions that make a dramatic turnaround unlikely. Exposure to the stock should be avoided ahead of their Q2 earnings release on July 24.
Disclosure: I am short AKS.