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This Steel Producer Is Positioned to Grow

By Vladimir Zernov – Feb 4, 2014 at 9:12AM

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AK Steel's return to profitability in the fourth quarter is a good sign for investors.

After several quarters of losses, AK Steel (AKS) was able to return to profitability in the fourth quarter, reporting net income of $35.2 million. Still, its shares are down 14% year to date. Will the company's improved performance bring more value to shareholders?

Watch the costs
AK Steel stated that inputs like scrap, coal, coke, gas, and iron ore account for approximately 60% of the company's costs these days. Fortunately for AK Steel, prices for these materials have been depressed for some time.

What's more, the company expects coal and coke costs to decline in 2014, starting in the second quarter. That's good news for AK Steel and bad news for met-coal producers like Walter Energy (WLTGQ), which is suffering from a prolonged period of low coal prices and high debt.

AK Steel also expects lower iron ore costs, as its investment in the Magnetation pellet plant will start to pay off. The company plans to receive production from the plant in the second half of the year. After this, AK Steel's iron ore demand will be mostly satisfied by ore from Magnetation and Cliffs Natural Resources (CLF 3.53%).

As AK Steel projects lower iron-ore costs, and Cliffs is a major provider of ore for AK Steel, we can deduct that Cliffs will continue to operate in a low-price environment. Cliffs has recently been pressured by activist fund Casablanca Capital to separate its U.S. operations from its international business. The shares got a boost on the day of the news, but I don't think that such a breakup is a plausible scenario.

Steel will remain cheap in the near term
Raw material prices are low, but so are steel prices. AK Steel's fourth-quarter earnings report showed that the average steel selling price decreased by 4%. The bright side was the automotive market, which represents approximately 50% of total sales. Shipments to auto producers increased by more than 8% in 2013. Continued growth of auto production is necessary for the well-being of steel producers.

However, this trend could find itself under pressure if aluminum-rich vehicles like Ford's F-150 start to dominate the market. Alcoa (AA) has been stating quarter after quarter that it believes aluminum will gain a big share in auto production. At least some investors believe the story, as the stock is up 8% this year despite the soft fourth-quarter report.

Things remain tough in the electrical-steel market, which continues to suffer from excess capacity. Nucor (NUE 3.32%) stated that global steel production overcapacity was the greatest threat to the company and the entire industry.

Nucor blames government subsidies from China and other countries that allow large amounts of cost-inefficient capacity to stay in production. More government action is necessary on the anti-dumping front. Until then, the market will continue to be flooded with cheap imported steel.

What's in the future?
AK Steel has done a good job in the fourth quarter. The company managed to return to profitability and positive operational cash flow despite the drop in the realized steel prices.

The cyclical downturn in the steel market will not last forever. Also, dumping will ultimately come to an end. There are two reasons for that. First, the U.S. could finally implement strict anti-dumping measures. Second, governments cannot eternally subsidize cost-inefficient steel production. At some point, they'll have to give up.

All in all, AK Steel is well positioned to profit when the price environment changes for the better.

Vladimir Zernov has no position in any stocks mentioned. The Motley Fool recommends Nucor. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Stocks Mentioned

Alcoa Stock Quote
Cleveland-Cliffs Stock Quote
$16.42 (3.53%) $0.56
Walter Energy, Inc. Stock Quote
Walter Energy, Inc.
AK Steel Holding Stock Quote
AK Steel Holding
Nucor Stock Quote
$154.20 (3.32%) $4.95

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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