Why You Should Be Long AK Steel

| About: AK Steel (AKS)

Summary

AKS shares have started 2016 on a positive note despite a weak guidance release by the company last month, indicating that investors are positive about its long-term prospects.

The U.S. has imposed a 256% tariff on imports of corrosion-resistant steel from China, apart from 236% countervailing duties, which will make AKS’ products more competitive than cheap Chinese imports.

AKS gets over 50% of its revenue from the auto segment, which is good news for investors as U.S. auto sales in 2016 are expected to hit a record.

AKS will start shipping advanced high-strength steels from 2017 that allow substantial vehicle weight reductions, which should see strong demand due to the U.S. government’s plan to increase fuel economy.

AK Steel (NYSE:AKS) has gotten off to a good start in 2016 with its shares already up close to 5%. Looking ahead, I believe that AK Steel will be able to sustain this momentum for the rest of the year as the company will benefit from a number of positives emerging in the U.S. steel industry. This is despite the fact that last month, AK Steel announced that it will post a bigger-than-expected loss in the fourth quarter as investors seem to be focusing on its long-term prospects. In this article, we will take a look at the reasons why AK Steel is poised for more gains going forward.

Tariffs on imports will be a tailwind

Last month, the U.S. Department of Commerce enforced a tariff of 256% on imports of corrosion-resistant steel from China into the U.S., along with other countries. This is in addition to the 236% countervailing duties that were imposed in November, indicating that the entry barrier for Chinese steel into the U.S. is now very high.

This will allow AK Steel to become more competitive as the company has faced the brunt of cheap imports, which led it to lower its shipment forecast for the fourth quarter. More importantly, the utilization rate in the U.S. for steel manufacturing will now pick up pace. For instance, the capability utilization rate in the U.S. for steelmaking stood at just 60.2%, down from a utilization rate of 75.1% in the prior-year period. As a result of this weak utilization rate, the margin profile of the likes of AK Steel has been negatively affected due to a higher portion of fixed costs.

On the other hand, the persistent oversupply in its domestic market is forcing China's hand and the country is now reducing production. For example, the Hebei province, which accounts for 25% of China's steel production, has decided to reduce steel production by 8 million tons this year to reduce overcapacity.

Thus, a combination of low Chinese steel production and the imposition of import duties in the U.S. is good news for AK Steel as it will now be able to compete on a better footing.

End-market growth is another driver

With the barrier of cheap steel imports from China being taken care of, AK Steel will now be able to take better advantage of the growth in key steel consuming markets in the U.S., such as construction and automotive. For instance, after a record year in 2015 when sales hit 17.47 million units, 2016 is expected to be another big year for the industry as sales are anticipated to top 18 million units.

Now, this is good news for steelmakers such as AK Steel because steel is a key component in auto manufacturing, accounting for 60% of an average vehicle's curb weight. Now, in order to tap this market, AK Steel has been working on the development of Advanced High Strength Steel, or AHSS, by making changes to its Hot Dip Galvanizing Line at Dearborn Works. The modification to the line is expected to be complete this year, which will allow AK Steel to begin shipments of the next-generation AHSS from next year.

The advantage of AHSS is that it will allow automakers to reduce the weight of their vehicles without compromising safety since this brand of steel has greater formability and higher tensile strength. As a result, AK Steel should see an increase in demand for this particular product from automakers who are working toward meeting the U.S. government's corporate average fuel economy standards. In fact, automakers need to improve the average mileage to 54.4 miles per gallon in 2025 from 27.5 mpg in 2012.

One of the key ways of achieving this is by lowering the weight of vehicles, and since AHSS is known to reduce weight by 25%, AK Steel is investing in the right area for growth. More importantly, if we consider the fact that AK Steel gets over 50% of its revenue from the automotive steel segment, its investment in AHSS will turn out to be a growth driver in the long run.

Conclusion

AK Steel has a lot going for it in 2016. The imposition of heavy duties on Chinese imports, coupled with another strong year for the auto industry will help the company sustain its momentum going forward. So, in my opinion, investors should consider going long AK Steel in light of the points discussed above.

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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