AK Steel Holding Corporation, United States Steel Corporation Are Underdogs: Credit Suisse
6 July 2016
Today, Credit Suisse released its report on AK Steel Holding Corporation (NYSE:AKS) and United States Steel Corporation. The firm noted that consensus underappreciated both the steel manufacturers.
While reviewing AK Steel, Credit Suisse analysts anticipated more growth in steel prices as compared to consensus. The reason behind it is a cut in Basic Oxygen Furnace (BOF) capacity and limits on imports. Resultantly, it rated Outperform to the company’s stock with a price target of $7.
Furthermore, while covering United States Steel Corporation (NYSE:X), the firm noted that consensus missed the immense operational leverage that the steel manufacturer had to rising steel sheet prices, which is likely to sustain through second half of fiscal year 2016 (2HFY16). Taking this under consideration, the firm rated Outperform to the company’s stock with a price target of $26.
During the last 18 months, 7.8 million tons capacity of blast furnaces have been either shut down or put idled. Out of this, one million ton blast furnace of AK Steel, 5.2 million tons blast furnace of US Steel, and 1.6 million tons blast furnace of ArcelorMittal SA (ADR) (NYSE:MT) were involved. As per research firm’s estimates, these assets were producing around 5.6 million tons in CY14. Total US production of flat rolled products in CY15 was 55 million tons, whereby consumption stood 67 million tons. Hence, the halt of these blast furnaces are likely to impact US supply base for sheet products.
American Iron and Steel Institute (AISI) data for US blast furnace output confirms the sharp decline in integrated production in the US, with annualized 1QFY16 production levels down 3.2 million tons from CY15 and 6.8 million tons from CY14. Many of these blast furnaces would likely be operating at lower levels owing to above average market exposure to energy tubular goods. This will be in addition to the surge of sheet imports, which further impact domestic volumes in late CY14 and during CY15.
Shift in Commercial Focus
Both integrated and electric arc furnaces (EAF) mills are seeking exit from the US commodity hot band market. The steel producers continued to upgrade the product mix and make inroads into the more value add auto sheet markets. Over years, the integrated mills had witnessed losses; a part of these losses had been driven by cheap imports, which has negatively impacted EAF production rates as well. The removal of a significant amount of US hot band capacity from integrated mills, and to a lesser extent EAFs shifting product mix is expected to be a key long term positive.
Furthermore, the US market has become more consolidated now as compared to the late 1990's and early 2000's. Such conditions compel these blast furnaces to come back online and US Steel to complete its 1.6 million tons EAF project at Fairfield. Yet, it is expected that it will occur in a strong demand-driven environment, which would be a strong net positive for the sheet market when energy demand comes back.
The research analyst believes that the Wall Street had overly focused on AK Steel’s contract exposure, while underappreciated its spot market exposure, given the surge in flat-rolled prices. The consensus are estimating price decline in flat rolled sheets amid recent increases in China prices and scrap. However, this fact was overlooked that the furnace capacity halts and restricted import availability to sustain higher US prices.
AK Steel’s rich product mix suggests substantial average steel price (ASP) leverage as these volumes re-priced higher in 2HFY16. Assuming $250 per ton of ASP improvement relative to 1Q, the company is likely to achieve an annual run rate increase in earnings before interest, taxes, depreciation, and amortization (EBITDA) of $550 million.
AK Steel’s key earnings drivers include meaningful leverage to higher spot prices and favorable positioning for stronger pricing resets on its CY17 automotive contracts. Any concerns regarding liquidity have also been eased, following the recent equity offering. The company is now in a strong position to de-lever the balance sheet over the next several years, and selectively repurchase longer dated debt at a discount to par value.
The company is scheduled to announce its 2Q financial results on July 26, 2016. It might surprise the market with potential for an EBITDA response reminiscent of 2QFY14 results. Current market conditions are portraying the same environment as in CY14, when supply shortages and a slow import response resulted in elevated sheet pricing and drove the company’s equity outperformance.
During the last five years, AK steel’s returns have improved from negative 2.6% to positive 2.5%. This has been a combination of margin improvements with some capital discipline. In CY14, Severstal Dearborn’s acquisition had translated into a continued upward trajectory of returns.
United States Steel
US Steel Corporation has an estimated $2 billion annualized EBITDA upside to improving spot market dynamics. These dynamics are based on a blend ASP improvement of $250 per short ton in the US on 6.5 million ton spot; and $125 per ton improvement in Europe on 2.9 million tons. US sheet market is gradually developing, which in turn supports US steel price spread expansion relative to the global steel prices and to raw material prices. Furthermore, it is also anticipated that US Steel will recapture most of the automotive contract ASP headwind from CY16.
The company has the highest operating leverage to the bullish steel sheet pricing environment momentum. This momentum is likely to continue through the back half of the year. It also made significant cost reductions over the past several quarters as it transforms its business model to maximize profitability over volumes. These initiatives are projected to translate into better unit cost performance and significantly increase profitability as utilization rates inflect higher.
The company is also scheduled to announce its 2QFY16 earnings results on July 26, 2016, where it is likely to surprise with potential for an equity response similar to that in FY14. Street observe strong similarities in the current market to the environment in CY14, when supply shortages and a slow import response resulted in elevated sheet pricing and drove the company’s equity outperformance.
Following four years of consistent cash flow return on investment (CFROI) improvements, returns declined 3% in CY15, as a result of lower top line and margins due to commodity price declines. Market pundits are suggesting that with fundamental support from US prices and structural changes in US sheet markets this cycle will likely reverse.
Source : businessfinancenews.com