What Could Happen if Things Start to Go Well for Steel?

Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The steel industry has had a rough couple of years, and the share prices of integrated steelmakers certainly reflect this. Some companies have been beaten down more than others, and AK Steel Holding Corp (NYSE: AKS) has been one of the worst performers in the sector. It could also turn out to be a gold mine for new investors if they successfully turn things around. However, that is a very big if. Let’s take a closer look at why AK Steel is doing so poorly, what could happen if things start to go right, and some less-risky alternatives.

AK Steel in a nutshell

AK Steel was formed by the partnership formed between Armco Steel and Kawasaki Steel (hence, AK) that took place in 1989. The company is an integrated steel producer, whose main products are carbon, stainless, and electrical steels for use in a variety of end markets, a large percentage of which are automotive and construction-related. One of the most well-known products made by AK Steel are the crash barriers seen on the side of roads and racetracks, as those are still known as “Armco” barriers in some parts of the world.

Problems and (hopefully) solutions

As mentioned, the two biggest contributors to steel demand (and therefore pricing power) are the automotive and construction industries. Over the past decade or so, U.S. steel consumption has declined by an average rate of 1.9% per year, and worldwide production has increased, especially in China. In fact, a group of steel producers recently told Congress that steel imports from countries that subsidize their steel producers are mainly responsible for the decline of the U.S. steel industry over the past few years. 

With China’s recent economic slowdown, there is increased concern about dumping steel into the U.S. market, which could be partially to blame for this year’s nosedive in share prices. I personally believe that these fears are a bit overblown. I’m not saying that it won’t happen. I simply think that our government will be quick to act in regards to this issue. Once something concrete happens to further regulate steel dumping, the industry will breathe a lot easier.

There are a few problems that are unique to AK Steel, as well. First, AK Steel has very high debt levels relative to their peers. The company’s current long-term debt load is three times its entire market cap!  Before any real recovery can take place, the company needs a viable plan to address the debt issue. They have already taken steps to reduce their very high retiree and employee healthcare costs, and I would like to see them get the rest of their obligations under control. 

The numbers: it’s anyone’s guess!

If AK Steel (and the industry) does manage to return to profitability, as they are projected to do in 2014, they could provide excellent returns to investors willing to take a risk. As I have said before, uncertainty in the markets can create the best opportunities, and it is hard to find an area of the market with more uncertainty than the steel industry. Analysts don’t even know what to make of it. Earnings estimates for this year call for a loss of 39 cents per share, with individual targets ranging from a loss of 65 cents per share to a profit of 9 cents per share. Further out, it is even more of a mystery.  In 2015, the estimates range from a low of 38 cents to a high of $1.64 per share. If the actual number turns out anywhere near the high end, AK Steel could become a $20+ stock again easily. In other words, the high estimate implies that AK Steel is currently trading for just over two times 2015’s potential earnings. Bear in mind that if the actual numbers are near the low end, there could be even more pain ahead.

Two alternatives for those with less risk appetite

The two major competitors include U.S. Steel (NYSE: X) and ArcelorMittal (NYSE: MT), which are both much larger than AK Steel. 

U.S. Steel does have pretty high debt levels and pension/healthcare liabilities, but not to the extent that AK Steel does. I would consider U.S. Steel to be just slightly less risky of an investment than AK Steel, and it should be approached with almost the same level of cautious optimism, in my opinion. There is also a great deal of uncertainty among those analysts following the company, and next year’s estimates range from a loss of 40 cents per share to a profit of $3.00 per share, a huge range.

ArcelorMittal is in a class by itself in terms of its size, and by market cap is more than 40 times larger than AK Steel. The company is the world’s largest steel producer, and is actually ranked number 70 on Fortune’s list of the world’s largest corporations. As would be expected with such a large company, there is an added degree of stability and financial strength associated with ArcelorMittal. In fact, ArcelorMittal is the only one of the three that is expected to produce an after-tax profit this year. While ArcelorMittal offers considerably less upside potential than the other two, there is also much less potential for a further collapse. 

Final thoughts

While I believe that the vast majority of any investor’s holdings should be in companies much less speculative than those listed here, it is completely reasonable to allocate 5-10% of your portfolio to companies like this that could produce dynamite gains if things go right. I will rarely write about risky stocks worth speculating on, but I sincerely believe that AK Steel’s current risk/reward ratio is extremely favorable, and could pay off many times over if things begin to go right for the industry.

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Matthew Frankel owns shares of AK Steel Holding and United States Steel.. The Motley Fool owns shares of ArcelorMittal. Try any of our Foolish newsletter services free for 30 days. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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