AK Steel (AKS) has been a favorite component pick of mine for years in the steel sector and commodity related investments, but has been underperforming its peers in the last couple of steel-related market rallies. I want to explore the relative value of the stock at these levels, and what we can expect to see from AKS as we move forward into an environment that should be more favorable to steel stocks in general. Is AK Steel an overlooked value play at these levels, or are we looking at a stock that has been held back by the market for very apparent and valid reasons?
Steel Sector Rallies
There have been a few steel rallies in the trailing 18 months, the first initiated around the time of the Trump election in the U.S. and the belief in increased infrastructure spending. One way to watch steel movements across the industry is watching the action in the VanEck Steel Sector ETF (SLX) which displayed a growth trend in steel starting in January of 2016 and accelerating through February 2017. Another way to watch steel broadly is through the SPDR S&P Metals and Mining ETF (XME) which illustrated the same price action that SLX exhibited in the same timeframe. Having come off a general decline in steel and commodities beginning in mid-2014, this was a welcome turn for commodity and value investors alike, and signaled that China in particular was likely not dropping off a precipice as had been partially feared.
After seeing the sector dropping somewhat in the beginning of 2017, we saw a general strength returning to the sector throughout 2017 with a renewed vigor coming in late 2017 as steel pricing improved, the U.S. Budget talks solidified, infrastructure became a priority in Congress, and new talks supporting a domestic steel tariff surfaced from the Trump administration. While these talks have not supported the industry evenly or provided the fuel for a significant rally that many have expected, there seems to be a consensus momentum developing in the industry with stronger years projected ahead. As always, this is subject to U.S. growth levels remaining consistent and global economic health remaining positive. The increased risk of a trade war also is weighing on investors’ minds, providing some brakes to the sector.
Performance - AKS Compared to Its Peers
The first place to start in steel investing is with broad-based ETF products like the VanEck and SPDR products mentioned above. While these products are certainly reliable and less risky, I find that holding chosen specific stocks in a value portfolio is well worth the risk and provides the basis for the quality long-term appreciation many investors are looking for. In some cases, one can add the additional benefit of a strong dividend income stream which may be hard to replicate in any ETF.
The steel space is broad globally, but for the purposes of U.S. based value investing I tend to look towards stocks that allow easy trading on U.S. exchanges, have sufficient trading volume, and generally are engaged in the primary manufacture of steel as a commodity resource. There are certain stocks can be said to be ‘steel related’ in that they supply the raw materials necessary to create finished steel (Such as Cleveland Cliffs (CLF) or Arch Coal (ARCH) and Peabody Energy (BTU), but for the purposes of this article we will focus only on primary manufacturers. I am also going to look at those mfg. with significant operations within the U.S. for my focus on domestic value investing in steel as a commodity.
The primary stocks of attention in this space are Nucor (NUE) and Steel Dynamics (STLD) as they have proved to be very resilient and are well regarded and are soundly managed companies. NUE rallied from a low of $39.07 in early 2016 to a current price of $67.78 as of the writing of this article. STLD saw similar action coming off lows of $17.18 in late 2015 to a current price of $46.97. Other stocks to consider are U.S. Steel (X) with price movement off a low of $7.00 in Jan. 2016 to the current share price of $44.53 and Arcelor Mittal which began 2016 at $11.40 and has ridden to $33.16 currently and a recent high above $36 in January 2018. AK Steel began this period with a stock price of $2.04 in January 2016 riding to a high of $10.21 in December 2016 settling in currently at around the $5-$6 level with a current price of $5.62.
An investor beginning positions in stocks at these right times would have seen significant capital appreciation. Nucor showed an appreciation of 73% over this period, Steel Dynamics has risen 173%, U.S. Steel has risen a whopping 536% off the low, Arcelor Mittal at 190%, and our chosen target stock AK Steel at 175% in total to date. While most value investors would not be timing stocks in such a particularly growth-oriented fashion, if one were looking at this trend and had entered steel stocks beginning in 2015 or early 2016 with an eye toward the value in the stocks, an investor would be richly rewarded for his/her foresight. Also note that value investors concerned with dividend yield may be disappointed in many steel stocks – Nucor and Steel Dynamics having the only consistent dividend payments recently.
Where Does AKS Fit Into This Picture?
AKS exhibited a tremendous run to $10.21 in 2016 and having settled well below that range in 2017 and traded largely flat or lower during most of 2017. Given this recent 12-month period, is it possible that AKS represents a significant buying opportunity with the ability to generate a possible 70-80% upside from current levels? Is there hidden value in this stock waiting to be unlocked given that it shows an enterprise value of $3.85B while a market cap of only $1.77B? The consensus price target for AKS seems to be in the mid-$6 range for the coming year which is not confidence inspiring for such a run, and while no analysts seem to be rating the stock as underperform or sell, notably most are showing the stock as a ‘hold’.
AKS is a smaller market cap stock in the steel space, with a total current cap of $1.77B compared to peers U.S. Steel at $7.8B, Steel Dynamic of $11.09B and Nucor $21.55B. International players Arcelor Mittal (MT) carry a cap of $33.44B and our true international play (but U.S. tradeable) Posco (PKX) has a cap of $25.86B. Thus an investor could say that AKS is a small fish in a big pond, and a specialized one given its more unique steel product mix. AK Steel manufacturers a lot of unique stainless and rolled products, and through its recent acquisition of Precision Partners it has made an extra emphasis on value-added products to its portfolio. It is also a company that is heavily reliant on the auto industry in that 66% of 2016 sales were to that sector, and only 16% was to infrastructure and non-auto manufacturing. The Precision deal only heightens that reliance on the auto industry.
I believe the key to understanding the price action in AK Steel and also its long-term prospects are a) the issuance of stock in 2016 and the subsequent dilution in share value b) the reliance on the auto industry and c) the overall high debt/equity ratio of the company. The share dilution argument is self-evident, as is the trend in the U.S. auto industry in both technology moves towards other metals and the seeming cap on auto sales momentum. The debt is worth looking at - AKS currently stands as having the highest debt to equity ratio among its peer group due in part to recent acquisitions (Precision), and mostly to a past reliance on debt as significant part of its capital structure. This has not improved in recent years, as the company carries over $2B in debt resulting in a book value per share of $-.69. Management seems to be looking at debt as a long-term issue, but we saw 2017 close with more net debt than it began which does not build confidence.
While the company looks attractive at a forward PE of around 8 at the current price levels, we can see that the FCF situation is a little more precarious as the company eats significant funds in servicing the debt and always seems to have some impairment that drives down earnings. There are a lot of articles out there about the earnings situation so I will not regurgitate them here, however they are worth researching to see why AKS seems to always have a difficult time driving strong EPS.
So where does this find us as a value investor? In AKS we see a company that offers a specialized grouping of products that is looking increasingly to become value added and be less of a commodity-driven enterprise - which should increase consistency and long-term shareholder value. However they are also a business that operates in a commodity environment, and the recent investments have been toward the auto industry, which itself is cyclical. We see attractive steel industry trends in both pricing and volume, however we also see the broad market concern in automotive sales and steel usage. We see attractive share price growth and technical elements, coupled with value in the PE ratio, but have also been dogged with share issuances over the years and a high reliance on debt. We see positive political developments with renewed industry focus and supportive tariffs, but may also see a trade-war and a general economic challenge of import/export impairment.
Should a Value Investor Be Looking at AKS as a Long-Term Investment?
I am recommending those investors long AKS to remain in those positions, mostly for the positive reasons outlined above. While I see the negatives and risks, if you have believed in AKS before and see nothing here that gives you additional pause, I cannot create a strong enough case to exit the stock at these levels. For all others this stock should be considered speculative, and not a high-quality component of a value portfolio. The price may be depressed, but there are some good reasons for this. Of note - I also do not view an entry to AKS at these levels a ‘value trap’ in the traditional sense that an investor is believing in a false narrative and may be buying a decliner, but there may be better opportunities to consider in the steel space particularly NUE and STLD. Both are highly efficient and well-run companies, which have good future prospects even in an increasingly competitive environment. Tariff or no tariff – global competition will not abate.
Another option would be to look at MT for more international exposure with global operations and a strong presence in the EU. This is another traditional component of my steel and commodities portfolio, and I think worth a look in a new tariff-based reality. Could AKS stage a rally and gain momentum going forward? – I certainly think it is possible – however the recent performance of the stock does not lend confidence that the market is taking its reforms seriously. Until I can see both positive operational and financial results over a sustained time period, combined with the market rewarding those efforts, I have a hard time allocating more capital to AKS. I would also look towards additional debt issuances as very bearish, and any improvement on the debt situation should prove very bullish. As for pricing - I would look towards a price target of $6.50 as showing strength, and any drop below 2016 support levels of $4.75 as bearish and showing weakness. As a value investor I do not trade on technical analysis, however I must pay attention to what the market is telling me about the stock. In this case I don’t believe the market is wrong – the stock is a mixed bag, and so is the price. If you a believer in the direction of the company and feel they can capitalize on the favorable current trends I recommend going long. If not, I would look elsewhere.
